September 21 2009
by Scott Johnson

“Tranched” Investments

We occasionally do investments in stages or “tranches” where we put an initial amount of money into a company, with the option to put more in later when certain milestones are met.  Some investors like to do this, and some are philosophically opposed.  The opposing view is that contingent cash based on uncertain milestones adds too much stress to an already difficult task.  Hiring is harder, planning is harder, partnering is harder, and sometimes the milestones should change as time passes and opportunities evolve.  Better to put 24 months of runway in the bank and go heads down on business building.  I have to say that I agree with this, but still regularly elect to “tranche” investments.  When does this make sense?

Often we like a business that is very early in proving its model.  Too early to commit a full A round.  If we really have conviction about the opportunity and there are some near-term milestones that eliminate significant risk,   then tranching can be a great tool for us.  Entrepreneurs like it because they don’t have to scrounge for angel money, their cap table is cleaner, and sometimes they can get a better blended valuation over the two tranches and suffer less dilution than taking 24 months of money on day one.

The sticky issue is that entrepreneurs need to have confidence that, should they achieve the milestones, then they will get the additional money.  There is a real element of trust in this kind of deal, and so we are very careful to continuously earn the trust of all of our business constituents.  I haven’t seen the details (VCs can’t access them), but I suspect that the good rating we have on “The Funded” largely stems from our firm’s core value of always dealing fairly and openly.  So generally that issue gets put to bed fairly quickly, and the tranched deal structure becomes a win-win.

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