VC: Tranched Investments

1. Description
   1. “Tranched investments” (AKA milestone-based investments) describe when an investor agrees to fund a company in stages based on a series of milestones.
   2. Each stage (or trache) corresponds with a certain accomplishment or pre-determined goal that both parties agree to—this may be a financial metric like revenue or a product development milestone.
   3. This approach to investing is more common in the life sciences, where obvious benchmarks are more consistent throughout the profession due to regulations. It is also more common in the life sciences for the VC to have a mental model of Cofounder and an ongoing commitment to the company. Tranched investments are less common in tech venture.
   4. Contrast:
      1. Tranched investments are distinct from a verbal or informal understanding to “back the company”.
      2. VCs in an ecosystem often organize into specialization in different stages of a company’s development. They may informally have a division-of-labor that amounts to funding companies when they reach the next milestone, but there is not a contractual obligation and it is much more fluid.
      3. VCs in a given industry and ecosystem often develop an informal sense of what milestones are required for a company to raise a given named round. For B2B SaaS at a certain point, a Series A milestone was to have at least $1mil in annual recurring revenue. There was no contract or requirement that it was the case although it was widely understood for a certain period of time.
2. Benefits
   1. Less Money at Risk: For the investor, there is less money at risk and a lower valuation—often the valuation for the subsequent “tranches” is the same or tied to the previous lower valuations of the first tranche.
   2. Certainty for Management: For founder/CEO, there can be a sense of security in knowing where money will be coming from for future needs. This might also save time fundraising and looking for investors. In times when or places where there is less funding is available, this security can be more important.
   3. Alignment: When it works well, having clear milestones agreed between investors and management can bring clarity and alignment on goals.
3. Trade-offs
   1. Disputes: There may be disputes about if the company met its milestones to qualify for the next trachea of the investment. This is more likely if the deal terms are complicated. For example, if the milestones are too specific (experiment X complete with quantitative result Y) then you can miss the milestone in practice while meeting or exceeding in spirit. If the milestone is too vague (product X superior to competitor Y) then the decision to go forward is more subjective and open for dispute.
   2. Whose Bank Account: The cash for subsequent trachea is in the investor’s hands. Practically, they have an opportunity to decide later if they want to continue investing. It may be hard for a founder to enforce the agreement if the investor is no longer interested. (One mitigating factor can be a Pay to Play provision. If enough of the investors agree the milestone has been met, this can encourage other existing investors to fund their part of the next tranche.)
   3. Change is Constant: Markets or the company’s products might change, and so the milestone benchmarks might make less sense
   4. Power Dynamics: It can be harder for new investors to come to the company as there is a signed agreement with the existing investor. With less chance of a new investor, the existing investor has more power in the relationship with the company.
4. Reading/Sources
   1. Upcounsel Post
   2. Chris Dixon Blog
   3. Fred Wilson’s Blog

by Miles Lasater with Julian Jacobs

Thanks to Laura Tadvalkar for input.