Tranched Financings

Q: What type of structure have you seen where the VC agrees to fund over some time period 18-24 months and up to some level.

A: (Brad): These are commonly called "Tranched Financings."  The typical approach is that a VC commits to fund a specific amount in multiple "tranches" based on the company achieving some milestones.  For example, assume a $10m financing broken up into two tranches – an initial $5m investment on day 1 and another $5m investment after 12 months assuming the company "releases a product with performance characteristics acceptable to the investor."

There are numerous derivatives of this case.  The valuation on each tranche (or price per share) can be held constant or can vary (typically increase) for the second tranche.  The trigger (what causes the second tranche to get funded) can either be under the VC control (similar to a put option) or the company control (similar to a call option).  The amounts for each tranche can vary (they don’t have to be the same) and there may be even more tranches (I’ve seen situations where there are monthly tranches over a twelve month period.)  Finally, the characteristics of the trigger vary widely.

An alternative approach is to have a warrant attached to the financing round that is exercisable at the discretion of the investor within some time period.  This serves a similar purpose to a tranched financing, but gives the investor more control and potential option value in the case where the company is acquired early before the warrant expires.

Tranched financings tend to come into play more frequently in downside cases where a company and its investors are trying to extend the company’s life either to an exit event or another financing.  In these cases, the investors want to run a single process within their firms for getting approval for an investment, but then want to maintain control over how much money they invest at any given time in case the deal goes completely south (leaving the flexibility to decide to pull the plug in the hands of the investor.)

Occasionally tranches are used in the early stages of investments although more recently I seen the "warrant approach" instead of a tranched approach.

  • Jason Mendelson

    I would add that tranche financings that have milestones based like “product with performance acceptable to investors” can have a perverse affect sometimes in that the company will rush something to market that isn't quite ready for prime time. The key here is to make sure the characteristics are reasonably, honestly and clearly defined.

  • Bozo the Clown

    One place where milestone based financings can work reasonably well is in a space with regulatory driven milestones. Medical devices are the best example where the criteria are pretty easy to determine and agree on, while still being within a reasonable time frame. Milestones are pretty difficult to identify otherwise to everyones satisfaction. Even things that seem easy or in everyone's best interests –such as a commercial release of a product–can create perverse incentives as Jason mentioned. The closely related issue is whether there are other conditions to the exercise of the put/call option (i.e., reps/warranties, no litigation, etc.) that can make the rights more illusory than intended.