Tranche Investment: Everything You Need To Know
Tranche investment lets venture capital and other investors split investments into parts giving money to businesses over time instead or all at once.5 min read
2. Structured Financing: What is it?
3. Reasons to Think About Tranche Investment
4. Reasons to Consider Not Using Tranche Investment
5. Typical Tranche Investment Scenarios
6. Tranche Investment Tips
7. Terms You Should Know
8. Frequently Asked Questions
9. Steps to file
What is Tranche Investment?
Tranche investment lets venture capital and other investors split investments into parts. They can give money to businesses over time instead of all at once. Usually, a business getting a tranche investment will get prenegotiated payments as long as it achieves financial milestones decided by the investor. The word tranche comes from the French word for slice.
Structured Financing: What is it?
Structured financing is a broad term for the many ways businesses and banks can divide risky financial products, including loans. Businesses and banks often sell these new financial products to specialized third-party investors. These products often include insurance policies, mortgages, and other types of debt, including tranches. Tranching or tranche investment is a relatively new product to help investors lower risk and let startups get more funding. Something similar to tranching is simulated when an investor makes a seed investment in a startup and pre-negotiates the valuation or value of the company. Certain milestones trigger this value, sometimes called a post-money valuation.
Reasons to Think About Tranche Investment
- Tranches work well in industries that already have lots of technical or regulatory milestones, like IT or biotechnology.
- It gives investors more control over companies.
- Investors get all their equity in a company at the lower pre-money valuation when they make their initial investment.
- Investors can give money to companies over time, but they don't have to pay if their equity's value or stock price doesn't rise according to milestones.
- Companies don't need to look for investors for the next round of financing.
- Companies and investors can renegotiate milestones.
- Companies can get quick decisions from investors because their risk is lower.
Reasons to Consider Not Using Tranche Investment
- Investors can lower their risk in other ways, such as by negotiating a lower company valuation or contributing to a smaller round of investing.
- Tranching makes early hiring more difficult since prospective employees often ask startups how much cash they have on hand. Companies have to decide whether to give people a smaller, less appealing number.
- Businesses have to spend time with investors to get their prenegotiated tranches, also called follow-on tranches. Founders often present to investors multiple times.
- Tranching can make relationships between investors and company founders tense.
- Just missing a milestone keeps essential cash away from a company. It could even cause bankruptcy.
- Companies have to focus on short-term milestones instead of achieving long-term goals.
- Companies don't have cash on hand for unexpected expenses.
- Existing tranches often make companies less appealing to external investors.
- Tranching increases fees from third parties like lawyers.
Typical Tranche Investment Scenarios
An investor could invest a total of $250,000 and split their payments into three tranches of $30,000, $70,000, and $150,000. The investment increases as the business reaches the required milestones, reducing risks for businesses and investors. All the tranches are usually part of the same series or round of investments.
A bank offers a commercial loan to a small business and then splits it into tranches to avoid risk. These tranches are sold to investors, and many investors run specialized companies. If the business repays the loan on time, investors get the money from their original investment plus a high amount of interest. Tranches can have five, ten, or twenty year terms. Longer tranches earn the most, but they're riskier. If a borrower defaults, investors only receive part of their original investment.
According to Forbes, a seed-round investment usually gives a business 18 months of capital. At the end of 18 months, the company either starts to make a profit or starts to issue Series A stock to investors. With shorter tranche investment periods, founders often emphasize posit areive news for investors. Some companies even feel pressured to cheat on their financial reports to investors.
Tranche Investment Tips
- Before making the first tranched investment, an investor should set a small milestone for a company. Reaching the milestone will increase investor confidence and trigger the first tranche.
- Use simple milestones with just one or two clear conditions. Avoid vague language or subjective requirements.
- You can consult an experienced professional to modify tranche investments and reduce risks. Investors and company founders often prenegotiate valuation increases after each tranche. Companies can grant rights to investors only if they make a specified number of payments.
- With some agreements, founders can refuse a tranche if they get a better offer from another investor.
Terms You Should Know
- Sandbagging happens when an investor adds milestones or delays paying tranches.
- A bespoke tranche opportunity is designed by the investor.
- Bespoke tranche securities are bespoke tranches sold in a secondary market, sometimes for low prices.
- Collateralized debt obligations are mortgage securities similar to tranches. According to U.S. News, these securities contributed to the credit crash that caused the Great Recession.
Frequently Asked Questions
- How much is a tranche worth?
You can think of a tranche as an average of a company's current value and its projected value. Investors make more money if the company is more successful than expected.
- How is tranche investment different from mortgage tranching?
Investors in companies split their payments into tranches. Mortgage and other loan investors risk that borrowers won't make payments. Mortgage tranches split the risk among several investors instead of splitting payments.
- Are funds or securities for tranches risky?
Many funds and securities include loans or investments for hundreds or thousands of people or companies. Prices go down when the industry or the economy as a whole doesn't do well. This usually reduces risk, but a major crisis could discourage new investments. This causes a crash by keeping most members of the industry from functioning properly and lowering prices again. According to FinancialWeb, some funds divide their tranches based on risk to prevent this.
- How long do tranches last?
Investors can decide how long each tranche should last. Mortgage investors can choose a fund or security with tranches that suit their needs.
Steps to file
1. Invest less for startups.
An investor should give a startup a close milestone and invest less. If the startup hits its milestone, it may command a higher valuation. The investor won't be able to benefit from a tranched investment, but he or she has a better chance of overall success.
2. Use binary milestones.
Binary milestones are clear targets with clear rewards. For example, an investor could agree to give a startup a fixed amount of money for a CFO when they hire a CFO. Avoid tranches that have subjective milestones like increasing workplace happiness or getting close to a revenue figure.
Investors and businesses should use a lawyer to negotiate with each other. If your business can't get an investor to agree, your company could be overvalued or the investor could be overly cautious. However, cautious investors can still benefit companies.
If you need help with tranche investments, you can post your question or concern on UpCounsel's marketplace. UpCounsel only accepts the top 5 percent of lawyers to its website. The site has a wide choice of the nation's best startup attorneys. You can easily find a lawyer to help you negotiate a tranche investment or help you with other aspects of your business. Lawyers on UpCounsel come from excellent law schools like Harvard Law and Yale Law. They have an average of 14 years of legal experience, and many work with or for companies like Google, Menlo Ventures, and Airbnb. A great lawyer saves time and helps companies avoid mistakes.