tranched investments review at Starting Block Lawyers

Should startups avoid tranched investments

Tranched investments are where a total capital investment is agreed, but the funding is released in blocks as conditions are met.

Googling “tranched investments” will bring up a long list of entrepreneurs’ experiences as to why tranched investments (otherwise known as staged or milestone based investments) are a bad thing for entrepreneurs and startups.  You will also find a lot of information on why tranched investment relationships fail.

Tranched investments aren’t the enemy, and they can be used successfully by entrepreneurs, startups and investors.

The reality is that an investor has two options when considering risks associated with a startup investment. They can reject the high risk and complications and walk away, or accept the uncertainty and structure the investment to suit their risk profile.  This article discusses some of the ways that tranched investments can be structured to succeed, without killing the startup or its prospects.

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Starting Block Lawyers generally acts for the startup company, but not always, and we can deliver solutions from either side of the negotiation.  We hope the following provides insights into the “other side’s” point of view, and makes your next early stage investment negotiation a prosperous one.

Reference to “early stage” in this article is the point at which a startup seeks third party investment (not from the founders or their family and friends), and before it enters the expansion phase, where it has significant revenues, and month on month growth.

Post pitch

So the pitch is over. The entrepreneur and investor have agreed to negotiate terms of investment, and now they have to work out how to move forward.

Consider this:

  1. If you were investing money, would you want to be involved in the business so you can control how your money is being spent; or alternatively, would you want to spend months of your life working out if the entrepreneur standing in front of you (and their team) can deliver what is being proposed?  Do you have the time and technical skills to even make that assessment?
  2. If you were responsible for growing a company, would you want your investors hovering around, looking over your shoulder, second guessing what you are trying to do, and endlessly giving you tips about what else you could do to be more effective with their money?

See the problem?

Tranched investments allow an investor to mitigate the potential for losing significant amounts of money; with structured reporting built in. A tranched investment also allows an investment to get underway without the levels of due diligence that might otherwise be brought to bear on an investment for the full amount of capital being sought by the entrepreneur.

By reducing initial risks and structuring a path forward, tranched investments can provide a number of benefits for both the investor and the entrepreneur. The key benefit being that the arrangement can get underway reasonably quickly with reduced risk for the investor and an opportunity for the entrepreneur and their team to prove themselves, and their strategy.

What is the problem with tranches and milestones?

There are two fundamental problems with tranched investment arrangements in the early stages of a startup.

First of all, tranched investment arrangements suffer and often fail if ill-conceived millstones are used to determine funding rounds. Preparing useful milestones for early stage startups takes more work than for established businesses. As a result this key step is often rushed and the milestones don’t suit the startup business or what it can achieve in the given timeline. Unfortunately, this can lead to future rounds of funding being put in jeopardy even though the entrepreneur may be meeting the intent of the agreed milestones.

Second, in addition to subjecting the startup to ill-conceived milestones, if an Entrepreneur cannot predict how an investment decision will be made in regard to a milestone, this can cause systemic management problems. Entrepreneurs, or anybody managing a company’s finances, will become frustrated if there is significant uncertainty relating to the financial resources of the company. In tranched investment arrangements, common complaints include: lack of autonomy; lack of control; inability to plan and execute outside of the current round of funding; inability to retain quality staff; and, time spent reporting on factors that don’t represent the position or outlook of the venture.

To illustrate, what would you do if you were offered the following opportunity as an entrepreneur? “You can work for 75 – 100 hours a week, without a wage, for the next three months and then if you have managed to structure the company’s affairs, hire talented staff (who’s wages you might need to pay personally if the next round of funds isn’t forthcoming), register all possible intellectual property that the business needs to maintain its competitive position, do some market testing to see if the business idea is going to fly, and then if you have demonstrated adequate performance, I’ll consider if I care enough to give you some more cash to do something else next quarter”.

Are you shaking your head? This ridiculous arrangement is indicative of the types of problems we see in poorly executed tranched investment arrangements. The milestones are imprecise, so it is impossible to determine whether the items have been achieved or not. And further, even if it were possible to determine that the milestone requirements had been met, the funding for the following round is entirely at the investor’s discretion.

There is no certainty about the value the investor is getting for their money.

There are no achievable tasks for the Entrepreneur, and no certainty relating to future rounds of investment.

Creating effective milestones

Creating an effective milestone isn’t rocket science. An entrepreneur should be able to list out all the things that need to happen in their business to achieve the desired result. They should also be able to identify what elements they can manipulate to gain an advantage for the venture.

In the early stages milestones should precisely record what will be done by when, and what the expected results will be.

With startups there can be a lot of uncertainty about a range of issues relating to the business in the early stages, both internal and external. It is common for startups to drastically change direction, or pivot, once some initial work has been completed; and it is important that the milestones and the decision framework support this. Using “performance” based milestones in the early stages is fraught, because often there are too many unknowns and no “business as usual” for any useful comparisons, or calculations to be made.

To allow flexibility in milestones in the early stages of a startup, the milestone should be a checkpoint that tests progress and value (time, effort, application of knowledge to a problem), not simply whether a certain number of items have been checked off a list, or the company has met some arbitrary performance criteria.

Milestones can start to effectively use performance criteria once a startup gains traction, is able to test its viability and future outlook, and starts to deliver the first commercial release of its product or service into the market. At this stage using key financial indicators, metrics, and other performance criteria is important to monitor the financial and strategic elements of the business; and the company should have access to sufficient data to make this type of analysis worthwhile. The trick is determining the transition point for the milestones, and using this to ensure that the startup’s focus changes from getting established to being in the game.

Decision making

On the one hand, investors typically like to have discretion whether they invest more money or not.

On the other hand, entrepreneurs want certainty about the capitalisation of their startup for the medium term, which usually spans a number of milestones.

A well designed tranched investment structure will provide an investor with the capacity to stop putting money into the venture in certain circumstances. That’s the whole point of a tranched investment. However, this doesn’t mean that a entrepreneur can’t have some certainty built into the system also.

A decision framework that exists independently from the milestones can deliver both certainty and flexibility within defined limits.

An effective decision framework allows for a predetermined amount of “failure”, small changes to be made, significant changes to be made, or funding amount variations to be requested and fulfilled; all without further negotiation. The investor and the entrepreneur can then understand the scope of variation that will be accepted, after which the investor can either revert to discretionary decision making or simply stop investing.

Other considerations

Investments in startups are generally governed by various sources of rights and obligations. These include a company’s articles of association, constitution, or the replaceable rules. There should also be a shareholders agreement or specific terms and conditions that attach to the shares issued to an investor. For the purpose of the following these will be cumulatively referred to as “terms of investment”.

When things don’t go to plan, an investor pulls the pin, and an entrepreneur needs to seek funding from new sources, the terms of investment will usually dictate whether the startup will simply fail or if it can be resurrected by the entrepreneur.

Putting suitable terms of investment in place for startups is a balancing act, and should be considered along side the milestones and decision framework. Where an investor decides not to put any further money in to a venture, and the terms of investment include heavy handed pre-emptive rights to protect their interests, these can result in the investor making a total loss because they block the entrepreneur from securing funding from other parties, so the venture fails..

The terms of investment can be set up to allow the entrepreneur to seek third party investment to keep the startup going. But this requires that an investor be willing to relinquish some rights so that incoming investors aren’t deterred by the prejudicial terms being offered to them. As you might imagine it is very difficult to obtain further investment when the existing shareholders have an enduring anti-dilution right, price protection, veto rights, or other common protection mechanisms that undermine value or control for new investors.

Final thoughts

Tranched investments provide a logical mechanism to facilitate investment into early stage, high risk ventures. So long as the parties put measures in place to mitigate the shortcomings associated with this type of arrangement, a tranched investment can be very beneficial for both parties.

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If you want to discuss funding options for an early stage company, please contact us.

 

Simon Fifield
Focus: technology businesses Likes: disruptive technology and funding growth Profile
Simon Fifield
Posted in Articles, Investment.