Introducing tranches--the round within a round
A new VC funding technique breaks rounds into smaller increments.

March 13, 2002
2002 Red Herring
By Julie Landry

When Seth Jutan set out to raise funding for his company last year, he didn't want it all at once. The CEO of TrustAsia, a digital security company, wanted to work for it. Mr. Jutan told investors he wanted a few million at a time, with each piece tied to predetermined milestones. By doing so, he hoped to keep the company focused on meeting concrete objectives in a timely fashion.

The strategy worked. Between March and October of last year, Mr. Jutan's team met a series of objectives, including signing a key deal with VeriSign and opening offices in Singapore and Shanghai. In return, he raised $10 million in three separate "tranches," or stages pegged to specific milestones. "I'm loath to take money unless there's a specific direction, and just 'building a business' is not a specific enough direction for me," he says.

These days, it isn't specific enough for some investors, either, especially those burned by $100 million flameouts and who are wary of entrepreneurs' promises. Instead of pumping in funding in successive rounds spaced 18 to 24 months apart, with increasingly larger amounts each time, many investors are opting to divvy up their commitments into 3- or 6-month tranches.

It's a little like giving kids a weekly allowance: they only get the money if they finish their chores. While management teams may feel like kids whose parents don't trust them, investors that support the tactic argue that it's a handy way to make sure a company's valuation continues to increase--slowly but surely--over time. Even in a punishing market, they say, investors are willing to push up the valuation if a business is progressing according to plan.

Dividing funding into several checks can also make a large funding commitment more palatable for investors that are flat-out leery of the overconfident swagger that a $20 million deposit can impart on a startup. "We like large commitments, but two or three tranches contingent on milestones can really focus management," says Robert Gold, CEO and president of the late-stage investor Ridgewood Capital. In October, his firm participated in a $20 million second round for Gigabit Optics. The money is slated to be parceled out in three tranches, each about six months apart and based on milestones like customer wins.

The concept does have its critics. Turnaround consultant Marty Pichinson, cofounder of the business advisory firm Sherwood Partners, warns against making a company's management team beg for the additional funding. Although he believes in staged financing and the right of investors to set goals, he stresses that the capital must be available when needed.

More traditional venture investors prefer to set a longer runway--usually at least a year, to account for long sales cycles and market fluctuations--for a portfolio company to meet predefined objectives. "You should start with what the company can do, not with what the VCs can afford," says Martin Gagen, CEO of U.S. operations at the 3i Group, a VC firm.

Mr. Gagen argues that the risk of a large up-front commitment is what pays off in the venture capital model. Venture investments are made with the aim of multiplying the original investment 10 to 20 times when a company is sold or taken public. And a few big gambles that pay off is what makes it all worthwhile. But, Mr. Gagen adds, "10 to 20 times a couple million dollars is pretty much worthless for a big venture fund."

Mr. Gagen and others say the first injection of funding--whether it's a standard $10 million first round or a smaller tranche--should be enough to allow a company to fill any holes in the management team and finish a first product. Once that first round has been spent, says Mark Saul, general partner at the early-stage firm Foundation Capital, a company should not only have a beta product, but something that generates real customer feedback. More specific, shorter-term goals, many VCs maintain, can actually be more of a headache than anything else.

Funding that's contingent on extremely specific targets can create uncomfortable dynamics between investors and their companies, according to Erik Lassila, managing director at Clearstone Venture Partners. "It may give management incentive to put the best face on company progress," he says. He worries that companies might mask snags in sales and product development just to make sure the next injection of cash is forthcoming.

In the end, the decision of whether or not to dole out money in tranches is really a reflection of how investors choose to deal with the rough financing market. Some are sticking with the traditional model--putting all the money out there, up front, and risking it in support of a portfolio company--while others dish it out as slowly and carefully as possible. Entrepreneurs, meanwhile, will take it however they can get it.

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