CEOs looking for money these days are telling investors that they don’t want it all at once, they now want to raise money a little at a time, with each piece tied to predetermined milestones. By doing so, they believe they can keep the company focused on meeting goals and objectives in a timely fashion, which then supports and justifies the need for additional capital. Raising money in “tranches,” or stages pegged to specific milestones, is not a new strategy, but has become a popular way to raise money in a difficult economic environment.
Private capital investors, especially those burned by $100 million dot-com flameouts, 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 three or six-month tranches.
While management teams may not be exactly comfortable with the process, 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.
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 ten 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 current rough financing market. Some private capital investors and VC groups are sticking with the established 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.