Tranched startup investment is a terrible idea.

Or is it?

First, some definitions.

Venture capital investments are, by definition, “tranched”. The tranches are called: Pre-Seed, Seed, Series A, Series B and so forth. Startups are risky little things. Most of them perish before they have a chance to flourish. But there is meaning to the madness. As companies hit milestones (team, product, customers, scale, profit), they become less risky. And as they become less risky, valuations go up.

It might take $100m+ of investment for a company to go from inception to IPO. But writing a $100m cheque to a pre-seed stage startup with a likely failure rate of +90% seems cavalier. And then there is the question of dilution.
So instead of investing $100m up front, investors start with a smaller cheque of – say, $500k. And each major milestone then unlocks a higher valuation and the next funding tranche. In other words: tranched investment.

But VC investors often talk about something slightly different when they talk about tranched investment. Rather than tranching investments to major milestones, the idea is to use smaller waypoints. Same idea. But smaller tranches. Now the Seed or the Series A round is no longer a “big cheque” to hit the next major goal. It’s a smaller cheque to hit one or more smaller goals on the way.

At face value, this might seems like a pragmatic approach.

Venture capital orthodoxy is that this is a bad idea. And generally, I agree.

Startups are hard. It often takes superhuman effort and focus to make it to the next major milestone. They are also unpredictable. And founders have lots of pitfalls they need to navigate on the way to that milestone. As a result, the last thing founders need is to constantly worry about whether they will run out of cash in 2 weeks. It’s not good for the founders. And it’s not good for the business.

BUT

What should founders do if there is a mismatch between valuation and desired capital? If they need $4m to hit the next major milestone, but markets currently value their business at $4m pre? Of course, you could give up half of the company. But there might be times when it’s better to do half and half. E.g. half at $4m and the remainder at a higher valuation once a few smaller milestones have been hit.

Most investors would agree that a “fully funded plan” is ideal. Enough capital to get to the next major milestone. With a bit of buffer. That’s the orthodoxy.

But sometimes “best” isn’t available. And in startup-land, orthodox ideals sometimes need to make way for pragmatic alternatives.

In those situations, tranched investment is worthy of consideration.