How do VCs Use the Tranche Approach to Balance Risks, Relationships, and Rewards?

A tranche is a portion or slice of a pooled set of financial instruments.  

In the context of Venture Capital (VC), a tranche is an investment method where funding is provided to a startup in portions or stages rather than as a single lump sum. Typically, each tranche (portion) of the investment is allocated contingent on the startup meeting certain predefined and agreed upon milestones or objectives.  ‍

For example, a VC firm may commit $2 million to a startup in its portfolio. Rather than providing the entire amount upfront, the firm divides the investment into tranches. The VC may allocate a first tranche of $500,000 immediately. They might then release the next tranche of $750,000 once the startup achieves a development milestone (e.g., a product prototype). Further tranches could depend on milestones more aligned with a more mature scale-phase startup, such as hitting a target number of customers or a specific revenue level.

Because the release of funds correlates with business milestones, early-stage founders working with a VC firm that takes a tranche approach are more likely to gain structured, ongoing support. The built-in accountability structure generally positions the startup for staged financing, which tends to improve goal alignment and risk mitigation over the long startup journey.  

For investors in a VC fund, the tranche approach also offers many benefits. Most notably, it balances risk appetite with investment goals. Because the VC partner methodically allocates capital in increments based on the achievement of predefined milestones by the portfolio companies, investors benefit from greater levels of risk control, capital preservation, and alignment with the ongoing goals of the VC for its fund and portfolio.  ‍

How a Tranche Approach Supports Strong Investment Outcomes

Because it is methodical and controlled, the tranche approach is an effective way for a VC firm to manage risk, reward, and relationships. Startups in the portfolio are incentivized and supported as they work to set and meet performance objectives. With capital contingent on outcomes against agreed-upon objectives, the VC and startup team are likely to have a regular collaborative cadence and productive working partnership. Rather than a hands-off approach, this is a high integrity, high accountability, and high candor VC-founder relationship.

Beyond raising the chances of better outcomes for the startup, the tranche approach improves alignment with investors as well. There is ongoing visibility into how the portfolio company is using their capital to gain traction and scale toward target outcomes. In addition, the efforts that go into the tranche approach help to manage risk in a variety of ways.  ‍

• ‍Performance-Based Funding: By tying the release of funds to specific milestones, VCs can make sure the portfolio company is progressing through its startup journey at a controlled pace and as planned. The gateways help to reduce the risk of investing large sums in a company that might not meet its targets.
• ‍Continuous Evaluation: Tranches require ongoing assessment of portfolio company performance. If a startup fails to meet its milestones, the VC can institute specific performance support measures to help them solve business issues or fill gaps. That equips the startup to fix problems before they become fatal, helps avoid additional investment in a faltering enterprise, and helps to ensure that investors don't take a loss on their contributions.
• ‍Incentive Alignment: Aligning the startup's incentives with those of the investors can provide strong motivation for a team because they are clear that subsequent funding depends on meeting certain specific goals.  
• ‍Resource Optimization: Instead of investing too large a sum too early in a portfolio company's trajectory (i.e., a massive dollar amount given in a Seed round), funding is portioned appropriate to the maturity of the startup and the work it must do to grow.  
• ‍Risk Mitigation: A tranche can limit exposure for the VC firm and its investors because not all committed funds are released at once.
• ‍Adaptability: The methodical approach enables investors to adapt their strategy based on market changes or new information about a startup's potential, which can reduce risks created by external factors.    

Put simply, the tranche approach is a structured and controlled method for VC investment that balances the potential for returns with prudent risk management.   ‍

What Founders Should Understand about the Tranche Approach  

Whether you are a founder or an investor considering a partnership with a VC firm, it’s useful to understand if they engage the tranche approach and, if so, how. A few specific questions can help to gather that information. For founders and startup teams, in particular, asking a possible VC partner about the following considerations and resources can reveal a lot about how the working partnership will unfold over time. ‍

• ‍What are the key milestones? Understanding what the VC considers as key company performance measures is crucial for founders to plan how and when they will receive further funding.  ‍
• What is on the term sheet? Founders must be familiar with the term sheet to understand and navigate the terms of investment.  ‍
• How does the equity piece work? A founder is giving away a portion of their company in exchange for funding, so they must understand how that agreement works and the agreement they are making.  ‍
• How will dilution work? Future funding rounds can dilute their ownership further, making it imperative that founders understand the impact of the whole funding journey with the VC partner.  ‍
• What is the optimal burn rate? As founders work to manage their finances, they must factor in how long their funding will last and when each tranche might need to take place.  ‍
• What is the vesting schedule? Particularly if the startup has employees with equity stakes, it's necessary to know how their ownership stakes will mature over time.  ‍
• What is the role of a convertible note? Founders should understand if a convertible note (short-term debt that converts into equity) is a funding option.  ‍
• What is our exit strategy? Founders should have an idea of their exit strategy – the investor has likely considered it, and everyone is working toward optimal outcomes.  ‍
• What is my valuation? Investors should understand the portfolio company's valuation to determine whether the investment total and schedule seem appropriate to the company, and to understand the equity they will receive.  ‍
• What is the chance of a liquidity event? Staying informed about liquidity events keeps investors knowledgeable about how they will realize investment returns.  ‍
• Where am I on the cap table? It’s important to understand the percentage of ownership and how it might change over the five-plus years the startup is likely to be in the portfolio.  ‍
• Has due diligence uncovered anything? Of course, the startup team should be doing its own diligence, but to have full awareness of the information the VC is using, it is wise to inquire about their findings.  ‍
• What is the role of a convertible note? Founders should understand if a convertible note (short-term debt that converts into equity) is a funding option.  

What a VC's Tranche Approach Conveys About How They Operate  

A VC's tranche approach conveys a lot about how they conduct their business. First and foremost, it indicates their approach to risk management. Specifically, a VC with a tranche-based investment philosophy is likely to be more conservative, selective, and intent on working to prevent any losses.

It also conveys that the VC firm is a committed, hands-on partner to investors and startups for the long term. For example, the BIP Ventures Performance Engineering group works closely with each portfolio company investment team to stay at the shoulder of our startups through their full scaling journey. They offer resources and guidance to help the portfolio company move through milestone achievements necessary for funding and toward an optimal outcome. It's an active results- and partner-oriented mindset.

For the investor, evidence of a high-support, high-accountability approach to portfolio management is a good indicator that the VC is unwilling to 'take a loss' with its portfolio companies.

Ultimately, the tranche approach is a prudent, disciplined, strategic use of capital resources that balances the need for risk management with the potential for high returns. It demands adaptability, alignment, and active partnership with the portfolio company team. And because the approach is so hands on, it indicates that the VC you’re considering as your investment partner is selective, rigorous, deeply engaged, and genuinely caring.  

As BIP Ventures has seen, integrating the tranche approach to funding is an effective way to seek a win-win for founders and investors. It is a way we show mutual appreciation for our partners. And it is one of the ways we show our commitment to building business and wealth together.