The SCIF term sheet provides an option for investment funds to be paid in tranches against achievement of milestones.
There are a variety of approaches to tranching, but at a high level it usually works like this:
- the company and the investor agree on the total amount to be invested
- the total amount is divided into two or more tranches (in New Zealand, two tranches is quite common)
- the company and investor agree upon the milestones that must be met for payment of the second and later tranches, including the dates for achieving each milestone. Common milestones for early stage companies include completion of product development for beta or commercial release, achieving regulatory approvals (particularly important for life sciences companies), signing [x] number of customers or achieving $[y] sales targets, or completing key hires such as a CFO, CTO or sales director
- the first tranche is paid on completion of formal investment documentation and satisfaction of any conditions
- subsequent tranches are paid subject to achievement of the agreed milestones by the agreed dates
- if a milestone is not met by the agreed date, the investor will have the option not to proceed with the next tranche of the investment. In New Zealand, failure to achieve a milestone often results in renegotiation of terms for the next tranche – it is less common for investors to withdraw support for the company.
Investing in tranches helps investors to manage investment risk. The smaller the amount of money invested up front, prior to key business milestones being met, the lower the risk for investors.
On the other hand, tranching generally increases risk for companies, because receipt of the balance of the investment is conditional upon future events. The further out the milestones and the harder they are to achieve, the greater the risk for the company.
We usually advise companies to avoid tranching if they can. The obvious reason is the risk associated with a conditional funding commitment. However, a number of other problems that can arise, some of which can hurt investors as well as the companies they invest in:
- founders and management can become overly focussed on achieving milestones, to the detriment of the business as a whole, for example because non-milestone related risks or opportunities are overlooked
- the business plans of early stage companies tend to change a lot, as companies develop a deeper understanding of their markets, customers, markets and competitors. Milestones that make sense when an investment deal is signed can become less relevant to the success of the business over time, and a company can end up pursuing milestones that have become of little value to the company
- while it is possible for investors and founders to agree new milestones to adapt to changing circumstances, this can be quite difficult as it has financial consequences for both parties. Renegotiating milestones can cause a lot of friction between investors and founders, and can damage relationships.
In our experience, tranching causes particular problems when it is used to bridge a significant valuation gap. This occurs when an investor is sceptical of the valuation sought by the company, and addresses this by setting financial or commercial milestones for subsequent tranches which justify the valuation from the investor’s perspective. In this scenario, investors can see the company’s valuation as a placeholder, to be renegotiated if the company’s actual performance is below target.
However, companies and their founders who have had difficulty agreeing a valuation up front will obviously be unwilling to renegotiate the valuation after the fact, regardless of any performance based evidence that the investor now has to justify a lower valuation (the phrase reality distortion field comes to mind). In our experience, what tends to happen is:
- the company’s founders become hyper-focussed on achieving the required milestones in order to avoid a reduction in their valuation, regardless of the impact on the business as a whole. This is particularly problematic where milestones were poorly chosen in the first place
- if it becomes apparent that the company will miss a milestone, the focus may turn to other means of avoiding a valuation reduction. One approach is to try to find a new investor who will buy in at the original or a higher price, with all the attendant distractions that capital raising brings. Another is to slow down the company’s cash burn, to defer or remove the need for the next tranche, even if this harm’s the company’s growth prospects. Worst case, a company’s founders may be prepared to risk the failure of the company rather than be forced to draw down a tranche at a lower valuation (sounds far-fetched, but it happens!).
For these reasons, we think it is much better to try to do the hard yards up front to agree a valuation that both sides are happy to go forward with, or to not do a deal at all.
If investors insist on milestones, we advise companies to:
- ensure that milestones are specific, tied to objective achievements (not subject to the judgement of the investor) and that above all are achievable
- try to chose milestones that support their core business proposition, so that that they will continue to be relevant even if the detail of the business plan changes over time (this is hard)
- try to limit the time period for tranching to the shortest time possible, ideally no more than 6 months. The longer the time period for payment of tranches, the greater the uncertainty and risk for the company
- structure the investment so that shares are issued progressively only as tranches are paid, as opposed to issuing all of the shares to the investors up-front (which is what some investors ask for).