The week before the Fourth of July holidays, and after five months of negotiations, I received the final term sheet for a capital injection of $750,000 into my business. The money was to come from a great team of investors. It’s a moment I had dreamed of many times before. If I signed, I’d be running a venture-backed company.
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But in the end, I didn’t sign the papers, and I didn’t take the money. The fallout wasn’t easy. I was left with $24,000 in development debt, $11,000 in lawyer fees, $34,000 in personal business loans coming due, and the emotional pain of calling two soon-to-be-full-time employees to let them know that I no longer had positions for them. In light of such a bad situation, why didn’t I take the money? It all came down to tranche investing.
What’s tranche investing, you ask? It’s a pretty simple concept: Instead of an investor giving money to a business all at once, it’s spaced out, usually over four quarters of a year. Each “tranche” (the word comes from the French, for “slice”) is released only when the company hits agreed-upon milestones.
On the face of it, tranche investing seems like a great way for an investor to protect against large losses and for the entrepreneur to more easily gain access to capital. While the two advantages may be true, there are four critical reasons why tranche investing is a terrible idea for both the entrepreneur and the investor.
1) It’s Inflexible.
Most investors invest in the team first and the idea second. Even the best startup ideas will shift and shake a few times before they are truly ready for the market. A team therefore needs to have the flexibility to shift its strategy and tactics—and in fact this is something the investor should be encouraging. The problem is that the agreed-upon metrics to unlock the next tranche of money are usually established in the beginning, and they get outdated very quickly as the idea evolves. This sets up a situation in which the team, in need of money to continue operations, may have to stay focused on the wrong metrics instead of moving to where the company really needs to go.
2) It Erodes Trust.
A typical seed-round investment gives a team a full 18 months of capital to operate the business before either getting a positive cash flow or starting to issue Series A stock. Investors’ commitment of 18 months means they’ll be in bed with the team through the good, bad, and downright ugly phases of a start-up. For the team, it means they can be brutally honest with their investors—after all, they’re stuck with each other for at least 18 months. It’s through this frankness that the famed business writer Jim Collins believes companies can go from good to great. If the capital “runway” is shortened from 18 months to as little as three months, the team will stop being brutally honest and instead downplay the negatives and highlight only the positives. They know they need to do whatever they can to unlock the next tranche of money. This is bad news for both the investor and the entrepreneur; the relationship between the entrepreneur and the investors is likely to slowly become adversarial.
3) It’s a Distraction.
It took me six months to almost raise my seed round. Ask any entrepreneur who’s raised money and they will tell you it feels like a full-time job. With the 18 months that goes with a typical seed-money investment, an entrepreneur and her team don’t have to worry about raising money for a while and thus can put all of their energy toward executing on their vision. But with only three month of money at a time, an entrepreneur is forced to siphon off time, energy, and resources to raising money for the next tranche. Every hour focused on raising money is an hour not focused on growing the company.
4) It Makes It Harder to Get Top Talent
I usually end job interviews by asking applicants if they have any questions for me. Both of the A-Players that I was planning to hire once I got funding asked me the same question: “I know start-ups can be risky, so how much money do you have in the bank to keep going?”
It’s a great question, and one that everyone looking to join a start-up should ask. Unfortunately, I had to sugar-coat the answer. I knew that if I said I had only three months, neither would’ve left their current job to come and work with me. Instead, I said we have access to $750,000 in investment capital spaced out over a year, which would easily be enough to get us to positive cash flow.
I left out the part about how each tranche is connected to a set of metrics, and if we didn’t hit those metrics, we didn’t get more money. It’s against my character to lie by omission, but telling the full story about our investment would’ve killed the hires right then and there.
Hiring top talent is hard, and if often involves poaching people from other companies. Without a longer-term runway of capital in the bank, most A-Players won’t take the bite. The alternative is to lie by omission, and to this day, the fact that I did it still leaves a bitter taste in my mouth.
As I said in the beginning, tranche investing sounds like a nice idea on the face of it. And there may even be times when it could work, if you set up enough clauses in the term sheet to allow for lots of wiggle room for the metrics for each tranche.
For me, next time I’ll save myself six months of time and $11,000 in lawyer fees to realize what I know now, once I dug into the reality of tranche investing–that it’s generally a bad idea for both the entrepreneur and the investor to commit to such a deal.
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