In the fundraising context, tranching refers to splitting the total amount equally into various tranches, at different valuations. The below picture best explains this concept.
Tranching is considered to be the best fundraising strategy especially during the pre-seed and seed rounds, to get momentum on your funding/raise.
Elizabeth Yin, the co-founder of Hustle Fund VC succinctly explains this strategy on tranching your fundraising, in her recent tweetstorm. This post is inspired from that thread, duly incorporating my thoughts in a structured manner, wherever possible.
But, let's start with ...
Why Should You Tranche Your Fundraising?
The concept of a fundraising "round" is basically dead during the early stages i.e. pre-seed / seed. Most of these rounds are being done using SAFEs or Notes, since 2010. This is the case, even from well-known/established VCs.
SAFE stands for Simple Agreement for Future Equity. It was created by the team at Y Combinator in late 2013, and since then, it has been used by almost all YC startups and countless non-YC startups as the main instrument for early-stage fundraising.
Just download the SAFE agreement on the YC website and mutually sign with your investor/s. The new version (Sept-2018) incorporates certain changes, which are here.
Why SAFE or Notes?
At the early stage of a startup, it can be relatively difficult to accurately arrive at the valuation of a startup because there is usually very little data. That’s where a SAFE/Notes comes into play - it’s a form of convertible security that allows you to postpone the valuation part until later on i.e. mostly at Pre-Series A or Series A rounds.
This is great for entrepreneurs/founders because it means that you don't need a lead investor to raise money. You can just agree on a cap/discount and amount with any investor and can sign and wire with no legal costs.
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What is Tranching, and Need for It?
It means you can sign and get the amount wired, whenever you want. You can get some investors immediately at a lower valuation, and get some investors later at higher valuations. There are various ways you can use tranching:
You can just take one check now and then raise subsequent amounts later.
Or you can continuously raise in 2-4 different time periods.
Or raise all at one stroke. Unlike equity, this flexibility is gold.
Notably, you can also decide on a valuation cap that is different for each investor. No longer does everyone have to be in the same round with the same terms. This makes sense because your investors should all be different in their "value adds" so shouldn't they get different terms?
Besides, the earlier investors are taking immense risks at the earlier stages, and thus should be rewarded with better terms i.e. lower valuations.
Lastly, SAFEs/Notes give the entrepreneurs more leverage in creating the FOMO/urgency to push the investors to decide faster.
How to Tranche Your Fundraising?
Let's say you're raising $1 M at the seed round. Now, if you go to investors and ask them to give you the full $1 M, most of them won't commit so easily. Why? Because it's always better for them to wait until other investors commit, and since you're very far from raising the full $1 M, investors know they've enough time to twiddle their thumbs.
This is not a good situation for any entrepreneur!
Unfortunately, this is more like a chicken and egg situation - investors won't commit until there are other committed investors. However, there won't be other investors until some investors commit!
Enter the tranche strategy, and here's how you do it.
One way to solve this is to break up your $1 M raise into smaller pieces. You decide those parts i.e. $300K-$700K, or $300K-$300K-$400K etc., albeit at different valuations i.e. lower valuations in the early tranches, as is visible in the above image.
Eventually, you're still raising $1 M. But for those investors who can move fast, you're doing $300K at special terms.
First $300K Tranche
Offer a lower cap on a SAFE for the first $300K, and tell every potential investors that this offer will only be available until X date OR until you hit the target of $300K in signed SAFEs.
And that eventually the cap will most likely go up post that.
This allows investors who commit early to be rewarded for being early. It also allows you to get momentum on your raise. But most importantly, it also allows you to test the pricing of the cap. If you have a TON of demand on that special first tranche, it means the cap is too low. However, if you have no demand, then the cap is too high OR no one seems interested.
When no one is interested in these special terms, then you have a bigger problem and should probably pause your fundraising activity until you hit a worthy milestone.
Often it's hard to know whether your cap is too low or just too high (assuming investors are interested), so by testing with a small tranche, you're not giving up much, even if you price too low. That momentum is still valuable to you.
Moreover, once you've got some money in your hands, you need subsequent cash even less. So, now you can afford to ask for a higher cap on the later tranches. It's less critical than the first tranche.
Besides, once you're getting close to filling the first tranche, that is the time to go to all the investors you're in touch with and keep them abreast of the situation. "Hey - just wanted to let you know, we now have $100K left of our first tranche. After that, the cap is likely to go up. Would you like to be in?"
Once you fill the first tranche at those special terms, you can assess whether it was easy or hard to raise. If it was hard, you might not want to increase the cap. You may even want to consider postponing the rest of the raise depending on your learnings.
This strategy works with big and small investors. If you are approaching large lead investors, you still tell them "Hey, I'm raising $1 M round, and I'm starting to bring in smaller checks on a SAFE/Note, but we are raising a large round that fits your sweet spot. Would you like to review us?"
If a lead investor wants to come in with a large check, they will offer you an equity deal, and you can roll all your SAFEs into the round at that time. This is how to reconcile lead investors into this process. However, if no lead investor wants to come in, then you can party-round your way to success with this tranche strategy. There is NO REASON to hold up your round to wait for a lead investor.
During fundraising, the founders should talk to lots of investors - big and small. Ultimately, what gets fundraisers done is the sheer momentum. Using this tranche strategy, you are creating urgency so that investors will prioritize a decision on YOUR COMPANY over all others.
What could happen during the later-stage rounds?
Larger checks warrant in-depth due diligence, and secondary investors expect a reputable lead to handle it. Unfortunately, the differential prices seem to also be frowned upon, while this strategy doesn’t work for late-stage rounds, you can still create urgency by going for more investor meetings. And since it’s late-stage, hopefully, the traction speaks for itself unlike in the early stages.
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