Tranche Venture Rounds

Perhaps the most common complaint about being a founder is how long fundraising takes, and how distracting it can be. Fundraising is an all-encompassing process, and takes the undivided attention of the founders in order to close a round. Founders want to focus on doing what they are good at: building the product, team, and company. I have heard of very few founders who have stated that they enjoy fundraising, because they want to get back to doing what they are best at. Despite that, fundraising — especially at later stages — can take a very long time to complete, and takes away a lot of time from founders who, frankly, have better things to do. How can we reduce the inefficiencies in fundraising so that founders can worry less about raising money, and more about their business? A good place to start would be reducing the length of the due diligence process.

Fundraising takes so long because venture capitalists are in the business of funding risky ventures, and so they need to ensure that they are making calculated and informed bets. VCs and angels spend a lot of their time doing due diligence — conducting background checks and verifying the veracity of information provided by founders. The amount of due diligence that needs to be conducted when investing in a Seed round is relatively low, primarily due to the fact the business has little to investigate. That being said, investors still invest a lot of their time reviewing metrics (revenue, product progress, et cetera), evaluating the product, reaching out to references that the founders have provided, analyzing the market, and checking information the founders have presented to them. When an investor is investing in a later-stage round, due diligence takes a longer period of time, for two reasons. Firstly, there is more information to review — the business has been around a lot longer. Therefore, the investor has to spend more time fact-checking, and reviewing all available data to ensure there are no major red flags or unnecessary risks associated with investing in the business. Secondly, the investor is likely committing a larger amount of capital. Investors do not want to invest capital without first ensuring that their capital will go to good use, and so are very deliberate when evaluating companies.

If due diligence and background checks are such an important and established part of mitigating risk for investors, is there actually a way to optimize these processes? Rather than spending a large amount of time conducting due diligence because a large amount of capital is being invested, venture capitalists could instead agree to invest through a “tranche round”. In this case, the venture capitalist would not invest the entire sum of capital upfront. Rather, they would give a certain percentage of the capital to the founders upfront, and would give the rest of the money to founders in installments, once they reach certain benchmarks. For example, a founder who is raising a $1m seed round for a consumer SaaS company with $15,000 ARR could get $200,000 upfront from investors, and unlock the other $800,000 as their revenue increases. Once the business makes $20,000 ARR, then they unlock another $400,000, and they will unlock the rest when they earn $40,000 ARR. The investor is taking on less risk because they are only investing a small amount of capital upfront, and only invests more capital if the business shows signs of success. The investor therefore needs to do less due diligence, because the business will only unlock the next stage of their investment if they reach a certain milestone.

A “tranche round” would allow founders to raise money and be paid in installments, which will mean they need to reach certain targets before being allowed to access the next stage of capital in the tranche. Tranche rounds would decrease the amount of time that founders would have to spend fundraising because investors would be taking less risk — they would only have to invest a small amount of capital upfront. If the startup fails before they have unlocked more capital, then the investor has lost less capital than they would have if they had made a full investment into the founder. The venture capitalist could make a Seed-round decision within a few days through a tranche round — a week maximum — because of the reduced amount of risk involved in making the investment. Venture capitalists could mitigate risk, and founders could get back to building their business quicker through tranche rounds. I think that, in the future, more venture capitalists will start to fundraise founders through tranche rounds. Investing through tranche rounds would also allow give an investor a competitive advantage over others — they will reach a decision and a term sheet quicker because they have a limited amount of due diligence to do upfront based on the reduced risk being taken.

JamesG Snippets are unedited, and his raw thoughts. Rather than filtering content out in the form of essays, I will share my verbatim manuscript through these Snippets. JamesG Snippets are things that are interesting and too long for Twitter, but too short for an essay (in their current form, at least).

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