How Tranching An Investment Can Affect Investor Ownership

by Mark Peter Davis

In my post, Investors Tranche Fundraising To Reduce Risk, I address one of the key considerations that drives VCs to decide whether to tranche an investment, or not.  While tranching an investment is always better for reducing risk, it's not always better for maximizing ownership.  

A VC may or may not be better off by tranching their investment.  Ultimately, the determining factor for determining whether a VC should capitalize a company in one round or several when seeking to maximize ownership is the percentage of the company's lifetime capital requirement that the VC will be providing.  In a nutshell, the greater percentage of the company's total required capital that the investor provides, the more capitalizing the company in first round will increase ownership.

The Logic Behind This

If the investor plans to provide all of the company's required capital, they have an incentive to do the entire investment in the first round, when the valuation is lowest (valuations tend to increases between tranches).  The simple logic here is that it enables the investor to maximize their ownership of the company.

In contrast, a venture fund that can only provide a portion of the company's required capital is poised to own more of the company if the financing is tranched.  This is because by breaking the total capital invested in the company into tranches, the investor's capital can represent a greater percentage of the company's first investment round.  Since the remaining capital will be invested in subsequent rounds at a higher valuation, the investors capital will be diluted less than it would have been if all of the capital was invested in the first round at the same valuation.

In sum, majority investors want to buy as much stock as they can in the company at the lowest average price - subsequent rounds increase their average share price.   Minority investors want subsequent investors to pay a higher price than they did to reduce the extent to which their ownership is diluted.

An Example

The table below illustrates an example of how this math works.  Note that the numbers I picked are not indicative of the average deal structure - I simply chose numbers that make the math easier to follow.

I use the term "majority investor" loosely below to describe an investor that provides the majority of the invested capital.  Conversely, the minority investor provides only a small portion of the invested capital.

What you'll notice is that the minority investor owns more of the company in the tranchedscenario and the majority investor owns more of the company in the one-round scenario.

Making Sense Of This

This math leaves majority investors with a bit of a quandary.  They have conflicting incentives.  The majority investor is both incented to tranche the investment to mitigate execution risk and incented not to tranche the investment to maximized ownership.  How these investors ultimately decide to proceed is likely to be a function of their perceptions of execution risk and their risk tolerance for the investment (which is driven by where the investment sits in the life cycle of the fund and how much of a cowboy they are at heart).

Some have argued that the inherent incentive alignment partially supports the model of having smaller VC funds.  That's another dicussion for another day.