7 reasons for entrepreneurs to avoid tranched investments

wavesOriginally published on Venturebeat on April 3, 2013 3:44 PM 

Investments, like the ocean, can come in waves, but that doesn’t mean they should.

A “tranched investment” is an investment that is split into one or more parts. In order for the company to receive the latter parts of a tranched investment, it usually has to achieve goals or objectives set as part of the conditions of investment. A typical example of a tranche is: the investors give you half the investment amount right now, and half the investment when your revenues reach ‘x’.

Generally speaking, the current thinking around tranches by most investors is that they are a good tool to motivate founders to reach a milestone or alternatively to reduce their exposure to risk. However, tranches are more damaging to the long term success of a company than investors may typically consider, particularly if milestones are not met or the company comes dangerously close to just meeting them.

Specifically, I think tranches can:

  • de-motivate founders and potentially reduce a founder’s drive (according to Daniel H. Pink’s view of extrinsic motivation, see below for more on this)
  • reduce a founding team’s creativity on how to grow the business in a way that might be long-term better, but short-term fails to achieve the next pre-determined milestone. Think of a company sticking to a product rather than pivoting in hopes to hit a deadline, but then ultimately sticking with a product that long term will not yield the maximum returns.
  • potentially reduce good-behavior (read: cheating to hit numbers). If someone is really really needing the cash, temptation to do something to cut corners is there.
  • promotes “sandbagging” by the investor rather than full commitment
  • creates a self-fulfilling prophecy. In the words of the CEO of Zemanta, Bostjan Spetic, “the cash you are raising is usually what you need to get to a significant milestone, like break-even. Tying that budget to sub-milestones implicitly reduces the chances to actually hitting the big milestone, because it increases the risk of running out of cash prematurely. I firmly believe that.”
  • create an accelerated cash burn to achieve the goal, and then if missed by a little, leaves the company in a vulnerable position for subsequent fundraising.
  • makes the company toxic for an external investor that would be interested in investing, if the company doesn’t receive the tranche from its existing investors.

So, if you’re a founder, what do you say to an investor who’s hell-bent on implementing tranches in your term sheet? And, if you’re an investor, how do you reduce the risk of your investment so that you aren’t over allocated prior to the key inflection milestone being achieved?

My recommendation for both these questions is to get a dialog going to agree on one of the following three potential alternatives:

1. Reduce the amount of money and target a closer-term milestone for the startup to achieve. Yes, this implies that if the startups hits its milestone, it may command a higher valuation and the investor will not have been able to secure the economics of a tranched investment, but in exchange, the investor is getting a higher probability of overall success for their investment. Note: This should not constitute an opportunity for predatory investors to under-fund a company by picking too-early a milestone for founders to accomplish, as this not only hurts the company’s likelihood of achieving it, but also the likelihood of the company being able to secure follow-on capital.

2. If an investor really needs to have tranches, implement “binary” milestones that are simple and clear. What you want to avoid are tranches that have partial or subjective achievement, such as when a company comes pretty close to hitting its revenue figure or number of users. An example of an ideal binary milestone would be: You will get a sum of money unlocked equaling the salary of a new CFO when you hire that CFO. The target is clear (hire CFO), it is not ambiguous or ‘close enough’; you either hired the CFO or you didn’t, and then the amount of money is tied to that achievement.

3. If you can’t agree on either of the above, that implies either the company is overvalued for where it is, or the investor may be overly cautious; if the latter, then the founder might want to reconsider taking them on as investor (assuming he/she has a choice).

One more thought on why the carrot/stick theory behind tranches doesn’t work: In his book Drive, author Daniel H. Pink walks through classical motivation models and compares them to his observations on actual motivation. He makes a very compelling case for companies, managers, parents, and just about anyone to rethink their preconceived notions on motivation, particularly around old carrot vs. stick methods.

He says the old form of motivation fails because for three reasons. One, It doesn’t mesh with the way many new business models are organizing what we do — because we’re intrinsically motivated purpose maximizers. Secondly, It doesn’t comport with the way that 21st century economics thinks about what we do — because economists are finally realizing that we’re full-fledged human beings, not single-minded economic robots. Finally, it’s hard to reconcile with much of what we actually do at work — because for growing numbers of people, work is often creative, interesting, and self-directed rather than unrelentingly routine, boring, and other-directed.

This topic may yield contrasting views on the efficacy of tranches by investors, but I sit squarely on the side that tranches, as they are generally used, are more value dilutive than value accretive for all parties involved.

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How do you issue the right number of shares/options to an employee or an advisor?

HM Revenue & Customs at Mevagissey Harbour
HM Revenue & Customs at Mevagissey Harbour (Photo credit: Cross Duck)

Most founders have desire to share their equity with people that helped them along the way, both as a thank you, but also as a motivation tool. However, how to share is always a big question mark for every Founder. The two most frequently asked question is, “How much equity should I assign an advisor?”, which is shortly followed by “How do I know when to issue shares to new employees and how much do I give them?”.

So, let’s take step back and look at why we are doing this in the first place.

Motivating employees and or advisors is a key part of having a productive workforce. One key element to unlock this productivity is by creating a culture of fairness. In his book titled ‘Drive’, Daniel H. Pink talks about how an employee’s productivity can be binary provided that the right results-oriented work environment is created AND they are treated fairly from a compensation point of view. Effectively, if you don’t create a feeling of fairness in terms of compensation, relative to the market, employees will simply not be ‘open’ to be fully motivated as they will feel slighted. It’s a simple concept on paper, harder to implement in practice.

Therefore, the word ‘fairness’ is what’s important here.. how do you define the fairness culture in your startup?

Let’s start with advisors:

Advisors need to commit some time to your company to ‘earn’ their equity. The first thing to do is to define what kind of role this advisor is going to take. Is he going to provide board-level feedback and help or just operational help (marketing, for example). Is she going to meet with you once a week or once a month?

Then, define a time period for this relationship before you review it for extension. As in, Joe, your marketing advisor, will work with you once a week for 9 months, at which point you can review your working relationship to see if he is needed any further or if it is working out.

It’s really quite simple, find someone that can help you, narrowly define expectations you have of each other and for how long, and then find an equity amount that is in line with the market and that makes them happy.

For the USA, the Founder Institute has come up with some guidelines on numbers, and you can read about those here:

They also include an agreement you can sign with your advisor to narrowly define the engagement. For the UK, I’ll be linking to one soon… stay tuned.

Onto Employees (which is a bit trickier and I’ll include the topic of valuations as a bonus):

Back to the topic of Fairness… Fairness is defined by having the total compensation of your employee meet his or her expectations as defined by the market. As such, you need to think of your employee’s total compensation (cash + equity) as something that is within the boundaries of the market norm for his or her role. Deviate too much and not only is hiring hard(er), but you will have inherently unmotivated employees. Total compensations at startups usually have low or no salary, so that fairness is established by assigning equity.

So in order to quantify the value of the equity portion of the total compensation of an employee, one important thing to consider is that the total value of the option package issued, is a function of both the total number given, but also the strike price they have. The two go hand in hand.

But before we go any further, a quick definition check on Strike Price:

An option’s strike price is the fixed price assigned to an option for the purchasing of the underlying share (typically ordinary shares) in the company. In effect, you have to pay the [strike price x  the options] you’ve been granted, to exercise your right to buy the underlying shares. Once you’ve ‘exercised’, you own the shares.

Pricing strike prices is a bit of a pain. In the USA, you have to do 409A valuations. More on that from Fred Wilson here:

Pricing in the UK is both simpler and more difficult. More difficult because it isn’t as clear as the USA, but simpler, because there is more flexibility.

Here is the exact language from HMRC (http://www.hmrc.gov.uk/shareschemes/emi-new-guidance.htm#10):

If EMI options in an unquoted company are granted the company can, if it wishes, agree the market value of the shares with HMRC Shares and Assets Valuation (SAV). To agree a market value with them the company will need to propose a value for the shares and provide background information to support the proposal. It will need to complete form Val 231 for EMI options.
The form outlines the information needed to support the proposed valuation. When it is complete, it should be sent it to HMRC Shares and Assets Valuation (SAV).
If the form is not used or the company does not supply all the information requested, it may be asked to supply the missing information before a valuation can begin. This could delay the agreement of the valuation. When HMRC Shares and Assets Valuation (SAV) receive your completed form, they will tell you within ten working days if they need any further information.
Asking HMRC to agree a valuation is not the same as:

  •    notifying HMRC of the grant of EMI options
  •    or making the annual tax return required for EMIs

This language does give you some flexibility on how you want to value and define your company’s value at the time you are setting the strike price. Book an appointment with someone like
http://www.completeaccountingsolutions.co.uk/ to discuss how you might go about setting this, or with your lawyers. Getting this right is important because if you don’t get it right, it will have serious tax implications for your employees or any other option recipients.

So back to strike pricing and its effect on the value you give to your employees:

If you have a very high strike price, you affect the employee’s total return on an exit. In a simplified equation (that isn’t designed to give you the present value of your options (Black–Scholes), but rather just the mechanics of cashing out), the value of the options will be:

(Share Price at Exit * Options you have) – (Strike Price you have * Options you have) = value to employee in cash at exit

You can see where to match employee 100, who comes in when the company is worth a lot more, with employee 10, who came in early, you’d have to issue employee 100 many more shares to ‘equal’ the same given to Employee 10. Try explaining all that to your hundredth employee and also to your first few, who might feel slighted that someone has more ‘shares’ than they do for the same job function.

Also, here is an interesting point to consider: different exercise prices for fully vested employees will cause them to behave differently. An employee who has 100 shares to buy, but only at $1 each will act differently (buy the shares and be a passive shareholder) vs an employee that has 100 shares at $100 (more likely to make a calculated decision as to whether to exercise (or not) the options upon a departure). Remember, if you set an exercise period after someone leaves the company, the question is, do you want them to keep the shares as a bet (low price) or only keep them if they really believe in the company (high price)? Again, no right answer as you balance between equity you give out.

So how much equity to give them?

After the above exercise, you see the challenge between articulating fairness mathematically, but also in terms of how employees chat between themselves and can sometimes get the wrong impressions based on not having all the facts.

Transparency is very useful in the early stages of a business, but as you grow, you may choose to just share the basic information of your company’s equity buckets, or strata. It’s really up to you and how you want to stratify the different kinds of employee equity issuances, for example: director level, supervisory level, and admin level.

The trick here, is really in how to ‘define’ who is what. I’d say that the important strata are:

  •    Those that set strategic direction overall (typically the founders or CEO)
  •    Those that set functional strategic direction (typically someone like a CFO, or CMO)
  •    Those that set budgets to hit strategic goals (Directors, VPs)
  •    Those that manage people according to budgets (Supervisors, Line Managers)
  •    Those that execute (Developers, Sales people, etc)

Then, you define what’s a fair total comp bucket value for each of these, and then use the math equations to give you the relative values of equity for each strata.

As with most things of this nature, however, there are more than one way to slice the onion.

Fred Wilson’s post below on what to issue each strata is useful as a guide for both an equation to calculate absolute numbers, but also to help understand the different tiers of employees.

And here is Guy Kawasaki’s suggested split (via @brandid):

Lastly, here is another version of how to divide things ‘fairly’ between everyone (via @gosimpletax): http://www.brightjourney.com/q/forming-new-software-startup-allocate-ownership-fairly

Once you’ve chosen your preferred method, one mistake to avoid is to promise early employees ‘percentages’. Meaning, don’t say, I’ll give you 2%, but rather say, I’m giving you 2,000 shares which represent 2% of our current cap table. The reason is that if you leave it verbally at 2%, you may inadvertently make them believe that at the next round the will continue to have 2%. Don’t assume all employees understand the mechanics of financing rounds and/or dilution.

Another mistake to avoid is not including a vesting period. Without a vesting period, your employees have full access to what you’ve promised them, whether they’ve spent time to ‘earn it’, it is dangerous for the company to not have one. Read here an explanation of why that’s important:  http://www.seedcamp.com/2012/11/seedhack-founders-collaboration-agreement-version-2-0.html

In the end, this is more of an art, and you will get it wrong at least once, and don’t be afraid to experiment, but as long as you have a process, I believe you will have less issues going forward, particularly when the company grows larger, than if you leave things entirely open-ended.

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