What is a Traunch?
A traunch represents a segment of payments dispersed over a specific period, contingent upon the fulfillment of certain performance objectives. This method is often employed in venture capital (VC) to aid startup companies in securing funds through staggered investment rounds.
The term ’traunch’ originates from the French word ’tranche,’ meaning ‘slice.’ Apart from venture capital, the concept of tranches is also relevant in securitization, such as mortgage-backed securities (MBS).
Key Takeaways
- A traunch delineates investments spread across time, tied to achieving set performance goals.
- Predominantly used in VC investing, this method mitigates investor risk.
- Traunched funding can pose challenges for entrepreneurs by limiting flexibility and tightening growth timelines.
Understanding Traunches
Investors counterbalance the risks embedded in startup investments by segmenting their contributions into separate traunches. For example, consider a startup seeking $5 million in financing. Instead of disbursing the total amount upfront, the investor might structure the deal into two traunches—$2.5 million now and the remaining $2.5 million later, dependent on hitting certain milestones.
By allocating funds in traunches, investors can reduce risk by withholding future payments until the company meets the pre-defined goals. These milestones can span product development, revenue targets, additional capital acquisition, or other operational benchmarks. Startups face the inherent challenge of meeting these targets within limited time frames, adding a layer of intensity to their early phases.
Difficulty for Startups
Restrained flexibility often complicates life for startups in multiple ways. Limited initial funds can hinder the company’s ability to attract top talent essential for efficient development. Moreover, maintaining hired personnel becomes challenging without assurance of continual funding.
The traunch system can also lead to a mismatch of incentives between investors and entrepreneurs. Entrepreneurs might avoid forthright communication about challenges, fearing it could jeopardize the next traunch. This environment may promote skewed performance metrics, misleading investors about the actual progress.
Broadly, the rigid targets set during early investment stages may prevent entrepreneurs from pivoting or capitalizing on unexpected opportunities. This leads to a focus on pre-ordained milestones, potentially relegating more critical opportunities to the background.
Real-World Example of a Traunch
Imagine being the founder of a startup that agrees to a traunched investment structure. The financing deal stipulates $1 million upfront, $2 million in 12 months, and a further $7 million in 24 months.
Meeting these successive funding rounds necessitates hitting specific goals. Within 12 months, your startup must scale its hiring. By 24 months, it must generate at least $500,000 in revenue. Missing these milestones would forfeit the next round of funding.
However, uncertainty about meeting these targets looms. Recruiting critical staff could be challenged by the lack of long-term guarantees. Similarly, achieving the stipulated revenue goal can be daunting, especially if potential clients and partners hold off agreements awaiting your company’s stable financial platform.
Related Terms: tranche, securitization, mortgage-backed securities, milestone funding.
