Tranched rounds is the idea that an investor will commit to a total financing and give out portions as the entrepreneur achieves certain milestones. A tranche is ultimately a negotiation and there isn’t a fixed amount or metric around it. As you would expect what typically happens is 50% now, 50% later, with the latter being an operational target say around number of users or revenues. There are obvious reasons why VCs would want tranches, the pitfalls are more detrimental to entrepreneurs.
Tranches happen much more commonly in emerging ecosystems, whether by vertical (for instance biotech rather than tech) or by geography. A tranche fundamentally reduces risk but it can be the end result of a few very different scenarios:
Scenario 1: The investor doesn’t have full conviction but wants the ability to invest a certain amount of money. The two common variants to a tranche are getting a discount towards the next round or a warrant ie the option but not the requirement to invest more later.
Scenario 2: The investor is a VC who doesn’t have enough funds in the bank just right now but will have soon, either because they will have their next capital call or some liquidity from another investment. In this case, the VC won’t usually negotiate for the startup to reach certain milestones
Scenario 3: The investor is a strategic one that has stricter limitations around budget and/or wants to tie funding to business traction. This happens very commonly when there is a tech risk and the strategic is corporate.
Scenario 4: The investor and the entrepreneur are disagreeing on how much capital the business will actually need and thus compromise on a staged financing. This happens when there is a science risk and the entrepreneur is much more optimistic than the investor and doesn’t want as much dilution.
Scenario 5: The startup may not need the next tranche but the investor is a strategic who wants to continue exercising influence, typically to influence co-development or acquisition.
In all these scenarios the motivations of the investor are fundamentally different but the reasons for entrepreneurs to take the deal are the same. Namely, they really want this particular VC for their experience, network or brand. Or if they don’t want to spend another cycle raising funds in the near future.
Otherwise there are no good reasons for an entrepreneur to take tranches. They will likely constrain your growth and send an ambiguous signal into the market — why did you not take a better deal elsewhere? Instead of a tranche, if you have enough revenues entrepreneurs might as well take a credit line from a bank or raise debt. If you are too early to have significant collateral then don’t raise VC, maybe better to go for other sources of capital such as crowdfunding, family offices, corporates, foundations, or government grants.