What is an Investment in Tranche?
Tranche investing enables venture capitalists and other investors to segment their investments. They might provide firms money over time as opposed to everything at once. Typically, a firm receiving a tranche investment will receive predetermined payments as long as it meets predetermined financial goals. The origin of the term tranche is the French word meaning slice.
What is Structured Financing?
Structured financing is a wide phrase that encompasses the several methods in which firms and banks might partition hazardous financial items, such as loans. Frequently, corporations and banks market these innovative financial products to specialist third-party investors. These products frequently consist of insurance policies, mortgages, and other forms of debt, such as tranches. Tranching or tranche investing is a relatively new concept designed to assist investors reduce risk and increase capital for companies. Simulating tranching occurs when an investor makes a seed investment in a business and pre-negotiates the company’s price or worth. Certain milestones activate this value, often known as a post-money valuation.
Reasons to Think About Tranche Investment
Tranches are effective in sectors with several technical or regulatory milestones, such as IT and biotechnology.
It grants investors greater power over businesses.
When making a first investment, investors receive all of their stock at the lower pre-money valuation.
Investors can donate money to firms over time, but they are not obligated to pay if the value of their equity or stock price does not increase according to predetermined benchmarks.
Companies are not required to seek investors for the next round of financing.
Investors and companies can renegotiate milestones.
As a result of their reduced risk, investors can make speedy choices while evaluating a company.
Reasons to Consider Not Using Tranche Investment
Alternatively, investors might reduce their risk by negotiating a lower firm valuation or participating to a smaller investment round.
Tranching makes early recruiting more difficult since prospective workers frequently inquire about a startup’s cash on hand. Companies must determine whether to provide individuals with a lesser, less desirable number.
To obtain their prenegotiated tranches, also known as follow-on tranches, businesses must spend time with investors. Founders frequently give many investor presentations.
Tracing can strain ties between investors and business founders.
Just missing a milestone deprives a corporation of necessary funds. It may potentially result in bankruptcy.
Companies must prioritize short-term benchmarks above long-term objectives.
Companies lack cash reserves for unforeseen costs.
Existing tranches can reduce a company’s appeal to external investors.
Transcription raises the expenses of other parties, such as attorneys.
Parties
Current shareholders & company
The agreement should be signed by all current shareholders (including the founders) and the company, however it may not be practicable for all minority shareholders to sign if there are a considerable number of them.
Investors
As the investment agreement relates to the subscription of shares by investors in exchange for investment funds, it should bind all participating investors, including any independent funds that are investing.
Future shareholders
It is customary to include a clause requiring every transferee or new allottee of shares to sign a deed of adherence, which has the effect of treating the new shareholder as if he were an original party to the investment agreement and so obligated by its terms. Typically, the board has the ability to waive this condition, and those exercising options are excluded.
Tranche payments
It is customary for investments in IT and health sciences enterprises to involve tranched payments, with each tranche based on the completion of certain milestones. Typically, these milestones are assessed against the various stages of product development, the company’s acceptance of new advances, or the outcomes of pre-clinical or clinical studies. It is usual for investors to have the option to waive milestones or other completion requirements if they are not met.
Completion conditions – initial tranche
Before the initial investment tranche can be completed, the investors will require that certain conditions must be met. These terms might include the following:
Completion of any required due diligence on the company; delivery of a satisfactory business plan and management accounts; obtaining any required tax clearances; having the necessary authorities (board and shareholder) in place to issue new shares to investors as part of the investment; and adoption of the new articles of association. This will likely necessitate the passing of shareholder resolutions (either by written resolution or by the holding of a general meeting), which may impact when the investment can be finalized, depending on how quickly these resolutions are passed; the founders and key management having been issued shares or options; the assignment of all necessary intellectual property rights owned by the founders and other persons to the company; and appropriate insurance, such as keyman insurance.
Initial tranche conclusion procedures
These activities must be completed following the conclusion of the initial investment tranche:
Approval of the investment agreement and, if applicable, the disclosure letter; issuance of subscription shares and related certificates to the investors; appointment of the investor director(s) to the board of directors; and an obligation on the part of the investors to transfer the subscription funds to the company’s bank account.
Adoption or commitment to adopt a share option plan; approval and execution of service agreements if the founders are to become executive directors; and adoption or commitment to implement a share option plan.
The investment agreement will indicate that the investment funds (whether from the initial or later tranches) must be utilized for the achievement of the specified milestones and the execution of the approved business plan or budget.
Completion conditions – future tranches
Typically, completion constraints are linked to each successive investment tranche. Typical examples include:
The completion of the initial investment/previous tranche; the absence of a material adverse change (i.e., a negative event that has a significant impact on the business, the result of which may affect an investor’s willingness to invest in a company); the achievement of the agreed milestones related to the tranche in question; the absence of a material breach of the investment agreement, the new articles of association, or a director’s service agreement; and the continuation of the company’s financial performance.
Mechanisms for further tranche completion
These are the measures that must be completed upon completion of the succeeding investment tranches:
issuing of new shares and corresponding certificates to the investors; and a need for the investors to deposit the subscription funds into the company’s bank accounts.
Warranties
Warranties are representations given by the warrantors, who are often the company’s founders, that certain company-related claims are true and truthful as of the closing date. Although the investors will have conducted due diligence on the firm and, under common law, have the ability to sue the founders for misrepresentation if the information given is false, the investors will prefer to have such assertions clearly stated in the contract.
At times, the warranties are issued upon the completion of succeeding tranches after the completion of the original tranche. If, prior to the completion of a tranche, any of the warranties provided by the warrantors prove to be false, the investors have the contractual right to sue the warrantors for breach of warranty. The warrantors may qualify the warranties through a disclosure letter and agree in the investment agreement to any limitations to the warranties (such as time limitations, materiality thresholds, and financial limitations on a claim (which, for a founder, is typically linked to a multiple of his salary and, for the company, is typically the entire investment value)).
Due to the firm’s limited trading history, the remaining warranties will have limited applicability if the investment is made in a startup life sciences company, with the exception of IP warranties. IP warranties in life sciences investments, regardless of the stage of the firm, are frequently more thorough and expansive than other warranties, due to the value, extent, and complexity of the IP they possess or products they intend to produce. If a bio sciences business is undergoing a second or later round of funding, warranties will likely be even more comprehensive.
Additional examples of standard warranties include:
business strategy; shares and company constitution; obligations and contracts; directors and workers; and tax information (particular for life sciences companies that are not involved in their first round of investment).
Investor consent regime
On completion of an initial investment, the investors will typically own a minority stake, i.e., less than fifty percent of the company’s shares. Historically, however, it is not uncommon for investors in life sciences companies to quickly hold a majority interest, especially if the company requires multiple rounds of investment due to the size of each investment and the amount of money that is frequently required to develop the product of a life sciences company (s). According to English company law, a majority of shareholders or at least 75% of shareholders can vote on most shareholder concerns.
The investors will seek a contractual provision that prohibits shareholders from making crucial decisions without their permission. This relates to both management and shareholder choices, including:
modifying the rights attaching to the shares; issuing or granting options over the company’s securities; adopting new articles of association; removing or appointing a director; making a material change in the nature of the company’s business; acquiring any shares or other securities; making any changes to the service agreements; incurring unbudgeted capital expenditure exceeding a certain threshold; entering into any litigation; incorporating a new subsidiary; and acquiring any assets.
The amount of consent is highly reliant on the number of investors in the firm. If there is just one investor, it is customary to stipulate that none of the foregoing actions may be conducted without the investor’s prior consent. However, when there is a consortium of investors, it is impractical and time-consuming to obtain the agreement of each individual investor prior to addressing any shareholder or board concern. In this situation, it is considerably more common to demand the approval of the investors who collectively own a particular number of shares (often preferred shares – see below).
Information about finances
When bringing on an institutional investor, management is frequently required to generate management accounts, audited accounts, financial models, and budgets for the following fiscal years, which they must present to investors by specific deadlines. This can be difficult for administration to develop. In addition, investors are likely to seek inspection access to the company’s financial records upon request.
Board representation
In most instances, investors in life sciences firms will require an entrenched right to choose a director, and a majority, if not all, of the directors selected by the investors must be present for a quorum to exist at a board meeting. An investor director might provide his industry knowledge and experience. Founders may also possess a permanent power to choose a director. In some instances, investors may seek ‘observer rights’ so that they can send non-directors to witness board meetings and obtain board documents without the power to vote. Although board presence is required, it may become unmanageable if a firm has undergone many rounds of financing, with new institutions acquiring board members with each round.
There are rules under company law regarding conflicts of interest of directors, and the investor director must declare any interests he has in the investor he represents, such as being entitled to a bonus or carried interest if the fund is successful or directorships in competing companies, before the board can approve them.
restrictive clauses
The goal of restrictive covenants or non-competes is to prohibit founders from competing with the firm’s business while they are active with the company and after they leave. Usually, restrictive covenants are included in both the service agreement and the investment agreement. However, restrictive covenants in the investment agreement are often more enforceable than those in the service agreement, as the founders grant the restrictions as shareholders (and not as workers) as part of the investment consideration.
Exit
A term in the investment agreement may declare the parties’ intent to work toward an exit, such as a listing of the firm on a recognized stock market or a sale of the company, within a set time frame (usually 3 to 5 years). Generally, this purpose is accompanied by an acknowledgment that an investor will not provide any warranties or indemnities about the operations and affairs of the firm upon a departure, with the exception of warranties pertaining to the company’s ability to sell its shares.
Confidentiality
There will be a provision in the agreement requiring all parties to maintain the confidentiality of all private information. Typically, an investor is specifically permitted to share information to its workers, members, etc.
Costs
Typically, the company pays for the investors’ fair legal and due diligence fees, or a fraction of such fees, as well as its own costs and, on occasion, those of the founders.
Other considerations
As a condition of their investment, certain investors in health sciences enterprises may demand the company and its founders to enter into specific commitments or obligations, especially if they are charity organizations or have a particular social purpose or objective. These will need to be carefully considered when negotiating the term sheet and the definitive legal documents, as a breach of them can frequently have severe repercussions for both the investor and the company, such as requiring the investor to sell its shares or refraining from providing additional funds in subsequent rounds of investment.
