Milestone tranching gives the investor a free option on the company's progress. Here is how to price it, from both sides of the table.
A tranched round lets a growth investor buy the second half of its cheque at the first-close price, but only once the company has hit a milestone, so it holds a free option on the company's progress. In an illustrative 40 million round at 200 million pre-money, split into two 20 million tranches, the investor's expected multiple rises from 2.55x to 3.06x, and if the milestone is hit the second tranche arrives worth 9.09 million more than it costs.
Worked in full in The Growth Equity Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Tranching is common when the investor and the founders disagree about how fast the plan will happen. The founders get the headline valuation on the whole amount; the investor commits less money up front and funds the rest only if the plan proves out. Whether that is a good trade for either side depends on numbers that the term sheet does not show: the price the second tranche would command on the day it is funded, and the outcome if it never is.
| Input | Value |
|---|---|
| Pre-money valuation, US$ millions | 200 |
| Shares outstanding before the round, millions | 20.0 |
| Round price per share, US$ | 10.00 |
| Total commitment, US$ millions | 40.0 |
| Tranche 1 at closing / tranche 2 at month 12, if the milestone is hit | 20.0 / 20.0 |
| Pre-money a new investor would pay at month 12 if the milestone is hit | 320 |
| Probability of hitting the milestone | 60% |
| Exit equity value in year 5: milestone hit / missed | 900 / 30 |
Single close: 40.0 ÷ 10.00 = 4.0 million new shares; ownership 4.0 ÷ 24.0 = 16.67%.
Tranche 1: 2.0 million shares; ownership 2.0 ÷ 22.0 = 9.09%.
Tranche 2, milestone hit: another 2.0 million shares at 10.00, ownership back to 16.67%. At a fair month-12 price of 320 ÷ 22.0 = 14.55 a share, 20.0 would have bought only 1.375 million shares, for 14.44%.
Value transferred at tranche 2 = shares bought × (fair price − tranche price) = 2.0 × (14.55 − 10.00) = 9.09 million.
Exit payout = MAX(ownership × exit value, MIN(amount funded, exit value)). In Excel: =MAX(B3*B8,MIN(B4,B8)).
| Outcome | Single close: proceeds | MOIC | IRR | Tranched: proceeds | MOIC | IRR |
|---|---|---|---|---|---|---|
| Milestone hit, exit at 900 | 150.0 | 3.75x | 30.3% | 150.0 | 3.75x | 33.8% |
| Milestone missed, exit at 30 | 30.00 | 0.75x | −5.6% | 20.00 | 1.00x | nil |
| Expected, 60% hit | 102.00 | 2.55x | 98.00 | 3.06x |
When the plan works, the two structures end with the same 150.0 million, because the investor ends with the same 16.67 per cent. The tranched investor simply paid half of it a year later, which lifts the IRR from 30.3 to 33.8 per cent. When the plan fails, the difference is capital at risk. The single-close investor has 40.0 million in a company that sells for 30, takes the whole 30 under its preference and loses 10.00. The tranched investor has only 20.0 in, takes its 20.00 back, and the common holders keep the remaining 10.0.
On expected values the tranched investor makes 66.00 of profit on 32.0 of expected capital, against 62.00 on 40.0 for the single close: more profit on less money. The 9.09 million it gains at tranche 2 is the reason. Had the second tranche been priced fairly at month 12, the investor would own 14.44 per cent and exit with 129.9 rather than 150.0, a 3.25x multiple.
| Probability of hitting | Single close MOIC | Profit | Tranched: expected capital | MOIC | Profit |
|---|---|---|---|---|---|
| 40% | 1.95x | 38.0 | 28.0 | 2.57x | 44.0 |
| 60% | 2.55x | 62.0 | 32.0 | 3.06x | 66.0 |
| 80% | 3.15x | 86.0 | 36.0 | 3.44x | 88.0 |
| 100% | 3.75x | 110.0 | 40.0 | 3.75x | 110.0 |
| Fair pre-money at month 12 | Fair price per share | Value transferred at tranche 2 | As % of the tranche |
|---|---|---|---|
| 220 | 10.00 | 0.00 | 0.0% |
| 260 | 11.82 | 3.64 | 18.2% |
| 320 | 14.55 | 9.09 | 45.5% |
| 400 | 18.18 | 16.36 | 81.8% |
The less certain the milestone, the more tranching is worth to the investor, because the option to walk away matters most when walking away is likely. At certainty the two structures converge. The transfer table is the founders' side of the same trade: if the milestone is hit and the company would then command 400 pre-money, the second tranche hands the investor 16.36 million of value, 81.8 per cent of the cheque, in exchange for having been willing to fund at all.
The common mistake is to treat the headline as the price of the whole round. Founders announce 200 million pre-money on 40 million raised, but in neither outcome is that the deal they get. If the milestone is hit, the second half is sold at 10.00 a share when the company is worth 14.55; if it is missed, only 20 million arrives. The investor-side mistake is the mirror image: reporting the multiple on committed rather than funded capital, which understates what tranching did for the fund. The headline valuation question is worked in what entry valuation a growth investor can pay and still make 3x, and the preference mechanics in at what exit a 1x non-participating preference converts.
Negotiating point: a founder who expects to hit the milestone should ask for the second tranche to step up in price, or for the right to raise it from a new investor at the market price. A step-up to a 260 pre-money, 11.82 a share, buys the investor 1.692 million shares worth 14.55 each: it still receives 4.62 million of value, but 4.48 million of the 9.09 million stays with the existing holders.
A tranched round is a round plus a free call option. Price the option: the gain at tranche 2 if the plan works and the capital not lost if it does not. In this case that turns a 2.55x expected multiple into 3.06x on the same headline valuation. The book's ownership and reserve arithmetic is in the free workbook for this book.
A round in which the investor commits the full amount but funds it in instalments, the later ones conditional on milestones such as an ARR target. The price is usually fixed at the first close. In the illustrative case 20.0 million is funded at closing and 20.0 million twelve months later at the same 10.00 a share, if the milestone is hit.
It reduces their dilution only if the milestone is missed, and costs them if it is hit, because the second tranche is bought at a stale price. If the company would command 320 million pre-money at month 12, the second 20.0 million tranche transfers 9.09 million of value to the investor, 45.5 per cent of the cheque.
On funded capital, because uncalled tranches are not at risk. In the illustrative case expected funded capital is 32.0 million, and the expected multiple is 3.06x; dividing the same expected proceeds of 98.00 by the 40.0 committed would understate the result.
This article is one calculation from The Growth Equity Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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