NVCA Today

written by Stephen B. Thau

Introduction. Tranched financings, in which investors commit to fund a company over time, have long been used in the life sciences industry and are becoming increasingly common in other sectors. For investors, tranched financings offer a number of benefits. By deferring the timing of investment, they can improve ROI. Later tranches are also relatively de-risked, as the investors will have greater visibility into the success of development or commercialization activities and strength of the management team. Tranches may also reduce uncertainty about a company's financing plans and the need for reserves for future investment in the company. For management and existing stockolders, tranched financings can reduce financing risk and result in less frequent fundraising, allowing management to focus more on developing their business.

Tranched financing are most commonly used where the capital needs of a company to achieve significant value-creating milestones are significant, and where intermediate milestones show a path to success but are not necessarily value enhancing. Examples include the development of a drug candidate to the point where it can enter human clinical trials. There are many steps down this path, including completion of toxicology studies, manufacturing sufficient quantities of the drug candidate, demonstrating stability of the drug candidate and the like. In other industries, tranching could occur around milestones such as the completion of beta testing, execution of important customer contracts or the hiring of key members of the management team.

Successfully structuring a tranched financing requires careful attention to a variety of considerations and the balancing of competing interests. There is no "one-size-fits-all" approach, and a variety of factors come into play.

When will the future tranches be funded? The most important consideration in a tranched financing is when the tranches will occur. In drafting contractual language, care must be given to the descriptions of the tranching milestones, which can become conditions to the closing of each tranche, triggering legal obligations to fund. Often, precise milestones are desired, both to give management comfort that if the milestones are met, the next tranche will be funded, and to give investors assurance that the company is in a position to effectively spend its next installment of capital. Clear agreed-upon milestones can also avoid disagreements among investors about when and whether to fund future tranches.

Depending on the purpose of the tranches, however, precise milestones may not always be appropriate. For example, occasionally a tranched deal is structured in anticipation that the company may be acquired. An initial tranche may fund the company through the period of potential acquisition, and investors may commit to additional funding if the acquisition does not occur in that anticipated timeframe. This way, the tranched structure can reduce dilution to existing investors if an acquisition occurs before the subsequent tranches are required. In this context, precision around the tranching may work to the disadvantage of the company and its investors by signaling to a potential acquiror the optimal timing for negotiation around closing.

A related question is who decides whether the tranching milestones are met. No matter how precise the contractual language, there is often room for interpretation. Often the determination is made by the board of directors of the company. Investor representatives should be mindful that when making these determinations as board members, they are acting as fiduciaries on behalf of all stockholders. An alternative is to require the determination be made by the investors, or a subset of a syndicate of investors in a syndicated deal (sometimes in addition to board approval), which may afford more latitude in making these determinations.

An additional consideration is whether the tranches are automatic if milestones are met, or whether investors retain discretion not to fund. Contracts can be drafted to require funding (the tranched closing "shall occur" upon the attainment of the milestones) or to leave it at the investors' option (the tranched financing "may occur" upon the attainment of the milestones). This question is also raised by discussions of whether to include a "no material adverse change" condition in addition to the specified milestones. There has been little reported litigation regarding material adverse change clauses in connection with tranched financings; however, in the M&A context, where the absence of a material adverse change is often a condition to closing, courts have generally been loath to find a material adverse change, even in the face of significant negative developments in the target company's business. Accordingly, investors should be mindful of the signal that including a "no material adverse change" clause would send to management and existing investors, and whether the potential benefits of such a clause outweigh the potential costs.

Does the price stay the same? A commonly negotiated question in tranched financings is whether the tranches should all be priced the same. Management and existing investors will often make the case that the attainment of milestones to trigger subsequent tranches should be accompanied by a step-up in valuation. The alternative is to set a single price for all of the tranches. If the tranches are priced differently, the most common approach is to use sub-series of preferred stock (e.g., Series B-1, Series B-2 etc.), so that each has a liquidation preference per share corresponding to the price of each tranche. To facilitate closing of the subsequent tranches, it is generally advisable for the company's board of directors and stockholders to approve the creation of each sub-series of preferred stock before the first tranche. Practice varies as to whether to formally create all the sub-series at the same time by including them in the company's certificate of incorporation at the time of the first tranche, or whether to pre-approve new certificates of incorporation that will be filed before each tranche closing.

What happens if all syndicate members don't participate? In a syndicated transaction, consideration should be given to the consequences to an investor who fails to participate in a subsequent tranche when the conditions to closing have been satisfied. Consequences for a defaulting investor are heavily negotiated and can vary greatly. Examples include having some or all of the defaulting investor's preferred stock convert to common stock, loss of voting rights, loss of board seats and loss of antidilution protection. The severity of the punishment for the defaulting investor may depend on how subjective the tranching milestones are, how significantly the default upsets the company's capital raising plans and other factors.

What about options?</em> If management will be receiving option grants in connection with a tranched financing, the company's board will need to decide whether to grant options based on the total potential size of the financing if all tranches are funded, or whether grants should be made on a tranche-by-tranche basis. Granting all of the options at once provides management certainty around the number of shares and pricing, but also locks in option-based compensation for a long period of time, limiting the board's (or compensation committee's) ability to make performance-based adjustments. For compliance with Section 409A of the tax code, option grants in connection with future tranches will potentially have different (and possibly higher) exercise prices than grants made in connection with a first tranche, and commitments for future grants need to be carefully drafted to avoid unintended consequences. For example, it is often required that the optionee be employed by the company at the time of the future tranche to be eligible for the grant. Whether option grants based on future tranches should have a vesting commencement date of the current tranche or that relates back to the initial tranche may also be the subject of negotiation. Another approach is to grant options in connection with an initial closing that relates to future tranches, and have the vesting on such option start at the time the future tranches close. While helping address management concerns about certainty around the option grants, FAS 123R calculations and the accounting treatment for options with non-standard vesting of this sort will be complex.