Economic terms - tranched investments, preference dividends, and growth shares

read time: 5 mins

15.01.25

Sam Brown

In venture capital, the economic terms of a term sheet extend beyond valuation, liquidation preferences, and anti-dilution protections. Other provisions, such as tranched investments, preference dividends, and growth shares, can have significant economic implications for founders and investors alike. These terms are often tailored to the specific needs of the deal, balancing the risk and reward for both parties.

This article in our ‘Anatomy of a term sheet’ series dives into these lesser discussed yet crucial economic terms, exploring their mechanics, practical examples, and the motivations behind their inclusion in a term sheet.

What are tranched investments?

A tranched investment splits the total funding commitment into multiple stages (or tranches), with each tranche tied to specific milestones. The release of subsequent tranches depends on the company achieving agreed objectives, such as revenue targets, product launches, or regulatory approvals.

Advantages for investors

Risk mitigation: by tying funding to milestones, investors reduce their exposure if the company underperforms.
Control: enables investors to monitor progress and adjust their level of commitment based on performance.

Challenges for founders

Uncertainty: founders face the risk of not receiving subsequent tranches if milestones are missed, potentially leading to cash flow issues.
Dilution management: each tranche may require issuing additional shares, further diluting founders’ equity over time.

Example:

A VC agrees to invest £5 million in a start-up:

Tranche 1: £2 million is released upfront at a valuation of £10 million.
Tranche 2: £1.5 million is released upon reaching £1 million in annual recurring revenue (ARR).
Tranche 3: £1.5 million is released upon securing regulatory approval for the product.

While tranched investments are attractive to investors, founders should negotiate clear and achievable milestones to avoid funding delays or disputes.

What are preference dividends?

Preference dividends are payments made to preference shareholders before any distributions to ordinary shareholders. These dividends can be cumulative or non-cumulative:

Cumulative dividends: accrue over time and must be paid out before ordinary shareholders receive any dividends or proceeds upon liquidation.
Non-cumulative dividends: do not accrue and are paid only if declared by the board.

When are preference dividends used?

Preference dividends are often included in deals where the investor seeks a guaranteed return, regardless of the company’s exit valuation. They are particularly common in later-stage investments or distressed situations.

Example:

A Series A investor holds £2 million in preference shares with a 10% cumulative dividend.
After three years, the company exits. The investor is entitled to £2.6 million (£2 million principal + £200,000/year for three years) before any proceeds are distributed to ordinary shareholders.

While preference dividends provide investors with a baseline return, they can erode the upside for founders and ordinary shareholders.

What are growth shares?

Growth shares are a special class of equity designed to incentivise key employees or founders. These shares entitle the holder to a portion of the company’s future growth in value but are structured to exclude rights to the company’s existing value.

Key features

Threshold value: growth shares only participate in distributions above a pre-agreed valuation threshold.
Performance alignment: designed to reward holders for contributing to the company’s success while protecting existing shareholders.

Example:

The company is valued at £10 million. Growth shares are issued to key employees with a threshold value of £12 million.
If the company is sold for £20 million, growth shareholders share in the £8 million surplus (i.e., £20 million – £12 million).

Growth shares are commonly used to incentivise senior hires or management teams without diluting early-stage investors or founders.

Practical considerations for founders and investors

Tranched investments

For founders: ensure milestones are realistic and aligned with the company’s growth trajectory. Seek flexibility in case of unforeseen challenges.
For investors: tie tranches to measurable, objective milestones that reflect key inflection points in the business.

Preference dividends

For founders: negotiate for non-cumulative dividends to avoid compounding liabilities and ensure dividends are tied to profitability.
For investors: include cumulative dividends in deals where a guaranteed return is critical, but balance this against potential founder pushback.

Growth shares

For founders: use growth shares to attract and retain top talent without giving away control or existing value.
For investors: ensure growth shares are carefully structured to align management incentives with value creation while minimising dilution.

Analysis: founders’ perspective vs investors’ perspective

	Founders’ perspective	Investors’ perspective
Motivations	Founders aim to preserve equity and minimise risks that may jeopardise the company’s cash flow or ownership structure. They prefer terms that incentivise growth without creating unnecessary liabilities.	Investors seek to protect their capital while aligning incentives with the company’s performance. They prefer terms that balance risk mitigation with the potential for upside.
Preferred position	Tranched investments: milestones should be realistic, with flexibility to adjust if market conditions change. Preference dividends: favour non-cumulative dividends or exclude them entirely in early-stage deals. Growth shares: use to incentivise key team members without diluting existing equity significantly.	Tranched investments: milestones should reflect the company’s progress and de-risk their commitment. Preference dividends: provide a guaranteed return in uncertain or later-stage investments. Growth shares: reward management for achieving specific growth targets without eroding the investor’s share of existing value.
Risks	Aggressive terms, such as rigid tranches or high cumulative dividends, can undermine financial stability and dilute founder control.	Overly stringent terms may alienate founders or discourage future investors from joining the cap table.
Where they align	Both founders and investors benefit from terms that balance protection with performance incentives. Clear and measurable milestones, fair dividend structures, and thoughtfully designed growth shares can foster alignment and support long-term success.

In summary

Tranched investments, preference dividends, and growth shares are important tools in structuring venture capital deals. While they offer unique benefits, their implementation must balance the interests of both founders and investors.

By understanding these terms and negotiating strategically, founders can secure funding while preserving flexibility, and investors can protect their capital while aligning incentives with the company’s growth trajectory.

Read the next article in our "Anatomy of a term sheet" series, where we’ll focus on the board, exploring how its composition, powers, and decision-making dynamics are structured in venture capital deals to balance control between founders and investors.

If you're navigating the complexities of venture capital term sheets or preparing your business for investment, our experienced team is here to help. Get in touch to discuss how we can support you in securing the right deal for your business.

Our anatomy of a term sheet series

Our 'Anatomy of a term sheet' series breaks down each critical section of a venture capital term sheet, offering technical insights and practical real-world examples to help founders with their fundraising journey.

Our aim is to demystify term sheets and empower founders and their advisors to navigate negotiations with clarity and confidence.