What are tranches in stocks?

Tranches in stocks refer to the process of dividing an investment into different segments or portions, each with its own specific terms, conditions, and characteristics. 

Tranches are very important to understand if you’re an advanced investor who selects stocks for the long-term. While most retail investors usually invest in the same tranche, institutions usually have access to others too.

In this article, we’re going to understand the concept behind tranching a financial instrument, what it means, and how you can choose the investment tranche in equity that best suits your investment needs.

What is a tranche in investment?

A tranche is a French word that translates to “slice” or “portion.” In the investment world, it refers to a specific segment or portion of a larger investment opportunity or fundraising round. 

Tranches are used to structure and differentiate various components of an investment or financing deal, allowing for different terms, risk profiles, and potential returns.

Understanding investment tranching with an example

Imagine investors financing a new apartment complex construction. Instead of funding the entire project upfront, they break it down into tranches or smaller portions.

The first tranche covers initial costs like land and permits – higher risk but potentially higher returns.

Subsequent tranches fund construction, interior work, stabilisation – each with its own risk/return profile.

Tranches allow different investors to participate at various stages based on their risk appetite. Early tranches are riskier but can yield higher returns, while later tranches are less risky as the project progresses.

Why are tranches created?

Here are some broad reasons why investments are tranched into different risk and return profiles:

• Effective management of risk: Tranches allow investors to diversify their risk exposure by investing in different portions of a deal with varying levels of risk and potential returns. Lower tranches usually have more risk (but also more reward) and vice versa.
  
• Staged financing: Startups usually require different stages of funding during their life to take care of their capital needs. The earliest investors in a company take on the most risk, and subsequent investors take less and less. Tranches, hence, enable investors to invest in the round that best matches with their risk and return goals.

Types of tranches

Tranches can take various forms, depending on the specific investment. However, in this article, we are only covering equity tranches. Here are some common ones.

Seed / Series A

This early stage tranche is typically used to finance a startup’s initial operations, product development, and market entry. Investors in this tranche face the highest risks but also have the potential for substantial returns if the company succeeds.

Series B / Series C

As a company grows and requires additional capital for scaling operations, marketing, or expansion, later stage equity tranches like Series B and C are offered.

Preferred equity

This tranche involves issuing preferred stock, which has preferential rights over common stock in terms of dividends, liquidation preferences, and other protections. Since preferred shareholders take less risk with their capital, this fundraise is usually treated as debt on the company’s balance sheet. Hence, preferred investors also have their upside capped. 

Common equity

The common equity tranche represents ownership in the company’s common stock. This tranche often has the highest potential returns but also the highest risks, as common shareholders have lower priority in the event of liquidation or exit. This is also the tranche you usually buy when trading stocks on the NSE or BSE.

Employee stock

Companies may set aside a specific tranche of equity for employee stock options or compensation plans.

Valuing and structuring different tranches

Here are some things to note about the equity tranches introduced above:

• Different tranches may be valued differently: Since these classes have different risks, they are valued differently for investors. As a general rule, if you take higher risk, you have a potential for greater returns.
  
• Liquidation: Different tranches get different priority if a company is liquidated. For instance, debt – which is senior to equity – gets paid back first if the company is sold for parts. Equity holders get whatever is left over.
  
• Protective provisions: Some tranches may also include specific protective provisions or veto rights for investors, particularly in areas such as future financing rounds, management changes, or major strategic decisions.

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