In my post, Should You Tranche Fundraising?, I discussed why an entrepreneur might want to stage the funding of their business.  There are also reasons why VCs often prefer to capitalize the company through a series of investments.  The two key reasons for this are mitigating risk and optimizing ownership.

Risk Reduction:  The first and foremost reason VCs want to allocate capital to a company through a series of investments is that it enables management to demonstrate their ability to execute against a number of operational challenges before more capital is put at risk.  

For example, let's assume a VC intends to put $5 million into a company over its lifetime.  Let's also assume that the major execution risk faced by the company is getting customers to pay for the company's service.  In this scenario, the investor has two options - they can put all $5 million into the company on day one, or $1 million, which is just enough for the company to go out and sell a few customers and prove that they are willing to pay for the service.  If it turned out that customer are not willing to pay for the service, the investor who chose to tranche their investment will have preserved $4 million.

It's generally very difficult to take invested capital out of companies, so it is often better for investors to only put it in as their confidence in the opportunity increases.

There are other considerations in the decision to tranche an investment. I will discuss the impact of tranching on investor ownership in my next post.