Optionality in venture funds
Investing where cards are being shuffled
There are several ways to frame participation in early-stage companies from a financial perspective. One is the Buffett way—a fundamental analysis of future free cash flows. And, while it’s healthier than several other schools, it fails to capture multiple nuances of early-stage companies.
Fundamental analysis approaches the problem from a deterministic position of minimizing randomness and hence excels in markets and businesses where the future is likely to look a lot like the past. While it gives a healthy framework for venture investors later in the mature phases of a company’s journey, it is not rich enough of a perspective for early-stage companies where uncertainty is extreme and more often than not, investors are placing their belief on the discontinuities between the past and the future of a market.
I’ll try to frame a different perspective here that is quite familiar to most early-stage investors which is optionality, mainly preoccupied with positioning in an asymmetric way to win big if a certain future plays out vs. predicting a particular future with higher accuracy.
What is a call option?
A call option is a derivative financial product between a buyer and a seller where the buyer obtains the optionality to buy a pre-determined quantity of the given security (S) at a pre-determined price (strike, K) before a pre-determined contract expiration date (maturity, T). Hence, the payoff of a call option is max[S−K, 0] at any time (t) before T, minus the fixed price paid to buy the call option at t=0.
Call options with a security price (S) that is lower than the strike price, hence without any intrinsic value, are called out-the-money call options. Such options only possess time value, basically the chances of security overshooting the strike price before the option expires. Far out-the-money options are where the security price is further away from the strike price (K), hence possessing a low likelihood of paying out anything. That makes them cheap but with an asymmetrically rich upside relative to their initial cost in case of a payout—in a way that’s quite similar to investing in early-stage startups.
A venture fund is a portfolio of (far out-the-money) call options
It is often discussed how early-stage companies are similar to call options. Here, I’ll attempt to expand on the idea.
Early-stage startup equity is not equity in the common sense definition as the right to participate in the free cash flow of a business. Reasonable early-stage investors are aware that an early-stage company will not have any free cash flow in the near term and attempts to forecast it is wishful thinking.
Similar to the strike price (K) of a call option, for an early-stage company to be worth something, it is required to hit a minimum threshold of de-risking and size. The rest usually go bankrupt, become zombie companies, or minor acquisitions that don’t matter to the investor.
For an early-stage investor with a closed-ended venture fund, investments are often time-bounded and need to be liquidated to be distributed to limited partners. So, on average, every early-stage check has a maturity (T) of 10-12 years—and investments are often liquidated as they hit particular thresholds (+$1b, $10b+, etc.) corresponding to the strike prices (K).
Both out-the-money call options and early-stage investments rely on trading fat tails, extreme events of low probability. The investor knows that the chances of a payout are low, but the chances of an extreme payout are not as slim as many other market participants (or a normal probability distribution in the case of call options) would think.
Both out-the-money call options and early-stage investments have convex pay-off distribution. Similar to an out-the-money call option where the downside is limited by the option price that’s often quite cheap and the upside is unbounded, the cost of participating in an early-stage company is limited by the initial sum that was historically cheap in comparison to the expected pay-off in case of a payout.
Overall, participation in an early-stage company can be seen as a far out-the-money call option with:
The strike price (K) which is often based on the target of returning the fund, which is a multiple of the entry valuation and ratio of the check size to the fund size. It can also be based on reaching a certain magnitude of outcome ($1b+, $10b+, etc.), but again, the selection of such targets will eventually depend on the particular fund size and entry valuation.
The security price (S) which is lower than the strike (K) by a large difference given the security price of an early-stage startup is zero in financial terms but determined arbitrarily based on capital needs and the bargaining power of the entrepreneur.
The maturity (T) which is often 10-12 years for early-stage funds, gets shorter and shorter as one moves to invest at later stages.
Trading volatility and time
Options traders not only trade the security price but also volatility and time as the option price is highly sensitive to all of these.
![{\displaystyle {\begin{aligned}C(S_{t},t)&=N(d_{+})S_{t}-N(d_{-})Ke^{-r(T-t)}\\d_{+}&={\frac {1}{\sigma {\sqrt {T-t}}}}\left[\ln \left({\frac {S_{t}}{K}}\right)+\left(r+{\frac {\sigma ^{2}}{2}}\right)(T-t)\right]\\d_{-}&=d_{+}-\sigma {\sqrt {T-t}}\\\end{aligned}}}](https://substackcdn.com/image/fetch/f_auto,q_auto:good,fl_progressive:steep/https%3A%2F%2Fsubstack-post-media.s3.amazonaws.com%2Fpublic%2Fimages%2F9d708887-048f-45b1-802b-7bbe70b4bb68_425x105.svg "{\displaystyle {\begin{aligned}C(S_{t},t)&=N(d_{+})S_{t}-N(d_{-})Ke^{-r(T-t)}\\d_{+}&={\frac {1}{\sigma {\sqrt {T-t}}}}\left[\ln \left({\frac {S_{t}}{K}}\right)+\left(r+{\frac {\sigma ^{2}}{2}}\right)(T-t)\right]\\d_{-}&=d_{+}-\sigma {\sqrt {T-t}}\\\end{aligned}}}")
The Black-Scholes formula above also informs us on the implied sensitivity of an option’s price concerning security price, time, volatility, etc. Many traders delta-hedge their book by short-selling a certain amount (delta) of the security to be directionally neutral of it and to isolate their volatility exposure—not caring about the price itself, but caring about its volatility.
That is often overlooked by early-stage investors, but some smart investors and angels apply these principles. One good example recently was an angel investor selling NVIDIA stock to invest in an early-stage semiconductor company—that is a directionally neutral trade on the market, but creating extra volatility exposure substituting the early-stage company for a mature one.
Similarly, most venture funds perform better in a market of steep ups and downs rather than steady growth. If you own something worth nothing, the dispersion of the potential outcome increases the likelihood that this will be worth something. Imagine the simple scenario of a zero-sum coin toss (heads is +10 and tails is -10) where you own a call option with a strike of 0. Fattening the tails (heads is +20 and tails is -20) increases the value of the call option without an impact on the expected value of the bet as the call option only captures the upside. The same applies to the value of venture portfolios as they have convex pay-off structures like call options, built to capture right-tail events.
Time is another underappreciated concept as early-stage companies, similar to out-the-money call options, rarely have any intrinsic value but only possess time value, namely the chances of a company hitting a critical scale within a given period. Hence, early-stage portfolios bleed money with time. In the absence of clear de-risking to shift the underlying probabilistic processes, the value of an early-stage startup doesn’t remain the same but decreases over time as the clock is ticking—that puts a higher bar on follow-on investments. And, efficient capital allocation often buys time for startups as many investors rightly point out that one might be surprised at how fast things might improve for smart teams with enough runway iterating quickly in the right markets.
Investing where cards are being shuffled
We tend to index what has worked before. The future often rhymes but doesn’t repeat the past. Looking back on the past decade, one can observe how cloud and mobile have created massive companies and crowned multiple venture funds as beneficiaries. However, one needs to consider that these markets might have matured and are not as high-volatility environments they once were whereas early-stage companies instead thrive in market dislocation that creates high volatility and high chances of multiple right-tail outcomes.
Similarly, for investors, domains with shuffling of cards create fruitful open spaces to be positioned with a couple of successful initial bets, and then to compound this initial network, brand, and judgment to be crowned as the new kings. Many times, we’ve seen paradigm shifts challenge the position of power of successful venture firms and some struggled to stay relevant paving the way for the new ones—both created and destroyed many venture funds1.
Paying more for call options of lesser optionality
One thing where call options differ from venture is pricing. While options traders (and resulting market dynamics) are meticulous in their pricing, early-stage valuations are often a factor of market sentiment, startups’ capital needs, founders’ bargaining power, and thumbsuck on the side of investors.
And, interestingly enough, while the strike price (K) is exogenously determined for call options, for startups it is endogenously determined by founders and investors who set the valuation for the investment round. An example is that once a startup raises seed capital at a $100m valuation, then the next successful step is finding someone to capitalize the company at a valuation north of that number (ideally by multiples) which is a lower likelihood vs. the company which fundraises at a $20m valuation. The same idea applies to the necessary scale the company needs to reach for a successful exit as the same number (valuation, hence strike) is part of the mental math of all investors. From this, it follows the popular idea of not fundraising at a spuriously high valuation2, as it turns the startup into an option with a higher strike price (K), that is probabilistically worth less as now the startup would far surpass that valuation in a lower number of potential futures. Funnily enough, investors end up paying more for such early-stage companies.
Venture capital has a pay-to-play nature, where not only bad investors, but many good investors often pay up as they mature to make sure they are part of the biggest success stories partly since they can afford it (and need it) with more capital and credibility, partly due to their more granular and selective pattern recognition, partly due to the shifts in motivation as they value their time and effort more.
On the other hand, when many market actors do so to catch a few companies, this deprives the investment of its optionality, creating regression to the mean. When it becomes systematic, overpaying is an effective way to kill the whole portfolio’s optionality. While one can only hypothetically argue that the chances of a better outcome tomorrow increasing, one can be certain of paying more today.
For LPs, all these mean that one needs to position in markets that have high volatility and are reasonably priced3, be it certain domains or geographies, or certain pockets of talent, to maximize the upside asymmetry. It also means that one cannot afford to create static strategies in a backward-looking way and expect venture-scale returns, rather bet on discontinuities and update the strategy and the resulting portfolio along with the market shifts.
Although, it affords extra time value for the startup as it gives potentially longer runway with less dilution.
Still, one needs to recognize the existence of adverse selection and some exceptions where you release some constraints might pay more than the rule in venture.