The asset and its optionality
Enterprise value is made up of two elements: the asset and its optionality. The asset is the business everybody knows, and which defines the enterprise in present form, the base. Optionality is the future possibilities, unknown and perhaps unknowable.
At the inception of a business, the ratio of optionality to asset is very high, maybe infinite, and this diminishes as the business grows, matures, and takes a shape. Though optionality doesn’t altogether vanish, unless the business does… Even the staid electric utility may one day become an electric vehicle manufacturer, or vice versa, which combination may lead to a multi-sided market and a payment platform and eventually a bank… and it all started with the lightbulb.
It’s all possible, it isn’t known, at best it’s dreamed about and speculated. But some assets may inspire greater dreams and speculations than some others, which optionality is theoretically captured in the value that is recognized and awarded. It’s all, or almost all, about the distant future, though the proportions and the distances may vary.
The asset and its options are connected, and sometimes, in essence, the asset is its options. Uncertainty is high, and capital is venture capital.
A view through the conflation
With the above by way of backdrop, the recent discourse on venture flows and valuations — particularly as the narrative of overpriced unicorn IPOs and their post-IPO performance takes hold — is in substance incomplete.
Before the IPO, the private market value that is set is typically reflective of a preferred equity structure with top-most ranking in the preference cascade — a waterfall that usually also flows past other preference layers on the way down to where the common stock awaits, in line behind the satisfactions. This is a structural protection against unknown/unknowable risk dynamics, as described.
It’s not to say that things play out this way in life with the successful ventures, but theoretically they could, and deals get done the way they do to address the risk that’s taken, before the benefit of hindsight. So it is less cavalier than it may be imagined, to set a value way up high when there’s an asterisk and footnote in the fine-print, before the preferred shares convert and become common.
What’s more, the private market can’t be shorted, so value is not consensus value but long consensus only, and only the most bullish longs among them. On one hand, thus, private rounds are inherently optimistic, while on the other hand, inordinately cautious… And with such idiosyncratic aspects back of mind, the semblance is not between the mega private round and IPO, but between the private funding and another private type…
Bridge Finance — which, truth be told, is characteristic of all private rounds — early, mid, late, a bit of each, indefinite…
The skin and the game
These things that are discussed are aspects of asymmetry. When one party has more (or different) information than another, or when one has more (or less) control, or more (or less) at stake, or greater (or lesser) resources. One equalizer, as the story goes, a way to keep all parties honest, motivated, balanced, and engaged, is having skin in the game.
The story, as recently popularized by Nassim Nicholas Taleb in his collection of essays, has a much more nuanced plot than the summary slogan might imply. The notion of standing to lose proportionately with one’s wrongness seems straightforward enough on the surface, though proportions aren’t always accurately measurable, just as loss and wrongness also sometimes appear arbitrary and subjective.
But the professor’s idea isn’t as much about nuance within the concept as to draw contrast with instances where there is none. Such as, for instance, the insistent suggestions of an author, say, who has no interest in the outcome of being taken seriously. But even then, there is reputational damage, or its risk, at least in principle, which can lead to other kinds of losses, more quantifiable in nature.
Then there’s the conceptual opposite to consider, the talking of one’s book. This is the case where skin is clearly in the game and the investor is at risk, but, just because of this the views and insights shared are to be taken with some caution. There may be comfort knowing that the captain goes down with the ship, as it were, but for passengers along for the big sail that comfort may be fleeting, especially not really knowing the captain’s circumstances…
That is to say, the loss may matter much more to the follower than to the leader, if the latter has a more diversified portfolio of gains and losses. In some cases the portfolio is so large and so diverse, you have to wonder if there is really any skin in the one game at all, whereas, on the other hand, the follower may be all-in.
A more practical dynamic — particularly for the complicated world of business building — which relates and overlaps with investment complexities and financial needs, is the following:
Authority without responsibility is no skin in the game at all, just as responsibility without authority is probably all skin and very little game, so to speak.
This also is a symmetry dynamic needing constant care, and seems a segue to the next and final sections, on communication, balance, and support.
Moneyball and rings
In the cascade, value is created from below. The common stock, subordinated, will make the senior preferred rise as common gains in value. The cause is not that prefs surpass their baseline preference or the value that was set by the investment, but that the common down below expands to make it so.
The value that’s created there is in the asset, made by execution. The other value element of the enterprise, its optionality, is all in the beholder’s eye, and anyway once that takes form it isn’t option value anymore but an addition to the business.
Solid and consistent execution is the hardest of all things in a team context… combining, as a group, energy and inspiration, organization, diligence, persistence, connectedness, and obviously skill… But more than skill alone, a way to fit the unique skills of individuals into a cohesive blend that’s rhythmic and harmonious, even if the movement appears scattered.
And even then, with all conditions met, resources may not be enough, and circumstances change, unplanned and unexpected… the competitive environment, economy, customer delays or new requirements, defections or new roles that may need filling… it’s a turbulent affair, which, when successful, makes or adds to or perfects the asset. A thing of beauty.
As in sports, this is a win, which needs to be repeated and continuous, the sequence incrementally more challenging with added size and expectations and the progress of the seasons. At the common level, down where the players live, below, the exercise is one of chemistry. In the sports analogy this is akin to basketball, which is akin to music, and which the best teams will have mastered.
But for the preferred that is above, with a diversified portfolio and glimpses of each business from the top, the game might sometimes seem more as in Moneyball, which is to say, statistical analysis.
It’s a game of hits, they say, referring to baseball batting averages.
Perhaps the best investors, those with consistently superior returns, or, if you will, the best performance at the plate, have an innate understanding of the game’s dynamic — the game in its totality — mindful of the role they play around the team, the difference between assist and interference, between a steady hand that makes all players better and the barbell of neglect and dominance.
In the end, the players win the games, and when they do, the value of the whole increases, for the glory of the coach whose star will rise, up above the common layer.
Finally, the other side
To listen is a precondition and a practiced skill, up and down the ladder, all the way around. Big or small, the value of the speech is asset value, the value of the listen, optionality. Substance grows and its potential rises as the option/asset ratio also does, much as in any startup.
Whether downward up or upward down; anywhere in the cascade, and at any stage of asset evolution; regardless of the game, with skin in it or not… the mathematician’s wartime precept, by the same token, governs: “What can be said, can be said clearly. Whereof one cannot speak, one must remain silent.”
Everyone is in the venture business, in the end.
The preceding were originally published separately in my daily journal of snippets about markets, other networks, technology, finance, books, and assorted other subjects. The selections seem to fit together, and collectively comprise a longer post for the benefit of those who like their reading longer.
Related reading: Finance notes from underground