Angels and Options

Understanding how pre-growth investors should view their portfolios.

Angels that invest in pre-growth startups essentially are considering this pitch from founders: “We have this idea that we think will grow. If we prove that, we’ll need a lot of money to grow it, but we’re not sure how to do that yet so please give us a smaller amount to figure that out.” If the angel investor thinks there’s any potential at all they make a small bet. If growth materializes, they double-down by investing in future rounds; if not, they walk away. In essence, the angels are paying a small premium to delay a larger investment decision until they know more about the market — which pretty much describes an option.

Here’s how an Angel investment maps to a traditional option: (Note: I’m going to use a bit of option-lingo here, so if you’re unfamiliar with the terms then see this post to familiarize yourself with the basics.)

  • The option premium is the angel investment itself.
  • The option expiration date is the investment divided by the burn rate.
  • The option right being secured is the pro-rata to the next round.
  • The option strike is the investment required for the next round (implied, and sometimes explicit when using instruments like capped notes.)
  • The option exercise event is buying into the next round.
  • The option spot is the post-money valuation of the next round.
  • The option price is the strike less the spot (i.e. the pre-money valuation.)

In short, all of the components necessary to create an option are present in these transactions. With this, we can access the broader set of tools and investment strategies developed for traditional options.


Early-stage investors that recognize this dynamic have greater insight in how to organize and manage their portfolios. For instance, Dave McClure of 500 Startups recently went on a tirade noting that investors should not be asking for revenue projections from startups because they are nothing but lies.

Founders remotely honest with themselves know that revenue projections for pre-growth startups are total fabrications, but if they are demanded by investors then a founder is going to produce them. Some unscrupulous investors may later use the (invariably missed) projections as a pretext to beat down the entrepreneur on subsequent valuations, but even absent such malfeasance once revenue projections become part of “the plan” then founders feel the pressure to deliver on the promise even if it was unrealistic at inception.

In the investors’ defense, VCs are in the business of generating returns like any other fund manager and can’t be expected to just throw money around without some indication of the payback. Still, investors need a model that can produce an ROI calculation without employing fantasy revenue projections that distort the entire process.


I’ve developed such a model (called Innovation Options) based on well-known option-pricing methods that basically works like this:

  1. It considers a series of possible outcomes (good/bad/indifferent), then
  2. It determines the terminal value for each possible outcomes, then
  3. It sums the discounted expected values of those possible outcomes into a specific valuation at that point in time for that series of outcome, then
  4. To find the actual value, we simply need to determine which of the possible outcomes is real.

Here’s a quick visual to help.

Each node on this pricing tree shows a hypothetical outcome for an investment. At the beginning (on the left), any outcome is possible: from roaring success (up and to the right) to total failure (crash and burn.) As the project moves through time, we learn more about what’s real by testing the market, and our assessment of that activity represents the actual path, with the option value adjusting to the new reality accordingly.

Remember, the core value of an option is the ability to delay an investment decision until more information is known about the market.

So we see why McClure asks not for fantasy forecasts, but actual metrics: by determining what’s real we can not only get the answer to the over-arching question (should/can we exercise?) but also a sense of the value we’re creating in real-time. Meaning: each node in the pricing model represents the expected post-money value of the startup at that point in time for that set of metrics.

This also explains that while he doesn’t need to see revenue he does need to see marketing (i.e., growth) plans and projected expenses.

These plans are the strike price of the follow-on investment; if things hit, what will it take to fund the growth? Knowing the strike is required to get an accurate assessment of the option premium (i.e., the appropriate investment for this opportunity.)


The option-based model is not without its own risks: it is susceptible to GIGO in either the assessment of progress or the final market potential of the opportunity. If either of these turn out to be wrong then the valuation will also be wrong as well. Still, when compared to traditional cash-flow based methods that require projections which are impossible to forecast by definition, the advantages of the option-based approach as a more realistic framework for early-stage valuation are clear.

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