Awesome post.
Nebojsa Lazic

Yes, that’s right. And when you look at actual early-stage deals, unless there is some other exceptional factor (like repeat founder, etc.), the valuations are about in line with what actually happens in the real world.

As a practical matter, the $2M is the premium for the option, with the strike is the same as the spot at inception. (This is true because if you do absolutely nothing you will have precisely zero value at the termination of the option [time 1]; thus, at time 0 the strike and the spot are equal.)

You’ll also notice that the first positive move above neutral is no less than $15M. This is a function of the math, but it’s still interesting to note that this is roughly what you’ll need in a pre-money to get another round of funding if the last post was around $6.5. (Anything less, and there isn’t enough for new investors to get their 20%.) So either you create enough value to make it worthwhile for new investors, or you’re worthless. And again, you’ll see things like bridge loans and down-rounds at this stage, but they are quite rare. Mostly the investors just let the options expire.

BTW, this is also why most angels absolutely insist on pro-rata rights. They know they aren’t going to get huge returns on their relatively small initial investments; they are buying the strike price of the next round. Yeah, it’s called “doubling down”, but it really is option exercise for anyplace where the spot is above strike.

I’m writing another post with the algorithm in detail. Follow my account to get it when it’s done.