VC is options trading
Traders move the present, VC firms trade the future
VC is risky business so it’s important carefully to manage risk on behalf of our entrepreneurs, investors and ourselves. Idea stage investments that we make at Forward Partners £250k are typically broken down into three stages paid over the course of a year. Investing in stages mitigates risk and adds value for all parties throughout this fledgling year.
There are lots of good reasons for offering staged investments. It allows us to provide aspirational targets for entrepreneurs while ensuring that we agree a plan and anticipated cadence of events which helps to inform the valuation at which the next stage is invested. Taken altogether this forms a flightpath to Series A that ultimately benefits both parties.
The other side of this is the risk management angle. Intuitively, if we were to offer a £250k lump sum at the beginning of the year that would place a lot of responsibility on the entrepreneur’s shoulders and would entail us taking on a large degree of risk. There are two kinds of benefit that we derive from being able to ‘delay’ our investments / invest in stages. The first type of value is the increase in valuation of the business at each stage of investment, each up-round as it were. The second is the benefit that we gain from the option to ‘wait-and-see’ how the business performs before investing more money. Start-ups might meet, exceed and underperform relative to our expectations so there is value in being able to see how things play out.
There are so many different valuation techniques in finance — none of them perfect — and often it’s hard to know which one might be useful to apply when. When you have the ability to delay payment in anticipation of an increase in value in the future you can use option valuation.
Options are usually bought and sold in an investment-banking context for either speculation on or protection from the price movements of a stock, the price of energy, or pretty much anything else. However, the valuation techniques can be applied to a real world context. The core idea is that there are two types of value. The first is intrinsic value i.e. the value that you can easily calculate from seeing the difference between the price of the investment and the price of the asset. The second is time value that quantifies the benefit that you get from paying some money to ‘wait-and-see’ before you make a bigger investment in the future. This time value is affected both by the volatility of the investment (how well/badly the investment might perform) and the amount of time that you have before you have to invest your next bit of money.
Option pricing is directly applicable to staged or tranched investment — some people call it ‘Real Option Pricing’. The time between investments represents the opportunity for start-ups to flourish and to use our team to increase their chances of success. As we deliver each stage of investment the valuation of the start up changes. The uptick in business valuation between tranche each represents intrinsic value. The time that we get between the tranches to help and to assess the start-ups — time value — can be quantified using options. The same logic can be applied to the same investor in different rounds (given adequate pre-emption provisions).
Let’s take an example. We’re thinking about investing in a business and over the course of a year we will deliver three tranches of £30k then have an option to invest another £90k then a further £130k. Between the first and second tranche we anticipate that the business will become twice as valuable. Between the second and third we anticipate that the business will become half as valuable again. That means that if we invest £30k at the start, that money will be worth £60k at the time of tranche 2, and then £90k at the time of tranche 3. The intrinsic value of each of these valuation jumps is £30k. There will also be some intrinsic and time value associated with the uptick between investing the 2nd and 3rd tranches.
Time value, because of the volatility of outcomes, is difficult to calculate. There are plenty of models to use however. I’ve used the market standard here — the Black Scholes model. If you are investing in companies in stages you are effectively buying call options (the option to buy further into the company). Here’s how it works along with a little bit of jargon explanation:
Now we have our framework, it’s time to put the data in from the example scenario outlined above. For this example we’ve assumed that the volatility is 100%. This might be an exaggeration but it certainly reflects the highly unstable and uncertain world of start-ups.
We have some interesting results. In the first instance the time value of the option is actually negative! This reflects the highly unstable environment and the proportion of our investment at risk (all of it). However, from there things start looking up. The options to carry on our T1 investment and invest our T2 through to T3 provide positive time values. These time values — the value of being able to wait — are actually 13.6% of the value increase that we expect to see in the business.
The valuations of businesses at this stage are highly subjective — they’re often not based on cashflows or anything totally quantifiable. There are also some (very) large assumptions that you have to make in your option calculations. Nevertheless this kind of analysis helps us to focus our minds. Investing in start-ups is highly risky, no more so than at inception (where time value is negative). This is far from a panacea for deal analysis but it’s another tool for us to assess our decisions.
Furthermore, this quantification of risk provides more evidence that the investment studio model has grounding in theory and practice. We take daring (absurd to some) risks, we do it responsibly and we’re well aware of what we’re getting into.