op·tion·al·i·ty: The value of additional optional investment opportunities available only after having made an initial investment
In other words, optionality is the sum value of all options created by a decision.
If a decision creates no new options, it has no net-new optionality. If a decision forces you to one outcome, it has zero dollars of optionality and in fact has net-negative optionality. The best decisions create net-new optionality. Those are the nice juicy decisions that lead to great financial outcomes.
One of the most important lessons that I have learned from my father is that “optionality creates real value.” On optionality, in his own words, he says: “Very Few People ‘Get’ This… But It’s Worth So Much Money.” In his world, optionality is the option on the precious metal discoveries made on the land by the operators of their royalty properties. But optionality is by no means limited to the natural resource industry. It absolutely applies to technology startups in financial tech or otherwise. While it’s important to keep the concept of optionality in mind at all times, I’m going to focus on three areas of particular importance to startups.
Optionality of product/market fit is the trickiest one to get right. On one hand, you want to focus on a specific product and market and find fit as soon as possible. However, focus taken to the extreme, can easily put your company in a situation where it’s building a product for a single unique customer. I’ve seen it happen more than once. Having one customer is neither scalable nor fundable. There is zero optionality.
On the other hand lack of focus kills startups. Every aspect of every product requires development, testing, marketing, and distribution. The probability of failure goes up exponentially as the number of product features increase. There is no optionality left when you’ve run out of runway and still have no product.
Maximum optionality on product is achieved when you’ve focused sufficiently on a small feature set in a reasonable market with large tangential markets that provide significant optionality.
Don’t underestimate how hard it is for ventures with unusual corporate structures or cap tables to raise capital. No excuse is too feeble for investors to say no. Non-conforming corporate structures appear to especially be an issue with Canadian startups. I never saw this as an issue in SF/Valley but I’ve seen this repeatedly, and far too often here. The litany of issues I’ve seen in the last five years includes:
- 50+ investors on the cap table
- Multiple millions in convertible debt
- Publicly listed investors on the cap table
- Participating preferred shares
- Aggressive liquidation preferences (this I did see in the Valley)
- Non-ESOP warrants and options on the cap table
Most of these are fair game for a natural resource venture raising money on Bay Street. However, when it comes to fundraising for your tech venture each of these issues removes optionality. To avoid this keep your options open: raise capital in the form of equity with simple preferred shares, and keep the number of investors you have down to a minimum. Avoid the merchant banks, exempt market dealers (EMDs) and anything to do withRTOs or IPOs on Canadian exchanges. The last thing you want to do is lock yourself out of C and D rounds from Valley investors. If you’re looking to raise $75mm+ for tech venture, the only viable source of capital is in the Valley and they won’t touch you if you’re public or have any number of other cap table issues. Again, no excuse is too feeble. Why give up optionality? For an extra million or two in valuation? Forget it. That big valuation may in fact be a hindrance.
Probably the biggest loss of optionality comes from the inflated post-money valuation that we are seeing more and more often. Your post money valuation is very simply the lowest value that determines how far you have to build your company to be able to raise money again. It’s easy to fall into this trap: which founder wouldn’t want the (false) sense of accomplishment of raising money on the biggest pre-money valuation you can get? The problem here is, as long as you are pre-profitability the larger your post-money value is the less optionality you have going forward on fundraising. To maximize optionality, you’ll want to raise money on a valuation that gives you, the founder, the ability to raise more money in the future with some wiggle room for any number of normal startup issues: stalling growth, inability to hire fast enough and so forth. I haven’t found a single startup yet that’s had absolutely flawless execution.
Never give up optionality. Keep your corporate structure/capital table clean and valuations reasonable.
Likely the biggest destroyer of optionality for a startup is exit potential. After 50+ investors, the next most cringe-inducing startup mistake I see is some iteration of “Our only exit option is to sell to X, hopefully before we run out of cash ” This creates zero optionality and zero potential for any real monetary gain for either the founder or investor. Why? Because knowing they, X, are the only potential buyer, they aren’t likely to over pay.
Optionality comes when a startup has a virtually limitless set of options:
- Keep the company private and growing forever: aka cash cow
- Acquired by any number of companies
I understand it’s hard to consider the exit potential of your startup at the beginning but, if you can, make sure to keep as many options open as possible for as long as you can. I’ve seen too many tech startups cut themselves off from various exit scenarios for questionable reasons.
Whether you are a founder or a funder: real wealth creation comes from optionality. Don’t ever give it up.