I believe that what I’m about to say is accepted by venture capitalists as fact, even trivially obvious fact, yet very few entrepreneurs I meet seem to understand it.
An option on a share of stock of an early stage company is (for all practical purposes) equal in value to a share in that early stage company. Not less, as most entrepreneurs seem to believe (and god forbid you think “the VCs have the option to put in more money” is economically advantageous to you).
Here’s why. Black and Scholes (and Merton) won a Nobel prize for inventing the Black-Scholes model, which was the first model that somewhat accurately modeled options pricing. Using this model, and making a few reasonable assumptions (the option is “near the money,” the maturity is sufficiently far away), the key driver of an option’s value is volatility (in fact, if you listen to option traders talk, they actually talk about prices in “vols”). In public markets, options are usually priced at some fraction of the share price. This is because public stocks under normal circumstances have volatilities around, say, 20% (at least they used to 10 years ago when I was programming options pricing algorithms).
The volatility of the value of a seed stage startup is incredibly high. I don’t know if any data exists for what volatility estimate would be good to use, but for an informal analysis suppose the average volatility of a seed stage startup is 300%. Then try putting 300% into the volatility field of a Black-Scholes calculator:
So if your share price is $1, an option (European Call is a fancy word for options similar to what are given out in startups) is worth $0.9993 dollars.
This is good news for start up employees, directors, and advisors who are awarded stock options. Their options are economically as valuable as stock but have better tax treatment.
Here’s the bad news. At least since I’ve been observing early stage deals (since 2003), so-called financial innovation in venture capital has been all about creating new kinds of options for investors, each one more obfuscatory than the last.
- The first way they create options is by simply doing nothing – telling the entrepreneur “great idea, come back in a few months when you’ve made more progress.” The logic is: why would you invest now when you could invest in, say, 3 months with more information? (as VCs say, why not “flip another card over”). This is obviously perfectly within their rights and logical, but ultimately, in my opinion, penny wise and pound foolish. While the VCs might be successful with this strategy on a specific deal, in the long run they are hurting themselves reputationally and also probably by letting some good deals slip away.
- Next there is tranching – this is pretty literally an option. Even if the pre-negotiated future valuations are higher, the option has basically the same value as a share at the current price. Try the Black-Scholes calculator but changing the strike price to 10 (simulating the idea that the seed round is $1M pre and future valuation is $10m pre):
The point is with the super high volatility of startups, you can structure the option in almost any way and it’s still like giving someone shares. (I discuss the problems with tranching in more detail here.)
- Next there was “warrant coverage.” This is perfectly legitimate in many cases (e.g. as a “kicker” in a venture debt round, as part of an important strategic partnership), as long as the entrepreneur understands 1 warrant basically equals 1 share. One mistake entrepreneurs often make is to focus so intently on nominal valuation that they don’t realize their “effective valuation” with warrants is much lower. For example, if the valuation is $10M pre and you give 100% warrant coverage, the valuation is really $5M pre.
- Over the past few years with big VCs starting “seed programs” we’ve seen the emergence of situations where there is no contractual option but the signaling value of the VC’s potential non-participation gives them option-like value. I discuss why I dislike these deals here. (This might be one point on which Fred and I disagree…?).
- Super pro rata rights. This is a new term that’s popped up lately. Pro-rata rights are options, but seem like reasonable ones. If as an investor I bought 5% of your company, pro rata rights give me the right to invest 5% in the next round. They are arguably a reasonable reward for taking a risk early on. Super pro rata rights mean if I buy 5% of your company now I have the right to invest, say, 50% of the next round. This is a really expensive deal for the entrepreneur. If an investors puts in $250K for 5% of your company now with super pro rata rights on 50% of the next round, I’d just for simplicity assume you sold ~20% (assuming the next round sells 30% and the VC does half of that) of your company for $250K. (The actual analysis of the value of super rata rights seems tricky – maybe some finance PhD will figure out how to price them at some point).
Good VCs don’t mess around with this stuff. They realize that real value is created when you invest in great people and innovate around technology, not finance.
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13 comments ↓
I think the option pricing model needs more work — At such a high vol, startups should be viewed as down-and-out barrier options, for which Black-Scholes formula is not the optimal pricing tool.
Of course, I wish I could have provided a more constructive/definitive comment had I not been tied with work.
[...] rest is here: Options on early stage companies Share and [...]
Interesting post. I used to be a credit trader – not an options trader – so I don’t have the math/skills to provide an alternative, but would point out as Jerry did that Black-Scholes is probably a poor model choice to price start-up options as the return distribution is clearly not normal. (Credit also has an interesting outcome distribution – limited upside/downside of zero, effectively an option as well, but the other way round…) Would be interested if any of your (option trader) readers had some suggestions of what would be a better model, and what prices it would give for your 1x and 10x examples.
As an investor, I think options (and seed programs) can be a good thing if not used to obsfucate or confuse the founders. However I think your posts on the subject are great in terms of raising awareness of this possibility and highlighting (in plain english) some of the possible toxic pitfalls. I don’t subscribe to the ‘caveat emptor’ school of ‘if I can get away with it I’ll do it’ investing. I suspect most of the best early stage investors feel and act the same but it’s clear that the more the community can inform entrepreneurs about capital raising and capital structures the better.
If I ever get time, I’d like to write a post on why options should be used more often in early stage funding and under what circumstances (type of company, market, exit expectations, etc.) they are more or less useful (or even unwelcome.)
Thanks for the comments. I realize my treatment of options pricing here is extremely simplistic. I was just trying to get the gist across to entrepreneurs who don’t have a background in finance.
When an investor asks an entrepreneur to come back in 3 months because they found the idea to be great, the entrepreneur should sell the investor an option to delay their decision.
Voottoo Chief – I think that would be perfectly acceptable, that is if they can: in most cases however I think if the investor is dragging their heels they probably wouldn’t pay much for such an option.
When faced with first time entrepreneurs, we always are upfront about pointing out that as investors – all other things being equal (which isn’t always the case admittedly) – it is in our interests to wait for the reasons Chris points out above. Honesty is the best policy. However (good) investors know this strategy also has risks (ie the option isn’t completely free): the entrepreneur could find another investor, the opportunity might fade and/or execution risk become higher by delaying, etc.
As an investor, if you truly believe in the team and the opportunity, you will want to ‘move the ball down the field’ promptly and your interests quickly become aligned with the founder(s). It’s not a science but an art as to how quickly or slowly to move and is entirely dependent on the particular dynamics of the deal and company in question.
Again, imo the key is to be upfront and transparent about this with the founder and keep the dialog open at all times. Doing otherwise is not only cynical but ultimately bad business: in-the-money options that you let expire worthless are just that.
There’s a simple explanation of why employee stock options are equivalent to equity at the onset, independent of the distribution model used for the volatility possible exits. For all companies, a share of equity represents a call option the pro-rata future earning of the company in perpetuity discounted back to today. At day zero for a company, the equity and options are effectively worth the same as they both capture the same value with zero historical volatility. Obviously, I’m ignoring the strike by assuming it is comparably tiny.
I didn’t mean to imply there was zero volatility in my above comment, just no historical volatility (but as you stated, independent of modeling or pricing methodology, vol is incredibly high).
And yes, the tax benefits of taking options at the onset should more than offset the strike price.
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“This is good news for start up employees, directors, and advisors who are awarded stock options. Their options are economically as valuable as stock but have better tax treatment.”
Chris, this is not necessariiy the case. Non-employee Directors and advisors are not generally eligible for ISOs, so they get non-quals. When non-quals are exercised, ordinary income tax is due on the gain. This is true regardless of whether the underlying stock is sold, so you may well have taxes payable on unrealized income. This is a major disadvantage to non-quals. Gains after the date of exercise are eligible for capital gains treatment going forward assuming you meet the holding period requirements.
It is true that there is no tax payable upon the grant of the stock. In a true raw startup though, the common stock often has so little value that you may be better off getting the stock and paying the nominal amount of tax. Obviously, that is not the case in later stage companies.
Don’t even get me started on how AMT destroys the supposed tax advantages of ISOs for many people.
Meant to say “It is true that there is no tax payable upon grant as there would be with stock” in the second to last paragraph. Sorry.
Reid – yes, you are right. Thanks. My point was more about economics/finance than taxes but thanks for correcting me.
[...] deals with the intention of actually making money on those investments, instead of just looking for options on companies in which they can invest “real money.” In the meantime, however, a lot of young [...]
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