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VC Cliche of the Week
Several years ago, we were offered the opportunity to sell our interest in Inteliseek, which was merged yesterday into the new Nielsen Buzzmetrics. We declined the opportunity because although the offer for our stock was fair value given where the Company was at the time, we felt that our stock had option value.
Option value is a cliche I hear a lot in the venture capital business and it is fundamental to what we do, particularly the early stage venture business.
I believe that regardless of the "valuation" placed on the Company in most first round investments, what you are really paying for is option value.
Option value means the potential for a gain. If you own 20% of a company, you own 20% of the current value plus 20% of the potential upside. It's the latter that I am calling option value.
I heard recently about a book or an article that made the case that options are bad. That people actually prefer less choice not more choice. That may be true in real life, but it is certainly not true in money and finance.
Options, particularly long life options, which is what early stage stock really is, are very valuable. It's hard to value these instruments with traditional option pricing mechanisms but we know that if you hold onto them and good things happen with the portfolio company, you are going to get rewarded.
So the next time you buy or sell early stage stock, think less about the current value of what you are buying, because there honestly isn't much value in an early stage company, and think more about the potential value creation, the odds of success, and the time frame it would take to get there, and value what you are buying or selling as an option. You may be surprised at the results of that analysis.
January 18, 2006 Venture Capital and Technology | Comments (4) | TrackBack (0)
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another useful concept that relates to "option value" would be PVGO - or present value of growth opportunities
Posted by: Simran | Jan 18, 2006 1:12:49 PM
Well option thinking also applies to alot more than just startups.
Every very large industrial project has "real options" built into the plan.
An excellent investors resource is Michael J. Mauboussin's book:
Expectations Investing
http://www.expectationsinvesting.com
see also some of his free PDFs.
http://capatcolumbia.com/Articles/FoFinance/frontier1.htm
The HBS book on "Real Options" is also good for the PHBs.
But I would assume that stagewise options analysis is the core of any significant decision making process, and if its not it should be.
Posted by: Charlie Sierra | Jan 18, 2006 9:02:30 PM
Thanks for the reassurance. I am having difficulty raising money for my venture www.1num.com and had begun looking at drastically changing the valuation. The "option value" hasn't changed so I will hold close to our original valuation.
Question: If "option value" plays in a VC's thinking then why do I get hammered with a "pre money valuation"? The "pre money valuation" is close to 0 (as with most seed money deals). It is the "option value" they are buying. Thanks for the post.
Posted by: brandon McLarty | Jan 20, 2006 3:43:24 PM
Brandon,
You get hammered on pre-money valuation in a seed deal because those take a lot of time, energy, and attention, and as a result the VC wants to own a significant piece of the business in order to get paid for the underwritten risk and attendant effort.
Pre-money valuation a seed deal is almost a meaningless concept that as a VC we back into. "given that today there is no business here, what is the amount of capital it will take to create something of substantially more value [product prototype, team assembly, first customer or even just market validation, etc.]?" Let's say that's $X. "Well, I want to own 1/3 of the company for $X so the Pre-money valuation is $2X and the post will be $3X and I'll own 1/3 of it."
If $X is a small enough number and you don't want the dilution or the VC's help in getting to your next value inflection point, you can always write the $X check yourself, hit that next inflection point and get yourself a higher pre-money valuation.
Just don't be surprised when the pre-money value you get if you need $Y in the next round is $2Y and the VC wants 1/3 ownership...
Posted by: just.a.guy | Jan 25, 2006 1:01:22 PM
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