Many practitioners at venture capital funds use net present value (NPV) and discounted cash flow (DCF) as methods during their valuation process of early-stage companies. In fact, the International Private Equity and Venture Capital Valuation Guidelines focus mainly on those two methods. The weakness of these two methods is that they concentrate on a certain “expected scenario” of cashflows. For example they do not capture the flexibility of the management to adapt their strategy in response of an unexpected market development. Especially in the early stage world with strategy shifts very common, this “expected scenario” outlines a big restriction. Flexibility in the future while facing new information arrivals, which could change your investment outcome drastically, is key.
In our previous article, we introduced the First Chicago Method which addresses this problem in a trivial way. However, it is not dynamic i.e. there are scenarios which you can’t even consider right now because of their unlikeliness. This is the point where the concept of option pricing comes into play.
A broad theory has been developed over the last 50 years, first started with the celebrated Black Scholes formula. While these models initially were used to value traded options, in the recent years they found their way into Venture Valuation Methods. Benefits in a highly volatile and uncertain market are pretty obvious. The main purposes of using options are:
- Improving upside potentials
- Minimizing downside losses
This works well with Options, as they may be considered like an insurance. Actually, many venture investors are already using this concept without knowing, as they use “hedge terms” (like “anti-dilution” and such) in their shareholder agreements. Many transaction terms are equivalent to contingent claims. To differ between classic options based on financial assets and specific terms during a venture capital transaction, we will call them Real Options. Real Options are based on the investment project itself.
This fact enables a way to determine the strategic value of an asset, facing an investment/acquisition decision. Of course, this strategic aspect brings a lot of subjectivity into the process which aggravates the valuation process under the assumption of information asymmetry between the contracting parties.
Although almost all professional venture investors use Real Options in their early stage investment process, few of them determine a value for them and even less startups usually see the implied discount given to their investor when accepting them.
Due to the enormous possible ways of setting up a term sheet and/or a shareholder agreement and the subjective nature of real options, it is a complex task to develop a consistent framework for the valuation of any real option. Nevertheless, there are real options which depend directly on the enterprise valuation. In these cases, we will first calculate the enterprise value following common valuation concepts and then determine the real option value conditioned on the assumptions we used for the enterprise valuation.
This approach fits Real Options which have “direct” impact on the investment return (e.g. liquidation preference). They don’t have a direct influence on the enterprise value, rather they are derived from the enterprise value in a linear way (in other words the dependence between the value of the enterprise and the real option is linear). Hence the expectation is a linear functional, the deal valuation expresses in the following way:
Deal Value = Enterprise Value + Real Option Value
Now we want to address values of Real Options which have “indirect” impact on the investment return (e.g. vesting). In general, the value of these options are far more difficult to measure. They are more adjustments to the assumptions you considered during your enterprise valuation process (similar to the concept of Bayesian inference). For example, if you have vesting as a term in your transaction you have to consider the change in the part of the risk-factor which belongs to the team. This thoughts lead us to the following representation of the deal value (“|” means conditioned on in this context):
Deal Value = Enterprise Value | Real Option
At Venionaire we have a sharp focus on Real Options as part of the valuation process. After calculating an enterprise value, we shift to Real Options trying to the hedge certain risks and enhance the flexibility as an investor. There are Real Options with a wide scope which deliver a good adjustment for many cases. On the other side, every transaction is unique and needs its own customized Real Options. Our team developed a framework to structure transaction in a way which fits best to the investor profile as well as the current stage, industry and region of a startup.