Angels and Options

This is the Founders’ pitch to Angel Investors:

“We have this idea that we think will grow, but we aren’t sure. Please give us a (relatively) small amount to prove that it’s the Next Big Thing(TM). Like most startups, we’re likely to fail — but if we succeed we’ll need a lot more money and you’ll have the inside track on that opportunity.”

If the angel investor believes in the growth potential, he participates in the round. If growth materializes, he doubles-down by investing in future rounds; if not, he walks away. In essence, the angel is making a small investment today to have the opportunity to make a larger (and more valuable) investment in the future when he knows more about the market. And while this smaller investment commonly takes the forms of preferred shares (equity) or a convertible note (debt), for all practical purposes the angel investment is an option.

Here’s how an Angel investment maps to a traditional option: (Note: I’m going to use a bit of option-lingo here, so if you’re unfamiliar with the terms then see this post to familiarize yourself with the basics.)

Early-stage investors that recognize this dynamic have greater insight in how to organize and manage their portfolios using the broad set of tools developed for option investing. I’ve developed such a model from those tools (called Innovation Options) based on well-known option-pricing methods that basically works like this:

  1. It considers a series of possible outcomes (good/bad/indifferent), then
  2. It determines the terminal value for each possible outcomes, then
  3. It sums the discounted expected values of those possible outcomes into a specific valuation at that point in time for that series of outcome, then
  4. To find the actual value, we simply need to determine which of the possible outcomes is real.

Here’s a quick visual to help.

Each node on this pricing tree shows a hypothetical outcome for an investment. At the beginning (on the left), any outcome is possible: from roaring success (up and to the right) to total failure (crash and burn.) As the project moves through time, we learn more about what’s real by testing the market, and our assessment of that activity more closely represents the actual path, with the option value adjusting to the new reality accordingly.

So unlike more traditional financial models (such as NPV) that rely on fantasy forecasts, Innovation Options encourage actual metrics: only by determining what’s real can we get the answer to the critical question of “should we invest?”

The option-based model is not without its own risks: it is susceptible to GIGO in either the assessment of progress or the final market potential of the opportunity. If either of these turn out to be wrong then the valuation will also be wrong as well. Still, when compared to traditional cash-flow based methods that require projections which are impossible to forecast by definition, the advantages of the option-based approach as a more realistic framework for angel-round valuation are clear.