More optionality in startup valuations

Mint reports that Indian e-commerce biggies Flipkart and Snapdeal are finding it hard to raise more money at the valuations at which they raised their last funding rounds. One line from the report:

Despite Morgan Stanley’s markdown in February, Flipkart is still approaching investors asking for a valuation of $15 billion, but it hasn’t had any takers yet, the first two people cited above said.

The problem with the valuations is that it includes significant option value. It is common in startup funding to include implicit options in favour of the new round of investors to protect them from the downside of any future decrease in valuation.

Typically designed in the form of “ratchets”, when the firm raises a fresh round at a lower valuation, the investors in the previous round will get additional shares so that their overall share in the investment remains the same (won’t go into the exact mechanics here). This downside protection allows investors to be more aggressive on their valuations of the company, and the company is able to report higher headline numbers.

Ratchets have two problems, both of which are illustrated in the difficulty of Flipkart and Snapdeal in raising more funds. Firstly, optionality in funding means an automatic markdown of funds held by investors in progressively earlier rounds. This is not explicit, but a ratchet is basically existing investors writing an option in favour of the new investors. While the cost of this option is not explicit, it is the earlier investors who bear the cost.

So Series C (and earlier) investors bear the cost of the optionality given to Series D investors. Series B and earlier investors bear the cost of Series C’s optionality. And so on. Notice that this telescopes, so the founders (original owners of equity) have written options to everyone who has invested (of course they also benefit from the higher overall valuation).

Now, if a “down round” (funding round at lower overall valuation than previous round) happens, this optionality gets immediately gets “paid out”. So if the Series D valuation is lower than Series C valuation, Series B and earlier investors (and founders) immediately “pay” the difference to the Series C investors (these options are American, and usually without an expiry date). So Series B and earlier investors (and especially founders) will not like this round. And they will hunt around for offers that will ensure that they don’t have to pay out on the options they’ve written. I suspect this is what is happening at Flipkart and Snapdeal now.

The second problem with ratchets is that stated valuations are inflated. A common share in Flipkart (don’t think one exists. All investors in that firm are effectively either long or short an option in the same stock) is not valued at $15 billion, so that valuation is essentially a misnomer. When Morgan Stanley says on its books that Flipkart is actually worth $11 billion, it is possible that that is the “true value” of the stock, without accounting for the optionality that latest round of investors receive. In other words, the latest round of investors invested at a price, which if extended to all stock, would value the company at $15 billion. But the rest of the company’s stock is not the same as the stock these investors hold! 

The problem, though, is that the latest “headline valuation” (inclusive of optionality) is anchored in the minds of founders and other earlier investors, and they see any lower price as unacceptable. And so the logjam continues. It will be interesting to see how this plays out.

With IPO being way too far off an event for determining if a company has “arrived” I propose a new metric, with shorter horizon. A company can be declared as having arrived if it manages to raise a round of equity with no embedded options. Think about it!

Valuing a flexible week

For the last couple of weeks my wife has taken time off from work, and given that I’m freelancing, we as a couple now have a flexible week. Yesterday, we went shopping. We were at the Bangalore Central store in JP Nagar, and for the first time in a really long time, were able to shop without bumping into fellow-shoppers every other moment. My wife didn’t have to wait endless hours in the queue just to get into the trial rooms (yeah, this happens at large format apparel stores on weekends). We shopped at Food Bazaar sub-store, and could take our time in deciding what to buy, without sharing aisles with other shoppers. The checkout counter was empty, ABSOLUTELY EMPTY, and we had an extremely peaceful experience there. It was an awesome day of shopping.

There are certain things that are done so much easier on weekdays than on weekends. Shops are significantly less crowded. If you have to get work done in government offices, you are better off going there on a weekday than on Saturday (when there are more consumers, and the employees are pissed off at the end of a long week). You don’t need to book cinema tickets hours before. Restaurants aren’t crowded. If you go for a day trip, you can expect your destination to not be flooded with other tourists. Of course, there are activities which are so much easily done on weekends rather than on weekdays – this involves anything that involves driving across the city in “peak traffic” hours.

So it’s clear that the “flexible working week” that I have provides some intangible value. Of course, since my wife doesn’t have a flexible week, we as a couple don’t always get to enjoy my flexible week, but leave that aside for now. What I’m trying to understand is the extra value that I”m getting thanks to my having a flexible week, and if I can put a number on it.

One way I can think of valuing my flexible week is in terms of optionality. I’ve listed down some of the advantages of doing certain things on a weekday. Maybe I can quantify the value of each of them? Maybe the value of the time I save by not standing in a queue at a checkout counter? The economic value of buying more and better clothes because I can shop peacefully? The additional value I get by having the picnic spot to myself rather than sharing it with a hundred others. The option value of being able to walk into a movie hall and buy tickets a minute before the show. And so on. And all this multiplied, of course, by the probability of my wanting to do each of these activities. Sounds right?

Of course, I’m talking about a flexible week here, and not about a week where you have weekly holiday on a weekday, like my wife had earlier this year. Thanks to some power supply issues, the local electricity distribution company mandated different weekly holidays for heavy industries in different parts of the city, thanks to which my wife had her weekly off on Wednesdays. And they were among the two most disorienting months I’ve been through. We were unable to do all those things that we would have normally done on weekends (and which are more advantageous to be done on weekends). I couldn’t do a full day of work on Saturday to compensate for not working on Wednesday. And I would try to work on Wednesday but wouldn’t be able to because my wife had her weekly off that day. It was absolutely mindfucking.

So yeah, maybe the next time someone asks me how much I”m making as a freelancer, I must include the “value of a flexible week” in the number I tell them!