VC Funding, Ratchets and Optionality

A bug (some call it a “feature”) of taking money from VCs is that it comes in with short optionality. VCs try to protect their investments by introducing “ratchets” which protect them against the reduction in valuation of the investee in later rounds.

As you might expect, valuation guru Aswath Damodaran has a nice post out on how to value these ratchets, and how to figure out a company’s “true valuation” after accounting for the ratchets.

A few months back, I’d mentioned only half in jest that I want to get into the business of advising startups on optionality and helping them value investment offers rationally after pricing in the ratchets, so that their “true valuation” gets maximised.

In a conversation yesterday, however, I figured that this wouldn’t be a great business, and startups wouldn’t want to hire someone like me for valuing the optionality in VC investments. In fact, they wouldn’t want to hire anyone for valuing this optionality.

There are two reasons for this. Firstly, startups want to show the highest valuation possible, even if it comes embedded with a short put option. A better valuation gives them bigger press, which has some advertising effect for sales, hiring and future valuations. A larger number always has a larger impact than a smaller number.

Then, startup founders tend to be an incredibly optimistic bunch of people, who are especially bullish about their own company. If they don’t believe enough in the possible success of their idea, they wouldn’t be running their company. As a consequence, they tend to overestimate the probability of their success and underestimate the probability¬†of even a small decrease in future valuation. In fact, the probability of them estimating the latter probability at zero is non-zero.

So as the founders see it, the probability of these put options coming into the money is near-zero. It’s almost like they’re playing a Queen of Hearts strategy. The implicit option premium they get as part of their valuation they see as “free money”, and want to grab it. The strikes and structures don’t matter.

I have no advice left to offer them. But I have some advice for you – given that startups hardly care about optionality, make use of it and write yourself a fat put option in the investment you make. But then this is an illiquid market and there is reputation risk of your option expiring in the money. So tough one there!