Accelerated Cookie Licking

For a few months now, I’ve been reading Hardcore Software, a “sub stack book” that’s being written by Steven Sinofsky, about his time at Microsoft. In one of the “episodes” (the book is literally being written in public chapter by chapter, the same way I would go if I were to write another book), he introduces this spectacular concept called “cookie licking“:

Microsoft developed a vocabulary that to this day dominates discussions between alumni. Cookie licking is when one group would lay claim to innovate in an area by simply pre-emptively announcing (via slides in some deck at some meeting) ownership of an initiative.

Cookie licking is one of those concepts where once you’ve seen it you “can’t unsee”. Now that I’m aware of the concept, I keep finding it all over the place. And thinking about it, it is literally all over the place.

And it can happen in many ways. One way is how it happened at Microsoft – where multiple teams might have “been eligible” to work on a particular project, and one team tries to grab the project by “licking the cookie”. It is a pretty common corporate tactic. “Oh, why do you want to work on it when the XXXX team is already working on it?”.

Then, I also see it happening in the startup space. You go to a potential customer or mentor or investor with a certain idea. And then they tell you “why do you want to work on it when XXXX is already doing it?” (usually XXXX is a larger or better known company, but not always). And many a time you fall for the bait, assume that the cookie has been “jooThaafied”, and try to do something else. In a large number of cases, though, the licker of the cookie would have done nothing to consume it apart from the act of licking itself.

I don’t know how exactly to describe cookie licking from a game theoretic perspective, but I can imagine concepts such as “cheap talk”, “game of chicken”, “option value” and “bluffing” coming into play there. The question is if you will fold or call (yay, I made a poker analogy) when you are shown this licked cookie.

And while I was talking about this wonderful concept with someone earlier this evening, I realised that there also exists this concept that I will call “accelerated cookie licking”. Here, you not only lick the proverbial cookie, but also get paid for doing so.

For this, you need to have an independently built reputation (either a successful corporate career, or an exit from an earlier startup, or having been a VC, or some such). And thanks to this reputation built elsewhere, all you need to do is to say that you are licking the cookie, and people will come forward to pay you to do so.

And once you have licked the cookie and raised money for your company, you have an automatic moat – anyone else who wants to eat the same cookie will be told by any potential investors “why do you want to get into this when <this hifunda person with an independently built reputation> is already doing it, and is so well capitalised? Do you really want to take him on?”.

Thinking about it, in poker terms, this is equivalent to bluffing with a really large raise. Even if the opponent knows you are bluffing, it takes a lot for them to be able to call your bluff. And so it is with “accelerated cookie licking”.

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!