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The key issue is that a lot of startups use various contractual terms -- things like options on exit, liquidation preferences and others -- to take money into
by cjlars 9y ago
The key issue is that a lot of startups use various contractual terms --
things like options on exit, liquidation preferences and others -- to take money into into the business at high nominal valuations, while still offering downside protection (optionality) to investors. The public at large usually just quotes the nominal valuation and goes from there. However, the optionality of those terms has substantial financial value, so the nominal valuation is often far from the truth.
These authors have developed a system to tease out the optionality using standard financial methods (using methods like Black-Scholes, for example), which can give us all a better understanding of the true worth of these companies. Far overdue in my opinion.
- deepGem 9y agoI totally agree. A startup founder has to spend so much time and energy understanding these preferential downside protections. Raising money is so time consuming solely for this reason. If everyone were to just stick to the fundamentals of simple accounting, the startup world would be a far better place. I really appreciate what these professors have done.
- gjem97 9y agoFWIW, this is what a 409A valuation is supposed to do. But that is often done long after a funding round is closed. The PR people and journos need a simple number to report on the story as the deal is announced. I would argue nobody really knows what the company is worth at that point (with the exception of the new lead investor, who may have a model for it).
- jsw97 9y agoInterestingly, the authors look at 409A valuations, which funnily enough have the opposite problem. From the article: "Low values reduce taxes; coincidentally, 409A valuations commonly use questionable assumptions that significantly deflate values." (p. 8)
- bogomipz 9y ago>" while still offering downside protection (optionality) to investors." I'm not familiar with tern "optionality" can you say what that is and how it provides downside risk protection to investors? Thanks.
- gjem97 9y agoThe optionality in startup investing has mainly to do with the "limited liability" in Limited Liability Corporation (other types of corporations and partnerships also have limited liability). That is, if you invest a dollar in a corporation, your losses are capped at a dollar. But, your gains are potentially infinite. Another instrument that has that characteristic--limited downside and infinite upside--is an option. The startup equity isn't actually an option, but it is useful to discuss its "optionality" because it does have some similar characteristics.
- bogomipz 9y agoThanks for the explanation. A related question I have then is would RSUs be considered as providing downside risk(but no upside) for employees then as the value is independent of the companies actual performance?
- jsjohnst 9y agoI'm far from an expect, but unless I'm misunderstanding your question, no, that's not it. RSUs negate some of the downside risk for an employee (vs an option), but have similar upside. With an RSU, it has value as long as the company has value, with an option, it has no value unless the sell price is above the strike price.
- bogomipz 9y agoI probably didn't articulate that as well as I could have. You answered my question though thanks. I actually don't hear about RSUs as much except for some unicorns that seem to be staying private for longer and longer.