Startup Options

“A value is valuable when the value of value is valuable to oneself.”– Dayananda Saraswati

A colleague of mine recently made an interesting comment to me when discussing startup investing. "Startup investing is simply the purchase of an out of the money option in a unproven company that you think has the ability to execute a scalable business model". That comment really stuck with me and made me think about the current state of the startup funding scene and particularly how it applies to companies that are raising capital via a token.

First off, what is an option which is more popularly used in public equities and stocks? An option contract is an agreement that a buyer has the right to buy or sell shares in a publicly-traded company at a pre-agreed upon price. Options are financial instruments often used by investors to place a speculative bet that the price of a company's shares will increase or decrease and when the investor redeems the contract they are hoping to capitalize on the delta or difference in the price at some future point in time and the price of the option contract they bought. 

Quick example, say company A's shares are trading at $50 a share and after doing research you think that they can grow, so you buy a call option for $65 a share meaning that you have the right to buy 100 shares of the company at $65 a share. 6 months later the company is trading at $75 a share so you excise the contract and immediately capitalize on the $10 difference between the current share price and the option price that you purchased. That $10 share delta times 100 shares in the contract equals a $1,000 profit. Not bad.

Startups are privately held companies that don't have options given that there isn't a public market for their shares. So instead of engaging in a public market option trade, venture capitalists invest capital as part of a private round and buy illiquid shares which they hold until there is some sort of liquidity event. Now, this isn't a 1 for 1 comparison but the same growth projections from an illiquid entry point to a liquid exit point is being calculated and a future price "delta" on those illiquid shares are what is being projected.

Take a startup raising a $1M seed round at a $10M valuation at a $1 share price.  The investors that supply the financing attain 1M shares at that $1 price per share and they now have given themselves the option to sell them later should the startup find a successful exit. Investors will have done their market research and have a projection that perhaps this startup can reach an IPO at say a $1B valuation. They can roughly project the number of funding rounds and the dilution they would take on but imagine the startup goes public at $50 per share. Now that those shares are listed on a major stock exchange and the early investors can now "excise" their option and liquidate those 1M shares for $50M, a $49M delta. They bought that option in the seed round of the company.

Again, similar to an option contract, you pay a premium today for the option to take advantage of the spread later. Like an option contract that has an expiration date, VCs know there will be a hold period on their investment and they construct their funds and deploy capital according to these time horizons. They also perform extensive due diligence given that they often are making long-term, illiquid investments. The model works, just like trading options are part of a healthy public equities market. Venture Capital is a critical part of the innovation economy and those "options" in oftentimes unproven companies are what give entrepreneurs the opportunity to prove themselves and their ideas.

Before I get into web3/crypto startups deploying tokens. I want to say that overall I'm a believer in blockchain technology. This isn't a critique of the underlying technology but a concern with how these tokens are being marketed, perceived, and how consumers or retail investors are missing this fundamental mechanic

Many crypto/web3 startups these days offer "utility" tokens that they deploy at the earliest stage of the company's lifecycle. These startups have a traditional equity cap table which functions as we described above with VCs who come in and deploy capital. Often as part of deploying capital into the cap table of these startups, anyone who invests is either given an allocation of tokens, and often that token comes at a discount to the price that the token gets listed on major exchanges at. For the private, early-stage investors this is essentially an instant call option that they can excise once the token gets listed.

Most options as we discussed above have an expiration date sometime in the future, the further out the expiration date, the more expensive that options gets since the buyer has more time to wait for the option to pass that price and then cash in on the difference in the option price and the realized price. In the case of many web3 startups that issue tokens to investors, they essentially get to arbitrarily set both the price of the option (the cost basis of the token for the investor) and the price of the token upon listing. Here is an example.

I can raise $1M from private investors and VCs for my web3 platform with plans to launch a token that has some future function that we have scoped out. My investors get 10% of the equity in my startup in return for the $1M investment. They also will get tokens allocated to them at a $1 cost basis before the network goes live as part of their $1M investment. Say we are issuing 10M tokens, at $1 then my investors would get 1M tokens from the pool. But in order to buy/sell these tokens, we need to list them on a major exchange like FTX or Coinbase.  Say, there is a ton of energy and excitement about our project and we decide we can list the token at $3 per token. Well, you can do the math, my investors now have an option they can excise on a $1 token that is listed at $3 on the open market.

Is my company worth $3 a share? It might be, but often with these early-stage startups, they are not. That is why when VCs buy into equity on the cap table, they are buying a long hold option. 

VC funds are structured to make investments in that manner, and the capital that invests in VC funds are aware of the time horizon on which they will get their investment back. My concern with these highly liquid tokens and retail investors getting involved is two-fold.

1) They often don't understand this dynamic around early-stage companies, when you buy in, you are often buying out of the money options and holding for a long time, if the token is liquid and the price drops, many retail traders simply see a declining price and panic sell.

2) This also puts unnecessary pressure on a startup that is already dealing with simple pressures like trying to find product-market-fit to simply survive as a business. Combine that with a declining token price and there are now unhealthy short-term incentives for the founders to possibly impact the token price.

Look, I love financial engineering and think that finding new ways to help capital markets flow more efficiently, but I can't help but think here that we rushed into this token-powered future without thinking about the consequences. Options trading is so difficult and risky that most stock trading platforms require you to prove that you have deep knowledge of the space before they even allow you to trade in them. So I ask this, why should tokens be any different?