Although an investment in a startup gives the investor equity ownership in the company, the return of the investment is actually better thought of in terms of having bought a call option on the company. Here’s why.
The main drivers of the value of a call option are its underlying stock price, strike price, time to expiration, and volatility.
At the time of purchase, a call option has an underlying stock price that is below the strike price. If the underlying price rises above the strike price, you exercise the option at the strike price and make the money between the higher stock price and the lower strike price at which you exercised. This means that, at the time of purchase, a call option is out of the money. Similarly, at the time of the investment, a startup is valued at a higher figure than its fundamentals suggest. You invest with the hope that the company’s fundamentals grow, and pay a premium for this optionality. If they don’t, you very often lose money on the investment.
The longer a call option’s time to expiration, the greater its value. Similarly, an investment in a startup is a long journey that, excluding an acquihire which might take place earlier, takes upwards of 7 years and often much longer to produce a return.
Finally, the greater the volatility of a call option, the greater its value. Similarly, startups are highly volatile investments, both at the startup level as the company tries to build a product, achieve product market fit, and scale, and at the portfolio level, with many more startups failing than succeeding.
As a result of these reasons, if you view startup investments as traditional equity investments, you’re less likely to make the types of investments that succeed than if you view them as call options.
Also published on Medium.