Author Archives: cankut

Startup investments as call options

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.

Startup: A Silicon Valley Adventure

I recently read the book Startup: A Silicon Valley Adventure by Jerry Kaplan. Jerry was the founder of hand-held pen computing pioneer GO Corporation in 1987, and the book tells the story of the challenges, pains, and joys on the road to building and eventually achieving a modest exit with GO.

It’s a story which highlights the importance of product market fit (it turns out that a hand-held pen computer’s close cousin, a touch-based hand-held or in other words a smartphone, is the right solution), timing (GO was a few years too early), and competition (large markets attract the attention of large tech companies with greater resources than startups, and the startups that succeed achieve distribution before incumbents achieve innovation).

I strongly recommend reading the book, which you can check out here.

Wind sculptures

A wind sculpture is a sculpture that changes shape based on the strength and direction of the wind.

I first encountered a wind sculpture when my wife and I visited Buenos Aires about a year and a half ago. The Floralis Generica at the United Nations Plaza in Buenos Aires not only has petals that close in times of high wind, but also changes shape based on the rising and setting of the Sun.

Here’s a video with more examples of wind sculptures.

Besiktas in the UEFA Champions League

Turkey’s sole contender in this year’s UEFA Champions League, the top European football club competition, is Besiktas.

The group stages just ended this week and Besiktas achieved something that no other Turkish football club has done in the competition so far. They completed their group stage matches undefeated with 14 points, after winning 4 and drawing 2 of their games. This represents the highest number of group stage points ever collected by a Turkish football club in the UEFA Champions League.

I congratulate Besiktas and the club’s fans on this excellent performance, and look forward to seeing what’s next in store. It could be quite surprising.

Doing less rather than rushing

When you’re giving a presentation in a predetermined time slot and you realize that, if you continue at your current pace, your presentation isn’t going to end on time, you have two options. You can either speed up your pace by talking faster or cover less content by focusing only on the most important remaining content.

The former approach creates stress, and that stress impacts not only your ability to communicate your thoughts but also your audience’s ability to understand your message due to simultaneously thinking about your frenetic body language.

The latter approach means that you don’t cover some content. However, by skipping the content that isn’t a priority, you can get the key elements of your message across, thereby retaining your calm and increasing the likelihood that your audience understands your message.

The reasoning outlined above regarding what to do when you’re pressed for time when presenting can be generalized to other contexts. Specifically, when you’re pressed for time, it’s better to do less by prioritizing the important things than to do the same amount by rushing through it all.

The drivers of revenue multiples

The revenue multiple, or in other words the ratio of a company’s valuation to its revenue, is a commonly used metric to value startups. The reason is that most startups have negative EBITDA and net income, so it isn’t possible to value them based on these metrics.

However, it isn’t possible to simply take one company’s revenue multiple and directly apply it to value another company.

Specifically, different companies demand valuations which reflect different revenue multiples. The reason for this is that a company’s revenue multiple is driven by numerous factors. The most important of these are:

  1. The company’s growth rate: Companies that are growing faster command higher revenue multiples.  Since it’s easier to grow fast off of a small base, earlier stage companies tend to command higher revenue multiples than later stage ones.
  2. The size of the company’s addressable market: Companies targeting larger addressable markets have more room to grow their revenue by capturing more of their addessable market. As a result, they command higher revenue multiples than companies targeting smaller addressable markets.
  3. The company’s margin structure: Companies with superior margin structures (higher gross margins, contribution margins, EBITDA margins, net income margins, …) will have more money left over from each dollar of revenue that they make. They will therefore command higher revenue multiples. Although most startups have negative EBITDA and net income margins, many have positive gross and contribution margins. It’s therefore possible to value them based on gross margin and contribution margin multiples, which are better reflections of the fundamentals of the business than the revenue multiple.
  4. The company’s long-term defensibility: Companies with business models that are difficult for competitors to challenge will be able to retain their revenues and profits for longer periods of time in the future, and will therefore command higher revenue multiples.

Fundraising for the existing average business and the new and promising idea

After a startup raises money, three things can happen.

The first is that it performs well, either with its initial business idea or following a pivot, and goes on to raise more funding based on this performance.

The second is that its business does not grow, attempts to pivot do not either, and the business therefore fails.

The third case lies in the middle. Specifically, the startup ahieves some growth in its initial business idea. However, this growth is not high enough to raise more funding based on the company’s performance, and it’s not low enough to declare the business a clear failure.

Startups that experience this third scenario often come up with a new business idea that is adjacent to the initial business, and try to raise money for the new idea. When this happens, they need to decide whether to stop working on the initial business to focus on the new idea, or to continue working on both in parallel. Many decide to work on both at once, and therefore pitch new investors the combination of an existing average business and a new and promising idea.

When this happens, interested investors want to invest in the new and promising idea. However, they don’t want to pay for the existing average business, and they don’t want the team to spend any time on the existing average business.

As long as the existing average business continues, this makes it challenging for the startup to raise money.

If you don’t want to raise money, you can keep working on both businesses in parallel.

However, if you want to attract investors, you’ll very likely need to close the existing average business and raise solely for the new and promising one.

One day at a time

“The best thing about the future is that it comes one day at a time”

This is a quote attributed to Abraham Lincoln, and I have two takeaways from it.

The first is that you can’t do everything at once. If you have a goal, you have to make patient and consistent progress towards it on a daily basis.

The second is that most goals that seem very far away are actually more achievable than they appear. The analogy of climbing a mountain is helpful in explaining this.

Specifically, when you’re at the bottom of a mountain, you can’t see its peak. With each step of the climb, you see parts of the mountain that were previously inaccessible to you. To get to the peak, you must traverse through these intermediate parts. You can’t climb further than your reach at any particular step allows.

Similarly, when you first start working towards a goal, it’s difficult to envision achieving it. By making steady daily progress towards the goal, you unlock new levels that take you closer to your goal, until you can eventually see yourself achieving it.

And just like when you’re climbing a mountain, there’s no short cut. You have to go through certain places before you can get to other places.

The rules that aren’t widely known

There are a set of rules which govern how our world works. In the physical sciences, these rules are precise and map directly from inputs to outputs. In the social sciences, these rules are approximations and produce a general mapping from inputs to outputs.

For example, force = mass * acceleration is a physical science rule, while the input of being kind to others making them more likely to like you as an output is a social science rule.

If the rules that govern a particular context are widely known, there are a lot of people who will be able to apply those rules. As a result, the returns to applying the rule will decline due to competition.

It’s the rules that aren’t widely known that produce the greatest returns for those who identify and apply them.