In last month’s column, I posited that private investments in venture and early-stage companies are ideally characterized by their potential for positive asymmetrical outcomes (PAO), where the risk of losing the entire investment is offset against the potential for high-multiple returns on investment. But PAO refers to more than just the non-linear relationship between risk and return; it also refers to the appeal of investments where multiple liquidity and exit outcomes are possible.
This is often referred to as optionality or current knowledge of the potential for a variety of future outcomes.
According to his book, In an Uncertain World (Random House, 2004), Robert Rubin is said to have developed his appreciation of optionality in his prior days of risk arbitrage at Goldman, where he displayed a penchant for keeping his options open and avoiding a mindset that restricted decision-making to binary and zero-sum outcomes.
It is believed that Larry Summers ultimately coined the phrase “preserving optionality” back when he was deputy secretary of the Treasury under Rubin in the Clinton Administration. It was meant to describe a strategy of keeping options open and fluid, before all of the uncertainties have been resolved in dynamic environments where there is a high likelihood for the emergence of new and material information.
For entrepreneurs, optionality in rapidly evolving scenarios (such as a startup) means leveraging real-time data and experience before making important decisions that are either resource intensive or cannot be easily reversed, such as pursuing a market vertical, developing a new technology or application, embarking on a joint venture, or contemplating multiple exit strategies.
In most instances these options were not conceivable at the outset of the venture because, at best, a startup’s business plan is to an entrepreneur what a treatment is to a script writer: a first draft. It is the actual, real-time development of the story line and its characters that ultimately determines the movie script, or the path to monetization for a new business venture.
Investors and experienced entrepreneurs know this. I have rarely seen a startup that successfully monetized itself based upon the mission, objectives, and milestones envisioned in its original business plan. That’s because time in the market is often more valuable than time to market with respect to improving the quality of the critical decisions that are of material consequence.
Author-epistemologist-investor Nassim Taleb gets it. In Fooled by Randomness (Random House, 2005), he characteristically opines “people overestimate their knowledge and underestimate the probability of their being wrong.” He suggests that by being ever aware of our limitations of prescience, and keeping our eyes and our options open, we can make better, more educated, and lower-risk decisions. He is correct.
This implications and realities of preserving optionality often positions entrepreneurs at odds with investors. For the entrepreneur, preserving optionality is an interest that frequently requires a balancing act against intrusive, non-strategic, no-value-add investors who view accountability and measurability as metrics preeminent to the benefits of prudent executive flexibility and strategic discretion.
On the other hand, the investor’s need for optionality is particularly relevant today in light of the macro market malaise and minimal marquee exits. With venture-backed IPOs now more an exception, venture investors need to stipulate optionality with respect to cash flow and exit rights as a contingency to their investment commitment.
The Implications for Advisors
Optionality is relevant for investment advisors who evaluate or allocate to venture investments on behalf of their clients. Advisors need to see visibility to alternative liquidity events such as dividend distributions or return of initial capital beyond the sale or merger of the company or its assets, or a less-than-likely IPO.
It is of no surprise that investors have a preference for positively skewed outcomes and hold an aversion to negatively skewed outcomes despite the fact that linear or variance-based risk measures generally weigh the outcomes equally.
Yet investors seeking the potential for multiple and positive asymmetric outcomes on their commitments must also apply the measures of asymmetry and optionality to their deal diligence and terms. More than ever, investors should require visibility on multiple paths to liquidity. The investor has the responsibility to appropriately balance his interest in ROI with the survival or expansion cash-flow needs of the portfolio company.
Why so many “professional” investors are so passive on this issue is puzzling. Advisors who allocate to private investment should demand more of their client’s dollars than only the possibility of a high-multiple exit.
Jeff Joseph is an investor, financier, CEO of Prescient Advisors, former RIA, and the author of the blog at venturepopulist.com. ([email protected]) Send comments, questions, and column suggestions at [email protected].