Nassim Taleb is one of the most visionary thinkers in modern finance. His books Black Swan and Fooled by Randomness are must reads for anyone in the investment business. Tren Griffin writes a good blog about investing, and this post is inspired by his article A dozen things I’ve learned from Nassim Taleb about optionality/investing. Thanks to Josh March for the pointer.
Griffin and Taleb’s main point is that we should all seek investments which offer high optionality. He explains why in his first bullet:
1. ”Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny).” Venture capital, when practiced properly by a top tier firm, is a classic example of a business that benefits from optionality. All you can lose financially in venture capital is what you invest and your upside can be more than 1000X of what you invested. Another example of optionality is cash held by a disciplined patient value investor with the temperament to not buy until Mr. Market is fearful. As just one example, Warren Buffett did exactly this during the recent financial panic and earned $10 Billion by putting his cash to work. Seth Klarman, Howard Marks and other value investors use dry powder in the form of cash to harvest optionality since Mr. Market is bi-polar.
He later explains why venture capitalists build portfolios of risky options:
Warren Buffett believes: “If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually- independent commitments. Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Most venture capitalists employ this strategy.”
The corollary of this is that when valuations get too high, or the amount of cash raised gets too high then the asymmetry between the upside and the downside disappears. The optionality is therefore lost and the investment becomes less attractive. This is all from the perspective of the venture investor.
Interestingly though, I think things end up looking pretty similar for the entrepreneur. In this case the investment is largely in the form of time committed to the startup, and hence the downside is the time lost to other opportunities. Most entrepreneurs work as hard as they can to grow their businesses quickly and for the good ones the limits to growth are generally exogenous – i.e. they come from outside the startup, usually in the form of market readiness for a solution or the availability of enabling technologies – so there isn’t much that can be done to change the investment or limit the downside. There are however many important decisions to be made that change the probability profile of the upside, and following the Munger/Taleb logic they should be made to maximise optionality.
The most important of these decisions is how much money to raise. Many entrepreneurs seek to raise the maximum amount of money they can at the highest valuation possible at the earliest possible time, but that locks the company on the path of seeking a very high exit and looking through the lens of maximising optionality it’s clear that from the point of view of maximising founder returns it isn’t always the right thing to do. The examples are pretty obvious to think through. If after a $5m Series A a founder holds 30% of her company and then goes on to raise a $20m Series B at $60m pre-money her stake will drop to 22.5% but she will most likely now be sitting behind a $25m liquidation preference and have taken on new investors who want to exit the company for at least $240m (to get 3x on their investment). The probability of getting to a big exit will have increased but the commitments to new investors will have reduced the chances of getting a smaller exit and the amount of cash the founder gets from those smaller exits will have reduced, particularly at sub $50m exits when the lions share of proceeds will go to the preference holders.
The upshot of this is that in the situation where it’s too early to have real confidence in the big upside opportunity AND there is a viable go slower option raising the maximum amount of money at the highest valuation isn’t the smartest strategy.
Griffin puts it this way:
7. “[Avoid] companies that have negative optionality.” Companies (1) focused on a niche market, (2) have employees with limited technical skills, (3) which raised too much money at an inflated early valuation or(4) are highly leveraged are examples of companies with negative optionality.
8. “[Avoid[ A rigid business plan gets one locked into a preset invariant policy, like a highway without exits —hence devoid of optionality.”
Locking into arrangements that demand a high exit is a form of rigid business plan.