Don't Mistake Options for Cash Flow
Price early-stage bets as options on a range of outcomes, not discounted cash flows
- Difficulty
- Moderate
- Time to result
- ~weeks to results
- Steps
- 7
- Confidence
- 87%
The framework separates two activities that share the word investing. In the Ben Graham sense, you take a series of cash flows a business generates, apply a discount rate, adjust for margin expansion and growth, and derive a price. Seed-stage venture involves none of that: it is a founder and an idea on a napkin, and yet a number like twenty million dollars gets attached. Once you accept there is no DCF to build, the honest model is option pricing. You value the range of potential outcomes and the probability of each: is this a zero, a billion-dollar company, or a hundred-billion-dollar company? That immediately explains two behaviours. Venture capitalists obsess over TAM because the magnitude of the possible outcomes is what the option value is most sensitive to, and they build diverse portfolios because the outcome range is too wide to survive concentrated. The essential corollary from Altos Ventures is that options thinking is for pricing, not for conduct: startups are not lottery tickets, and venture is a multi-turn game.
Origin
Attributed on Acquired to Michael Mauboussin, whom the hosts met at Capital Camp, with the founder-treatment corollary credited to Ho Nam at Altos Ventures.
Core principles
- 01The word investing covers two completely different activities that happen to share a name.
- 02Classical investing values a known series of cash flows; early-stage investing values a range of possible outcomes.
- 03Option value is most sensitive to the magnitude of the upside, which is why venture obsesses over TAM.
- 04A wide outcome range demands a diversified portfolio, not concentration.
- 05Most real investors sit on a spectrum between the two modes rather than at either pole.
- 06The option framing is an analytical tool, not a licence to treat founders as lottery tickets.
How to run it
- 1
Classify the asset before valuing it
Determine whether you are looking at a business with an existing series of cash flows or at a founder with an idea. The two require completely different machinery even though both are called investing.
Pro tip If you cannot name this year's revenue without inventing it, you are in option territory.
- 2
Abandon the DCF where there is nothing to discount
Stop trying to justify a twenty million dollar price by assuming your way to cash flows that do not exist. Arguing about the discount rate on imaginary numbers is what makes venture valuation look like voodoo.
Watch out Fabricated projections do not become more rigorous by being spreadsheeted.
- 3
Map the outcome distribution
Write out the plausible outcomes explicitly, including a zero, and estimate the probability of each. This is what venture capitalists are already doing, whether or not they are conscious of it.
Pro tip State the top outcome as an absolute figure rather than a multiple; it forces honesty about magnitude.
- 4
Attack the magnitude term first
Option value is most sensitive to the size of the upside, so interrogate the market ceiling before arguing about probabilities. The question is what you would pay for an x% chance of the next Apple.
Pro tip This is why TAM dominates every partner meeting; it is the highest-leverage input.
Watch out You can debate the probability weighting endlessly and change the answer far less than adjusting the ceiling.
- 5
Diversify to survive the range
Because the outcome distribution is so wide, hold a portfolio rather than a single position. The point is to smooth the risk while keeping exposure to the asymmetric upside.
Watch out Concentration in an option-like asset converts an asymmetric return profile into a coin flip.
- 6
Blend the two modes where reality is mixed
Most investors sit between the poles. Where a startup is generating real revenue or cash flow, apply a multiple to it and combine that with the option view of the upside, adapting as multiples move.
Pro tip Say out loud which portion of your price is option value and which is cash-flow value.
- 7
Keep the framing out of your behaviour
Founders are real people with families, employees and bank accounts, and venture is a multi-turn game. Behave well even when your option is clearly expiring worthless, because you do not know what those founders do next or who they talk to.
Watch out Treating a portfolio line item as a lottery ticket in front of the founder is how a firm's reputation compounds in the wrong direction.
In the wild
A seed investor meets a founder with an idea sketched on a napkin and no revenue, and the round prices at twenty million dollars. Under classical investing that number is indefensible, since there are no cash flows to discount. Under the option framing it is a straightforward question: what is the probability-weighted value of a claim on an outcome distribution that runs from zero to the next Apple? The valuation stops being voodoo and becomes an argument about the ceiling and the odds.
→ A price that can be reasoned about and defended instead of asserted.
A partner new to the industry wonders why every meeting fixates on total addressable market when there are so many other things to care about. Under the option model the answer is mechanical: the magnitude of the possible outcomes is the input the valuation is most sensitive to. Probability weightings can be debated, but the higher the ceiling, the more the option is worth.
→ An apparently obsessive industry habit revealed as the correct sensitivity analysis.
Common mistakes
Building a DCF for a napkin
Applying cash-flow machinery to a business with no cash flows produces precise-looking nonsense and discredits the whole exercise.
Arguing probability before magnitude
Option value moves far more with the size of the upside than with the odds. Debating probability first spends effort on the least sensitive input.
Letting the model set your manners
An option that is expiring worthless is still someone's life's work. Venture is a multi-turn game and how you behave in the losing turns follows you.
Is it for you?
Best for
Early-stage investors and founders who need to reason honestly about pre-revenue valuations.
Not ideal for
Mature businesses with predictable cash flows, where the Ben Graham approach genuinely applies.
From the transcript
“really venture capital in the early stage is not at all cash flow based investing it's actually options investing”
“the higher the magnitude of the outcomes the more valuable the option is going to be”
From the episode
The Playbook: Lessons from 200+ Company Stories