Real options in venture capital and private equity investments

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Real options in venture capital and private equity


Łukasz Florczak

Katedra Finansów i Strategii Przedsiębiorstwa Wydział Zarządzania, Uniwersytet Łódzki

Łódź, Polska

Adrian Nowak

Avallon Sp. z o.o. Łódź, Polska

Abstract— The main purpose of the paper is an attempt to answer the question whether real options can be an efficient valuation tool for venture capital and private equity investors. Venture capital and private equity funds play a peculiar role of financial intermediaries that invest capital especially in unlisted companies that may be at different life cycle stages – seed, start-up, growth or maturity. Taking into account the investment process, one of the most significant phase is business valuation. It is quite difficult especially when concerning valuation of young companies due to lack of historical information and uncertainty that occur in the market. As a result there is a necessity to complement traditional valuation tools by real options analysis.

Keywords- real options, venture capital, private equity, investment, valuation, uncertainty


Over the past decades VC/PE funds have become an important source of working out and implementing innovative solutions, emerging new industries (e.g. biotechnology) and economic development. Nowadays private equity is one of the most significant sources of alternative financing for small and medium enterprises that are characterized by high potential for growth. It differs from standard forms of financing in that there is much more involvement of investors [1] – besides financial capital they provide knowledge and experience in the fields of additional financing, strategic and operational planning, value based management and recruiting managerial staff [2].

The investment process of VC/PE funds has cyclical character – these are often established for 5-7 years and the result of the investment is critical for the opportunity of setting-up further funds. There are 4 main stages of the investment process [3]:

 Preparing conceptual framework of the fund (legal entity form, strategy of investment), getting capital from investors and searching for new attractive investments,

 Establishing a fund (selection of business plans, extensive analysis of initially chosen projects – due diligence, business valuation, negotiation and planning particular stages of the investment, capital investment),

 Controlling and supporting portfolio companies in value creation process by participation in supervisory board, continuous investment appraisal, recruiting managerial staff, strategic and financial advisory,

 Divestment process (initial public offering, management buyout, trade sale or liquidation) and achieving financial benefits by VC/PE fund.

Considering above stages, one of the most problematic is business valuation. Early-stage companies are burdened with high risk because of uncertainty that occurs in the market, inexperienced senior staff, lack of loyal clients, high risk of bankruptcy, lack of reliable information about the time needed to realize profitability etc. Moreover, VC/PE investment is perceived as a multistage and elastic project. As a result, it is quite difficult to estimate fair value of the company by using traditional valuation tools such as discounted cash flows (DCF) or valuation multiples. Some sort of remedy for problems connected with uncertainty and lack of flexibility is application of real options analysis.

Valuation of portfolio companies is applied in the following situations [4]:

 Acquiring shares of the company being the object of VC/PE investment,

 Managing the value of the company,

 Reporting value of portfolio companies to the investors of the VC/PE fund,

 Selling the company to another strategic investor or exit from the investment by initial public offering,

 Liquidation of the company when there is no perspectives for the future and further functioning of the company would lead to augmenting loss.


Business valuation based on DCF assume forecasting a certain amount of cash flows in the future and discounting these using cost of capital as a discount rate. It is significant that the model embrace plenty of assumptions concerning cash flows and the cost of capital. Employing DCF requires predicting future, looking for dynamic fit between an organization and its business and competitive environment in order to make effective strategic decisions. Once a course of action is chosen, it becomes important to quantify the results of the decision [5]. After discounting future cash flows it is possible to put a valuation on the company but there is a major limitation – using DCF there is no possibility of putting an additional value stemming from flexibility – value of the


Figure 1. The relationship between real options and company value [10] company is a function of the time value of money only [6]. The

risk connected with the company is considered as a threat to forecasted cash flows – growing level of risk and uncertainty leads to higher cost of capital and as a result it decreases the value of the company.

On the other hand, there is a theory of real options that treats the perception of risk and uncertainty strikingly different. According to real options, increased level of volatility is perceived as a potential source of additional value. Taking into account the flexibility of realized projects it enables to modify its component parts while realizing investment. That means transition from static to dynamic perception of investment project appraisal and business valuation [7]. According to Copeland and Anticarov, a real option is the right, but not the obligation, to take an action (e.g., deferring, expanding, contracting, or abandoning) at a predetermined cost called the exercise price, for a predetermined period of time [8]. The meaning of the word „option” indicates that there is a possibility of gaining an additional value that appears with time – this kind of value is possible to quantify with using real options valuation [9].

Taking into account the analogy between financial options and real options it is possible to value real options using Black-Scholes model or binomial lattice model. Then, the value of the company can be represented as a sum of discounted cash flows and value of real options (in some cases the value of real options might comprise even more than 50% of the total value of the business).

By creating a portfolio of real options a company is able to respond to various trends emerging from an uncertain environment. It results in better ability of the firm to compete efficiently and to gain and sustain competitive edge. Strategic options are result of dynamic fit between resources and competences of the company and external market opportunities. Each of identified options ought to be evaluated using three dimensions: cost of creation and maintenance, the likelihood of execution and ability to create other options in the future [10]. Using real options analysis enables better understanding of investment directions and provide higher level of knowledge in the field of processes and factors that influence the quality of decision-making. Moreover, managers tend to look for elastic projects or make an attempt to embed the elasticity in considered projects, thus they actively look for value in realizing risky projects [11, 12]. The overall relationship between real options and company value is presented in the figure 1.

Real options approach constitute a good complement to the traditional method of discounted cash flow, especially in following situations [13]:

 Company executes plenty of contingent investments – starting particular project depends on previous decision on another investment project,

 The activity of the business being the object of valuation is characterized by high level of risk – in some cases the investment ought to be stopped temporarily in order to gain additional information that

reduce the level of risk taken – as a result the company avoid regret for irreversible investments,

 Value of the project depends mainly on opportunities and benefits that may occur in the future and to a lesser extent on static cash flows,

 Company that is the object of valuation function under conditions of high uncertainty. In this situation, starting an investment project results in additional elasticity that comprise a potential source of extra value,

 Company often tend to modify its investment projects when obtaining the information about volatile external environment.

It is significant that there are also additional benefits of using real options analysis that goes beyond valuation of the company [14]:

 Broaden horizon of strategic alternatives that can be executed in the future,

 Extended range of potential markets,

 Better understanding of risk connected with the activity of the business,

 Recognizing the role of coincidence in achieving success.


Taking into account the character of VC/PE investment, traditional methods of business valuation are insufficient when managers or investors possess decisional flexibility (e.g.

Market requirements Potential options Resources and competences Option analysis: Maintenance cost Value potential Basis for new options

Portfolio of firm’s options

Competitive advantage

Maintained and executed options

Company value M ark et co n d it io n s


Figure 2. Sequential character of VC/PE investment [21] diminishing or increasing the level of production, temporarily

curtailment of development or abandonment of realization of the project). These changes influence the value of the company and the DCF techniques do not allow to assess the real value of the business. In addition, portfolio companies often obtain the capital in a few phases in order to increase the level of motivation (entrepreneur deserve getting alternate round of financing when the company shows good results and prospects for the future) and reduce investment risk in the company. As a result, there are following kind of options that can be employed by VC/PE funds: growth option, option to abandon, deferral option, option to alter operating scale, time-to-build option.

Growth option is a call option that enables to assess additional benefits connected with an investment that gives new opportunities for realizing further ventures in the future, e.g. broadening of production, implementing new generations of products or entering new markets [15].

Option to abandon (exit option) is a put option that gives the right to dispose of a stock or an asset and to recover the salvage value when market conditions change lastingly or market expectations remain inauspicious. As a result, the sale of an asset compensates for losses and allow to allocate capital in new assets [16]. This kind of elasticity plays a key role for VC/PE funds that invest in companies characterized by significant investment expenses (e.g. aviation, construction or biotechnology industries) [17].

Deferral option gives the possibility of adjourning an investment in order to wait for propitious changes in the market or gaining additional information [18]. The investment will be continued only under favorable circumstances, otherwise it will be stopped.

Option to alter operating scale enables to expand or contract operating scale depending on the perspectives on the market. This kind of option is especially useful when company is going to enter the market characterized by high risk or introduce new product on the market. Option to alter operating scale concerns mainly industries characterized by high R&D expenses (e.g. drug or cosmetic industry) and investments in exploitation of natural resources [19].

Time-to-build option gives the possibility of dividing an investment into several stages. Each stage is treat as an real option that can be realized after finishing previous investment stage. The general value driver is possibility of adjustment the complex investment process to the current market conditions. It is also significant that the investment expenses are borne in specified sequence [20]. The character of time-to-build option resembles the logic of VC/PE investment – VC/PE fund bring the capital into the company gradually, depending on the current position or value of the company. Application of this kind of option allow an investor to divest and reduce the loss to the level of amount of money invested on the previous stages. Taking into account that every stage of financing is connected with uncertainty, the VC/PE fund must possess an opportunity to decide whether and when invest further amount of money in the company. The sequential character of the VC/PE investment is shown in figure 2.


There are two basic models that are applied in real options valuation:

 Black-Scholes model (BS),

 Binomial lattice model (CRR).

The main assumption of BS model is that the underlying asset’s price structure follows a Geometric Brownian Motion (GBM) with static drift and volatility parameters and that this motion follows a Markov-Weiner stochastic process [22]. Real options valuation using BS model is a real inconvenience due to its assumptions. GBM is difficult to use in practical real options problems involving many sources of uncertainty and interrelated decisions – relatively few managers have the ability to estimate the values of the volatility parameters needed for using BS model to value complicated real options [23].

The basic assumption of CRR model states that the change of the underlying asset’s price is described by step distribution. According to the basic version of CRR, present value of the future cash flows may increase or decrease depending on conditions in the market (e.g. as a result of high or low demand). Assuming that the process of valuation proceed in risk-free conditions, it is possible to estimate the probability of rise and drop of the price of underlying asset in the future and finally to establish value of the option [24].

Because of plenty of assumptions that are embraced in real option pricing models, there are five basic approaches connected with valuing real options [25]:

 Classic approach – it assumes valuing real options using techniques characteristic for valuing financial option. The investment process requires following stages: identify the replicating or tracking portfolio and estimate its price and volatility; describe the size of the investment to the replicating portfolio; calculate the value of the option using financial option pricing tools,

 Subjective approach – it is based on arguments of replicating portfolio and no-arbitrage, but it omits the phase of identification of replicating portfolio.

D S Ex In Ex In Ex In Ex In

Seed Start up Growth Expansion Bridge IPO

In – invest Ex – exit

S – success and exit D – divest


According to subjective approach, calculating the value of the option requires to use financial option pricing tools, but the price and volatility of the underlying instrument are estimated subjectively,

 Equilibrium-based approach (MAD) – this approach is not based on the existence of a traded replicating portfolio – this role is substituted by discounted cash flows. Valuation process consist of: calculating cash flows of the underlying investment and its NPV; estimating volatility using Monte Carlo simulation; assessing value of the option based on binomial lattice and risk-free rate,

 Revised classic approach – it suggest that classic concepts of valuation may be used when analyzed project depends mainly on risk connected with market risk. Otherwise, it is urged to use simulations or decision tree analysis,

 Integrated approach – it is based on market and individual risk that are perceived as immanent qualities of each project. According to integrated approach there is no requirement to indicate what kind of risk is dominant due to specification of the valuation model. According to accepted rules the optimal solution is applying classic approach to valuation of real options when there is a possibility to identify underlying asset. In a situation, when there is no chance for creating replicating portfolio, it is a good practice to employ subjective or MAD approach [26].


Modelling and assessing value of the company by employing real options analysis is vitally elastic tool especially from the perspective of VC/PE fund. It enables valuation of the business depending on changing conditions in the market and observing value of the company according to various variants of action. As a result, using real options allows to assess the value of particular projects realized by a company and finally – value of the company as a whole. Taking into account above arguments, process of employing real options in business valuation gains in popularity. There is also the opposite side of the coin – value of the real options depends on input parameters that are estimated by analysts. As a result, it leads to gaining only approximate value of the project or business and it may differ depending on assumptions made by an analyst. There are a few reasons that using of real options among VC/PE funds is still not popular:

 Lack of knowledge how to evaluate the project or business using real options analysis,

 There are some problems and doubts connected with estimating input parameters to the valuation model (e.g. how to quantify uncertainty? How to identify option possessed by firm in a proper way? How to cope with the lack of historical data?),

 Complicated and time-consuming process of valuation, Despite above arguments, real options analysis assuredly is a valuable tool that consult volatility of market conditions and an opportunity to actively amend business activity. Taking into

account that putting too high focus on valuation based on real options may lead to inflating the value of the company, this tool should be used as a complement tool to the traditional methods of business valuation.


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