Options

Decision Making In An Entrepreneurial Venture.

What are options?

In a literal sense, an option is an available decision point where we can choose to take an action but are not under any obligation to do so.

This is extremely important to understand because the optionality can arise in almost any situation or a context in the venture. It can come as a part of any contract, in financial decisions, in funding negotiations, or in internal dynamics of the culture in a company.

Gain strategic advantage with closing gap between entrepreneurial venture dynamics & finance.

Examples

Contracts To Purchase Something In Larger Quantity Than Originally Decided.

Assume a scenario where you are a coffee roaster and you buy green coffee beans from a large grower. You are completely certain about the overall demand of roasted coffee beans in the market in coming year but you have some fair idea. In a hypothetical transaction scenario, you buy 100,000 kgs of beans at $2 dollars per kg. Thus, your total outlay is going to be $200,000. In your discussions with the grower you tell them that you may purchase a larger quantity of beans, may be 400,000 kgs more if you are able to acquire a large contract on demand side but you will need a better pricing from the grower. The grower tells you that you can take the advantage of scale today and buy all 500 kgs at $1.7 per kg.

The grower tells you that you can buy beans between 100k. kgs to 500k kgs at the prevailing rates when you come at a later date. Given the weather conditions in the the current year and on the basis of geopolitical events, the cost of beans are expected to rise in next few months. But instead of plainly accepting this, you offer them below. You tell them that you will pay $10,000 extra today to get the rights to buy the beans at $1.7 if you place an order of 400k kgs of beans. You make no promises about definitely placing this order in future but you would like to keep this option open for you. When you choose to place an order of 400k kgs of beans within 6 months from today, the grower will have to honour the arrangement and deliver the green beans to you at $1.7 per kg even if the market rate at that point of time is $1.9 for 400 kgs of beans. If you do not place your order for additional 400k kgs of beans, the grower will not be required to give back your 10k to you.

This, my friend, is the power of keeping your options open in negotiations. This principle applies to a lot of scenarios in entrepreneurial ventures and in negotiations of value across time.

Optionally Convertible Preference Shares

Imagine you are an investor looking to invest in a company 'A'. The company is at its initial stages with certain amount of sales and gross/contribution margins that give a good understanding of the business model and profitability model. What you're uncertain of is the ability of the entrepreneur to scale the business and any future market conditions or competitions. Although you have good trust in the entrepreneur based on their background, you may want to protect your money in case the scale is not achieved as estimated.

With this in mind, you decide to invest money in the company in the form of debt as a loan. On this loan, the company pays you fixed interest of about 5% every year. In addition to this, you decide upon the below conditions:

This is a term loan, and the loan ends at the end of 5 years. This means that, at the end of 5 years, the entrepreneur or the company will be liable to pay back the principal that you have invested in the business. The interest is going to be paid every year at the end of the year.
You also agree to the fact that, before the end of the period, if the company is able to achieve a good scale and get into a series of funding, the amount of the loan that you have given to the company can be converted into the equity shares of the company. When the conversion of equity shares happens, you will receive the shares of the company, and the company will not be liable to pay back the principal amount to you at the end of 5 years.

This is a very plain structure or arrangement where you have the option of converting the loan given to the company into the equity shares of the company. If you choose to do so, the entrepreneur and the company will be obligated to allot the shares to you.

Thus, above is an example of an option in the financial terms when it comes to investing in a company.