Managing VC Investments in Competing Technologies Using Exotic Options and Secondary Markets

Abstract

This article demonstrates what could be done when a liquid, secondary market in venture-capital investments exists. It uses exotic options to manage VC investment in two competing technologies, only one of which will be the winner in a technology race. Without a secondary market, the VC has to either fully invest in both technologies to eliminate risk (the overkill strategy) or forecast which technology will win the race (the speculative strategy). The article offers an alternative explicitly recognizing that the VC needs only to introduce the (ex-post) winner of the technology race. The max option strategy meets this objective and has lower cost (risk) than the overkill (speculative) strategy. It takes a dynamic position (initially less than 100%) in each technology and adjusts the positions as new information about the relative value of each technology arrives. The cost savings of the max option strategy depend on the correlation between the benefit streams of the competing technologies, the money-ness of the two individual options, the ability to (dis)invest from each technology, and the number of times one adjusts the positions. The author presents a detailed application to competing electronic process technologies that demonstrates how to implement the new strategy.

TOPICS: Private equity, risk management, options, portfolio construction