Excel Models
RE Binary Call Options
Imagine offering startup employees an additional incentive: you’ll pay them another $5 million if they manage to increase the company’s value, which is currently $40 million, to $200 million. How would you assess the value of this additional incentive today?
The offer mentioned above represents a Binary option, as the condition will either be met or not, and the bonus will either be exactly $5 million or zero. The payoff diagram of a binary option looks like this*:
When evaluating the PCP (Preferred Convertible with Participation) structure used by venture funds to finance startups, it’s necessary to use binary option pricing techniques because the payoff diagram is sharp. PCP = Redeemable + Convertible + Common.
In essence, PCP means the following: when a startup goes public (IPO), the fund will first take back the amount it invested (Redemption) and then participate in the remaining profit proportionally (Common Share). However, if the company’s value exceeds a certain predetermined threshold, the fund’s shares are forcibly converted into common shares, meaning the right to withdraw the invested amount is lost. Thus, we get a payoff diagram that looks something like this:
According to this example, if the company’s value exceeds $90 million, even by just one dollar, the fund loses its right to the $4 million.
The diagram up to $90 million can be read and calculated with RE Call options, while the discontinuous part can be valued using RE Binary Call options.
The solution model: RE Binary Call Option Valuation – Excel
P.S.
The answer to the problem presented at the beginning of the note is $120,000: Excel
Adapted from the Source:
*Venture Capital & the Finance of Innovation – by A. Metrick & A. Yasuda