Sunday, June 23, 2013

Why, mathematically, startups make more sense than ever today

The underappreciated engine behind the startup boom is the reduction in startup costs...but not for the reason people think.

Most people believe that the lower costs of starting a company (thank you, Amazon Web Services!) have resulted in a startup boom because it has allowed more people to start Web companies.

This is true.

Many others believe that there is a benefit to investors because founders can now seek product-market fit and traction on their own (bootstrapped) dime.

This is also true.

But most people don't realize the math behind the impact lower startup costs have had.

The simple fact is that startups are call options.  They offer huge potential upside, but include enormous risk.

The way to think of startup value is to apply (in a loose way) the Black-Scholes model for option pricing:

According to Black-Scholes, all other things being equal, increasing volatility increases the price of the option.

Thus lower startup costs have a double impact.  First, they lower the price of the option, making them more attractive.  Second, the crowded startup market that results is more volatile, increasing the value of the option.

The result is that the options (startups) are both worth more and priced less than in the past.  It's small wonder that both entrepreneurs and investors are jumping in.

But we ought to remember that Black-Scholes is a model, not a surefire formula.  Myron Scholes and Robert Merton shared the Nobel Prize in economics for Black-Scholes (Fischer Black had died a couple of years prior).  Less than a year later, their hedge fund, Long Term Capital Management blew up in spectacular fashion.

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