Do put options really work?
I know many investors in alternative markets who insist on including a put option in their investment agreement. Though I understand the motivation, I always caution the negotiating parties about options because of their unintended consequences.
During the negotiations, the entrepreneur is so caught up in the soon-to-arrive disbursement (another post) that the point-blank question “Do you understand what a put option is?” fails to elicit an honest answer and simply causes the person answering the question to respond in a way the will keep the momentum going towards disbursement.
After the proceeds have been spent in accordance with the investment memorandum and subsequent contracts (sure they have! another post), then controversies arise and the stakeholders begin to examine the legal documents more meticulously. That’s when the real questions about terms begin.
“What’s a put option?” asks the entrepreneur fully 18 months after disbursement – the investment officer usually answers “Remember, we talked about this before we signed; it means that we have the right, but not the obligation, to sell you our shares a this valuation once the option has vested – I explained it several times.” The look of utter astonishment on the face of the entrepreneur as she realizes that she has signed a post-dated check to the tune of several million dollars quickly changes to denial, then anger – acceptance may never come. Trust has been undermined.
Once in a while you’ll find an entrepreneur who understands options. In order to accept the put, she insists on a call option – it’s only fair, if you’re mitigating your exit risk by obligating her to buy your shares in the future at some valuation set now, potentially forcing her to buy shares at a “premium”, she’s going to keep the upside by obligating you to sell your shares at a maximum price set now, potentially at a “discount”. Thus, if the company survives but doesn’t become a star, the investor gets his money back and something for his trouble, potentially at a price-per-share above its market price. On the other hand, if the company does skyrocket, the entrepreneur can buy her company back at a price-per-share that may be lower than fair market value (the investor still makes money, mind you, but not as much as he would have without the call). That’s the way it’s supposed to work, in theory anyway.
The problem with options arises when the investor tries to exercise his right to sell – it has been several years since they negotiated and signed the agreement, and the very fact that the put is being exercised means that the company has not done as well as planned. This usually means that there have been disagreements among the shareholders (on who has made poor management decisions, on why the company has missed its targets – you get the idea), which means that there is some degree of enmity between the writer of the put (the entrepreneur) and its holder (the investor). Furthermore, as the entrepreneur is most likely illiquid (investor normally insist that their portfolio entrepreneurs have some “skin in the game”, which normally means, most of her worldly possessions), the put becomes contentious. At best we face a situation where the entrepreneur wants to buy our shares, but can’t, and at worst we face an entrepreneur that not only can’t, but won’t comply with the option. So how do you enforce a put in this condition?
Keep in mind that most of the “alternative” markets work under civil law, wherein the letter of the law is enforced and contracts are limited to repeating what has been legislated – not at all like what our “northern” brethren experience, common law, where the system supports the stipulations of the contract – read more about legal systems. Imagine, then, what happens to a put option clause when “options” have not been included in the local Code of Commerce. Surely, in the face of this void, the legal system will recognize the spirit and intent of the contract and do the reasonable thing?
I know that in more advanced jurisdictions, jurists undergo many years of academic and practical training, and that public service is a laudable professional pursuit. Unfortunately, that is not always true in markets off the beaten path. Because the public sector normally pays so poorly, those lawyers who can, go into private practice, leaving “the rest” to pursue their careers as judges and prosecutors. For sure, there are some great people in the public sector, but more often than not, their knowledge of the law and jurisprudence is tenuous, the motivation is questionable, and their intellect challenged. A ruling, in many cases, boils down to “arguments” not necessarily related to law…
On the other hand, if the investment goes very well and the entrepreneur exercises her call, it is in the best interest of the investor to comply.
Thus, put options don’t really protect investors from the downside, could limit their upside, may undermine the investor-entrepreneur relationship, and will introduce unwanted legal risk into the investment contract.
Please see the rules.
[13 Nov 2008: I get a lot of traffic to this post on the "do put options work?" search string. I'm curious: are you getting what you're looking for? Leave me a comment, maybe I can improve it.]
