“Who’s short?” is one of the favorite questions asked by risk managers. If traders have a money-making strategy, for example, some person or entity is paying them.
Some traders think of the money-supplier as their victim, but this is generally a bad idea. Risk managers prefer to cast that entity as the customer. You want to know your customers, and to serve them better so they will pay you more. You want them to survive and grow, and you want to outcompete others offering a service similar to yours.
Aaron Brown
Perhaps most importantly, knowing your customer means you can observe when business is slowing or reversing. Otherwise, the only way you know your strategy has stopped working is when it loses money, and that can be expensive.
I do a lot of work in technology company investing and advising, and I’ve always felt that failure to ask “Who’s short?” is one of the reasons for the boom-and-bust cycle in technology ventures.
Everyone has options – founders have equity and options, and equity in a startup is really a kind of option. Employees have options. Investors have options. Partner businesses have options. Many of these are complex, and some are unwritten. But everyone’s long options, and therefore everyone acts as if volatility is good.
When I ask, “Who’s short these options?” I often get blank looks or hand-waving answers. As a risk manager, I worry that the people with an interest in lowering volatility – the people who short the options when everyone in Silicon Valley is long – are absent from everyone’s minds. I think that leads to excessive volatility, neglect of key strategic information and poor customer service.
Dissecting Tech Valuation Theories
I don’t think there is one precise answer that suggests an entirely new theory of tech valuation. Rather, there are multiple perspectives, each of which casts a different light on matters. Technology risk managers should be familiar with all of them, as any one of them might be important in some scenarios.
One popular answer I get is, “the founder is short.” This model envisions the venture like an oil well. The founder owns the property and enlists capital and labor from others with promises of equity shares and options on any oil that is produced. Portions of the founder’s ownership (which was originally 100%) are doled out in a quest to increase drilling.
In this scenario, the founder is short, despite owning equity and possibly options herself. To maximize the company’s odds for success, and to improve her share in the final result, the founder should try to reduce volatility. On the other hand, the people long options (e.g., investors, employees and partner entities) should be willing to pay the founder more for taking additional risk – which helps them and hurts her.
I think there is a grain of truth in this theory, but mainly for companies in which the founder’s idea, vision and talent are close to 100% of the value – like someone owning an oil deposit. Most ventures I’ve been associated with are collaborative projects, with most of the value created by the synergy of creative people working together. Moreover, even with a superstar founder, the model only makes sense early in the process, as all successful ventures require collaboration at some point.
Another popular answer is the shorts are the eventual public or institutional investors who will come in when the company has a stable capital structure. The equity and options granted before that time will determine the price at which public investors come in, and therefore the return they will get.
Under this scenario, the opinions of traditional financial investors and institutions are the brake on excessive volatility. These are the people who must be kept happy and solvent.
There is some truth in this theory in the later stages of venture capital funding, when the company first starts thinking seriously about an initial public offering or private institutional capital raise on traditional legal terms. It’s certainly true that the temperature of the IPO market exercises a strong influence on the more successful still-private companies.
A third approach is to say, “nature is short the options.” In this view, the value of the company will be wrested from its natural evolution – which will create human wealth that never existed before and would not have existed without the company. I don’t take this very seriously. For one thing, it offers no entity to dampen risk, no customer to understand or please or protect. It’s an excuse to move fast and break things, not a useful economic theory.
Keep an Eye on Competitors and Tech Outsiders
Another problem is I don’t think anyone can predict the any technology venture's impact on human happiness. Almost certainly, each venture will help some people and hurt others. And we don’t know whether someone else might have developed the same product/service, or a better thing, if the company never existed.
But this does suggest a fourth proposal. What if competing companies are short the options? After all, if one tech company succeeds, it may displace others with ideas in the same field.
While not usually stated in these terms, this is the most popular implicit belief among tech entrepreneurs and venture capitalists I know. They instinctively feel that their customers are the tech ecosystem, and their success depends on other ventures being willing to pay for their options. I consider this an important perspective to keep in mind.
A less common view, but one I think is important, is the shorts are all the people in tech who don’t form or work for ventures. This includes the famous “two guys in a garage” who may work for years but never get to the company stage.
Moreover, it includes the many people who give away their work in shareware and public internet sites, as well as engineers who work on ideas after work and on weekends. Collectively, these ideas represent a type of seed capital for ventures – a tremendous economic value that is never monetized. Indeed, the excess value in this approach to shorts can be used to create valuable options, because it does not require any return.
Unfortunately, since few people seem to share this view, I don’t think enough attention is paid to nurturing this community, nor to following it for signs that it is changing. So, it does not serve as much of a brake on tech volatility.
Parting Thoughts
A final view is one I think is dangerous: the people who are short are those who own assets and businesses that will be stranded if the venture succeeds. This is analogous to traders who think they are trading with victims, not customers. You can think of this group as the bricks-and-mortar retailers who were short Amazon’s venture-stage options.
This is a vision of tech companies as wolves planning to feast on the sheep of traditional businesses. In this scenario, there’s no reason to try to understand and provide service to your intended victims, who are short your options. There’s also no reason to keep volatility low for the benefit of businesses you intend to eliminate.
For the same reasons I don’t like the “wrested from nature” perspective, I think this “feasting wolves” theory about shorts on technology ventures is mostly wrong. Moreover, it suggests perverse behavior and negative risk management.
However you feel about the various answers to my title question, and whatever other answers you have of your own, this is a useful conversation to have with technology managers, workers, investors and bystanders. Knowing your customer is a key to long-term sustainable success in any enterprise.
Aaron Brown worked on Wall Street since the early 1980s as a trader, portfolio manager, head of mortgage securities and risk manager for several global financial institutions. Most recently he served for 10 years as chief risk officer of the large hedge fund AQR Capital Management. He was named the 2011 GARP Risk Manager of the Year. His books on risk management include The Poker Face of Wall Street, Red-Blooded Risk, Financial Risk Management for Dummies and A World of Chance (with Reuven and Gabriel Brenner). He currently teaches finance and mathematics as an adjunct and writes columns for Bloomberg.
Topics: Data
