Early-stage venture capital (VC) has always been the oddball in asset management. Unlike other asset classes, it offers the highest potential returns, but it also comes with the highest variance—especially when portfolio construction isn’t done right. On top of that, it has an inherent “default rate” of about 80%.

Tell a traditional fund manager about this 80% default rate, and you’ll likely get a strange look.

A few months ago, I was trying to explain how VC works to a fund manager. After covering the usual points—how VC is essentially a home run derby with many misses—he paused and said, “I get it. VC is like buying call options on startups.”

I hadn’t considered it that way before, but he was absolutely right.

For those unfamiliar, buying a call option gives you the right, but not the obligation, to purchase a stock at a predetermined price (the strike price) before a specified expiration date. Investors use this strategy to profit from an anticipated—but not guaranteed—increase in the stock’s price. If the stock price rises above the strike price (plus the premium paid), the option becomes profitable. The potential profit is theoretically unlimited, while the maximum loss is limited to the premium paid.

Similarly, investing in a startup gives you the chance to acquire equity at an attractive price, with a ~20% chance the startup will take off—though this usually takes about a decade to materialize. VCs use this strategy to profit from a potential—but not guaranteed—rise in the company’s value. If the startup succeeds and its valuation soars beyond the investment (plus associated costs), the return can be massive. The potential profit is virtually unlimited if the company becomes a breakout success, while the maximum loss is limited to the initial investment.

VC and call options are strikingly similar, don’t you think? They’re like twins!

From now on, I’ll tell people: Venture capital is call options on startups.

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