Required Rates of Return and Financial Contracting for Entrepreneurial Ventures
50 Pages Posted: 26 Aug 2009
Date Written: May 1, 2009
Investments in new venture involve financial contracts between an entrepreneur and one or more outside investors. Outside investors (such as venture capital firms) generally represent well-diversified investors. Even private investors generally commit small fractions of total wealth to any given venture. The entrepreneur, in contrast, usually must commit a substantial fraction of human and financial capital to the venture. In this paper, we assume that the Capital Asset Pricing Model is a reasonable approximation of the asset pricing model used by well-diversified investors, and that the entrepreneur faces the risk-return tradeoff of the CAPM as the opportunity cost of holding an under-diversified portfolio that includes investment in the venture. The result is that the entrepreneur's required rate of return depends on total risk of the investment, in the context of other assets in the entrepreneur's portfolio. We model the required rate of return of the entrepreneur, assuming that investment in the venture is one of two assets in the portfolio and that the other is the market portfolio. Since the required rate of return for the entrepreneur is always higher than that of a diversified investor, opportunities arise for value-enhancing financial contracts to be devised based on allocation of risk. In the paper, we explore opportunities for value creation when the parties to a financial contract have different costs of bearing risk, and where adverse selection and moral hazard are both concerns. The analysis yields a number of testable implications for the structures of new venture financial contracts.
Keywords: venture capital, cost of capital, entrepreneurial finance
JEL Classification: G11, G12, G24
Suggested Citation: Suggested Citation