An Entrepreneur's Guide to Understanding the Cost of Venture Capital

18 Pages Posted: 3 Apr 2012

See all articles by John D. Martin

John D. Martin

Baylor University - Department of Finance, Insurance & Real Estate

V. Ravi Anshuman

Indian Institute of Management Bangalore

Sheridan Titman

University of Texas at Austin - Department of Finance; National Bureau of Economic Research (NBER)

Date Written: March 30, 2012

Abstract

Entrepreneurs who deal with a venture capital firm (VC) for the first time often find themselves unprepared for the experience. The financing terms (deal structure), which specify the percentage of the firm’s common stock that goes to the VC often require that the entrepreneur forfeit a large proportion of the firm’s equity to the VC. The resulting ownership share is important but it is not the only determinant of the cash distribution rights conferred on the venture capitalist. Specifically, the entrepreneur often grants the VC control rights (the right to fill board seats, voting privileges of a common stockholder even though the VC holds preferred stock or debt, etc.) as well as liquidation rights (the right to be repaid before the common stockholders in the event of the sale or liquidation of the firm) that are not conveyed to the holders of common stock. Consequently, to fully understand the financing terms offered by the VC, the entrepreneur must not only account for cash flow rights, but must also incorporate consideration for control rights and liquidation rights. In this paper we attempt to explain why VCs seek very high rates of return that are so out of line with the returns required of established firms. Our explanation hinges on differences of opinion between an overly optimistic entrepreneur and a less sanguine VC.

Keywords: Entrepreneur, Venture Capital, Cost of Capital

JEL Classification: G31, G32, M13

Suggested Citation

Martin, John D. and Anshuman, V. Ravi and Titman, Sheridan, An Entrepreneur's Guide to Understanding the Cost of Venture Capital (March 30, 2012). Available at SSRN: https://ssrn.com/abstract=2033222 or http://dx.doi.org/10.2139/ssrn.2033222

John D. Martin (Contact Author)

Baylor University - Department of Finance, Insurance & Real Estate ( email )

P.O. Box 98004
Waco, TX 76798-8004
United States
254-710-4473 (Phone)
254-710-1092 (Fax)

HOME PAGE: http://hsb.baylor.edu/html/martinj

V. Ravi Anshuman

Indian Institute of Management Bangalore ( email )

Bannerghatta Rd.
Department of Finance
Bangalore, Karnataka

Sheridan Titman

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-232-2787 (Phone)
512-471-5073 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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