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

11 Pages Posted: 13 Oct 2012

See all articles by V. Ravi Anshuman

V. Ravi Anshuman

affiliation not provided to SSRN

John Martin

Baylor University

Sheridan Titman

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

Date Written: Summer 2012

Abstract

Entrepreneurs who deal with a venture capital firm (VC) for the first time often find themselves unprepared for the experience. The deal structure language used to describe financing terms, and the methods used to value the investment, are unique to the VC world. The authors have two objectives in preparing this entrepreneur's guide to venture capital finance: First, they explain why VCs require rates of return that are considerably higher - even after adjusting for difference in risk - than the returns required by the shareholders of established companies. Their explanation focuses on differences of opinion between overly optimistic entrepreneurs and less sanguine VCs. Second, the authors discuss the difficulty faced by entrepreneurs when trying to understand the actual cost of VC financing (including the dilution of value that occurs when entrepreneurs fail to meet targets or milestones). The problem can be traced to deal structure terms that typically call for the VC to receive preferential treatment in the event the entrepreneur's scenario does not turn out to be accurate. More specifically, entrepreneurs often grant VCs control rights as well as liquidation rights that, when things go wrong, dramatically increase the effective cost to entrepreneurs of venture financing.

Suggested Citation

Anshuman, V. Ravi and Martin, John and Titman, Sheridan, An Entrepreneur's Guide to Understanding the Cost of Venture Capital (Summer 2012). Journal of Applied Corporate Finance, Vol. 24, Issue 3, pp. 75-83, 2012. Available at SSRN: https://ssrn.com/abstract=2161189 or http://dx.doi.org/10.1111/j.1745-6622.2012.00391.x

V. Ravi Anshuman (Contact Author)

affiliation not provided to SSRN

John Martin

Baylor University

Waco, TX 76798
United States

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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