Opportunity Cost of Capital for Venture Capitalists and Entrepreneurs
52 Pages Posted: 17 Jun 2001
Date Written: July 2001
We develop theory and evidence related to opportunity cost of capital for venture capital investors and entrepreneurs. New venture investment involves a financial contract between an entrepreneur and outside investors. Investment managers, such as venture capital firms, represent investors who are well diversified. In contrast, the entrepreneur necessarily is underdiversified and must commit a substantial fraction of human and financial capital to the venture. Consequently, the entrepreneur's required rate of return depends on total risk in the context of the entrepreneur's other assets. With the Capital Asset Pricing Model as an approximation of the model used by well-diversified investors, the entrepreneur faces the risk-return tradeoff of the CAPM as the opportunity cost of underdiversification. We model opportunity cost, assuming investment in the venture is one of two assets in the entrepreneur's portfolio and the other is the market portfolio. We investigate opportunities for financial contracting to create value when the parties have different costs of bearing risk. To provide empirical estimates of cost of capital for entrepreneurs and well-diversified investors, we compile data on systematic, total risk, and beta for 2623 newly public firms in eight high-technology industries The equity of newly public firms generally is more than five times as risky as investment in the market and correlations between firm returns and market returns generally are below 0.2. Assuming reasonable market parameters and modest but reasonable levels of underdiversification, the entrepreneur's opportunity cost is more than twice that of a well-diversified investor. Over relevant ranges of diversification, the entrepreneur's opportunity cost decreases materially as diversification increases. The evidence implies substantial opportunities for value creation by contracting to reduce underdiversification.
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