Does It Pay to Play? A Multi-Perspective on Follow-On Funding, Funding Structure and Investment Profitability in a Venture Capital Context

Abstract

Within this paper, I propose a comprehensive modelling framework to evaluate venture capital (VC) investment decisions from an individual investors' portfolio perspective.

The approach integrates the perspective of different shareholding parties and allocation of rights usually determined via shares in each one's portfolio.

Using a basic model implementation of the modelling framework, I focus on the feasibility of follow-on funding of investment projects given underlying investment profitability. In particular, I evaluate the minimum levels of profitability of the investment, where funding is feasible.

Based on the model, I propose alternative explanations on observed phenomena in VC such as underinvestment (non funding of positive net present value investments) and funding of negative net present value projects which are ultimately rooted in common practice of venture funding structure.

In a first model extension, I also consider the effectiveness of pay-to-play rights on the minimum levels of profitability. Based on the model's result, I conclude that pay-to-play rights effectiveness is eventually limited by the investment approval of shareholders.

Keywords: venture capital, contingent claims, option-pricing, pay-to-play rights

JEL Classification: G12, G31, G32, G33