Opportunity Cost of Capital for Venture Capital Investors and Entrepreneurs
Claremont Graduate University Working Paper
56 Pages Posted: 21 Apr 2003
Date Written: February 2003
We use a database of recent high-technology IPOs to estimate opportunity cost of capital for venture capital investors and entrepreneurs. Entrepreneurs face the risk-return tradeoff of the CAPM as the opportunity cost of holding a portfolio that necessarily is underdiversified. We model the entrepreneur's opportunity cost by assuming the venture financial claim and a market index comprise the entrepreneur's portfolio. We estimate total risk and correlation with the market and examine how these estimates and opportunity cost of capital vary with underdiversification and by industry and financial maturity of early-stage firms. Early-stage firms have market risk levels similar to more established firms in our sample, but have higher total risk. Equity of newly public, high tech firms generally is more than five times as risky as the market and correlations with the market generally are below 0.2 so that beta is close to one. Assuming reasonable levels of underdiversification in the entrepreneur's portfolio and a one-year holding period, depending on industry and stage of development, the entrepreneur's opportunity cost generally is two to four times as high as that of a well-diversified investor. With a 4.0 percent risk-free rate and 6.0 percent market risk premium, for the sample average observation, the cost of capital of a well-diversified investor is estimated to be 11.4 percent, or 16.7 percent before the management fees and carried interest of a typical venture capital fund. The corresponding cost of capital for an entrepreneur with 25 percent of total wealth invested in the venture is estimated to be 40.0 percent. Empirical results are of the same order of magnitude as estimates derived by others, using different methods, but have the advantage of being based on public data.
Keywords: venture capital, cost of capital, diversification
JEL Classification: G11, G12, G24
Suggested Citation: Suggested Citation