Evaluation Cost of Venture Capital for Investors and Entrepreneurs in the French Market

Article excerpt

I. INTRODUCTION

Financing new venture capital-backed firms involves a contract between an entrepreneur and a venture capital firm. Investors in venture capital funds have a well-diversified portfolio. However, for a start-up entrepreneur his risk is necessarily undiversified and he has to allocate a substantial fraction of his human and financial capital in the company. Consequently, the return cost required by the entrepreneur depends especially on the total risk of the firm.

Investors are attracted by venture capital because it enables them to realize potential returns that are higher than returns obtained following investment in IPOs. Equally, Venture Capital (VC) entrepreneurs are attracted by an estimated much higher return than their human and financial capital. Nevertheless, despite the dearness of data, most studies on venture capital and entrepreneurship show that returns performed by VC firms can be generally compared to returns of IPO shares and that the entrepreneurs' financial returns are generally inefficient. Moskowitz et al (2002) assume that entrepreneurs can accept an inefficient financial profitability because they benefit from nonpecuniary benefits.

Moreover, some researchers have attempted to study estimated return of venture capital investments relying on the realized returns. However, the ex-ante projection of the realized historical returns represents a biased approach for future return estimation. Cochrane (2005) considers that most studies have been carried out basically on VC IPOs or during the financing of a new stage or in the case of VC repurchasing. As a result, these events are more likely to occur when the company performs a positive return. Thus, the author considers that the average adjusted return of VC studied firms is declining from 18% to 15%.

We are developing some evaluations of the opportunity cost of capital for investors of venture capital firms (limited partners, LP) and entrepreneurs. We will check if, after an IPO, beta, the total risk and correlation with the market are systematically linked to the size of the firm, its development stage or the nature of the firm's activity.

We notice that the average beta of new IPO VC firms is approximate to that of the market and that betas are negatively correlated with the age and the size of the studied firms. As for entrepreneurs, we have managed to identify the impact of non-diversification on the opportunity cost of the capital of projects. Knowing that entrepreneurs can allocate their wealth between the venture and the market index, we find out that the new venture cost of capital is generally two to four times as high as for well-diversified investors.

The organization of this paper is as follows. Section II exposes the literature review and methodology. Section III displays the evaluation methods we use to estimate the cost of capital for venture capital investors and entrepreneurs. Section IV illustrates the results of undiversified and well-diversified analyses. Section V provides an evaluation of the cost of capital for investors and entrepreneurs. Section VI is a concluding one.

II. LITERATURE REVIEW AND METHODOLOGY

A. Returns of Venture Capital

Several researches have included the required return of venture capital investments for the study of venture capital returns funds. Bygrave and Timmons (1992) and Gompers and Lerner (1997) find that gross-of-fee returns progresses on average from 13% to 31%. Venture Economics notices that the realized average returns of US venture capital funds between 1981 and 2001 was 17.7%. In contrast, for the same period, the average return of realized investments in the S&P 500 was 15.6%. However, explaining the premium difference between both studies remains ambiguous; it can be justified by a compensation for investment in venture capital or simply an artifact based on selecting data. In a recent study, Cochrane (2005) finds a geometric average of realized returns on venture capital investments of 5. …