Article

Required Rates of Return and Financial Contracting for Entrepreneurial Ventures

Richard Smith

in The Oxford Handbook of Venture Capital

Published in print April 2012 | ISBN: 9780195391596
Published online September 2012 | | DOI: http://dx.doi.org/10.1093/oxfordhb/9780195391596.013.0016

Series: Oxford Handbooks

 Required Rates of Return and Financial Contracting for Entrepreneurial Ventures

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This article focuses on determining the appropriate discount rate to be used by an entrepreneur who is deciding whether or not to proceed with a prospective venture. First, it analyzes the investment decision from the perspective of a venture capitalist (VC). It shows that the discount rates commonly used by VCs are consistent with the discount rates implied by financial economic theory. It then draws on the same financial economic theory to infer the required rate of return (i.e., opportunity cost of capital) for an entrepreneur who is undertaking a venture that will require commitment of substantially all of the entrepreneur's wealth and effort. Among other things, it concludes that the required return on the entrepreneur's investment is higher than the required return of a VC who represents well-diversified investors and is considering a similar financial claim. The analysis is extended to consider the required return for an entrepreneur who is able to divide total wealth between the venture and a well-diversified portfolio of market assets. It is shown that the required rate of return to the entrepreneur depends on the allocation of wealth between the venture and the market portfolio. Thus, to an extent, by selecting the asset allocation between the two, the entrepreneur can control the required rate of return on the venture. The article includes a discussion of methods of implementation, along with an illustration of one approach. It concludes by focusing on the design of value-maximizing financial contracts between entrepreneurs and outside investors.

Keywords: discount rates; venture capitalists; venture capital; rate of return; asset allocation

Article.  11952 words. 

Subjects: Economics ; Financial Markets

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