Staging of Venture Capital Investment: A Real Options Analysis

Abstract

This paper uses contingent claims analysis to investigate the staging decision of a venture capitalist in a principal-agent framework. Venture capital investment opportunities are modeled as real options with multiple volatilities, and the entrepreneur's incentive is assumed to maximize the probability of getting funded in the next financing round. The formulae of Black and Scholes (1973) and Geske (1979) are generalized to evaluate these real options. We find that staging not only gives the venture capitalist a waiting option but also mitigates the agency problem of the entrepreneur undertaking too conservative activities. Moreover, we find that the venture capitalist tends to stage her investment when the expected growth rate of the venture's market value is lower, when more capital is needed in future financing rounds, or when the venture is younger. However, the risk-free interest rate is not an important factor in the staging decision. Our model also provides a good explanation for existing empirical evidence on the staging of venture capital investment.