The performance of venture capital investments: failure risk, valuation uncertainty & venture characteristics

Abstract

The venture capital industry relies extensively on convertible contracts that allow VCs to convert their investments into an equity stake or a fixed debt position at a future date. We study convertible venture investments exposed to failure risk and valuation uncertainty using a double-hazard framework in which venture capitalists maximize the expected utility of their return from the convertible contract, the equity division’s determination takes into account the noisy valuation relation of venture profits to venture value, and entrepreneurs search for the best funding deal. These aspects of the model lead to new insights on how important venture characteristics affect key venture finance outcomes and the return-structure of the venture capital market. Model results show analytically that the expected return of convertible investments increases with growth prospects, funding size, initial value and VC productivity, but declines with failure risk, venture horizon and entrepreneur’s productivity. The model and numerical study further show that VCs with higher funding capacity will prefer to fund at later stages, as their expected return increases with investment size and competitive searching leads to an equilibrium in which VCs with lower productivities can coexist profitably as their expected return rises.