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Opportunity Cost of Capital for Venture Capital Investors and Entrepreneurs

Published online by Cambridge University Press:  06 April 2009

Frank Kerins ,
Janet Kiholm Smith  and
Richard Smith
Frank Kerins
Affiliation:
kerins@vancouver.wsu.edu, Washington State University Vancouver, 14204 NE Salmon Creek Ave, Vancouver, WA 98686;
Janet Kiholm Smith
Affiliation:
janet_smith@mckenna.edu, Claremont McKenna College, 500 E Ninth St, Claremont, CA 91711
Richard Smith
Affiliation:
richard.smith@cgu.edu, Claremont Graduate University, 1021 N Dartmouth Ave, Claremont, CA 91711.
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Abstract

We use a database of recent high tech 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. For early stage firms, we estimate the effects of underdiversification, industry, and financial maturity on opportunity cost. Assuming a one-year holding period, the entrepreneur's opportunity cost generally is two to four times as high as that of a well-diversified investor. With a 4.0% risk-free rate and 6.0% market risk premium, for the sample average, we estimate the cost of capital of a well-diversified investor to be 11.4%, which equates to 16.7% before the management fees and carried interest of a typical venture capital fund. For an entrepreneur with 25% of total wealth invested in the venture, our corresponding estimate of cost of capital is 40.0%.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 39 , Issue 2 , June 2004 , pp. 385 - 405
Copyright
Copyright © School of Business Administration, University of Washington 2004

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