The Optimality of Multi-stage Venture Capital Financing: An Option-Theoretic Approach
AbstractFor venture capital firms, facing undiversifiable risks, multi-staged financing is an optimal contract which offers significant risk reduction at a cost of only slightly lower potential return. The optimality does not depend on the presence of moral hazard and agency problems. Our theoretical model of multi-stage financing, largely based on Asian option pricing theory, allows us to compute the risk reduction ratio due to multi-staging. The return on a staged financing plan is equivalent to an exchange of a straight equity stake for that acquired through stochastic averaging over time. We compare standard deviation ratios for staged vs. up-front financings as well as across asset classes. We find that risk mitigation due to multi-staging is significant in and of itself and enough to markedly improve venture capitalâ€™s risk-reward ratios relative to alternatives.
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Bibliographic InfoArticle provided by Pepperdine University, Graziadio School of Business and Management in its journal Journal of Entrepreneurial Finance and Business Ventures.
Volume (Year): 9 (2004)
Issue (Month): 3 (Fall)
Venture Capital; Options;
Find related papers by JEL classification:
- G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
- M13 - Business Administration and Business Economics; Marketing; Accounting - - Business Administration - - - New Firms; Startups
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Wang, Susheng & Zhou, Hailan, 2004. "Staged financing in venture capital: moral hazard and risks," Journal of Corporate Finance, Elsevier, vol. 10(1), pages 131-155, January.
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- Geske, Robert, 1979. "The valuation of compound options," Journal of Financial Economics, Elsevier, vol. 7(1), pages 63-81, March.
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