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Opportunity Cost of Capital for Venture Capital Investors and Entrepreneurs

Listed author(s):
  • Kerins, Frank
  • Smith, Janet Kiholm
  • Smith, Richard

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%.

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Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 39 (2004)
Issue (Month): 02 (June)
Pages: 385-405

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Handle: RePEc:cup:jfinqa:v:39:y:2004:i:02:p:385-405_00
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