For 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.
G24, M13, G13
Venture Capital, Options
"The Optimality of Multi-stage Venture Capital Financing: An Option-Theoretic Approach,"
Journal of Entrepreneurial Finance and Business Ventures:
3, pp. 1-14.
Available at: http://digitalcommons.pepperdine.edu/jef/vol9/iss3/2