Journal of Financial and Quantitative Analysis

Research Article

Opportunity Cost of Capital for Venture Capital Investors and Entrepreneurs

Frank Kerinsa1, Janet Kiholm Smitha2 and Richard Smitha3

a1 [email protected], Washington State University Vancouver, 14204 NE Salmon Creek Ave, Vancouver, WA 98686;

a2 [email protected], Claremont McKenna College, 500 E Ninth St, Claremont, CA 91711

a3 [email protected], Claremont Graduate University, 1021 N Dartmouth Ave, Claremont, CA 91711.

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%.

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