Valuation, Returns and Disclosure

Entrepreneurial firms typically do not have significant cash flow to pay dividends on equity or interest on debt. Therefore, venture capital fund investments are valued primarily on the basis of a capital gain upon an exit event. Exits typically occur two to seven years after the initial investment, so it is crucial that venture capital fund managers accurately value a firm, or its potential, prior to initial investment in view of the resources to be expanded by the venture capital fund manager over the investment life. Unlike more traditional investments, the valuation of the initial investment depends primarily on an expected exit value, which is rather challenging to predict in view of information asymmetries and potential agency costs. The purpose of this chapter is to shed light on a typical methodology used in valuing venture capital investments by venture capital fund managers. As well, we present evidence on how returns to venture capital investment vary depending on the structure of the investment, with consideration to the characteristics of the venture capital fund, the characteristics of the entrepreneurial firm, the contractual relation between the venture capital fund and entrepreneurial firm, market conditions, and different legal settings across countries. It is noteworthy that over the life of the venture capital fund, venture capital fund managers are required to regularly report valuations of unexited investments, and returns of exited investments, to their limited partner institutional investors. As shown by Cumming and Walz (2004), the reported returns on unexited investments, however, tend to be biased upward (Phalippou and Zullo, 2005, confirm this finding). In this chapter we explain factors that lead to reports being biased upward with reference to an international dataset from Cumming and Walz (2004) from 39 countries around the world. The valuation of unexited investments has been a frequently debated issue in the media since the CalPERS lawsuit in 2002 (see Chapter 7) and an issue that has negatively influenced venture capital fund-raising on an industry-wide level. In this chapter we will do the following:
● Review the mechanics underlying the venture capital valuation method
● Present evidence on venture capital fund returns to show ways in which the discount rate or cash flows considered in valuations might be adjusted depending on the characteristics of the venture capital fund, characteristics of the entrepreneurial firm, structure of investment, market conditions, and legal conditions
● Present evidence that shows how returns are disclosed to institutional investors prior to an exit event