• Illiquid - No easy or short-term path to get out of the investment. An investor will most likely have to wait until the company is able to attract a buy-out or issue an IPO. A liquidity risk premium is a characteristic of the initial investment.
  • Long-term commitment required - Given the nature of the investment and the process of developing a viable business, VC investors must make a long-term commitment - at least three to five years; however, the profit potential is huge. This is mostly due to the time lag between starting a company and bringing it to a buy-out or IPO.
  • Difficulty determining market values - Since these assets do not trade in an active marketplace it's difficult to determine an objective value for the business and the investment.
  • Limited historical risk and return data - This is due to the fact that there are no active trading markets.
  • Entrepreneurial/management mismatches - Brilliant entrepreneurs don't always make the best business executives. Management styles that may have worked perfectly during a business's early stages may be disastrous as the company grows larger.
  • Fund manager incentive mismatches - Managers may be rewarded for the size of their fund, not its performance.
  • Lack of knowledge of the competitors - Because some entrepreneurs are developing new businesses, there is generally little information as to who else is working in their space. As such, competitive valuations are difficult to find in the marketplace.
  • Vintage cycles - The volume of business start-ups is dependent on the economic climate - some years offer more and better opportunities than others. It all depends on the market and who and when firms are entering and exiting the marketplace.
  • Extensive operations analysis and advice may be required - Most often, the start-up's founder and early manager has a specific type of business experience - say, financial expertise - but may lack operational or marketing experience.


Calculating the net present value of a venture capital project
Let's illustrate this with an example:

An investor can invest $2 million in a new project that will last five years and will pay $18 million. His cost of equity for this project is 14%. He also knows that the project could fail at any time and has given the following percentages for the failure rate as follows:



Year 1: 35%, Year 2: 30%, Year 3: 25%, Year 4: 20%, Year 5: 20%

Answer
1) The first step is to determine the probability that the project will work. This equals (1-.35)(1-.30)(1-.25)(1-.20)(1-.20)= .65*.70*.75*.80*.80=. 22 or a 22% chance of failure.

Now if the project failures the NPV =-$2,000,000 (the amount invested in the project); however, if it works out the NPV of the project if it survives five years = 18,000,000/1.14 to thefifth power = $9,255,000.

So the expected NPV = (.22 * 9,255,000)+(.78 * -2,000,000)=2,036,100 - 1,560,000 = 476,100.

Based on these calculations, an investor would take this investment because of the positive expected NPV.



Hedge Fund Basics

Related Articles
  1. Investing

    A Look Into The Secrets Of Venture Capitalism

    Venture capitalists own an equity stake in the start-up and have a say in the functioning of the company. Investments are generally made in early stages of a company with long term high growth ...
  2. Small Business

    Does Your Startup Need Venture Capital Money?

    Venture capital funding provides capital to grow a business. However, entrepreneurs will also lose some control over business decisions.
  3. Managing Wealth

    Seek An Adventure In Venture Capital

    Make a career out of chasing down the "next big thing".
  4. Tech

    The Risk And Rewards Of Investing In Startups (GOOG)

    Investing in startups is a very risky business but can reward investors greatly if and when they do pay off.
  5. Insights

    5 Ways To Get Venture Capital Funding

    Crowdfunding and online networking are just some of the ways you can find venture capital investors.
  6. Investing

    How Social Venture Capital Is Changing the World

    Learn what social venture capital is and the ways in which it differs from traditional venture capital. Identify two leading social venture capital firms.
  7. Small Business

    How To Use Crowdfunding To Start Your Business

    It may be difficult to raise enough money needed for a start-up. However, there's always the option of pooling together funds with a group of people.
  8. Investing

    Penny Stocks Vs. Venture Capital: Which Carries the Highest Risk?

    Learn how the challenges of venture capital investing and buying penny stocks differ and which type of investment carries the most risk.
  9. Small Business

    How Venture Capital Will Change in 2016

    Venture capitalists face a tech bubble on the horizon, along with an influx of new non-traditional investors via Wall Street and crowdfunding platforms.
  10. Financial Advisor

    A How-To Guide to Being a Venture Capitalist

    So, you want to be a venture capitalist? Here's what it takes (besides capital).
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center