Alternative Investments - Venture Capital Investment Characteristics and NPV

  • 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. Career Education & Resources

    How Hard are the CFA Exams?

    Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
  2. Professionals

    What it Takes to be a Financial Analyst

    A financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
  3. Career Education & Resources

    Financial Analyst: Career Path & Qualifications

    Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
  4. Career Education & Resources

    Financial Planner: Career Path & Qualifications

    Learn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
  5. Career Education & Resources

    Where to Find Non-Profit Finance Jobs

    The non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
  6. Career Education & Resources

    Portfolio Manager: Career Path & Qualifications

    Learn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
  7. Your Practice

    4 Professional Associations Advisors Should Join

    These four professional organizations are among the most respected and well known in the industry.
  8. Professionals

    Equity Research: Career Path and Qualifications

    Find out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
  9. Professionals

    What's on the CFA Level II Exam?

    The Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
  10. Professionals

    Financial Data Analyst: Career Path & Qualifications

    Learn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Security Analyst

    A financial professional who studies various industries and companies, ...
  4. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center