Corporate Risk Management

CHAPTER 11Venture Capital Risk with Optimal Financing Structure

External financing of venture capital projects that include considerable research and development is difficult because entrepreneurs have no loan guarantees or collateral to offer.¹ In addition, it is hard for them to convince potential shareholders to buy shares at a price that represents the value of the project. When projects are characterized by high uncertainty, traditional sources of external financing are generally unavailable. As a result, entrepreneurs are consequently obliged to turn to venture capital firms.

Investors require a high anticipated rate of return because investing in this type of project is very risky. Unlike banks, venture capital firms want to manage the business financed in order to increase the profitability of their projects. These firms generally have more business experience and financial knowledge than do the entrepreneurs/researchers who developed new ideas or inventions.

Venture capital financing contracts often differ in form from simple debt and equity. One form discussed in the literature is nonguaranteed debt (debentures) convertible into shares where the investor, often via the venture capital firm, becomes a shareholder when the profits reach a certain level. This form of financing lets investors protect themselves when the profits are low (or at least provides more protection than if they held shares) and obtain a higher return (than they would get from standard debt) in ...