Even though investments in venture capital projects pose significant risks, the investors are motivated by huge expected returns from at least some of the projects. The ratio of success to failure is very low, but the companies that succeed cover up their losses in other investments.
Unlike other businesses, venture capital projects also pose other risks such as inexperienced entrepreneurs, innovative ideas, and uncertain time to success.
However, venture capital funds invest in many projects and the risk of the entire portfolio will be lesser compared to individual investments due to diversification.
There are three key factors while valuing a venture capital project:
1. Expected payoff at the time of exit, if venture succeeds
2. Time to exit
3. Probability of failure
Let's take a simplified example to understand the payoff.
An investor is considering investing $1 million in a new project. he expected that if the project succeeds it will pat $10 million at the end of five years.
However, the risk is that the project may daily in any of these five years. The investor's cost of equity is 15%, and he has the following estimates for the project failure in the next 5 years:
| Year | Prob. of Faulire |
|---|
| Year 1 | 30% |
| Year 2 | 25% |
| Year 3 | 20% |
| Year 4 | 20% |
| Year 5 | 20% |
First we need to calculate the project will succeed, i.e., the project will survive to the end of 5 years. This can be calculated as follows:
= (1-0.30)*(1-0.25)*(1-0.20)^3 = 26.88%
The next thing we want to calculate is the NPV if the project is a success and earn $10 million for the investor. The NPV can be calculated as follows:
NPV if the Project Succeeds
= -$1 million +$10 million/(1.15)^5
= $3.97
NPV if the Project Fails: -$1 million
The expected NPV of the project will be:
=0.2688*$3.97 million + 0.7312*(-$1 million)
=$335,936
Since the expected NPV is positive, the recommendation is the aspect the project.
