Why do venture capitalists use such high discount rates?

Abstract

Purpose

Venture capitalists typically use discount rates in the range of 30-70 percent. During the startup stage of venture-capital financing, discount rates between 50 and 70 percent are common. The discount rate decreases from the first through fourth stage: from 60 to 30 percent. These rates of return are high compared to historical returns on common stocks or small stocks (12.1 and 17.8 percent, respectively). Such high discount rates cannot also be explained in the context of any existing asset pricing theory; that is, any reasonable risk-adjusted discount rates are not consistent with discount rates in the order of 30-60 percent. The paper provides a rational economic explanation why venture capitalists (VC) use such high discount rates. The paper aims to discuss these issues.

Design/methodology/approach

Let the discount rate of a venture project be 15 percent; this discount rate depends on the systematic risk of the cash flows from the project given that the project is successful. Using the procedure, a VC who estimates the probability of eventual success of the project between 60 and 40 percent will impose a discount rate between 42 and 74 percent. These discount rates are quite similar to the discount rates charged by VC in their startup and first stages.

Findings

The high rates of return charged by VC reflect the fact that not all their projects succeed in that they have no net cash-inflows. Adjusting for the probability of success of the project provides estimates of discount rates comparable.

Originality/value

The paper argues that reported rates of return of common stock are relevant for projects that have succeeded in that they have net cash-inflows.

Citation

Bhagat, S. (2014), "Why do venture capitalists use such high discount rates?", Journal of Risk Finance, Vol. 15 No. 1, pp. 94-98. https://doi.org/10.1108/JRF-08-2013-0055