Venture Capital Discount Rates
Venture Capital Discount rates used in conjunction with venture capital funds are generally higher than those found on regular investment portfolio funds. There are several reasons for this.
It is important to understand the difference between a discount rate and an interest rate. The interest rate uses the basic cost of the investment as the divisor in the formula, while the discount rate uses the expected return. A basic example of this would be a government bond that costs $80 and returns $100 in one year. The interest rate would be calculated by the formula, $100-$80 divided by $80, yielding an interest rate of 25%. The discount rate would use, $100-$80 divided by $100, yielding 20%. Why are venture capital discount rates generally higher?
One reason is that the venture capital fund is unable to hedge its investments as easily as other investment funds. The nature of the business ventures that attract venture capital limit’s their ability to diversify the fund to the same degree. Many times the venture capital firm involves a technology that will need to come to full maturation in order to become commercially successful.
It is the uncertain nature of the venture capital investment that influences the discount rate. Since the discount rate is concerned with ultimate cash flow return, this figure is very uncertain and will tend to change during the successive stages of the venture capital project. In the early stages, the technology must be proven to be viable or the project will be terminated. This will mean that the cash return will be limited to the liquidation value of the assets.
In the later stages of the project, when the venture is showing gains in acceptance and production, the cash return projections will be much higher. In the later stages of the project, when success is attained and the original investment goals are met, the cash return should be very high, which is the ultimate goal of any venture capital deal.
The higher discount rates charged to investors in venture capital funds result from the fact that despite the best efforts of the fund managers, all projects do not move from the early stage to the profitable later stages. The very nature of ground breaking technological start up companies means high risk versus high potential return. The investors in a venture capital fund must bear some of the risk, reflected in a higher discount rate, in order to have a piece of the possible greater return.