The Optimality of Multi-stage Venture Capital Financing: An Option-Theoretic Approach

Robert Dubil
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Robert Dubil: University of Connecticut

Journal of Entrepreneurial Finance, 2004, vol. 9, issue 3, 1-14

Abstract: For venture capital firms, facing undiversifiable risks, multi-staged financing is an optimal contract which offers significant risk reduction at a cost of only slightly lower potential return. The optimality does not depend on the presence of moral hazard and agency problems. Our theoretical model of multi-stage financing, largely based on Asian option pricing theory, allows us to compute the risk reduction ratio due to multi-staging. The return on a staged financing plan is equivalent to an exchange of a straight equity stake for that acquired through stochastic averaging over time. We compare standard deviation ratios for staged vs. up-front financings as well as across asset classes. We find that risk mitigation due to multi-staging is significant in and of itself and enough to markedly improve venture capital’s risk-reward ratios relative to alternatives.

Keywords: Venture Capital; Options (search for similar items in EconPapers)
JEL-codes: G13 G24 M13 (search for similar items in EconPapers)
Date: 2004
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