The Evaluation of Venture Capital As an Instalment Option: Valuing Real Options Using Real Options

Many start-up companies rely upon venture capitalists to begin operations. Typically, after the initial injection of funds, additional funding is provided as the firm reaches certain performance targets. The payment of the first funding round is comparable to an initial option premium. Further payments are contingent claims: the right but not the obligation to continue financially supporting the project. If at any point, the venture capitalist ceases to pay, the project is assumed to end. Therefore, the venture capitalist can be thought of injecting funds that not only keep the project alive but also retain the right to pay the remaining payments in the future. We interpret this type of corporate finance transaction as a multiple stage compound option, which is also known as an instalment option. In previous work by Davis, Schachermayer and Tompkins (2001, 2002), instalment options on traded assets were considered. In these papers, it is shown that static portfolios of simple European options can be formed that yield no arbitrage bounds on the value of instalment options. In this research, we extend the analysis to venture capital contracts. For imitator (clone) projects, we derive bounds on how much a venture capitalist should initially invest in such start-up firms. Under suitable assumptions, such bounds rely solely upon no arbitrage arguments. Upper and lower bounds can be enforced by constructing portfolios of European options on firms in the same industry. To the best of our knowledge, the relationship between the financing of imitator start-up companies and instalment options has not been identified previously. JEL classifications: G24, G32, C52