On the Return to Venture Capital∗

This paper provides a theory that explains the sizeable excess return to venture equity, and ties it to the high VC discount rates, i.e., to VC impatience. The theory is based on the shortage of venture capitalists (VCs) — people who have the expertise to assess the profitability of projects, and have liquidity to finance them. A VC must supply not only money but also his time, and it is the scarcity of the latter that keeps the return to venture equity high. Since the VC’s opportunity cost of dealing with a company is supporting a new profitable project, he is less patient with maturing firms than an ordinary entrepreneur would be. This may explain why VC-backed firms reach IPOs earlier than other start-ups and why they are worth more at IPO. The scarcity of VCs enables them to internalize their social value, so that the competitive equilibrium is socially optimal. We estimate the model and back out the return of solo entrepreneurs which is always below that of the return on venture equity.