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

Abstract

Venture Capital is an important source of funding for start-up companies and little is known about how much a Venture Capitalist should contribute to the Project. Real Option analysis has been proposed to evaluate staged financing of Venture Capital projects but many of the input parameters to option pricing models are unobservable leading to option evaluation that is not preference free. Instalment options are exotic options that resemble most closely the staged payment schedule for Venture Capital Projects and previous work has shown that the prices of such Instalment Options can tightly bound by portfolios of European options. When a Venture Capital Project is a “clone” of an existing firm project (imitator firm), the same approach to determining bounds on the value on the Project can be found by examining portfolios of European options on the existing firm. Such an approach leads to arbitrage bounds on how much a Venture Capitalist would be willing to invest into such a Venture Capital Project.

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