In considering the issue of valuation generally, one should understand the environment in which a manager of a venture pool operates; he is investing not in one but in a number of opportunities. One of the foundations of modern portfolio theory is the concept that the return on an asset cannot be viewed by itself; rather it must be judged by its contribution to the portfolio as a whole. Thus, when deciding to invest in a company, the venture capitalist must consider how the expected return on the new investment is correlated with the others he holds, ranking opportunities on both an ordinal and cardinal scale. In a significant sense, a cardinal ranking of sorts is always involved because the portfolio manager does not enjoy an infinite array of opportunities. If he is a venture manager, it is incumbent on him to put his money to work in venture investments, meaning that he has to compare each opportunity with what he has and what he is likely to be offered. If a given deal looks like it is better than anything else in sight, he is likely to take it on the founder's terms, even though his own number (based on his idea of valuation in a perfect universe) would be lower were his alternatives wider.
Again in keeping with the idea that it is the portfolio, not the individual investments, being managed (portfolio management), venture capitalists usually diversify their holdings by categories of risk, investing across varying risk levels: a cohort of start-ups carrying, say, an average (forecast) 40-percent compounded rate of return coupled with later-round financings which promise lower returns as a trade-off for better downside protection and the ability to cash out in the near term. Parenthetically, one must recognize that modern portfolio theory cannot be applied uncritically to a venture portfolio because, as one analyst has put it, venture investments "are not available in continuously desirable funding instruments." The new venture manager cannot decide to put 1 percent of the capital pool in a venture that actually needs 6 percent of the pool in order to reach the next development milestone, not unless someone else can be counted on to put up the next installment.
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
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