Class 4

1. Class 4 Based on Andrew Metrick’s slides

2. Industry Returns • Cambridge Associates (CA) • Venture Economics (VE) • Sand Hill Econometrics (SHE)

3. VC vs. Nasdaq (Net)

4. VC vs. Nasdaq (Gross)

5. Would you invest in this risky project? 0 -10 • -10 • -10 • -10 • -10 • -10 • +70 • -10 • -10 Note: The timing of the +70 NCF is random

6. Capital-Asset-Pricing Model (CAPM) ri = Ri = Rf + β(Rm – Rf) , • Beta risk = market risk = non-diversifiable risk = systematic risk = “covariance” risk • Idiosyncratic risk = diversifiable risk = firm-specific risk = residual risk

7. Beta and the Banana Birds • 100 islands, 100 trees on each island, 200 bananas per tree = 2M bananas in the world every year. • One person per island, only consume bananas. • No transactions costs. • Banana birds randomly land on half of all islands in each year, and eat all bananas while they are still green. Thus, birds get total of 1M bananas, and people get total of 1M bananas.

8. Banana Utility with Bird Risk

9. Banana Utility after Diversification

10. Banana Utility with Weather Risk

11. Performance Evaluation Regression Rit - Rft = α+ β(Rmt – Rft) + eit , where β, Rit, Rmt, and Rft are defined similarly to the earlier slide, except that previously the return variables represented expected returns, while here they represent realized returns for period t. The new elements in this equation are α, pronounced as “alpha”, the regression constant, and eit, the regression error term.

12. CAPM Estimation for VC Indices * Indicates statistical significance at the 95 percent level.

13. Fixing the CAPM (1) Style Adjustments (2) Liquidity (3) Stale Prices

14. Style Adjustments: The Fama-French Model (FFM) Rit - Rft = α + β * (Rmt – Rft) + βsize * SIZEt + βvalue * VALUEt + eit where α, β, Rmt, Rft, eit are defined as in the CAPM, SIZEt and VALUEtare the returns to portfolios of stocks designed to be highly correlated with their respective investing styles, and βsize and βvalue are the regression coefficients on these returns. These portfolios are called factors, so that the FFM is a three-factor model: a market factor, a size factor, and a value factor, and the betas are known as factor loadings.

15. Liquidity Adjustments: The Pastor-Stambaugh Model (PSM) Rit - Rft = α + β * (Rmt – Rft) + βsize * SIZEt + βvalue * VALUEt + βliq * LIQt + eit where LIQ is the new liquidity factor, βliq is its factor loading, and all other variables are defined as in the previous slide.

16. Stale-Value Adjustments and

17. PSM Estimation with Summed Betas for VC Indices * Indicates statistical significance at the 95 percent level.

18. Cost-of-Capital Estimation • ri = 4% (riskfree rate) + 1.83 × 7% (market) – 0.03 × 2% (size) – 0.52 × 5% (value) + 0.23 × 4.5% (liquidity) = 15.2%

19. Sahlman’s “Aspects of Financial Contracting in Venture Capital” Why do VCs use a 40% discount rate to evaluate the NCFs in business plans that they evaluate?

20. KPCB Returns 1Only $170M of Fund VII was ever drawn.

21. The Best VCs • Does it matter? Yes. • Hsu (2004) studies a sample of companies that receive multiple VC offers, and finds that “high-reputation” VCs • are more likely to have their offers accepted, and • pay between 10 and 14 percent lower for shares than do “low-reputation” VCs.

22. Returns and Investment

23. Group A • Accel Partners • Benchmark Capital • Charles River Ventures (CRV) • Kleiner, Perkins, Caufield & Byers (KP or KPCB) (John Doerr, Vinod Khosla) • Matrix Partners • Sequoia Capital (Michael Moritz)