Question

What are the criticisms of using high discount rates for the Venture Capital method? How do venture capitalists justify their use?

Answer 1

Though the Venture Capital Method is used as a Dominant method in early stage investments, it comes with its own share of shortfalls, few of which are :

Firstly, it relies upon projected growth & future revenues where in to predict the revenue on a future date is not only difficult but highly speculative. Secondly, this method relies on valuation multiples to derive a terminal valuation which in turn increases the uncertainty of this method in comparision to other methods.

Thirdly, the discounted rate of return is completely subjective based upon the perceived risk of a given investor. Hence, this method could produce varied results to various investors since there is no fixed method to assess a risk in relation to a subject business.

However, the rationale provided by VC to use this method is that basically not all of their projects would succeed & the high rate of return is to adjust the probability of inflows from common stocks & other financial assets even when few of their other projects bring no returns.