Venture Capital and the Finance of Innovation
The textbook treatment of valuation, terms and expected returns.
Summary
Andrew Metrick and Ayako Yasuda wrote the standard textbook on venture capital, treating it as a subject in finance with its own valuation and contracting problems rather than as a business practice to be described.
The first part covers the industry's structure: the limited partnership, the fee and carry arrangement and its present value to the manager, which Metrick and Yasuda analyse quantitatively in a way the industry does not, and the returns to venture funds and how they should be measured. Their finding that a substantial share of manager compensation comes from fees rather than from carry, particularly in large funds, is one of the book's contributions.
The second part covers valuation. They set out the venture capital method used in practice, its relationship to discounted cash flow, and then the more rigorous treatment: preferred stock with liquidation preferences and participation is an option on the firm's value, and valuing it requires option pricing rather than the simple share-count arithmetic that the industry uses. They show how the standard post-money valuation overstates the company's actual value because it prices common stock as if it had the same terms as the preferred. The third part covers the innovation side, including patents, research and development and the returns to innovation. The book is quantitative and used in graduate courses. Its treatment of preferred stock as an option is the analytical contribution most relevant to founders negotiating terms.
Key takeaways 7
- Preferred stock with liquidation preferences and participation is an option on the firm's value and must be priced accordingly.
- The standard post-money valuation overstates a company's actual value because it prices common stock as if it carried the preferred terms.
- A substantial share of venture manager compensation comes from management fees rather than from carried interest, particularly in large funds.
- The fee and carry arrangement has a present value to the manager that can be computed and that differs from its stated alignment.
- Venture fund returns must be measured against a public market equivalent to establish whether the illiquidity was compensated.
- The venture capital method used in practice is a shortcut whose relationship to discounted cash flow can be stated exactly.
- Contract terms rather than headline valuation determine what a founder actually owns in each outcome.
Who should read it
Founders negotiating term sheets and investors who want venture capital treated quantitatively, particularly the option pricing of preferred stock.
Where it sits in the reference 2
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