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ABSTRACT:
This paper measures the mean, standard deviation, alpha and beta of venture capital investments, using a maximum likelihood estimate that corrects for selection bias. Since Ūrms go public when they have achieved a good return, estimates that do not correct for selection bias are optimistic. The selection bias correction neatly accounts for log returns. Without a selection bias correction, I Ūnd a mean log return of about 100% and a log CAPM intercept of about 90%. With the selection bias correction, I Ūnd a mean log return of about 5% with a -2% intercept. However, returns are very volatile, with standard deviation near 100%. Therefore, arithmetic average returns and intercepts are much higher than geometric averages. The selection bias correction attenuates but does not eliminate high arithmetic average returns. Without a selection bias correction, I Ūnd an arith- metic average return of around 700% and a CAPM alpha of nearly 500%. With the selection bias correction, I Ūnd arithmetic average returns of about 57% and CAPM alpha of about 45%. Second, third, and fourth rounds of Ūnancing are less risky. They have progres- sively lower volatility, and therefore lower arithmetic average returns. The betas of successive rounds also decline dramatically from near 1 for the Ūrst round to near zero for fourth rounds. The maximum likelihood estimate matches many features of the data, in particular the pattern of IPO and exit as a function of project age, and the fact that return distributions are stable across horizons.

SUGGESTED CITATION:
John Cochrane, "The Risk and Return of Venture Capital" (January 4, 2000). Finance. Paper 39-00.
http://repositories.cdlib.org/anderson/fin/39-00