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RESEARCH PRODUCT

Valuing Common and Preferred Shares in Venture Capital Financing

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Abstract This article compares five different methodologies to value common and preferred shares with liquidation rights in a single-period setup of venture capital financing: the venture capital (VC) method; discounted cash-flow valuation with the Capital Asset Pricing Model (CAPM); discounted cash-flow valuation with market model in logs; a risk-preference-based approach; and the real options approach. The risk preference and the real option methodologies are the only ones that can properly account for the contingency in preferred stock. With small financings and small multiples the choice of methodology is not critical; however, with stronger preference rights, the VC method, the CAPM, and the market model in logs have difficulty coping with the contingencies, while the risk preference and the real option approach do well. The real option approach is fast and straightforward to implement as it requires only the venture value as input, which can be determined easily and accurately by any of the other four methodologies; the risk preference approach depends critically on unknown parameters and is computationally more intense.