1. In contrast to venture capital, commercial banks are notoriously conservative

Question

1. In contrast to venture capital, commercial banks are notoriously conservative in lending to new business firms.  What makes venture capitalists more eager to finance risky projects?

2. Suppose you are very favorably considering a venture that has the following risk-return profile.

Probability Return

1/3 -10

1/3 0

1/3 +13

Since the expected return = 1.0, you give it a thumbs up.

But the venture capitalist who will fund the venture requires that he receive 25% of any positive profit. How would that change your verdict??

Short answers please, original work only. Thank you.

Explanation / Answer

In finance basic principle says risk and return goes hand in hand. The more risky project is the more return investor expect it to generate. Commercial banks are bound by various rules and regulations like BASEL norms, Fed requirements etc VCs do not have such rules and regulations abiding on them which give them more autonomy. Also VC do thorough business analysis before investing into any risky projects which help them to analyze future prospect of business, its earning potential etc

2. Suppose venture generates 13% profit. But if VC takes 25% of it then owner will receive only 75%*13=9.75% returns for a risky venture and VC will receive 3.25% which is very less in comparison to the risk taken. So it may result in rejection of funds by VC. All this is under assumption that VC has opportunities to generate returns at higher rate.

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