Value-Creating Uncertainty – A Real Options Approach in Venture Capital

This article investigates how venture capital is able and willing to enter the scene of innovative startup enterprises as a primary source of finance, despite the significant degree of uncertainty surrounding these firms. The paper explores venture capital’s unique risk attitude by proposing a real options approach. The tools and mechanisms applied by venture capitalists enable them to take advantage of the flexibility and uncertainty associated with startups, to exploit the value-enhancing ability stemming from continuous corporate learning, and to profit from the opportunities offered by such firms. As a result, young, innovative enterprises receive a higher rating from venture capital investors who are willing to participate and compete with other sources of finance in the financing of such enterprises. At the same time, the article points out that adapting the valuation applied in the case of financial options to venture capital investments is methodologically problematic; supplementing the real option valuation by decision trees may better capture the value-enhancing effect of the flexibility inherent in startups.