Think Value

Startup Valuations: Venture Funds vs. The Pastor-Stambaugh Model

In the evaluation of startup valuations, venture capital funds often rely on The Pastor-Stambaugh model (PSM) instead of the Capital Asset Pricing Model (CAMP). This preference arises because startups place significant weight on liquidity parameters in the price of their capital risk.

Due to the nature of the research, it is believed that one index sets the upper bound, while the other sets the lower bound for the expected returns of venture capital funds.

The results of index studies show a high alpha (a measure of abnormal returns), which makes the standard CAPM (Capital Asset Pricing Model) inconvenient,

Thus, additional parameters are introduced into the model:

The Pastor-Stambaugh model introduces a liquidity premium, with its beta (as determined by statistical analysis) provided in the table, and the liquidity premium is assumed to be 5%*. (https://faculty.chicagobooth.edu/lubos-pastor/data)

Ultimately, the cost of equity for venture capital funds is estimated to be around 15% (although the ERP, or Equity Risk Premium, in this formula is 7%, which is quite high):

Source:

*Venture Capital & the Finance of Innovation – by A. Metrick & A. Yasuda