Idiosyncratic Risk of New Ventures: An Option-Based Theory and Evidence

Abstract

This paper studies idiosyncratic risk of new ventures. An option-based model of a new venture with multistage investments and jumps is developed. Our model explains (1) why new ventures' 'idiosyncratic volatility eventually decreases as they clear RD (2) the negative relation between jumps in value and subsequent idiosyncratic volatility - the jump effect; (3) the dynamics of idiosyncratic volatility under different schedules of staged venture capital investments; and (4) the effect of different schedules of staged investments on firm valuation with the presence of jumps. Empirically, we develop a generalized Markov-Switching EARCH model to simultaneously capture structural changes in firms' 'idiosyncratic volatility and the relation between jumps and idiosyncratic volatility. Using a hand-collected dataset of early-stage biotech firms, we find empirical evidence supporting the jump effect and the stage-clearing effect described by our model.