New venture cost of equity and risk models: a theoretical analysis

Accurate estimation of the cost of equity is critical for new ventures, particularly given their inherently high levels of uncertainty and risk. Traditional financial models often fall short in capturing the unique characteristics of early-stage ventures, especially when applied outside developed capital markets. This dissertation provides a comprehensive theoretical and analytical investigation into cost of equity estimation and risk modeling tailored to the context of new ventures. The study addresses the key research question of how risk can be effectively modeled, assessed, and reduced in entrepreneurial finance, and how this influences the calculation of a new venture's cost of equity. The dissertation is structured around three core contributions. First, it evaluates and classifies existing cost of equity models, including the Capital Asset Pricing Model (CAPM), multi-factor models (e.g., Arbitrage Pricing Theory and Fama-French), and models derived from behavioral finance. Their applicability to new ventures is critically assessed, with special attention to emerging market contexts where standard assumptions regarding market efficiency, investor rationality, and diversification often do not hold. Second, the work explores the multidimensional nature of risk in new ventures. A detailed typology of risk factors is developed, distinguishing between internal (e.g., entrepreneurial team, product viability), external (e.g., market conditions, institutional context), and financial risks (e.g., liquidity, valuation). Empirical data from existing studies is synthesized to highlight regional differences and institutional influences on venture risk perception and investment criteria. The dissertation identifies and analyzes how venture capitalists incorporate these factors into their decision-making processes, accounting for biases, heuristics, and subjective risk preferences. Third, the thesis proposes and develops two original models. The first is a Single-Stage Risk Assessment and Cost of Equity Model, which incorporates idiosyncratic and downside risk factors into a tailored estimation of the cost of equity for new ventures. This model integrates both quantitative and qualitative variables and includes a novel adjustment mechanism for risk aggregation and diversification effects. The second model is a Multi-Stage Risk Reduction Model, which reflects the dynamic nature of venture development and investment. It accounts for sequential funding, staging, transaction costs, and capital risk, providing a structured framework for venture capitalists to assess and mitigate risk over time. The models offer both theoretical and practical contributions. Theoretically, they extend financial decision theory by incorporating elements from entrepreneurial finance, behavioral economics, and institutional theory. Practically, they provide tools for investors and entrepreneurs to make more informed capital allocation decisions under uncertainty. The dissertation concludes with implications for venture financing strategies, investment criteria, and directions for future research, particularly in refining empirical applications of the proposed models and exploring their use in diverse institutional settings.