Adverse Selection : A VC Perspective

What is adverse selection, and how does it affect a VC and the whole startup ecosystem at large? Is the question I am going to address in this article.

“Information asymmetry, while very intimidating, should not be the soul cause of restraint towards entering into a transaction at the right price.”

Adverse selection, in a broader definition, is a state of market where the buyer and a seller have different levels of information about the product being traded. One of the parties in such a trade hence becomes overly cautious about the transaction and disengages themselves from it (in the fear of engaging into a rigged or an unfair trade.) This has cascading effects in the market which can range from lower volume if trades to exit of players from the market to ultimate market collapse.

I will be attempting to judge the impact of such a phenomenon in VC industry, where the market can be defined as startups (“the seller”) wanting to raise money from a VC (“the buyer”) and it can be established beforehand that the founders know more about what the startup is capable of than the VC (hence the information asymmetry). But first let us understand a more generalised example.

“The Market for Lemons: Quality Uncertainty and the Market Mechanism” is a paper published by economist George Akerlof who later on went on to receive Nobel prize in economics for his work on information asymmetry. The market for lemon hypothesises a used car market where the seller is aware whether the car is in good shape (identified as a “peach”) or in a bad shape (identified as a “lemon”), but the buyer is unaware of the state of condition of the car. As a general caution the buyer wants to avoid falling into an unfair trade and hence is willing to pay an average of what is considered a fair price for a “peach” and a “lemon” (of course a weighted average considering the availability of “peaches” and “lemons”). A seller of “Lemon” would happily accept this price since the average is more than what he would have gotten had there been information symmetry, seller of “Peach”, however, would obviously not accept this price and hence exit the market. This reduces the number of “Peaches” in the market and hence further reduce the average price the buyer is willing to pay which leads to more “Peach” sellers to exit and so on. That leaves us with a market which consists of only “Lemons”.

So, adverse selection is not only a problem of false positive but a problem of false negatives, which poses a grave issue for VC industry (the risk of missing out on a “Peach”). So might as well call it “Adverse Deselection”?

In the startup ecosystem as well, we have “Peaches” and “Lemons”. We often tend to be over cautious about the transaction we enter into and the valuations we perceive are fair, because the underlying variables (viz. discount rates, multiples, growth rates, etc.) are fair for the market as a whole considering the weighted average of availability of “Peaches” and the fair measure of variable for a “Peach” and a “lemon”. What might end up happening is that “Peaches” might be beaten down and discouraged and hence exit the markets while “Lemons” might constantly be encouraged by giving them higher valuations and more money than they deserve, while our motive of conducting the whole exercise was exactly the opposite (Economics works in a weird way, doesn’t it 😀).

So what do I mean by all this? “You can never be too cautious” right? Well, turns out, you can be and if you are, you are ruing it for the whole ecosystem and we will all be left with nothing but “Lemons”. So, information asymmetry, while very intimidating, should not be the soul cause of restraint towards entering into a transaction, and more importantly, at the right price.

Neighbourhood finance guy. I write about a lot of random things (anything I find interesting TBH) mostly related to economics or business.