Adverse Selection Risks in Venture Capital Investments for Investors

One of the solutions to this problem is to invest in information that will reveal the real value and risk profile of potential investments and management’s capabilities. This is accomplished by evaluating portfolio companies, which includes a process of due diligence and prudent investment decision-making . However, due diligence and monitoring come with costs that may outweigh the potential benefits of the deal. While doing this, the investors consider the attractiveness of the opportunity -the market size, the strategy, customer adoption and competition, the management team, and the contract terms.

Signals are important in this context, particularly with regard to management risks . This sometimes reflects a concern with the founder’s incentives, that the founder seems to show a lack of focus or have a difficult personality. More often, however, the concern is more about the management team being incomplete in some sense . Since venture capital is an early-stage investment in a startup, it is not solely an investment in the business's underlying concept or product. It is a wager on the ability of the business's founders to convert their business concept into a product or service that can generate a profit within a specified time frame. The investors are investing in a team they believe will succeed and in whom they have faith. This trust and belief may only exist if the investors have access to the same information as the founders/managers. In the absence of this information and the resultant quality uncertainty, the investors may be investing in an unfeasible project or in the wrong team. The fact that the founders are quite young and have a lack of experience may make an impression as to their incapability in the eyes of Investors. Therefore, founders may signal the quality of their venture by using signals such as entrepreneurial competence and endorsements from credible intermediaries.

They may also signal the quality of their venture by their willingness to invest in their venture, thus the quality of the venture increases with the amount of financial investment made by the founders . The amount of financial investment made by the founders is a credible signal to the investors, as the investors’ investment in the venture imposes a significant cost to her, an investment that she would not make unless the future payoffs from the venture look promising to her. Furthermore, the big-name investor’s approach to the founders and the presence of other investors may also alleviate the investors’ concerns.

Regardless of the signals, the parties to the agreement must find a means to close the information gap . In general, there are three solutions to this information asymmetry: (i) solutions that provide the necessary information; (ii) solutions that incentivize the party with the informational advantage to refrain from profiting from that advantage , and (iii) solutions that adjust the price to compensate for the asymmetry.

In practice, the investors would ask for warranties in share subscription agreements that relate to the personal history of the founders, the reasonableness of the business plan and the projections and assumptions underlying it, and a confirmation from the managers that they are not aware of claims under due diligence reports . In this way, the investors i) allocate the risks and ii) elicit more information from managers . In addition to that, the company may also be requested to provide another set of warranties with regard to the due diligence and the business plan, as the company itself receives the investment.

The allocation of voting rights, board rights, and liquidation rights are also quite vital in terms of adverse selection risks. Ex ante, investors may prefer to be in control in more states of the world for early-stage ventures, as in our case, that have not yet started to generate revenues. Depending on the company’s performance, the investors may strengthen their rights and obtain full control. As the company’s performance improves, founders obtain more control rights.

Investors may also choose to invest in stages which are mostly regulated under share subscription agreements. If so, Investors defer a part of the investment, giving them the option to abandon the venture and refrain from making further investments in the future if the venture proves to be unprofitable . In adverse selection situations, investors may choose to defer investment until they are convinced that the venture can provide a return of the present value of the total investment amount . The option to defer the investment until there is sufficient information about the venture's quality and the entrepreneur's skills, as well as the option to abandon the venture in the future if new information reveals that it is not profitable, are additional strategies for mitigating adverse selection risk.