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Information Asymmetry, Uncertainty, and Risk in Venture Investing

Reported rates of return in venture investing are famously (infamously?) sensational. But such fables can be misleading as they don’t reveal the complete picture of venture investing outcomes. Venture investing is risky business and a significant proportion of venture investment outcomes involve lacklustre returns and even total losses . There is an apparent disconnect here. Returns are inextricably connected with challenging characteristics of the venture investing environment (see article #1V3.2022) – three of which are the subject of this article.

Over the last four decades, a significant volume of scholarly research explored VCs’ investment decision criteria, including the financial aspects of target & expected returns and, to a lesser extent, perceived risks. Investors’ returns are a common independent variable in studies examining the effectiveness of VCs’ investment decision criteria. My dissertation lists & reviews the most significant extant research to 2022 and revealed a preoccupation with VCs’ fabled returns, a bias for evaluating successful investment outcomes, and a relatively low research volume dealing with risk, uncertainty, and information asymmetry . Yet, these three concepts are interconnected and each presents challenges to realizing investment returns in this specialized asset class. This article describes and differentiates them.

This article addresses information asymmetry related to differences in availability and sharing of information between an enterprise’s management and VCs. This can include information about possible markets, competitive threats, management capabilities & track records, and historical evidence of performance (e.g. effectiveness of technology & products developed). Differences in the availability of information between entrepreneurs & their management teams and capital providers can arise from ignorance, negligence, or willfulness. Willful withholding of information represents the particular risk to capital providers of adverse selection and/or moral hazard and can lead to conflicts between entrepreneurs and VCs. Avoidance or timely resolution of asymmetries can impact investment results. Two approaches commonly used are the 'financial discipline approach' (common amongst VCs and incorporated into deal structures) and the 'cognitive approach' (focused on understanding knowledge dynamics and common among angel investors). I encourage VCs to consider complementing their disciplinarian predisposition with the cognitive approach as this is consistent with my recommendations that VCs become sponsors of teamliness development within their investee management teams - it is conducive to having all stakeholders in the venture pulling together for the same reasons.

Risk and uncertainty are different: risk refers to situations where the possible outcomes and likelihoods of occurrence are known to or estimable by the decision-maker such that expected outcomes can be estimated. But, uncertainty involves situations where either or both of outcomes and probabilities are unknown – thus, it is impossible to calculate an expected outcome. The distinction has implications for enterprise valuation since known inputs can result in lower discount rates than when inputs are unknown.

Key uncertainties in new ventures are likely stage-of-development dependent. They can include technological feasibility, market acceptance, competitive developments, leadership capabilities & management team development (together with principal/agent hazards), and economic viability. As enterprise's evolve through the stages of the venture life cycle and achieve various milestones, more becomes 'known and uncertainties dissipate or become quantifiable risks. When seeking venture capital, entrepreneurs would be well-advised to reduce uncertainties (to the extent possible before seeking capital) and otherwise disclose those of which they are aware and how they expect to manage them in the course of building a viable investment case. This benefits capital providers by reducing information asymmetry and builds trust in management.

In this article, I describe five principal categories of risks in venture investing: agency/management risk, enterprise technology/product risks, enterprise market risks, enterprise financial risks, and investment risks. These risk categories map uniquely into VCs' three primary investment decision constructs (Management Capabilities, Technology/Product/Market Opportunity, Financial Factors) and VCs are well-advised to specifically articulate each of these risk categories and develop entity-specific risk premia in the course of pricing their deals - both initially and in subsequent rounds. This article also summarizes 13 risk mitigation strategies from a collection of authors, organized into four categories: VC-firm Internal Strategies and Strategies for the Pre-investment Phase, Investment Phase, and Post-investment Phase. For details, please download and read the article.

Embedding qualified financial managers ('QFMs') in an enterprise's management team can be useful to numerous stakeholders in the venture financing ecosystem, particularly when their role duality is broadly understood. QFMs are uniquely capable of minimizing the impact on VCs and other capital providers of various information asymmetries, uncertainties, and risks due to their roles, ethics, and knowledge of information required for making financial decisions. This article provides nine recommendations for how QFMs could be used to realize these benefits.

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