Venture Financing, Adverse Selection, and Risk and Return

Abstract

A venture capital market is crowded with low-quality ventures, where the chance of success of each venture is overstated by the entrepreneur, leading to a problem of adverse selection, a type of market failure known as the market for “lemons.” An entrepreneur developing a new product knows more than the investor about the product and its shortcomings. She may have an incentive to present the best information to the investor about the product and may overstate the chance of its success to obtain venture financing. It is difficult for an investor to distinguish between good-quality and poor-quality ventures. The venture capital market that is crowded with poor-quality ventures is consistent with the high failure rate observed with new ventures. Typically, five out of ten venture investments fail. Three out of ten are so-called, living dead or sideways, situations in which the investor might recoup the principal or a part of it. Only two out of ten investments may succeed, and out of the two successes, only one may provide a high return to the investor.