A bit less Asymmetry in the world of Venture Capital ?

Was thinking about Akerlof's lemon lessons and how it may be applied to Venture Capital after reading a post over at Vecosys, talking about a new Socnet to rate VC's. Inspired me to set down these thoughts this afternoon over a cup of coffee (the length of time to write a blog post . May not be definitive, or even accurate, but may start a debate worth having? (Note - added a few things later to make it clearer)

Venture Funding of new tech startups is a game with huge initial asymmetry of information where each player as a seller knows far more about what they are selling than the other - the entrepreneur about their company / technology, and from the VC / Funder about their financial logic, hurdle rates etc.

This is an interesting game, because (in theory) the entrepreneur knows more about their potential success than the VC, so the VC has to guess - ie the buyer knows more than the seller

(In fact the entrepreneurs' benefit in understanding their new technology companies can be largely discounted en masse, as the mean outcomes of small tech companies are fairly well known, so assuming an average portfolio this can be accounted for by probability theory (and in fact the more companies funded the better the predictability)

Nevertheless, what is usually far more murky to the entrepreneur are the funding conditions available from VC's, and to the VC's what the entrepreneur really thinks the business is worth.

There is an interesting example of a scenario where the buyer knows more than the seller in the asymmetric Information literature regarding health insurance in the US. In general, the nature of US health insurance - many underscale and disjointed operators - makes choice very hard for the customer. Search and comparison is very hard, so it is very difficult for the high quality providers to be spotted. It also makes it costly to operate so premiums are relatively high.

Net net anyone who does not need health care in this this way would rather avoid it, so the base is skewed towards people more likely to need it.

This leads each insurer to try to protect themselves by imposing conditions that make people with a high degree of confidence of a healthy outcome avoid maximising it, and so it selects for the most ill. To get over this, they seek increasingly large amounts of information from the insured and make the conditions increasingly less favourable, thus driving out even more of the "better" patients.

The model only survives as for most people the risks of not being covered are so catastrophic that they have to take it up.

Does this analogy have some lessons for VC funders - could the following scenario apply?

An unclear and disjointed industry structure leads to high transaction costs, and the lack of clarity of terms and conditions drives an information asymmetry. This means that it is hard to see the "good" VC companies, creating an environment for less good VC companies to thrive in.

Tech Companies who don't need the money (ie the most healthy) will thus avoid it, going instead to other capital markets where conditions are more transparent. (Or the entrepreneurs will pursue other options). Thus the Funder is driven to fund less good companies and people that need the money more desperately.

The VC's get over this risk by a raft of diagnostics, due diligences etc to discover more about the company - much like health insurers - and increasingly one sided terms and conditions. This potentially leads to even less pleasant funding conditions, driving even more of the "better" companies away.

The VC's are thus potentially left funding more and more of the worst companies, those that need the money most desperately.

However, it survives as a model because some potentially great players have to take this funding as there is no alternative.

At first this seems to be an heretical thought experiment...and no doubt many objections can be raised about the Health Care analogy. But in Asymmetric Information theory, the more information the buyer has, the more likely it is that high quality sellers can exist and obtain maximum value. In this case, regular market forces of supply and demand will prevail, the sellers will get the "highest price paid" , and the trend will be to weed out products with prices in excess of their quality.

So is it possible to imagine for a minute a more transparent VC industry, where the conditions are clearer - and thus transaction costs are lower?. We would argue that it is, and thus - in theory - it is not maximising its own value add, never mind serving its clients' needs.

For this reason services like The Funded and Venture Hacks, which are acting to reduce information asymmetry, should be welcomed by buyer and seller alike, as in theory they will maximise the benefits of both parties.

( In addition, prospective entrepreneurs should welcome opportunities to show extra information, so allowing VC's to be more informed sellers - at present historical "track record" is about all they really have)

Could it in fact be that one reason why Silicon Valley is so succesful is that, because there is so much VC competition and information transmitted in a closely knit community, that the information asymmetry is less than in say the UK, and thus there are more "great" companies that will accept funding ( and more VC's willing to risk more, more often)?