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Information asymmetry is common among economic agents such as buyers and sellers, consumers and brands, and governments and citizens. It arises when one party has more or better information than the other(s), creating an unfair advantage. The phenomenon is also rampant among entrepreneurs and venture capitalists, and there is a significant amount of literature on the topic. This paper will comprehensively summarise the previous studies' key findings and extend them to the deep tech sector.
Information between entrepreneurs and VCs is not shared equally.
Typically, venture capitalists invest in numerous deals over time, leading to a wealth of knowledge regarding investment protocols and an informed sense of what may or may not succeed. Entrepreneurs are unlikely to match the level of expertise that VCs possess in venture economics. Nevertheless, entrepreneurs can narrow this gap by familiarising themselves with VC terms, networking with investors, reporting on and communicating their progress, generating positive impressions of their venture, and participating in accelerator programs.
Entrepreneurs possess valuable private information about their venture, domain expertise, and a network within their sector. VCs often evaluate these factors during the due diligence phase, but uncovering all hidden information is impossible. To gain access to accurate and reliable information, VCs can establish a trust-based relationship with entrepreneurs, utilise sophisticated deal flow channels and digital tools, engage in syndication of the round, stage-based investments, create complex contracts, and conduct extensive monitoring.
Information asymmetry in the deep tech sector is broader.
There has been a rapid increase in scientific discoveries and technological breakthroughs within the deep tech sector, resulting in information overload. This surge has mainly led to information asymmetry between technical founders and VCs. VCs often find it challenging to digest the underlying information silo of a typical deal.
The case of the blood testing company Theranos is a famous example of information asymmetry in deep tech. One party – in this case, the entrepreneur, hid the truth about the affairs of Theranos, while the VCs were unaware of the facts and continued to invest in the company. However, information asymmetries that result from fraudulent activities are out of our scope.
There are several ways to overcome deep tech information asymmetry. One well-known method is educating potential investors on the core technology. Key points should be covered when educating potential investors: the core technology and its features, the potential applications, the risks associated with the technology, and the technology readiness level.
The typical founders of deep tech ventures are individuals with technical expertise in a specific domain, such as engineering, biotech, physics, etc. These founders deeply understand the technology they are working on, and the challenges associated with developing it. To be successful, however, technical founders must also be able to identify and solve complex business problems, navigate bureaucracies, and compete in the market. Therefore, adding non-technical competencies to deep tech ventures is vital to overcoming information asymmetries. Many deep tech VCs prioritise recruiting business experts as early as the proof-of-concept phase. The journey from lab prototype to MVP can be long and arduous. It can be filled with many challenges and roadblocks. Business experts could be instrumental in this process by signalling market needs, customer pain points, feature definitions, and total cost of ownership.
Deep tech ventures — many of which emerge from universities and research centres — would benefit from better advice at the beginning of their journeys. TTOs (technology transfer offices) can help these ventures navigate the complex and often expensive process of commercialising their technology, from patenting to finding the right investors and partners and recruiting non-technical team members. Hence, high-calibre TTOs can be a valuable asset in overcoming information asymmetries.
Government-driven signals to lower information asymmetries and market risk.
Substantial evidence demonstrates regulation's role in mitigating market failures due to information asymmetries, opening the door to private investment.
There is an increasing consensus among OECD countries that regulatory reforms can be a powerful stimulus to innovation while building public trust in innovative technologies. Regulations can influence the way innovation progresses by directing it towards socially desirable goals like sustainability, equity, and inclusion. These policies can also lead to a demand for innovative products or services that comply with the new regulations. Furthermore, changes in regulations can open up market gaps or create new opportunities for startups to fill, as seen with the emergence of privacy-focused ventures thanks to GDPR.
It is essential for startups to stay informed about regulatory and policy changes in their industry and to carefully analyse the potential impact of such changes on their business model. By doing so, they can identify new opportunities, pivot their strategy to take advantage of changing market conditions, and ultimately gain a competitive advantage.
For deep tech VCs to properly evaluate the market potential of technological innovations, they need the skills and experience to monitor regulatory reforms accurately. With a deep understanding of the regulatory environment, VCs may gain valuable opportunities and make better-informed investment decisions. Therefore, VCs need to stay up-to-date with the latest regulatory changes and have the necessary tools and resources to navigate this complex terrain. By doing so, they can better position themselves to identify and capitalise on emerging trends while mitigating potential risks and ensuring the long-term success of their investments.
Optimising technology risk by leveraging state aids for R&D&I activities.
Grant funding is vital in supporting research, development, and innovation. For investors, grant funding offers several advantages over traditional equity funding, including non-dilutive financing and validation from a trustworthy source.
Firstly, non-dilutive grant funding means businesses can secure additional funds without giving up equity. This is especially important for startups and early-stage companies that may not have significant revenue or assets to use as collateral. By securing grant funding, these businesses can continue to invest in research and development without diluting the ownership stakes of their existing shareholders.
Secondly, grant funding serves as a validation from a trustworthy source that the grant recipient has the potential to minimise technological risks. Grant funding organisations often have rigorous selection processes, meaning receiving a grant can be seen as an endorsement of the business's potential. This endorsement can be especially valuable for startups and early-stage companies with limited track records or credibility in the market.
Recent research has shown that companies that secure grant funding and equity are 17 times less likely to go out of business. This is likely because grant and equity funding provide complementary benefits to businesses. While grant funding can support research and development efforts and validate a business's potential, equity funding can provide the necessary capital to scale operations and enter new markets.
By providing financial support and resources for R&D&I activities, state aids enable entrepreneurs to enhance their technological capabilities and demonstrate the viability of their innovations. This increased transparency and tangible progress can help bridge the information gap between VCs and entrepreneurs, fostering a more informed and mutually beneficial relationship in the deep tech sector.
Conclusion
This text focuses on information asymmetry in the entrepreneurial and venture capital sectors, specifically emphasising the deep tech industry. In the deep tech sector, information asymmetry is common between technical founders and venture capitalists. Educating potential investors on the core technology and incorporating non-technical competencies into deep tech ventures is necessary to address this issue. Moreover, government regulation can help alleviate market risks caused by information asymmetry, while R&D&I grants provide tools to optimise technological risks.
References
- ACT Venture Partners (2022). The EU’s Draft AI Regulation and the Potential Impact on Venture Capital Sector.
- Department for Business, Energy & Industrial Strategy (2022). Getting from Principles to Practices for Innovation-Friendly Regulation.
- Du P, Shu H and Xia Z. (2020). The Control Strategies for Information Asymmetry Problems Among Investing Institutions, Investors, and Entrepreneurs in Venture Capital. Front. Psychol. 11:1579.
- Escobari, D. and Serrano, A. (2016). Reducing asymmetric information in venture capital backed IPOs. Managerial Finance, Vol. 42 No. 6, pp. 553-568.
- Glücksman, S. (2020). Entrepreneurial experiences from venture capital funding: exploring two-sided information asymmetry. Venture Capital, 22:4, 331-354.
- Gompers, P. A., Gornall, W., Kaplan, S. N., & Strebulaev, I. A. (2020). How do venture capitalists make decisions? Journal of Financial Economics, 135(1), 169-190.
- Koenig, L., and Tennert, J. (2022). Tell me something new: startup valuations, information asymmetry, and the mitigating effect of informational updates. Venture Capital, 1-23.
- UKRI (2022). Backing innovation-led businesses: the role of public investment.
Disclaimer
This document is not a promotion of any product or service. The text does not reflect the views of ACT’s Limited Partners but the fund managers' perspectives on the VC industry's evolving role. Reusing this document is allowed, provided appropriate credit is given and any changes are indicated.
