Venture Capital Redefined by Darek Klonowski

Author:Darek Klonowski
Language: eng
Format: epub
ISBN: 9783030833879
Publisher: Springer International Publishing

More Adverse Selection Problems in Venture Capital

It is important to raise the problem of adverse selection, which, as academics commonly acknowledge, was an issue already plaguing the venture capital industry prior to COVID-response. While the topic of adverse selection is normally discussed in the context of financial contracting, it is likely to arise much earlier in the venture capital investment process post COVID-response.

There are two unique selection problems in venture capital, with the first being that venture capitalists are likely to face issues related to the rejection of more promising deals post COVID-response. Thus, with reduced interactions, limited face-to-face meetings, and extended teleconferencing, venture capitalists are anticipated to experience increasing problems recognizing and ascertaining good investment prospects and value. The list of wrongly rejected deals includes some of the most prominent firms today, such as Apple, Dell, Cisco, eBay, Fedex, Fitbit, Intel, PayPal, Skype, and Twitter. Interestingly, while some venture capital firms failed to recognize the value creation potential of these innovative firms, others did choose to invest in them; this phenomenon of misappraisal is likely to continue in the future as screening and evaluation processes are increasingly compromised. On the other hand, the reverse problem will also continue to arise, as past experience confirms that advisors often question venture capitalists and their decisions to reject transactions. Advisors find both that venture capitalists may not have been able to spend sufficient time and resources in understanding the fundamental strengths of rejected deals, and that they are often over-fixated on certain investment cues including market sectors, “hot” industries, specific types of investment opportunities (i.e., market consolidation plays), or forms of transaction. The problem of rejecting valuable deals, and conversely, the second-guessing of rejected deals are both issues in the deal selection process that are anticipated to be more pronounced in the future.

A further complication of venture capitalists’ inability to do proper due diligence is that venture capitalists would likely continue to approach deals with relatively undistinguishable valuations, deal terms, and return expectations. With a compromised ability to perform these necessary functions, this generic approach to the marketplace will result in many superior investments being overlooked, thereby pushing superior firms to acquire other sources of capital or perhaps abandon their search for equity partners altogether. Consequently, the next generation of venture capital firms may end up with a disproportionate number of “lemon” investments and poor returns in their portfolio. On a positive note, however, evidence suggests that some venture capitalists continue to engage in exceptional levels of scope, breadth, and detail in the screening and evaluation process to fully appreciate the impact of COVID-response on all commercial and financial aspects of their potential investee firms’ operations. Of course, more in-depth due diligence can only mean higher chances of improved returns.

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