The Three Imbalances Of VC
We will get back in more details on these imbalances, but here’s an introduction for you on two of them:
- Moral hazard; and
- Asymmetry of information
One easy way to talk about moral hazard is to refer to events of the recent past.
During what is now called the 2008 Great Crisis, it was feared that bailing out banks would only make them take more risks in the future. If executives didn’t have to face the consequences of their actions, they would indeed not behave in the best interest of the company and its shareholders.
In private equity – of which venture capital is a sub-segment –, moral hazard expresses itself differently. Founders may mislead investors for their personal gain. One (in)famous example is Theranos. Founder Elizabeth Holmes is thought to have repeatedly lied to investors in the hope of keeping the company funded – thus preserving her position as a genius entrepreneur.
Asymmetry of information is a different concept, but it may feed moral hazard. The imbalance comes from the fact that entrepreneurs know more than investors about the state of their company, its market, the product’s strengths and weaknesses, the team’s cohesiveness and quality, and other critical parameters.
Term sheets try to minimize these two risks with clauses such as Board supervision, information & audit rights, and staged investing techniques (i.e., injecting money as the company hits milestones.)
VCs also try to mitigate these risks by working with people they know and running extensive due diligence, including background checks on the founders. But it’s not bulletproof.
In this course, we will tell you which clauses are trying to address which of these imbalances.