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VC Term Sheets

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Unit 3 of 51
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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.

Why do you think financial investors were misled so blindly in the Theranos case? Are there other recent examples of moral hazard or asymmetry of information issues you read about?

💬 Let us know in the Comments section below.

👀 Sources & Additional Material

  • The podcast series called The Dropout tells the fascinating tale of the Theranos case
  • Recent spectacular governance failures at Uber and WeWork also display blatantly display some of these issues at work
  • I think extensive media coverage and the need for the public to believe that that the next “Steve Jobs of pharmaceuticals” was amongst them. I don’t believe this type of rhetoric would be as likely in many european countries as we tend to have a more pessimistic, less benevolent and more concrete reflection on industrial leaders historically speaking, but nevertheless the internet age has meshed our individual national cultures with the american mindset, making a next episode of this scale quite possible.

  • Besides moral hazard and asymetrical information, one of the main reasons why I think that financial investors was misled so badly by Theranos was because people believe what they want to believe. It is highly likely that some red flags show up during the due diligence stage. Yet, financial investors desperate to find the next unicorn or decacorn, chose to overlook these red flags or even try to reason with themselves that these are “yellow flags”. If they were to be more objective, more honest with themselves, they may see through that everything was a scam.

  • A recent example of asymmetry of information is the fraud of Luckin Coffee, which was listed in Nasdaq, US. The management of the company inflated the sales artificially and convinced the US investor by the potential huge market for coffee consumption in China. As the US investor were not fully aware of the culturial difference in drinking preference and had no direct observation of the consumption happened in China, they were easily fell into the pitfall created by the Luckin management:(

  • In the case of Theranos, I would also add a “large ego” syndrome, where investors relied on the names of the existing highly regarded board members (even when most of those had nothing to do with the pharma industry) to form their own opinions on the company’s progress. Elisabeth Holmes appealed to both existing and new investors’ egos, which prevented everyone in the mix from clearly viewing and challenging the state of the company.

  • The Theranos case is a good example of moral hazard and asymmetry of information. Some of the reasons why investors were misled are the following:
    – Decisions were based on the manipulated reports of Theranos
    – They were investing money in a technology for which they had limited information and it was very difficult to understand
    – Their investment decision was driven by the fact that some reputable names were already investing in the company. That gave them more comfort but also it blurred their judgement.
    – FOMO
    An extensive DD could have mitigated the risks. Another recent example that comes to mind is the Luckin Coffee case. The company manipulated its financial statements, inflating revenues and profits, to attract investors and banks.

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