Overcoming Adverse Selection: Avoiding Lemons and Ensuring the Best Risk-Adjusted Return

Following on from my post the other day about Angels actively engaging in their community, I thought it important to outline exactly why information asymmetry, as discussed, can be such a problem for Angel investors.

Information asymmetry, the condition in which at least some relevant information is known to some but not all parties involved, leads to market inefficiencies. In this case, the most important inefficiency it causes is adverse selection.

In economic terms, adverse selection happens in a situation where sellers have relevant information that buyers lack. In the context of Angel investors and potential investee companies, this is where a company has some information (or there is information generally available in the community about a company/technology) that the investor lacks.

Post-engagement due diligence can reveal problems with a specific company, but by being plugged into the community, writ large, an Angel can gather enough context to help ensure that he or his group is seeing the best risk-adjusted opportunity with the highest potential for return that is our there in the market.

Having this information, you might find out that, even through the company you are conducting due diligence on is perfectly fine and a good investment opportunity, ceterus paribus, there are better opportunities, risk-adjusted, out there with higher potential returns. He might also find out that the opportunity has been shopped around for many years, never gaining any traction for a variety of reasons, and is generally considered to be a lemon!

Just one more benefit of being plugged in to the community: reduced averse selection!