Information Asymmetry Theory and Entrepreneurship
Information asymmetry refers to a condition where two parties in a market or organizational relationship have access to different levels of information about an exchange.
It acts as the alternative to the classical economic assumption of "perfect information." In the real world, one side usually knows more than the other, leading to power imbalances and market inefficiencies.
1. Regulatory Context: The "Insider" Problem
Information asymmetries are the primary reason laws exist to forbid insider trading.
Company insiders (CEOs, executives) possess a "high-definition" picture of the company's financial health, while the public sees a "low-resolution" version. As Aboody and Lev (2000) note, this gives insiders an unfair advantage when buying or selling stock. To counter this, executives have fiduciary responsibilities requiring them to be truthful and forthcoming.
2. The Entrepreneur's Dilemma
In entrepreneurship, asymmetry is a core source of friction between founders and investors.
An entrepreneur knows the real potential of their venture—they see the customer data and production flaws daily. Investors, however, cannot see this. Because investors know they have "less information," they assume higher risk. This leads to:
- Higher Cost of Capital: Investors demand higher equity stakes or interest rates to compensate for the "unknowns."
- Pecking Order Theory: Because external investors discount the stock due to asymmetry, founders often prefer internal funding (bootstrapping) first.
Real-World Example: Elon Musk & The SEC
There is a potential for abuse when entrepreneurs reveal information selectively. A famous instance occurred when Elon Musk tweeted that he had "funding secured" to take Tesla private.
Investors responded positively (stock price rose), but the reality was more complex. Because the information was not fully verified, the Securities and Exchange Commission (SEC) stepped in, highlighting the dangers of asymmetric information in public markets.
3. Internal Asymmetry: Co-Founder Conflict
Asymmetry doesn't just happen between a company and the outside world; it happens inside the startup team.
Technical founders (CTOs) often possess superior information about the feasibility of an innovation. If they do not disclose technical roadblocks, they may undermine the motivations of the sales-oriented founders. This is a classic Principal-Agent problem (Agency Theory), where technical founders may lead their business partners on.
Strategic Consequences: Spinouts and Failures
Information asymmetry forces structural changes in the market:
- The Spinout Solution: Lowe (2001) suggests that because inventors cannot fully prove the value of their idea to outside firms (due to asymmetry), they often stop trying to license the tech and instead build their own organization—a Spinout—to prove its value.
- Joint Venture Failure: Balakrishnan and Koza (1993) argue that firms often make poor partner selections in Joint Ventures because they cannot accurately assess the capabilities of the other partner.
Video: Asymmetric Information and Market Failure
Why does one side knowing more lead to broken markets?
Academic Sources
- Aboody, D., & Lev, B. (2000). Information asymmetry, R&D, and insider gains. The Journal of Finance, 55(6), 2747-2766.
- Balakrishnan, S., & Koza, M. P. (1993). Information asymmetry, adverse selection and joint-ventures: Theory and evidence. Journal of Economic Behavior and Organization, 20(1), 99-117.
- Lowe, R. A. (2001). Entrepreneurship and information asymmetry: theory and evidence from the University of California. Unpublished working paper, Haas School of Business.
