Information asymmetry theory and entrepreneurship

Information asymmetry refers to a conditions whereby two parties in a market or organizational relationship have access to different information about the exchange.  It can be seen as an alternative to the classical assumption of "perfect information" in economics.

Information asymmetries have been acknowledged by regulators who have made laws forbidding insider trading. Insiders have special access to the real financial picture of a company and have an unfair advantage when buying and selling company stock (Aboody, 2000). Company executives, like CEOs also have fiduciary responsibilities toward their investors which require them to be truthful and forthcoming.

Information asymmetry is also a potential source of problems in entrepreneurship. For example, an entrepreneur knows much more about the real potential of their ventures because they have inside access to knowledge about their customers and the issues with production. The investors, on the other hand, have less information about the true probabilities, so usually demands a higher return or interest rate to compensate them (see the pecking order theory).

There is potential for abuse of investors when entrepreneurs reveal information selectively, or make statements that are difficult to verify. For instance, when Elon Musk tweeted that he had secured investment to take the company private, investors responded positively, but the Securities and Exchange Commission was not impressed.  Even within the startup founding team, more technical founders may have better information about the potential of an innovation but may not disclose it if it would undermine the motivations of sales and business oriented founders (see agency theory). It is quite common for technical founders to lead on their business partners and boards.

Lowe (2001) proposes that information asymmetry creates problems in contracting between inventors and outside companies (would-be licensing partners) causing the inventors to seek to build their own organizations to bring their inventions to market. Similarly, an inventor within a company may see more potential in their technology than their managers do leading them to spin out the new technology into a new startup (i.e., a spinout).

Information asymmetries may also help to explain why entrepreneurs and firms often make poor partner selections when entering into joint ventures (Balakrishnan and Koza, 1993).

Sources:

Aboody, D., Lev, B. (2000). Information asymmetry, R and 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.

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