Question

4. Answer parts (a) and (b) of this question. Venture capitalists rely relatively heavily on criteria relating to characteristics of the inventor (for example, whether he/she is capable of sustained effort) when deciding whether to fund a new innovation-based venture. On the other hand, internal review procedures tend to rely relatively heavily on criteria relating to characteristics of the invention (for example, whether the invention is technically feasible). (a) [25 marks] Explain the meaning of the terms “adverse selection" and “moral hazard". (b) [25marks ]Describe the main characteristics of venture capital. In what sense can venture capital be seen as a response to adverse selection and moral hazard in the market for funding new innovations?

Answer 1

Adverse selection takes place between two parties because of asymmetric information existing between them. Here in the given question the inventor may hide some vital information from the venture capitalists about the product invented which may increase the risk of the venture capitalists or cause disadvantage to the them.

Thus, adverse selection is a situation when the seller who has more information about the product hides it from the buyers to their disadvantage.

Moral Hazard is a situation when one party knowing that there would be no consequences for it discloses wrong or incorrect information to the other party entering the deal which increases the risk of the party with wrong or misleading information.

Venture capital is a form of private institution that provides equity support ( risk capital ) to early stage enterpreneurs or startups in order to earn high return in the form of capital gains in future.

Venture capitalists are generally known to provide equity support to high-technology startups.

Venture capitalists bear very high risk of losing the invested capital if the startup or the new enterprise were to fail.

However, they may also earn very high returns in the medium term if the startup succeeds.