Wednesday, May 11, 2005

Why Are Startups Like Peacocks? (From Ventureblog)

Asymmetric information is one of the key concepts in modern finance. One setting where it often plays out is that managers (or owners) of a firm have better information about their firm's prospects than do the people they're trying to get funds from. So, the financiers can't easily separate the good firms from the lemons. So, they set terms based (depending on which model you believe in) either on the firm being the "average" quality or on it being the worst quality.

This gives the party with better information an incentive to somehow reveal their true quality. We commonly refer to this as "signaling" - the manager/owner takes some action that supposedly shows that it's a "good" company.

The problem is that the low-quality firm would like to be able to send the same signal, so that it will also be seen as a good firm.

So, in order for a signal to be credible ("non-mimicable" in economicese), it has to be costlier for the poorer quality firm to send than for the better quality firm. For example: firms don't like to cut dividends once they're raised them. So, raising the firm's dividend level is easier for the firm where the managers have confidence that the firm will be able to sustain the new, higher payout than for weaker firms.

Kevin Laws at VentureBlog uses this concept to explain how venture capitalists look at certain characteristics of startup firms to separate the good ones from the rest. He's also got a great analogy that I'll probably use in my class involving (of all things) peacocks:

Peahens like long tails, so a peacock with a big beautiful tail is more likely to mate and produce offspring. But that just pushes the problem back a level – after all, peahens shouldn’t like long tails if it makes their mates (and thus their children) more likely to be eaten.

Except that they have another incentive: they want to mate with only the best peacock to maximize their children’s success. But it’s hard to tell a good peacock just by looking at it (I know I can’t). You can’t tell if he’s healthy, has good eyesight, and can run fast. Since the peahen only sees the peacock during the mating ritual, she has to guess.

The tail resolves this dilemma. After all, it makes the peacock pretty easy for predators to spot and catch. It takes a clever, fast, healthy peacock to have such a ridiculous disadvantage and still survive. The bigger the tail, the bigger the disadvantage and the better the peacock has to be to survive. Though not useful by itself, it is useful in instantly communicating something that would normally take a long time to observe. For peacocks, size does matter.

By now, the relationship to venture financing should be obvious. Some features venture investors seek in a company are not directly related to the chances a company will succeed. Instead, many of the items are “peacock feathers” – ways for a venture investor to besure the company is not just puffing up for the mating ritual.

Very nice. Click here for the whole post.

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