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The Risk of Adverse Selection in Retail Equity Crowdfunding

By: Jeremy Colless

Asymmetric information often leads to a market problem that is known as adverse selection. Adverse selection occurs in a market when buyers or sellers would, on average, be better off trading with someone selected at random from the population than with those who volunteer to trade. A classic example of adverse selection occurs in used-car markets.

It can happen, that in equilibrium, the used cars that come onto the market are not a random selection from the population of used cars but just the worst ones.

The problem of adverse selection also applies to insurance markets. The customers that are most likely to want insurance are the people who face the highest risks, but these are the people that insurance companies would least like to have as customers. For example, the people who are most eager to buy annuities are those who have reason to believe that they will live for a long time.

Insurance companies are well aware that their customers will, on average, be worse insurance risks than a randomly-selected member of the population. Accordingly, instead of basing their estimates of the risks they face on statistics for the population as a whole, they base them on statistics for insured people in previous years.

Startup investing potentially works best when the investors have asymmetric information – special knowledge, insights and/or networks – that lead them to fund things that otherwise would have been overlooked or undervalued by traditional investors.

Startups benefit directly from the network effect of these active investors, be they experienced high net worth or angel investors, accelerators/incubators or financial or corporate VCs. They can leverage these networks to raise follow on capital, identify distribution partners and customers, and gain expert domain knowledge.

Equity crowdfunding platforms pool capital from a relatively large number of investors, who do not necessarily have the added strategic benefits of sophisticated or institutional investors. However, raising capital via an equity crowdfunding platform does provide a complementary and attractive source of capital for startups if it:

  • can close an already partially filled funding round quickly and efficiently, allowing the founders of an early stage startup to reduce the time they are fund raising and maximising the time they have building their business
  • reduces administrative burdens by pooling the crowd of investors into a single entity or trust. This also minimises the number of investors on the share registry and increase the likelihood of follow on investment (from VCs etc. who do not like to deal with an unwieldy number of early stage investors)
  • does not add additional reporting or administrative burdens to a small startup e.g. regulatory requirements – such as converting to a publicly unlisted company

Unfortunately, under the proposed Equity Crowdfunding legislation passed last week by the House of Representatives and soon to be presented in the Senate, the three points outlined above are not met.

This will mean that if the legislation is passed in its current form that the startups that are presented to the retail equity crowdfunding market are not a random selection from the population of all startups but just the worst ones that have failed to raise capital from any other source.

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