Asymmetric Information, Capital Supply, and Venture Capital Allocation

Abstract

This paper develops a model to explore how adverse selection and search frictions affect the allocation of venture capital. Entrepreneurs have private information about their projects' quality and compete in a search market to attract investors. The combination of low capital supply and information frictions can cause entrepreneurs with valuable projects to avoid the venture capital market. An increase in capital supply reduces the distorting effects of search and information frictions causing entrepreneurs with high quality risky projects to enter the market and venture capitalists to increase their allocations to riskier projects. These effects can persist even if riskier projects are ex ante more valuable. Several other model predictions are also consistent with empirical findings.