Buyers Playbook: How to Beat Sellers in Secondary Transactions With the Power of Data & AI
The Reverse Lemon Paradox
👋 Hi, I’m Andre and welcome to my weekly newsletter, Data-driven VC. Every Tuesday, I publish “Insights” to digest the most relevant startup research & reports, and every Thursday, I publish “Essays” that cover hands-on insights about data-driven innovation & AI in VC. Follow along to understand how startup investing becomes more data-driven, why it matters, and what it means for you.
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Most of my previous episodes were focused on data-driven approaches and AI across the VC investment process from sourcing over screening and due diligence to portfolio value creation. I spent little time exploring areas outside of the primary investment process. Today, I’m excited to have one of the top 20 thought leaders from the Data-Driven VC Landscape 2024 extending our view towards secondary transactions.
Olivier Huez is a partner at the VC firm Red River West where he invests in the best European companies to support their commercial expansion to the US. In addition to his role as investor, Olivier oversees the development of RRW’s proprietary data platform (called RAMP) for sourcing & screening deals and improving the team efficiency.
Thank you Olivier for sharing your thoughts and ideas on the future of secondary transactions with us below!
The Lemon Paradox
I used to live in Washington, DC. The city is manageable without a car, but my previous employer Orange Business Services was based out of Herndon, VA and a car was the only way to commute there.
So fresh from Paris, I told Dan, Brian and Steve, my new American colleagues that I was after some tips to buy a decent and affordable second-hand car as I couldn’t afford a new one. The first sentence I got back was “so are you one of those ‘tyre-kickers’ who will end up buying a Lemon ?”
They explained that a “tyre kicker” is someone who is content with kicking the tires with an expert air, pretending to assess them even if they don’t know much; and that a lemon is a car with a significant defect or malfunction that makes it unsafe to drive!
Obviously, it’s not always easy to determine if a second-hand vehicle is in as good a condition as the seller claims. So, there is a risk that you buy a car which breaks down shortly after being purchased.
This concept goes beyond my personal anecdote: In economics, a lemon paradox describes a transaction where the seller has more information than the buyer. Lemon markets were studied in detail in the 1970s by American Economist George Akerlof (who also happened to be professor at Georgetown, Washington, DC… I wonder if it’s a coincidence).
Most purchasing transactions of our day to day lives display symmetrical information: Whether you’re buying a pair of jeans, a piece of furniture or a smartphone, you know exactly what you’re buying and if the product proves faulty there are laws protecting the consumer who can get an exchange or refund.
Asymmetry of information is more typical in a second-hand transactions as there is less consumer protection. But for most items (a piece of cloth, of furniture etc..) the buyer can inspect the product and detect potential defects relatively easily.
A car is a complex product, and it’s sometimes possible to hide potential issues, especially to a buyer with limited knowledge in mechanics.
Now, Why am I Mentioning This?
In the world of tech investment, any transaction can be seen as a typical case of asymmetry of information, i.e. the investor buys shares of a company without knowing everything and has to rely on the word of the seller (the founders).
But in practice, this is relatively controlled: the founders stay onboard and continue working with the investor many years after the transaction, so they have limited incentive to hide anything, and the remaining uncertainty is part of the business of investing. Finally, there’s usually thorough Due Diligence done before the transaction closes.
Secondary transactions, i.e. where an existing shareholder in a company is looking to sell her shares to a new investor, represent a more interesting case from that perspective:
Let’s look at the typical seller profiles. They can be of different types, but the most common are: