The Market for “Lemons” is a seminal economics paper by Nobel Prize winner George Akerlof about used cars. Imagine that there are only two kinds of used cars: quality used cars and “lemons”, i.e., cars that, despite outward appearances, are in poor condition. Quality cars are worth $2000, but lemons are worth just $1000. Sellers know whether their cars are lemons or non-lemons — but buyers have no way of determining whether a car is a lemon or non-lemon. As a buyer, what would you offer for a given used car?
You would probably be hesitant to offer significantly more than $1000, since you would regret spending more than $1000 only to find you had bought a lemon. On the other hand, as a seller, you would refuse to sell a non-lemon for a mere $1000, since you know that quality used cars are worth $2000. As a result, due to “information asymmetry”, the only transactions that take place are those involving lemons!
Sometimes, the market for start-ups is a bit like the market for used cars.
Over the last year, I’ve observed a recurring pattern:
- A pre-revenue (or low-revenue) start-up pitches an exciting new product or service. The start-up asks for a seed investment, with a budget showing that the new capital will provide approximately 18 months of runway. Projections show the start-up achieving target metrics for revenue, active users, customers, or the like within a year. After those milestones are reached, the start-up plans to raise additional financing at a significantly higher valuation.
- The team is impressive, the market seems substantial, and due diligence indicates that potential customers are eager to work with the start-up. Investors invest.
- 15 months later, the start-up is back. Everything is going great — but the software development scheduled slipped and the pilot customer loves the product but can’t make a decision on a purchase because of a management transition. The company’s success is inevitable. It just needs more time — and, therefore, more capital. Would the initial investors please provide a “bridge” investment?
My question is always “A bridge to where, exactly?”