Adverse Selection in Private Markets: VC Crowdfunding as a Case Study¹

One of the biggest risks lurking in the shadows of private markets? Adverse selection.

Adverse selection is kind of this elusive, mythical risk in private markets. It is often discussed but seldom backed by empirical evidence. So, we were curious to understand what story the data tells. The natural starting point is VC—primarily due to the rise of 'retail' crowdfunding platforms. It's a fairly simple theory. Preeminent firms with a reputable brand and, presumably, dry powder to deploy, attract the best deals. Their brand is a proxy that creates 'signal' and accretes value.

It's also a magnet for broader investor participation: if a highly regarded investor thinks it's a great opportunity, it effectively de-risks decision making, and can inject biases—creating a halo effect. It'll usually be much easier to bring in other regarded investors. And if you're an entrepreneur, or a GP raising capital, this is the natural path of least resistance. Lock in a top tier investor and the rest can flow together from there. It becomes your first stop.

Hence, adverse selection.

As such, investors should be consistently asking themselves (i) why am I seeing this deal? and (ii) is this deal objectively (not subjectively) attractive irrespective of the brand effects?

Factors other than brand also tend to amplify this risk: ability to fund subsequent capital raises, value-add strategics, and so forth.

The first stop of a high-potential startup is more likely than not Sequoia, a16z, Benchmark, and the like. Participation from one of these firms is virtuously circular, it's helpful for recruiting/hiring, marketing and PR, etc.—in effect, their portfolio companies generally are both more likely to raise another round and therefore have an edge in defying the odds of survival.

Data supports this. VC is a vertical where performance persistence is strong. A top quartile fund in VC has the highest probability of remaining in that performance quartile for their subsequent fund relative to all other asset classes (Source: CAIA).

It seems these platforms are particularly exposed to adverse selection. They typically don't have their own balance sheet, don't confer a hiring halo, and the relative value-add is questionable—there's no virtuous brand effect. The logical deduction is then, why raise via crowdfunding? Unfortunately, the answer may well be, 'everyone else said no.' Worse yet, interests can be completely misaligned. It's an insidious loop.

VC crowdfunding platforms often market '0% management fees' to their investors, charge the company a placement fee, and then don't release performance data. As such, these platforms are generally incented to solve for platform volume, not quality. Company resources then, assuming they're aligned with key business KPIs, have a natural skew from the investment team to sales/marketing (form over substance).

Without shared risk (skin-in-the-game), from an investment team incented to solve for quality—the subsistence of these platforms is underpinned by a defiance of human nature. Incentives drive behavior. Why would a startup pay to raise money? Presumably, they have no other option. (No one should be surprised when 'time' does its job and filters out the truth!)

So, why do these crowdfunding platforms continue to raise droves of capital?

Well, as mentioned, they seldom have a track record, there's limited (if any) accountability… and… this is really all conjecture, it's hard to prove adverse selection due to the information asymmetry and opacity common to private markets. But, data availability has improved materially in the past half decade or so.

As a result, we partnered up with our friends at Vested to dig into what the data says about these crowdfunding platforms relative to traditional VC style investing.

Here's a breakdown of our approach:

• Pull data of companies that received funds from the top 5 crowdfunding platforms;

• Keep seasoned companies (pre-2021 vintage) as newer vintage startups have not likely gone full cycle; and

• Assess which of these companies raised a funding round following their crowdfunding raise.

The result:

Of the ~1.5K companies and ~$1.7 billion in capital raised in the sample, representing a basket of the top 5 VC crowdfunding platforms by volume, the performance of crowdfunded startups versus traditional VC-backed startups is materially worse:

VC Crowdfunding vs. Traditional VC

Percentage of Startups Raising Subsequent Funding by Size (2012-2021)

Source: Pitchbook, 2024.

• 22.7% of crowdfunded companies raised a subsequent round >$1.5M versus traditional VC at 44.2%.

• 9.1% of crowdfunded companies raised a subsequent round >$5M versus traditional VC at 26.4%.

• 5.3% of crowdfunded companies raised a subsequent round >$10M versus traditional VC at 16.9%.

• 2.8% of crowdfunded companies raised a subsequent round >$20M versus traditional VC at 9.7%.

That's a huge delta.

The median Series A round size usually hovers north of $7 million (per Carta data). Only ~6.8% of equity crowdfunded startups go on to raise a Series A-sized round of any kind, including a subsequent crowdfunding round and traditional VC, relative to 21.8% with the traditional VC path.

At best, one could argue that crowdfunded startups might go on to avoid follow-on rounds and be self-sustaining. But realistically, that's unlikely, and either way, the risk/return asymmetry is skewed given the very high failure rate of startups.

There are a few different ways one could have either used a slightly different methodology, or a more nuanced methodology—the directional takeaway is likely to be the same either way. Empirical data does seem to support the somewhat conjectural nature of adverse selection.

This is not to imply that crowdfunding is inherently bad, per se. Just that it requires a thoughtful approach. In the world of crowdfunding, proceed with caution.