Stories of entrepreneurs launching innovative ideas, raising millions in venture capital and turning startups such as Uber, Airbnb and Snapchat into multi-billion dollar companies has catapulted venture capital investments, setting record numbers since the dot-com era.
Venture capital investments in 2014 totaled $48.3 billion dollars, according to the National Venture Capital Association, with more than 40 percent accounted for by app startups. VC funds risk hundreds of millions of dollars, investing in companies with the expectation of hitting the jackpot and generating wildly large returns.
Take Airbnb for example, who within a few years of launching had raised more than $119 million in venture funding, $450 million three years later and, most recently, raised $1.5 billion, valuing the company at $25 billion dollars. Examples like this make fundraising seem easy, when the reality is very different.
Fundraising, particularly venture capital, is extremely difficult to secure. In fact, less than 1 percent of all ventures actually receive venture capital funding. In the world of entrepreneurship, venture capital investments are viewed as the Holy Grail of fundraising, being referred to as “black swan” events because they are a rare phenomenon for entrepreneurs.
Venture capitalists (VCs) are very selective with their portfolios, only choosing ventures of the highest caliber. The importance of sound investment decisions is critical in the investment world, as one mistake can lose a firm billions of dollars, not to mention a loss in credibility.
On the surface, it appears that investors have everything under control, exerting confidence in their decisions as they hit consistent home runs. But as we peel back the layers, empirical research shows extremely challenging and costly cognitive biases that must be battled to make sound decisions.
Cognitive biases are defined as “thinking patterns based on observations and generalizations that may lead to memory errors, inaccurate judgements, and faulty logic.”
“People are inherently biased and our unconscious biases affect our decisions and perceptions,” according to Dr. Khatera Sahibzada, an industrial/organizational psychologist who helps VCs and start-ups capitalize on talent by developing assessment and selection processes.
Investors are inherently biased, and intuition alone cannot consistently drive good decisions.
Because of the pressure and uncertainties investors face in making decisions, these biases are especially important to understand, as any bias factor can be amplified and become detrimental. For entrepreneurs, on the other hand, understanding how these cognitive biases come into play may provide leverage points for bringing ideas to fruition. According to research, the following five cognitive biases can affect investor decision making.
Similarity bias is defined as the tendency to categorize people as being similar to oneself, even when meeting them for the first time. According to one study on similarity bias, there are two distinct dimensions that affect an investor’s decision: education and work experience. Entrepreneurs will be categorized as similar if they have gone to the same school, worked at the same company or shared a parallel experience as the investor, which means they may have a leg up due to the favoritism that’s caused by the bias.
People feel more comfortable when they can relate to others who share similarities. And investors are no exception. In fact, researchers have found that when investors feel similarities to the entrepreneurs and startup teams, they evaluate the potential business in a more favorable light.
One specific type of similarity bias comes from a geographic similarity known as “local bias.” Local bias is defined as the “average geographic distance between the VCs and their investment.”
Researchers have found that investors are positively biased toward ventures located near their investment firms. For example, researchers tracked U.S. venture capital investments from 1980 to 2009 and found that nearly 50 percent of investments were located within 233 miles of the VCs.
VC funds risk hundreds of millions of dollars, investing in companies with the expectation of hitting the jackpot.
One reason for this bias may be the desire to have quick and easy access to information. Accessible information increases a sense of familiarity with the ventures. When entrepreneurs come from unfamiliar territory, it’s more likely for investors to decline deals. VCs who feel familiar with entrepreneurs tend to feel more comfortable, and as one particular study shows, being familiar with the entrepreneur or team can influence the investor to decide in favor of the deal.
According to Aziz Gilani, director of DFJ Mercury, local bias poses an opportunity for their firm particularly in the mid-continent. Gilani has made his career as a venture capitalist located in a region other VCs didn’t find attractive.
According to Gilani, “Venture capital definitely prefers other regions: The midcontinent only accounted for 10-15 percent of all venture investment in the United States in 2011, but it is home to a much larger share of patent filings, R&D budgets, and academic research. We call this discrepancy the ‘commercialization gap’ and focus our efforts on finding world-class opportunities that we can form syndicates around to catapult onto a growth trajectory.”
A similar bias, known as anchoring, is the tendency to rely too heavily on one factor or piece of information when making decisions.
“Anchoring often comes disguised as hard won experience, and painful experiences tend to create strong anchors,” explains Clint Korver, founder of Ulu Ventures and partner at Crescendo Ventures. “For example, if a promising portfolio company fails because of the CEO’s technical failings, I am likely to be extra sensitive to any CEO’s technical expertise in the future, regardless of its importance for that particular venture.”
Investors may find themselves focused heavily on one aspect of the venture because of past experiences, causing them to view the deal through rose-colored lenses or worse, blinders, potentially neglecting other aspects that balance the team or business model.
Additionally, investors typically have to process large amounts of data, for example analyzing technologies, teams, markets, trends, business models and different types of risks. The massive amount of information provided to investors can result in information overload.
Research has found that the more information a VC receives, the greater confidence investors will have in their decisions, a sentiment illustrated by Roberto Bonanzinga of Balderton Capital. “Some investors never give an answer and keep going asking for additional data points in the hope that the data will make the decision for them.”
Although this finding seems rather logical, the reality is that more information does not necessarily equate to better decision-making. Researchers have found that when investors receive more information, they tend to believe they will make better decisions, when, in actuality, more information simply increased confidence in the decision rather than accuracy. And, as confidence increases with more information, the accuracy of the decision actually decreases.
Finally, there is the proverbial gender bias that women must contend with in just about every industry. And, in particular, gender bias has been a hot topic for VCs as women claim their position in the entrepreneurial arena, proving the world wrong in their stereotypes and stigmas.
USCB professor Sarah Thebaud examined gender bias in entrepreneurship and found that “people are likely to systematically discount the competence of female entrepreneurs and the investment-worthiness of their enterprises.” She also found that participants rated women less skilled and less competent than male participants. Thebaud states, “The pattern of bias in favor of male-led businesses really boils down to the stereotypical belief that men are more likely to possess the types of skills and competence needed to make a new venture successful.”
Most cognitive biases are molded unconsciously and are shaped by our environment.
Not surprisingly, more than 97 percent of all venture-funded businesses have male CEOs. The irony is that, when we look at the facts, we find the perspective of gender bias to be flat-out irrational. According to a Dow Jones study, which analyzed 15 years of venture-backed companies and how women in leadership roles affected startups, a company’s odds for success increase as the percentage of females holding executive positions increases.
In addition, startups with five or more females had a 61 percent success rate and only 39 percent failure rate, which is rather startling, considering that the failure rate for most venture-backed companies have been cited in ranges from 50-75 percent. “There is an enormous untapped investment opportunity for venture capitalists smart enough to look at the numbers and fund women entrepreneurs,” according to Dr. Candida Brush, the lead author of a Babson study on venture capital investments in women entrepreneurs.
Although most cognitive biases are molded unconsciously and are shaped by our environment, there are tactics we can implement that will reduce the impact they can have on decisions. For example, Dan Lovallo and Olivier Sibony found that executives were able to achieve return rates up to 7 percent higher after implementing proactive steps towards reducing cognitive biases. Translate that over to investment decisions and similar results may occur.
If you’re an entrepreneur, you too can benefit from understanding cognitive biases by determining how they impact your own decision making, and tailoring your message to reduce the effect biases may have when pitching to investors.
Below are three ideas on how to develop awareness into biases and improve decision making.
Create Your Own Decision Process
Clint Korver uses a specific decision analysis to proactively reduce cognitive biases in his venture capital investment decisions. Korver states, “Failure may be the best teacher, but failure in early stage investing comes at a high cost.” He recognized the negative effects cognitive biases can have on decisions and, after becoming aware of the costly influence of biases, he created a concrete process rather than relying on simple heuristic analysis.
Korver created a decision analysis model, which helps him “structure judgement and quantify intuition in forms that can be easily tested with logic and evidence.” This disciplined approach resulted in quicker, more accurate decisions.
Analyze, Define, Adjust
Analyze your system, explicitly define your criteria and adjust until it’s fine-tuned. When venture capital firm Greylock first invested in Airbnb in 2009, the concept of renting space in your home to complete strangers seemed unthinkable.
So how did Greylock decide investing was the right decision? It fit their investment criteria of “fighting over the deal.” A few years earlier, the partners analyzed their investment meetings and looked at which factors led to their best and their worst investments. Through this analysis they noticed a pattern leading to their best deals — that is, the ones the partners fought over.
Being introspective, understanding and defining your decision making criteria, tracking your decisions and making continual improvements to the process will play an important role in your success.
Follow A Set Of Principles
In a recent HBR article Reid Hoffman, co-founder of LinkedIn and a partner at Greylock, shared two rules when making decisions: speed and simplicity. Hoffman states, “If you aren’t embarrassed by the first version of your product, you shipped too late.” This stresses the importance of getting your minimum version out in the world to begin testing in real time.
The world is rife with opportunities for disruptive startups to forever change entire industries.
One way to enable speed is by distilling complex decisions down to the fundamentals, framing them in simple terms and committing to a decision quickly. Using speed and simplicity as focal points, Hoffman has been able to quickly and intuitively make good investment decisions.
Using principles and rules of thumb to follow, you’ll build a personal framework for making decisions quickly and easily. As you make decisions based on a framework, you’ll hone your process and become more comfortable with ambiguity and uncertainty.
As the research shows, investors are inherently biased, and intuition alone cannot consistently drive good decisions. By identifying and understanding biases, systems, processes and tools can be developed to provide a more objective lens to decision making. Leveraging systematic decision processes will allow investors to boost the accuracy of their decisions and ultimately the success of the firm’s portfolio.
The world is rife with opportunities for disruptive startups to forever change entire industries. When entrepreneurs in a global market infuse a validated business model with venture capital, they can rapidly scale to become a billion-dollar brand.
Whether you’re starting a company or investing in one, increasing the effectiveness of decisions that launch you in a specific direction can help you capitalize on opportunities.