Recognize these signs of investor biases to ensure your next fundraise is fair, flexible, and on your terms.
With everything our brains have to process, it’s no wonder they look for ways to simplify information. Cognitive biases are the resulting “mental shortcuts” we take to help us get through life. While they can be helpful on a basic level, these biases can, unfortunately, also lead us to jump to conclusions and make decisions too hastily. As an entrepreneur, it’s important to recognize cognitive biases to fully equip yourself for fundraising.
Understanding cognitive biases is the key to overcoming it
In their most basic forms, cognitive biases help us make decisions. Without going through the “trouble” of thinking through something too thoroughly, we can quickly recall the times we’ve been in similar situations and use that information to make decisions based on those past experiences. This is why we many of us automatically recoil when we see a snake (we assume they’re dangerous) or ask leading questions when getting to know new people (we make assumptions as soon as we meet them). Even FOMO is technically a cognitive bias.
Cognitive biases first came into vogue in the 1970s when Daniel Kahneman and Amos Tversky began investigating behavioral economics. Kahneman was eventually awarded a Nobel Peace Prize for his work, and his book Thinking, Fast and Slow is a great read for anyone interested in learning more. Understanding cognitive biases is a particularly useful exercise for founders, as these biases can unknowingly have an impact on your fundraising round.
Pattern matching leads to conformists over contrarians
Pattern matching is a very common cognitive bias in the investment world. Investors think of the best deal they’ve done—or maybe the one that got away—and spend their careers trying to make more similar investments. For example, Ron Conway passed on Salesforce because he felt the valuation was too high at the time. Ben Lerer missed out on Uber, because he didn’t trust his gut. Investors who pass on what later becomes a startup “unicorn” oftentimes spend the next few decades making sure their next big opportunity doesn’t slip away.
While rampant in the investment world, pattern matching actually has its roots in these other well-known biases.
Hindsight Bias. This occurs when people see past events as having been predictable. (Ever heard the saying, “Hindsight is 20/20”?) Essentially, this lends an investor a false sense of confidence. If only I could find a similar company to my previously successful one, she thinks, I’d be making a smart investment. It becomes easy to over-value lessons from previous successes and be unwilling to make decisions that go against those lessons—even when confronted with logical reasoning.
Survivorship Bias. Successful companies can easily write the fate of other companies rather than looking at the lessons learned from the failed ones before it. The narrative of Silicon Valley—and, to a certain extent, American entrepreneurship—is built on survivorship bias. Simply refer back to the founding stories of Amazon, Apple, or Microsoft which have defined this past decade for the companies who followed suit.
Stereotyping. When stereotyping, someone unfairly expects a member of a group to have certain characteristics. This has discounted the value of entrepreneurs who come off as different than the mental picture investors have for a successful founder. In “The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success” private equity director and author William Thorndike paints a thoughtful analysis of modern leadership and challenges society’s ability to easily overlook the unconventional characteristics and traits of future leaders.
In addition to pattern matching biases, there are other biases to be wary and by being aware they exist, you can better prepare for them in the future.
Geographical Bias. Just four states control 80% of venture capital investments in America. As a result of this phenomenon skewing so significantly in recent years, there are now entire funds sprouting up with anti-Silicon Valley strategies. They are purposefully taking advantage of the fact that 50% of exits had no brand-name Silicon Valley VC in the seed rounds.
Bandwagon Effect. We discuss the Bandwagon Effect at length when we characterize the three types of investors. Essentially, the more in-demand a company is, the more in-demand that company continues to become. While it’s easy to feel on top of the world if you’re a founder experiencing this firsthand, however, hyped up valuations and momentous growth to quickly can prove fatal to a company which we have seen several companies this year fall victim to.
Clustering Illusion. The clustering illusion can cause investors to over-value (to your benefit or detriment) recent performance. This is why it’s so critical that you can quantify how much value your business is creating or destroying and explain that analysis in context. This is where Hum Capital’s Cost of Equity Calculator can be a helpful resource to help you understand and communicate these numbers upfront to investors.
During the fundraising process, it can easily feel like you’re out of control of your destiny when you’re putting your fate in an investor’s hands. By understanding these biases, you can take a stronger hold of the process and be better equipped to address these biases head on.
Turn your awareness into action with these steps
We’ve discussed at length the biases that can negatively impact your fundraising round—but there are a few ways that you can carefully and cautiously leverage biases to your advantage.
Information Bias. More information isn’t always better, but we as humans often perceive it to be. As a founder, this bias can work in your favor. The more comprehensive your financial projections are upfront, the more successful you’ll have presenting your vision to investors. (Note, this does not apply to a first impression or pitch deck, both of which investors expect to be brief.)
Sunk Cost Fallacy. This bias lends itself to the investors who believe that their previous investments (e.g., sunk costs of time or money) justify them to continue a behavior. Use this to your benefit by pursuing investors who have made their name in a specific industry or category. Consistent investments made over time or having dedicated countless hours to a subject that fits well with your own business could benefit you.
Investor biases are neither positive nor negative by nature, but they can lead to a number of detrimental outcomes depending on the circumstances. What’s important is that you’re able to recognize investor biases as they occur in the moment—and use that knowledge to your advantage. After all, hindsight is 20/20.
At Hum Capital, we are committed to equipping companies with the metrics and messaging they need to be successful in front of investors. If you’re interested in learning more about our process and how we can help you, reach out to us.