Much has been written about the psychology of decision making and how venture capitalists choose which companies they want to fund. Although due diligence is an important part of the process, first impressions and emotions play a huge role in reaching that stage. Diverse teams are vital to making sure that gut reactions aren’t driving poor investment choices in VC funds.
How do venture capitalists make their investment decisions? It’s a common question, frequently asked by entrepreneurs and scientists looking to raise funds. The classic answer is of course: through extensive due diligence. VCs will: study the business case; evaluate the future market need; look at the available data; interrogate the management team; and ask about the patent situation, to keep the competition at bay. After this thorough analysis, VCs will then follow up by consulting experts in different disciplines through many a conference call. Finally, once all the information from internal and external reviews has been collected, the case is weighted and debated by the investment committee. Then, and only then, will the investment decision be made.
Funding, fast and slow
Reading through the number of steps taken by VCs during the due diligence process, you’d be forgiven for thinking that investment decisions are purely based on logic and calculation. However, as will all decisions, funding choices are deeply rooted in human psychology. By considering a different perspective, we can shed light on the internal decision-making process, both leading up to the due diligence and when making the final call.
Prof. Daniel Kahneman is a renowned psychologist and economist noted for his work on behavioral economics (for which he received a Nobel Prize) and the psychology of judgment and decision making. Among other things, Kahneman has studied common human errors that arise from cognitive biases when making decisions in uncertain situations. This topic is particularly relevant for venture capitalists who, by definition, must make decisions while facing a lot of extreme uncertainties.
In his famous book, ‘Thinking, Fast and Slow’ (2011), Kahneman distinguishes between two cognitive systems involved in decision making:
System 1 is fast, instinctive and emotional; it operates automatically, with little to no effort, and we might refer to it as ‘intuition’.
System 2 is slower, more deliberative and logical; it involves allocating attention to effortful mental activities such as complex computations, and we can define it as ‘data-driven analytical evaluation’.
To see how System 1 might influence the VC decision-making process, we can substitute the question “Is this company worth funding and will it deliver a good return?” with a simpler emotional question like “How much do I like this company?”. These are related, but obviously different, lines of thought, where the second question is in fact not relevant to whether a fund should invest in the company. Indeed, according to Kahneman, although System 2 always has the ability to reject the results of System 1, in reality System 2 is lazy and often endorses System 1’s outcome without much scrutiny. In different stages and to different degrees, both systems play important roles in the funding decisions of VCs.
You’ve got to go through 1 to get to 2
Good salesmen intuitively manipulate both decision-making systems to their benefit. Pitching your new start-up to a VC is in many ways the same as selling a car to a potential buyer: the story needs to spark the listener’s imagination; there needs to be a click, an emotional connection and a genuine interest between the storyteller and the audience.
At most conferences, you’ll encounter investors absolutely inundated with funding requests, whose overwhelmed System 2s have given themselves over to relying on System 1’s decisions.
During an elevator pitch, there is insufficient time for detailed factual discussions. At most conferences, you’ll encounter investors absolutely inundated with funding requests, whose overwhelmed System 2s have given themselves over to relying on System 1’s decisions. According to Kahneman’s theories, the best investment pitches are the ones which activate System 1 of the audience. This is because System 1 quickly substitutes a difficult and multifactorial investment decision with the much simpler question: “Do I like this story?”.
Only once that barrier has been breached, will the path open onto the more advanced steps of the fundraising journey. The story and the data will of course need to hold up in subsequent meetings and deeper, content-driven discussions. But to get to the stage where System 2 takes over, you first need to appeal to System 1, and there is only ever one chance to make a first impression.
When systems fail
Already in 1983, Kahneman and his colleague Tversky found that people usually don’t use probabilities when making decisions. Instead, people fall back on heuristics: mental shortcuts used to quickly form judgements. There are many types of heuristics, but one that can easily lead investors astray is the representativeness heuristic. This heuristic used categorization: a person will assess the similarity of objects and organize them into groups based on similarities. The problem is that this type of classification can easily make mistakes and doesn’t represent real probabilities. Consider the following line of thought:
“The last three IPOs by companies with small molecule pre-clinical programs in orphan diseases were tremendously successful!”
This idea might spur an investor on to make a poor funding decision, because the fact that a company resembles others that have previously succeeded does not necessarily make it more likely to also do well. Of course, there are always exceptions to the rule, and decisions made on this basis can lead to fantastic investments and splendid VC returns. But this example illustrates the importance of engaging both System 1 and 2 before making a final call.
People usually don’t use probabilities when making decisions. Instead, people fall back on heuristics: mental shortcuts used to quickly form judgements.
Avoiding psychological pitfalls
It’s important for entrepreneurs to consider how decision making can be influenced when trying to win over inventors. For VCs, it’s also crucial to be aware of intrinsic psychological pitfalls like the representativeness heuristic and confirmation biases.
Investment firms have found multiple ways of dealing with these problems. Most VC firms work in partnerships, with unanimous support needed before a project is advanced. When discussing potential new investment cases, some funds even assign a person to play the devil’s advocate to tease out any weakness in the potential portfolio company.
These measures work very well to quell issues, so long as the decision-making teams are diverse enough to avoid having every team member’s System 1 triggered by the same factors. To collectively overcome the inherent imperfections of the human decision-making system, it is also vital that everybody’s input is openly shared and considered.
For our small investment team at V-Bio Ventures, it is a daily challenge to recognize situations where we may be vulnerable to errors and biases. It is one of the reasons we have endeavored to put together a team as diverse as possible, with a mix of backgrounds, knowledge and expertise. We do everything we can to get the best out of both systems and make the right decisions when the stakes are high.
