Here are some thoughts on Venture Capital or early-stage investing.
As readers of my blogs know, Alteris LLC has had professional Venture Capital firms as clients. We have acted as business valuators, but also in the role of “operating partners” to some of these firms. This situation has allowed us to observe best-practices in these early-stage investment firms.
Venture Capital and other types of investing is a competitive and often brutal activity. In a typical VC fund, a small number of investments typically account for a large portion of returns. The simple fact is that the majority of investments do not work out.
Professional Venture Capitalists (VCs) often search for tools that will give them an edge. Any edge to increase the chances of success. One firm we know of (not a client) uses what they call having a “prepared mind.” This means analyzing a market/industry and the trends therein to identify opportunity.
This is similar to the first investment methodology that I learned at the University of Illinois-Urbana as an undergrad, EIC. Analyze the Economy and determine which industries will do well going forward. Look at those industries and identify the companies that will prosper. It’s a simple top-down methodology and there are other ways to identify investment opportunities, but remains valid nonetheless.
Implementing such a seemingly simple approach has nuances that complicate things.
There are variations as to where trends in technology and the market are going that need to be identified. The resulting implications from that are considered. For example, the development of cell phones meant the base stations phone carriers needed the chips that would go into the phones and the associated new software. The opportunity wasn’t just cell phone designers and assemblers themselves. The Cloud was another tech trend that implied new hardware design and connectivity, software business models and security issues.
Ecosystems develop around the large companies driving the technology change. Startups can provide tech and services to fill these gaps as they emerge and therefore create investment opportunities.
Some sophisticated VC investors have used the ideas involved in behavioral science. An entirely new field of investing analysis in public markets emerged called Behavioral Finance. Initially developed for use in developed markets, these same concepts could be used in the startup world.
Often investors in both public and private markets brag about relying on instinct. You often hear of the concept of “pattern recognition”. But that can often be wrong. Accurate pattern recognition is a real skill, but sometimes so soft, with merely intuition as a driver, it is hard to explain how the pattern is recognized. Others usually, maybe often, can’t see the same pattern. Given human nature, if they can’t see it, it must not exist!
However behavioral psychology experiments going back decades show that human reflexes distort rational decisions. I would direct the reader to the Dunning-Krueger effect which is the topic of a previous blog. The result is inconsistency and poor investment decision-making.
Here’s an example of human decision-making foibles. Research shows that investors are often willing to gamble to avoid a loss, but are irrationally risk averse when investing for the upside. In VC land this can show up as premature profit-taking, which can leave huge returns on the table for someone else to enjoy. A founder or VC may be willing to take a low offer to sell their company when it is obvious that by waiting, the company valuation will increase.
Then there is the infamous confirmation bias. That means a person will filter out information that challenges a position they have already taken. There are so many examples of this! Sometimes VC investors will miss attractive Series B investments because they passed on the same company at the earlier Series A level. They don’t want to admit they made a mistake the first time, and want to keep their “gestalt.” We’ve seen that.
Of course, there are many other biases that humans have that lead them to make bad decisions or to hold obviously incorrect beliefs. Maybe that’s what makes people “interesting” in the negative sense of the phrase.
These same biases can be present in other parts of life rather than just investing. Of course, some of these other areas of life may be more important than mere money. Bad decisions there can be more harmful than just losing money.
Perhaps a balance between pattern recognition and understanding bias is the key. Regardless, the first step towards overcoming cognitive bias is to recognize it.
