Is 'Gut Feel' a Good Reason to Invest in a Startup?
Most investments in startups should never be made, at least when
using by-the-numbers reasoning. But funded they are. Laura
Huang believes investors use gut instinct to manage that risk.
The odds investors face when deciding which startup to back are
long enough to make any self-respecting poker player toss in their cards. “Most
investors know that when they write a $50,000 check they have a 98 percent
chance of never seeing that money again,” says Laura Huang, associate professor
of business administration in the Organizational Behavior Unit at Harvard
Business School.
And yet, investors take chances over and over often with great
success when they hit it big with a game-changing entrepreneurial venture. What
makes them do it? Huang finds that investors often point to a surprising
explanation: their gut.
“If they relied solely on pro-con lists, or what the hard
numbers look like for the company at their current state, probably none of
these investments would be made,” Huang says. “Gut feel is the factor that
allows them to invest despite what might seem overly risky.”
Unlike most situations where making an important decision based
on gut feel is seen as a negative, venture capitalists and angel investors
often brag about the wisdom of their midsections. “They have a lot of pride in
how they make their decisions,” Huang says. When she asked one investor how he
chose investments, he rubbed his belly over and over, saying “I do that.”
A blend of both
Gut feel in investing may not be as random or capricious as it
sounds, as Huang describes in the new research paper The
Role of Investor Gut Feel in Managing Complexity and Extreme Risk,
recently published in the Academy of Management Journal.
Behavioral psychologists typically divide decision-making
processes into two types. Type 1 is characterized by impulsive, instinctual,
emotional reactions, often made quickly and without much thoughtful analysis.
Type 2, by contrast, is more analytical and deliberate, using higher cognitive
processing.
While we might be likely to relegate gut feel to Type 1
thinking, Huang has found that what investors mean by the term is actually a
combination of Type 1 and Type 2 decision making. “When people are making these
sorts of decisions, it is much more complicated than we typically think,” she
says.
Huang arrived at that conclusion after interviews and
observations of more than 100 angel investors over the course of the past
decade. She also conducted dozens of interviews with the entrepreneurs they
funded; sat in on pitch meetings and board meetings to see if their
explanations matched their actions; and traced the performance of the companies
they invested in.
As she described in a previous
paper published in Administrative
Science Quarterly, decisions attributed to gut feel were surprisingly
effective. While they led to fewer successes overall, the companies that were
successful had much higher performance. “Putting it into baseball terms,
investors who relied on their gut feel had a lower batting average, but more
home runs,” Huang says. In the current paper, she attempts to drill down to
figure out what investors are really doing when they make decisions with their
gut feel.
She coded all of the interviews to see what investors really
look for and found that two distinct types of investors emerged. The first,
which Huang calls “checklist investors,” focus first on quantitative
information, including financials, markets, and intellectual property. Once
satisfied that a company has checked all of those boxes, the potential investor
takes the leap to actually investing based on a more intuitive feeling of
rapport with entrepreneurs.
The second type of investors, which Huang calls “syncopated
investors,” reverse that process, focusing first on whether they relate to
entrepreneurs on an emotional level—judging whether a fledgling company has the
grit and passion to succeed. If it clears that bar, they verify their gut with
a more quantitative analysis.
What type of investor are you?
Neither approach is necessarily better, says Huang. Rather, both
are investors’ ways of managing and rationalizing risk.
Checklist investors deal with uncertainty by looking for
elements they can control. “It’s such a risk-laden process, and they want to
feel like they are guided by their expertise,” she says. Syncopated investors
manage risk by feeling like they are willingly making the choice to invest.
“They feel like this is a fun endeavor that they’re embarking on with the
entrepreneur.”
For investors, knowing which type of approach they default to
can help them be more deliberate about how they make decisions, giving them
confidence that there is in fact a method behind their investment choices.
For entrepreneurs, understanding how investors make decisions
can help them deliver their pitches most effectively. But it’s not about gaming
the system, emphasizes Huang—startups need to make sure that they have both the
quantitative analysis to back up their idea and the “soft” factors that can
appeal to investors.
Depending on the signals they get from investors, they might
emphasize one or the other. “If you have an investor who is very
checklist-minded, you want to very quickly show your IP and your product
prototype, and then as they become more comfortable, work on developing that
chemistry,” Huang says. For a syncopated investor, entrepreneurs might focus on
developing a rapport first before drilling down into the numbers.
Also keep in mind that a decision to invest is just the
beginning of what will hopefully become a long relationship between an investor
and an entrepreneur. Understanding how an investor makes decisions at the
outset can help an entrepreneur decide whether they will be a good fit for the
long haul.
“It can be really painful to have the wrong investor,” Huang
says. “Being aware of how someone invests can trickle down into how they will
behave and provide advice in the future.”
by Michael Blanding
https://hbswk.hbs.edu/item/is-gut-feel-a-good-reason-to-invest-in-a-startup?cid=spmailing-19570592-WK%20Newsletter%2004-04-2018%20(1)-April%2004,%202018
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