How loss aversion can influence the decisions of startup investors.
A month or two ago I stumbled on a blog post from a well-respected venture capitalist, Fred Wilson from Union Square Ventures. In this particular post he talked about the returns of the first two Union Square Funds and how these had been influenced by the follow-on investments they did.
Early stage venture capitalists have to make judgements on a team and their ability to execute on an idea early in the life of the business, something that is not easily modelled in an excel spreadsheet. While many are very upfront with how they invest and the intangible factors they consider, in my opinion, what is often missing is an acceptance that fund managers are human and prone to behavioural errors.
This is particularly evident in the decision on whether to pursue a follow-on round or not. This is the situation where after an initial investment, there is an opportunity to participate in a further round of financing. In theory, the fund now has better information on the investment and how the company is performing, however this decision is not always easy or obvious. As Fred points out in his post, these investments can have a sizeable impact on the outcome of a fund’s overall performance, especially when you consider how much of a fund’s capital can be deployed in follow-on rounds. It is situations like these where loss aversion can emerge.
Loss aversion is a concept within behavioural economics, first written about by Amos Tversky and Daniel Kahnemann, in which they observed that humans feel a loss more keenly than an equal sized gain. This is not something that we are always conscious of when making decisions and so can influence our behaviour without us realising. There has been a lot written on how this can alter the decisions of investors in the public market. The classic example is an investor delaying the sale of an under-performing asset, trying to avoid a paper loss becoming a realised loss.
In the same way that these biases can play on the minds of investors in the public markets, they also have potential to play a part in the decision making of venture investors. Importantly this can be a factor when deciding whether to make a follow-on investment or not. The investor, not wanting to accept an investment as a loss may have a stronger urge to participate in a follow-on investment, particularly if is not a clear decision either way. Not participating in the round may register that investment as a loss, a feeling which humans naturally try to avoid.
While Fred doesn’t specifically mention loss aversion in his article, it is likely that it played a part in those decisions. He recognises this through his statement: “We could have, and should have, recognised our bad investments earlier and cut them off.” Of course hindsight is always 20/20.
There will always be a myriad of factors to consider in a follow-on round, however the potential for behavioural biases to play a part should not be underestimated. In a similar way when correcting for other unconscious biases, an individual needs to first recognise this behaviour and try to consciously override it. Unfortunately, no one can truly invest without emotion or ego all the time.
A further complication in venture capital is the long feedback loop, due to the length of time investments are typically held for and their long time to reach liquidity. This means an investor may only alter their strategy or approach after years of doing something in a particular way. The two USV funds mentioned in the post date back to 2004 and 2008 respectively. While all this seems like bad news, in venture investing as in many areas of life, it is the investors who learn from their mistakes that are going to ultimately thrive. As Fred puts it so eloquently in his post;
Making bad investments is humbling, frustrating, annoying, time sucking, and most of all, a big part of the VC business. I look for VCs who have done it a lot, have done it with grace and respect, and continue to learn from it. They are the best VCs to work with.
