How Venture Capitalists take Investment Decisions
Venture Capitalists make daily decisions about which startups will get the much needed funding, Miles Penn, a Stanford graduate and a contestant on Shark Tank starts his pitch to the sharks. His concept is great, and he is already getting some adoration from the sharks. His company, a hi-tech custom clothing company, wants to disrupt and replace the custom tailors. He has created a smartphone app that uses the onboard camera to measure the vital stats, and the final garment is shipped to you in few days. The investors thought it was an excellent idea, but Penn starts off on the wrong foot by comparing how good his venture is versus shark Daymond John’s clothing company. Then, as if he was in a trance, he makes another mistake, he values his business at $ 25 Million, when by his own admission, his 2015 budget of $ 2 Million is way off the mark given problems with his foreign suppliers. Miles gets booted out but also gets a sarcasm filled comment from Mark Cuban “You may be even more arrogant than I was, if that’s possible” If someone was carefully watching, the disgust on Cuban’s face was already visible well before he made that remark. Penn just walked into it flawlessly. From the sets of “The Voice” to “Shark Tank”, I intently watch for cues from the decision makers as to which way the decisions will go. I am also surprised that it seems that those pitching for funding are on auto-pilot unaware of what’s happening around them. Many times, the decision makers in the role of “Investors”, “Job Interviewers” and even “Mate Recognition” will be well trained to mask the cues. However, if one carefully looks, the cues are right there. One needs a keen eye and a well trained “Intuitive Spectrum” to pick them up.
So, what are the key factors in investor’s decision-making process ?
One key factor, “Exemplar Models”. Exemplar Models are patterns within the head of the decision maker of all resultant previous experiences. The models are well embedded in the “Intuitive Expertise” schemas of our Intuitive Spectrum within our Intuitive Mind. With sufficient training, even if investors can successfully mask their cues, our intuitive pattern matching skills can be used to pick up weak signals from the environment. These pattern matching skills can assist us in accurately deciphering what’s going on in the minds of these investors. Every startup founder thinks that the best shot at making a venture succeed is to have a big venture investor lined up behind them. Due to this, a lot of companies have cropped up which provide assist ventures in pitching to investors. As our research has shown, most of the pitching experts are as clueless about investor decision preference, as much as the enterprise founders themselves.
One thing that makes it very difficult to know what’s going on in the minds of the investors is that VCs and Angels will avoid publicizing their actual investment criteria in black and white as most of the investment criteria is implicit (in their head). Implicit Criteria is a Procedural Memory Vs Declarative Memory i.e it is not easily accessible to the investors them self. Procedural Memory is very hard to articulate and takes a lot of self-awareness to outline it. Secondly, investors don’t want to miss the next rocket ship by publishing a narrowed criteria too much, so do not clearly describe their criteria.
It takes months and months of conscious research to decipher the true denominators of investor decisions. It utilizes a lot of triangulation process, decision-making research, tons of academic reading and many successive approximations to actually figure out the mindset and preferences of an investor. Sometimes, investors themselves don’t know or know but cannot articulate it well enough. The key is to find the dominant holding pattern around which specific investors make investment decisions.
Factors Affecting Investment Decision Making
“Exemplar models” are abstract memory constructs in our head that combine all our previous experiences regarding a specific context strongly influencing our unconscious decision-making process. If one is ready to spend some time, they can use the framework below to draw up an accurate map of an investor’s decision models.
Risk Versus Reward – Most Investors are skeptical to begin with; irrespective of their culture and country of origin, investors are always making a conscious effort to mitigate risk. Age group of investors has a direct correlation with the level of risk aversion. The younger the group and the older the group, the higher the risk aversion tendency. By researching the investor, one can accurately decipher the level of risk the investor’s comfort level around the risk level. If the investor is an “Cautious Optimist”, they will be positively influenced if one outlines the risk and the risk mitigation in their venture concept early on. . Entrepreneurs or fund seekers should devise a very clear strategy around the findings which includes energy matching, low key or high key pitch, outline risk first or after the initial pitch A highly risk averse segment of investors love a detailed risk mitigation strategy grounded in reality fairly quickly into the pitch. If the risk discussion is prolonged, the investor can perceive doubts about the success of the venture and will back off
Pattern Recognition – Investors rely on their schemas and pattern recognition skills to decide whether the venture matches their criteria. Most of the pattern matching process in unconscious and investors are unaware of what’s going on in their head. Like normal people, most of the biases and personality blind spots of investors are cast in stone as personalities are very hard to change. If one carefully watches the facial expressions of the sharks in Shark Tank, it almost provides you an immediate indication of what decision they are likely to make. E.g Mark Cuban almost always signals well ahead by his expressions and is easiest to decipher but then he pulls off a surprise with utmost unpredictability at times). Basis this, if you don’t get a hook onto Cuban in the first few seconds, your next opportunity is towards the end of the pitch. He takes decisions on either end of the spectrum.
Market Size & Sector Preference– All Investors have market size and sector preference. One needs to diligently evaluate their past investments and a pattern of size and sector preference will emerge. The level of risk aversion also directly feeds into market size and sector preference. If a sector is perceived as highly risky, even though the investor has made past investments in it, they will tread cautiously next time around.
Decision-Making Pathways– Most Investors think that they are skilled at find the needles in the haystack. This is a big misnomer and successful ventures with an IRR > 40 are very rare. One should be aware of the decision-making sequence of the specific investor i.e how do they approach a decision post pitch ? What kind of questions they ask. How much data do they need ? Are they relying more on intuition versus analysis ? Do they take decisions over long periods or in spur of moments. One should learn how to be on the right side of the decision-making sequences in the investor’s head.
Luck- Contrary to the common belief, luck significantly influences investment decision and the fate of startup success. In great profitable ventures, luck of investors has to match with the luck of venture founders. Trained pattern recognition combined with luck is the strategy that works for those who are willing to put the hard work. By doing a lot of leg work and due diligence, by stress testing one’s pitch and the value proposition, by appealing to the investor’s cautious nature and by toning down any irrational exuberance, one may be able to position themselves in a zone where Luck can find them.
Finally, one should not factor the Investor’s net worth and/or fund Size, one should also research how they interact with people and how they generally treat entrepreneurs. It is now fairly easy to form an implicit model of Investor’s personality versus the Controlled Persona. Key thing to remember here is that nice is not always nice and arrogant is not always bad. There have been many cases on Shark Tank where Cuban initially despised the concept and then suddenly turned around and became the sole investor.One has to go deeper into the core personality aspects of those on the other side. The wiser and tempered an investor becomes, the less they give away and the harder it is to make educated guesses regards their thought train.
One should read all writings of the investors in public domain and notice how they interview on TV channels. Investors have well defined red zones, likes and dislikes and anyone who walks into that red-zone is sure to lose the opportunity. Most of the investors are not ready to challenge their biases till they experience a catastrophic investment event or personal life event. So, these red zones areas need careful navigation. It should also be noted that Opportunity Recognition faculty in serial entrepreneurs is statistically more enhanced than the Opportunity recognition faculty in Investors. Traditionally, serial entrepreneurs become better Investors. One should be very careful when founders are pitching to serial entrepreneurs turned investors.