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Behavioral Finance

Notes On Strategy; What Can We Learn From Religious Leaders About Building Early-Stage Startup Culture?

September 3, 2015 by Brian Laung Aoaeh

Alternative Working Title: Notes On Strategy; Engineering Your Early Stage Startup’s Culture For Longevity

What it’s like to work for Amazon http://t.co/7Nw93JDqz0

— The New York Times (@nytimes) August 19, 2015

Replace Just 2 Words in the Times Amazon Article and Something Amazing Happens @TKspeakshttp://t.co/bk3Y7ZCLCE

— Inc. (@Inc) August 21, 2015

The topic of culture has been in the news quite a bit since the New York Times published an investigative piece describing what it is like to work for Amazon. While culture is something I think about all the time, that article got me thinking about religion and culture . . . and how that relates to the early stage startups in which we invest.

In this post I plan to:

  1. Examine what we mean when we say “culture” and tie that to the work that startup founding teams do during business model search and discovery.
  2. Examine the structural characteristics of religious communities; How do they maintain a sense of purpose, direction, and elicit devotion and commitment from members of the community?
  3. Provide some pointers about how first-time startup founders might get things off on the right footing as far as culture is concerned by making certain deliberate choices early in the lifecycle of their startup.

I am thinking specifically of startups raising their first institutional round from seed stage venture capitalists, or perhaps a Series A round of financing. These teams are usually small, often fewer than 10 people.

To get things started; What is Culture?

Culture is the learned and shared behavior of a community of people which distinguishes that community from other communities. ((J. Useem and R. Useem. (1963). Human Organizations, 22(3). Page 169. See: The Center for Advanced Research on Language Acquisition (CARLA) “What is Culture?” http://www.carla.umn.edu/culture/definitions.html. Accessed Aug 29, 2015.))

Some of the things that distinguish a culture: ((Adapted from: Richard-Hooker.com; Clifford Geertz, Emphasizing Interpretation))

  1. It embodies a way of life, an approach to thinking, feeling, and believing about the world.
  2. It endows the members of the cultural community with a social legacy from prior members of the same community.
  3. It provides a framework that enables members of the community to think abstractly about how they should behave;
    1. It provides lessons about how members of the community should react towards recurring problems by pooling the collective wisdom of past and present members of the community.
    2. It provides a guide for community members when they need to interact with the external environment.
  4. It is the process by which the history of the community is created and brought into permanent existence.

In this analysis I am most interested in religion as a cultural system.

According to Clifford Geertz religion is: ((Clifford Geertz, Religion As A Cultural System. In: The Interpretation of Cultures: Selected Essays. Pp. 87 – 125. Fontana Press, 1993.))

  1. A system of symbols which acts to
  2. Establish powerful, pervasive, and long-lasting moods and motivations in people by
  3. Formulating conceptions of a general order of existence and
  4. Clothing these moods and motivations with such an aura of factuality that
  5. The moods and motivations seem uniquely realistic.

It is not difficult to see that a religion is in fact a specific type of culture and further, that every cultures is a kind of religion. In the rest of this post I will use the term “religion” and “culture” interchangeably. I also assume that a symbol may be tangible or intangible.

The structural characteristics of a religion are: ((William E. Paden, Religious Worlds: The Comparative Study of Religion. 2nd edition. Pp. 51 – 161. Beacon Press, 1994.))

  1. A religion inhabits a unique world: Religions create, structure and propose a universe that is unique to adherents of that religion such that members of the community can explain, make sense of, and differentiate what is within their world from what is outside their world. This helps establish lines of commonality as well as lines of difference, and helps confront change and challenges.
  2. A religion is grounded on certain myths: Every religion possesses sacred myths that tell a story about something that happened during the genesis of the religion and that continues to have great influence on contemporary realities experienced by adherents of the religion. Myths:
    1. Help devotees of a religion make sense of the past, the present, and the future.
    2. Are a powerful means of engendering a certain mood and attitude within the devotees of a religion.
    3. Focus our attention on that which is sacred and important within a religion.
  3. A religion possesses rituals: Rituals help to focus the devotees of a religion on specific concepts or ideas at a specific point in time, also rituals enable the adherents of a religion to express their beliefs about the world in the form of a tangible display that appeals to the senses through action.
  4. A religion possesses gods: In the context of religious worlds, gods represent instances of language and behavior that is held up by the religious community as exemplary, worthy of emulation, and possessing interpretive power in terms of how that community understands the world.
  5. A religion possesses systems of purity: These systems of purity help to differentiate what is acceptable from what is unacceptable, right behavior from wrong behavior. This is a system that enables members of the community deal with negativity within the community.

What role do symbols play within a culture?

  1. Anat Rafaeli and Monica Worline: Symbols in Organizational Culture – A symbol is a visible and physical manifestation of an organization. It is an indication of organizational life that derives its meaning from the social and cultural conventions and interactions among the people who belong to the cultural organization. Symbols can be experienced through the senses. Symbols play the following functions:
    1. They reflect organizational culture: Symbols communicate information about what we think we know about an organization. They act as a bridge between our emotional and cognitive responses towards an organization.
    2. They trigger internalized values and norms: Symbols serve as a cue to trigger certain expected, desired, and acceptable behaviors once a person enters the physical environment of an organization or whenever the person is acting explicitly as a representative of the organization to the outside world.
    3. They frame conversations about experience: Symbols act as a frame of reference for guiding the communication that takes place between members of the same organization, or between members of a specific organization with people who do not belong to that organization.
    4. They integrate organizational systems of meaning: Symbols integrate the culture, norms and values, and shared experiences of members of an organization into a coherent whole within which members of the organization experience the world.
  2. Sherry Ortner: On Key Symbols – A key symbol is an element of a culture that is crucial and distinctly unique to the organization of that culture. They perform the function of carrying and conveying cultural meaning to people within the culture as well as to people outside the cultural community. Key symbols might be identified when:
    1. Members of the cultural group discuss the symbol’s cultural significance,
    2. Members of the cultural group are positively or negatively aroused by the symbol, and none are indifferent towards it,
    3. The symbol appears in many different settings and contexts,
    4. There is much elaboration around the symbol, and
    5. The group imposes numerous restrictions around the symbol. For example, misuse of the symbol can incur severe sanctions.

There are two distinct categories of key symbols. Summarizing symbols express meaning in an emotionally powerful way that is of uniform significance for all members of a given culture. They are generally accorded sacred status. Elaborating symbols make it possible for members of the religion or community to communicate ideas and feelings with one another, and to translate such feelings and ideas into tangible action. Elaborating symbols are generally analytic in nature and rarely attain sacred status.

What does this mean in the context of building an early-stage startup?

  1. Communicate a clear world view internally and externally. One question I ask myself when I meet with a founder is this; Why is this specific person uniquely suited to solve this problem in this market and why do I believe this team will succeed in its effort to accomplish this incredibly difficult task?
  2. Preserve and embellish important stories, particularly those that reflect qualities and themes that the founder wants to become aspects of the startup’s long-term culture and identity. I listen for founders who express enthusiasm for the work that the other people on the team are doing. Team cohesiveness matters.
  3. Create and maintain rituals:  For example, does every team member understand what would get existing customers/users to become more engaged with the product, and reduce churn? Does every team member know what needs to happen for the startup to increase its growth enough to get to the next funding milestone? Does the founder have a firm grasp on the startups key performance indicators? Has the team chosen the right indicators to focus on at this stage?
  4. Focus on finding product/market fit: A startup that fails to find product/market fit is doomed. Are the founders experimenting enough to find an ideal early market for the product, or are they stuck in a cycle of dogma regarding an initial point of market entry? What indications are there to help me ascertain the quality of their decision-making processes?
  5. Create systems of accountability: At the very early stage of a startup’s life the individuals on the team have an enormous impact on the organizational culture that eventually evolves. What steps are the founders taking to ensure that the early team has the right mix of people?
  6. Create a sales and marketing plan: What steps is the startup taking to create strong bonds with its earliest customers/users? Is anything being done to create a brand? Are the choices that have been made so far cost-effective and appropriate for the startup’s stage of maturity and its funding status?

Closing Thoughts The job of an early-stage technology startup founder is basically akin to that of a religious evangelist. The founder must recruit believers. Early team members join the cause because they believe in the founder and in the vision that the founder wishes to bring into reality. Early customers become believers because they have a problem they believe the startup’s envisioned product can solve. Early investors join the cause because they believe in the founder and believe that the startup can create the future reality that it describes during investment pitches. Basically, at the outset . . . Building a startup is exactly the same as creating a new religion.

 

Filed Under: Behavioral Finance, Entrepreneurship, Innovation, Management, Organizational Behavior, Psychology, Sociology, Strategy, Team Building, Technology, Venture Capital Tagged With: Anthropology, Behavioral Finance, Culture, Early Stage Startups, Economic Moat, Long Read, Religion, Sociology, Team building, Teamwork, Venture Capital

How Studying Bankruptcy And Working On Two Turnaround Assignments Prepared Me To Become An Early Stage Venture Capitalist

August 1, 2015 by Brian Laung Aoaeh

The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)
The Chinese Character for Crisis; Danger + Opportunity (From The Ten Strategies For Leading At The Edge)

 

When I started business school at NYU Stern in the fall of 2005 my plan centered on taking every class in Bankruptcy & Reorganization, and Distressed Investing that I could. I took 3 elective classes in that area; Bankruptcy & Reorganization with Prof. Ed Altman, Case Studies in Bankruptcy & Reorganization with Prof. Max Holmes, and Investment Strategies: Distressed Investing with Prof. Allan Brown.

By my logic, if I learned how to assess and invest in dying companies, and then nurse them back to health, analysing, valuing and investing in healthy companies would seem easy by comparison. I was so sure of this that I also tried to turn my Equity Valuation elective into a pseudo Bankruptcy & Reorganization course too, by opting to value a bankrupt company for my final group-project. I do not recommend trying that.

I was still in business school when the economy began to falter. I moved from UBS to Lehman Brothers in late March 2007. A few days later New Century Financial Corp. filed for Bankruptcy. I was let go from Lehman Brothers a year later, on March 12, 2008. Bear Stearns collapsed and was acquired by JP Morgan Chase on March 16, 2008. I graduated from Stern in May, 2008. On September 7, 2008 Fannie Mae and Freddie Mac were taken over by the federal government. Lehman Brothers collapsed on September 15, 2008. On September 16, 2008 the Fed bailed out AIG.

The rest of 2008 was a bloodbath.

It was in that environment that I joined KEC Holdings, KEC Ventures parent company, in December 2008. I was employee #2. I had been hired into a new role that had not existed before at the company. My responsibilities encompassed any direct and indirect investments the company had made, or might make in the future.

Most notably, the company had already made 2 private equity investments; one in a private jet charter company and another in a fine-dining restaurant group – they were struggling to stay afloat given the economic environment. My first order of duty was to “make sure they don’t die” and “help them come out of this mess stronger than they were going into it.” There would be no financial engineering gimmickry. No tried and true business school textbook “indiscriminate” cost-cutting shortcuts. I had to roll up my sleeves and work with each company as intimately as necessary to achieve the objectives.

This post is about how we navigated that period. It is also about what that period between December 2008 and August 2013 has taught me about the challenges startups face, and my role as a venture capitalist.

Every day is a journey, and the journey itself is home. - Matsuo Basho
Every day is a journey, and the journey itself is home.
– Matsuo Basho

Further Background

Both companies were generating top-line revenues in the range of $20,000,000 – $30,000,000 per year. Both had fallen short of budgetary expectations in 2008, but the aviation company had a more prolonged string of losses than the fine-dining restaurant, partly because the restaurant was a more recent investment at that point. I functioned as an “external management consultant”; I was not a full-time employee of either company, but I worked with employees across the hierarchy of both companies. The restaurant company employed between 400 and 500 people while the aviation company had between 30 and 40 employees after several previous rounds of downsizing.

Both companies had watched as some of their competitors ran into strong headwinds, and subsequently shut down operations because the economic environment was so bleak.

Lesson #1: Understand The Business

Once a company is in financial distress investors have to decide if it is worth saving, and they also have to answer the accompanying question; can it be saved given current known constraints? The only way to do this is to develop a deep understanding of the business, and the context within which it is operating.

Between 2008 and 2012, confidence in the economy was very low. People simply were not splurging on expensive meals or luxury jets. An economist would say that private jet charter and fine-dining both have a high elasticity of demand.

I had no prior experience working at, let alone helping to run a restaurant or a private jet charter company. So I decided to spend the first six months in learning mode. I studied everything I could about both markets while I helped the executives and managers at both companies deal with day-to-day nuts-and-bolts issues.

This was important if I was going to build personal credibility, and if I wanted to win buy-in for my ideas from the executives and managers later on. I had to be able to influence them into doing things they probably did not believe in at the outset, and I had to do this with little real influence.

How this applies to early-stage startups: Today, I look for founders who embrace their expertise, and demonstrate a knowledge of their business that surpasses mine. However, the founder also has to demonstrate an ability to assist me learn enough about their industry to make a decision, and act as a useful sounding board for decisions that have to be made in the future.

Lesson #2: Understand The People

During those six months, I also tried to understand the protagonists in each situation. I relied on a technique I had learned in my Literature in English classes during secondary school in Ghana; character analyses.

A character analyses involves performing an in-depth study of the key characters in a drama, and trying to figure out each character’s story; What motivates that person? Why is that person who they are? What is the person afraid of? What drives that person? How does that person communicate? How does that person respond to pressure and stress. What does that person gain the most satisfaction from? What’s the state of that person’s family life? How does that person perceive me? How do I perceive that person? Does that person buy into the need for a turnaround? Is that person willing to commit to the turnaround? What biases does the person exhibit that I can identify? How does that affect things?

I had to be honest, and to contend with the pleasant and the unpleasant, especially around the perceptions other people had of me at the outset.

I took copious notes, and added to them until I felt I had a decent understanding of each of the people with decision-making authority that I would be dealing with most often; executives, managers, and front-line employees.

Perhaps an important, but often overlooked insight is that an investor should strive to understand the people within the context of the business. For example, is this person a leader or a manager? The distinction matters because it can spell the difference between beating about the bush with no results to show, or getting to the heart of the matter and fixing the problems that need to be solved at a tactical and granular level. Fred Wilson writes about this problem in: Leaders and Executives.

How this applies to early-stage startups: We make seed stage and series A investments. That early in a startup’s life, the people make all the difference. The market is important, so is the product. However, at this stage the future is still so nebulous and difficult to envision that the team that has decided to embark on that journey matters more than anything else. So, I have learned to focus on questions like; How did this team come together? Do the founders take responsibility for outcomes, or do they have a habit of passing blame? Do they have the intestinal fortitude to withstand the difficulties they are bound to face as individuals, and as a team on this difficult path they have chosen or will they wilt under pressure? What evidence do I have to support my answer to this question. What is their approach to learning, as individuals and as a team? Have they faced crises together? How did they fare when the going got tough? I will not ask most of these questions directly, but I will be processing every interaction, every bit of information I get, to determine answers to questions along this line of reasoning.

Lesson #3: Create A Sense of Urgency, But Provide Hope

Unlike a startup, a company in financial distress already has a product that it has sold successfully in the past, it also has a sense of who its customers are and where to find them. It is easy for the people within the company to succumb to status quo bias. This is identifiable by statements such as;

  1. “Everything will be fine, we just need to close this one sale.”
  2. “I feel confident it will happen, we have this sale in the bag.”
  3. “They are not our competitor, they do not do what we do!”

In the face of incontrovertible evidence that “they are up shit’s creek without a paddle” people will still choose to do what feels comfortable.

It was my responsibility to shake them out of that rut. As John P. Kotter says in Leading Change: Why Transformation Efforts Fail; 75% or more of a company’s management has to buy into the need for change, otherwise the chance that the change effort will fail is unacceptably high.

How did I do this? In both cases I did not shy away from asking questions that I expected to generate conflict. Indeed, on several occasions I had to have unpleasant and difficult conversations with the top managers and executives in both companies. I did this even if it appeared that I was “meddling” in areas where I had no business poking around. Of course, the idea that there was a part of either company’s operations that I “had no business” exploring was a fallacy only someone keen on maintaining the status quo would believe.

The message, delivered by the investors and the board, and reiterated by me during my frequent field trips, was simple; “The status quo is unacceptable, and failure for lack of effort is out of the question.” We had one chance to get it right, and we had to make the most of that chance even if it meant discomfort some of the time. We could get there with or without conflict. It was entirely up to us to make that choice.

How this applies to early-stage startups: The time for the whole team to start thinking about the Series A Round of Financing is the night before the Seed Round closes. Some one on the team should always be thinking about what it will take to raise the next round.

The time to start thinking about revenues is yesterday, even if you do not implement those plans immediately. Always have a plan. Always test your plan.

Lesson #4: Investors Have Ideas, But Management Runs The Business

Investors will always have ideas about how a business should be run. Sometimes investors know more about a certain topic than management. It is okay for investors to make suggestions, and to offer ideas to management. However, responsibility for choosing which ideas to accept and which to reject has to rest on the shoulders of management, and management has to accept accountability for the outcomes.

There are a number of ways this aspect of the relationship between investors and management might unfold;

  1. Investors can dictate to management what investors think management should do, or
  2. Investors can teach management how and why things should be done a certain way.

I chose the latter. That approach takes more time, but it is also more likely to lead to permanent change in behavior than the former. Also, once the lessons had taken root that approach allowed me to gradually pull back my involvement without jeopardizing the progress that management was making in improving results. It is an approach that builds self-sufficiency.

As part of the process, we cultivated the practice of communicating:

  1. Why a certain goal or strategic initiative was important for the company’s near term goals and long term vision.
  2. What had to get done in order for that goal or strategic initiative to be successfully executed.
  3. Who specifically was primarily responsible for seeing that it got done, and which executive they could go to as often as necessary in order to navigate what ever obstacles they might encounter.
  4. How it would get done, not in excruciating detail, but in broad terms. For example; Which teams needed to collaborate with one another in order to make it happen?
  5. When the team expected to be able to report back periodically on their progress, and importantly, when the project needed to be complete.

To do this successfully, I had to focus on asking questions and encouraging deeper levels of inquiry than was the custom beforehand. Asking probing questions helped us cut out the “bullshit” of conventional wisdom that is seductively easy to accept.

Each time I heard; “You do not understand, that is not how it is done in our industry.” I would ask; “Why?” That would lead to an examination of the assumptions behind the choices that had been made in the past. Often there was no good reason to refuse to try something different even if it seemed out of step with accepted industry convention.

How this applies to early-stage startups: I am looking for founders at the seed or series A stage whose judgement I can trust enough to feel they do not need me to opine on every decision they ever have to make. That does not mean I am passive. It means I need to trust their decision-making skill and maturity enough to feel confident they will consistently make the right choices for all the startup’s constituents without the need to run everything by investors.

From the investors’ perspective, a policy of “show, don’t tell” goes a long way. To paraphrase the oft quoted saying; “Give a founder a fish and . . . . ” If I feel there’s something a founder ought to learn, I’d rather provide a guide to enable that founder learn the applicable frameworks and how to apply them in day-to-day decision-making situations.

Lesson #5: Create Internal Value By Increasing Organizational Capacity

The way we defined it; Organizational capacity is the harnessing of a company’s human, physical and material, financial, informational, and intellectual property resources in order to enable the company to continually perform above expectations and strengthen its competitive position.

In difficult times especially, it is important that companies do not lose sight of the need to continue to find ways to increase organizational capacity.

One way we did this, in both cases, was to shift both companies off MS Exchange Server and onto Google Docs for Work. This was not easy because of cultural attachments to MS Exchange and fear of having to learn something new. Both companies made the shift, eventually. The immediate benefit they experienced was a dramatic reduction in the costs they incurred for IT assistance. A more important, though less tangible benefit was that both businesses could then afford to give every full-time employee a corporate email address and access to a corporate intranet portal. The benefits were enormous; easier collaboration, easier information transfer and sharing,  and increased security of corporate information and trade secrets. Quicker turnaround on tactical decisions because people could now communicate by chat.

Given the improvements in tools for collaboration, we encouraged the formation of cross-disciplinary teams to tackle some of the problems that each company was dealing with. This allowed people from one area of each business to interact more closely with their colleagues from another area of the business. They developed a better understanding of one another, and of the challenges and constraints that they each faced in trying to execute their day-to-day responsibilities. In turn this fostered a more collaborative relationship across the entire organization. It also enhanced the learning environment for all employees.

How this applies to early-stage startups: It does not take a lot by way of resources to create an environment that is rich in opportunities for cross-functional collaboration and learning. This comes in handy during due diligence because every member of the team will be able to speak knowledgeably about the startup’s immediate and long term plans.

Lesson #6: Direction Must Be Set From The Top, But Engagement Must Begin at The Bottom

We started working on trying to develop a strategic plan for both companies in summer 2009. Before this time, neither company had previously had a coherent strategy.

In consultation with the executives in each company, the board of directors set out the broad areas that the strategic plans ought to cover; Finance, Operations, People, Demand Creation, and Expansion.

Once those had been agreed on, it was my job to meet with front-line employees as well as managers in the field in order to obtain data and insight about how the strategic plan would have to be set up in order to function effectively for them given what each company was trying to accomplish.

That sounds easy. It is not. It took multiple meetings, of several hours each. The restaurant had multiple locations in NYC, one location in NJ and another in CT. I did not visit the location in Chicago, the CFO held discussions with them during his quarterly visits. I had to sift through everything I heard during those meetings, and I had to extract broad themes. Then I had to reconcile that with the strategic framework established by the board. Finally, I had to interpret that information from the perspective of the competitive landscape for each of the two companies. Finally, I had to synthesize it all into digestible chunks for the board, the executives, the managers and rank-and-file employees.

The goal of spending so much time on having these meetings with people across all ranks in each company was to ensure that once the strategy was developed and implemented, there would be complete alignment behind the vision embodied in the strategy, and just as important that every employee would be engaged in and committed to executing the tactical initiatives required to make the strategy succeed.

How this applies to early-stage startups: The founder creates the vision that investors and the startup’s team buys into. The team executes to turn that vision into a living, breathing, growing reality. Investors hopefully act as a positive catalyst to help the process unfold more quickly.

Lesson #7: Do Not Ignore The Soft Issues, Emphasize Both Hard and Soft Issues Simultaneously

My experience might as well be called The Tale of Two Turnarounds. In one company leadership admitted things were awful. They also admitted that they could use whatever help I could offer. They readily admitted their limitations as a team. We had many instances of conflict, but starting from a position of optimism and a willingness to try, the process moved along slowly, but steadily. We created a survey that we administered twice a year to get a sense of how employees were feeling, data that might not be captured in the key performance metrics we monitored weekly, monthly, quarterly, and annually.

We launched the strategic plan in January 2010 after 9 months of work specifically focused on that task. A year later the company made its first ever payments from a new profit-sharing plan that we had created as part of the new strategy. The payments were not huge, but they were evidence that the team’s hard work was paying off. It also created a feedback loop about how actions by employees affect the bottom-line performance of the company.

In the other company the founder, who was also the ceo, was grumpy and relatively uncooperative with investors. To cut a long story short, we launched the strategic plan in April 2010, after about 9 months of work specifically focused on that assignment. Within 6 months 75% of the managers with whom we had worked to develop and launch the strategic plan had left the company or had been fired. It was a classic case in which we would take two steps forward only to take four steps backward.

Morale dipped ever lower. The founders incessant talk about “a vision” and “a mission” became the butt of jokes among rank-and-file employees. It became clear that employees were becoming disillusioned with what the company stood for. While the company fared better than it would have if there had been no attempt at executing a turnaround and developing a strategy, it continued to perform well below its potential.

At a board meeting one day, the founder/ceo went into a vituperous rant about all the areas where the company was falling short. This was in early to mid 2012. I had to burst out in laughter. He might as well have been reciting problems whose solution formed the core of the strategic plan we created in 2010. Implementing that plan would have started the process of solving those problems he was so exercised about that day. We had lost two years for no good reason.

No amount of emphasis on key performance metrics made a difference. Without the founder’s full embrace of the strategic plan, nothing else mattered. I should point out that he had been intimately involved in crafting the strategic plan. This was not a plan that was forced down on him “from on high.” It became clear how badly things had deteriorated when a long time employee quit, this individual was the only employee at the company who had been there as long as the founder.

How this applies to early-stage startups: I am of a firm belief that the team is really important at the seed and series A stage, or at least until uncertainty around product market fit has been largely eliminated. So, I need to develop a sense that a founder is someone I can work with over the long haul . . . Actually, the kind of founder I am happy backing has to be someone I could envision myself working for if circumstances were different. Age, race, gender, religion . . . That is all irrelevant. Early in my process for assessing a startup I focus almost entirely on soft issues.

In one example, I sensed something amiss about the body language between 2 Spanish co-founders pitching a startup to my partner and I in 2013. I decided to tune out what they were saying in order to better observe their body language. There was something about their body language towards one another that did not align with what they wanted us to believe, in my opinion. We passed on their seed round, and decided to watch them till we could get more data about the relationship between the co-founders. That was nearly 3 years ago. I have heard no reports to suggest we made an error in that case.


Let chaos reign, then reign in chaos.

– Andy Grove, Only The Paranoid Survive


Lesson #8: Be Prepared For Chaos; Harness, Focus And Direct It, Empower People

Once employees understood the strategic plan as well as the tactical initiatives that accompanied it, they began developing ideas related to the various functional areas in each company and making suggestions to managers and excutives.

At first this was overwhelming . . . Managers had to do their own work, manage the work of the groups of people that they managed, and now . . . . They also had all these ideas being thrown at them from “left, right, and center.” The initial knee-jerk reaction was to try to “make it stop.”

That would have been a mistake. Among the deluge of ideas were some real gems.

For example, a maintenance department team member at the aviation company noticed that the company could cut down on its electricity usage by changing all the bulbs in its main hangar . . . No one had thought about that over the years, but our discussion about the strategic initiative around improving the product while reducing costs prompted him to take another look at the company’s hangars in search of opportunities to reduce operating costs. Thanks to improvements in technology over the years this was now a measure that could be implemented relatively easily.

In another instance, the team at our restaurant in CT had observed that on certain days of the week large groups of Chinese tourists visited the casino resort in which they are located. They had been thinking of a way to capture some of that business, but had assumed the corporate office would object to the menu changes they thought they had to make in order to execute that plan. As part of our implementation of the strategic initiative around increasing revenues, I suggested they conduct an experiment, analyze the outcome, and then seek assistance from the corporate office if the results looked promising. They did that, and saw a jump in revenues on two days of the week when business would otherwise have been slow. The corporate office gave its blessing, and assisted in making that practice more entrenched by using corporate resources to give it the polish required for company-supported initiatives.

How this applies to early-stage startups: A startup stops being a startup once its search for a repeatable, scalable, and profitable business model is complete. While that search is in process it is important that every member of the team feels empowered to contribute to the discovery of that business model. It can’t be the job of only some members of the team, it has to be part of everyone’s job. The faster a startup gets through the discovery process the better.

Lesson #9: The Turnaround Should Be Its Own Reward; Incentives Should Reinforce Change Not Drive It

It was nice to be able to make payments from the profit-sharing plan that we instituted. The payments were relatively small, yet they were tangible evidence to the employees, managers, and executives that they were collectively well equipped to make it through the ongoing turbulence and correct the mistakes of the past.

The sense of accomplishment employees felt translated into a number of things, among them;

  1. Newfound and increasing pride in being associated with a company that was succeeding where many of its rivals had failed.
  2. High levels of morale and optimism about the future of the company, and their place at the company. Less stress about employment security.
  3. A greater willingness to take the initiative in situations where the possibility of generating business for the company exists.

Basically, every employee was empowered to function as a salesperson on the company’s behalf. We arranged training sessions to equip every employee with the vocabulary they needed to understand in order to do that effectively. We also developed simple tools that they could use. They did not replace the company’s professional salespeople . . . They became an auxiliary sales force.

How this applies to early-stage startups: As startups grow, founders and early team members need to get better at the art and science of “managerial leverage” . . . What is managerial leverage? It is the process by which a manager creates output that far supersedes that manager’s input by using all the resources at the manager’s disposal to influence the work that is done by the group of people whose on-the-job effectiveness and work-output is affected by interactions with the manager.

What is a manager’s output? According to Andy Grove, co-founder and former CEO of Intel “The output of a manager is a result achieved by a group either under his supervision or under his influence.” Great managers create positive output that far exceeds expectations. Below average managers create output that fails to meet expectations given superior resources. Average managers? The team’s output would not be any different if the manager were absent.

The art of managerial leverage is in determining; how to apportion time, where to pay more attention, where to pay less attention, who to pay more attention to, who to pay less attention . . . . etc etc. The science of managerial leverage is in determining; what to measure, when to measure it, how often to monitor what is being measured, where bottlenecks are most likely to occur and why, and how to eliminate them . . . . etc etc.

Managerial leverage drives output. Output drives results. Results are measured and reflected in the KPI’s that founders and investors measure. Getting that order right is critical to a startup’s success.

Lesson #10: Learn To Listen, And Communicate Effectively

It is amazing how many problems can be solved relatively quickly if people would communicate more effectively internally and externally. Communication involves two actions; first listening actively in order to understand what is driving the actions of other people. Second, responding to what other people have said in a way that gets to the root cause of the problem being discussed.

During one of my field visits, I spent 8 hours on my first day listening to the executives talk about all the problems they each perceived, and how they felt the issues ought to be tackled. I spent that day with the CEO/President, the CFO, the Head of HR, and the Head of Sales. I encouraged open disagreement and debate.

On my second day I spent about the same amount of time speaking with the middle managers; again we discussed the problems they each perceived, and how they each felt the issues ought to be tackled.

On the third day I brought both groups together, and moderated an all day discussion about the problems the company was facing. Once again, I encouraged open disagreement and debate. Also, I put the inter-personal issues and conflicts that I had uncovered on the table. Things often got heated. It was my job to function as a pressure-release valve during those episodes. It was not pretty.

For example, I explained to the entire group how the CFO who was disliked by a large number of people within the company had made payroll on too many occasions by dipping into his personal 401(K) savings for example. The irony, the folks who disliked him routinely failed to provide the finance team with the data they needed in order to collect on accounts receivable from the company’s customers.

The outcome of this exercise was that;

  1. Everyone felt they had been given a chance to speak and be heard by the rest of the leadership team, and
  2. We discussed expectations in a fair amount of detail, enough so that more work could be done laying them out in adequate specificity rather than vaguely wondering what people could expect from one another, and finally
  3. Created an environment in which each member of the leadership team contributed in creating a communication framework against which they agreed to be held accountable

Our goals for the communication framework were that;

  1. Every employee should know what is expected of them, as individual team members,
  2. Every employee should know what to expect from every other member of the team,
  3. Employees should know what to expect from executives and managers, and lastly
  4. Accountability should be about improving team and company performance, not punishing individuals.

As Rosabeth Moss Kanter says in Four Tips for Building Accountability; “The tools of accountability — data, details, metrics, measurement, analyses, charts, tests, assessments, performance evaluations — are neutral. What matters is their interpretation, the manner of their use, and the culture that surrounds them. In declining organizations, use of these tools signals that people are watched too closely, not trusted, about to be punished. In successful organizations, they are vital tools that high achievers use to understand and improve performance regularly and rapidly.”

How this applies to early-stage startups: Startups typically have to move quickly, especially if they have taken in capital from institutional venture capitalists. A culture of blame, lack of cohesive teamwork, and a lack of organization-wide accountability is an insidious tumor that will eventually lead to failure. The founders who are most successful in the long run are those who do not shift responsibility when things are difficult, but instead serve as a model that other team members can emulate.

Closing Thoughts

Executing a turnaround and getting a startup through the phase of discovering a business model are really just two sides of the same coin. That experience has led me to the belief that it is when things seem bleak that great early stage investors prove their worth.

Further Reading

Blog Posts, Articles, & White Papers

  1. The Psychology of Change Management
  2. Motivating People: Getting Beyond Money
  3. The Irrational Side of Change Management
  4. The CEO’s Role in Leading Transformation
  5. The Role of Networks in Organizational Change
  6. All I Ever Needed To Know About Change Management I Learned at Engineering School
  7. Changing an Organization’s Culture, Without Resistance or Blame

Books

  1. High Output Management
  2. Only The Paranoid Survive
  3. How Did That Happen?
  4. HBR’s 10 Must Reads on Change Management
  5. HBR on Turnarounds

Filed Under: Behavioral Finance, Business Models, Entrepreneurship, Finance, Innovation, Investment Analysis, Key Performance Metrics, Operations, Organizational Behavior, Private Equity, Sales and Marketing, Startups, Strategy, Team Building, Uncategorized, Value Investing, Venture Capital Tagged With: Behavioral Finance, Business Models, Business Strategy, Competitive Strategy, Early Stage, Early Stage Startups, Leadership, Management, Persuasion, Strategy, Turnaround, Venture Capital

Question Everything; My Remarks At FOCUS100 2014

October 4, 2014 by Brian Laung Aoaeh

Startup Stock PhotosBackground: I gave these remarks at Digital Undivided’s FOCUS100 2014 Conference which was held between October 3rd and October 4th in New York City. A number of investors were invited to explain to the audience how they ought to pitch venture capitalists in order to win funding. Digital Undivided is a social enterprise that develops programs that increase the active participation of urban communities in technology. It has a particular focus on women. ((I have edited it by adding comments based on questions people at the conference asked me after I had spoken, mainly adding a little more context.))

I am not very good at listening to what other people tell me to do, so rather than outline what I think you should do in order to get funded by a venture capitalist, I thought I should instead share with you some of my beliefs about founders, and startups, and how I think about my responsibilities as an early stage investor. I hope in doing so you will question some of the assumptions you hold about how you should go about raising capital.

  1. The kind of founder that really excites me does not need a venture capitalist. She simply needs some capital to enable her build her vision and transform the world. My job is to give that founder sufficient reason to decide that she wants to undertake that journey with KEC Ventures as a companion.
  2. To get past the first meeting, a founder has to inspire confidence. She has to make me want to follow her over the edge of a cliff, or into a burning building. She has to make me feel I could trust her with my life because come hell or high water, she’s going to figure things out. She’s smart, hard working, can process an enormous amount of unfamiliar information and take action based on what she’s learned, she knows or can learn how to build and lead a team that’s going to do something ambitious. She might be an introvert, or an extrovert. She gets me to buy into her vision of how things should be, and how she will use technology to accomplish that. She wants to win, and she knows how to win. I do not believe in “pattern matching” in the way some well known investors have described it. I don’t pattern match people. That’s an intellectually lazy approach to picking investments. Instead I pay attention to ideas, problems, and the characteristics of successful businesses. Meeting and investing in startups led by founders with a vision to make the world a better place is what makes me eager to wake up each morning and endure the cognitive dissonance that is a daily and ever present aspect of my job as an early stage investor.
  3. I do not believe in founders who lack the intellectual and emotional fortitude to debate and argue honestly about what is best for the startup with their investors and with others who might have opinions about what they should do. I believe that the best decisions are made when one can debate issues with one’s self, and when founders and investors can engage in healthy, critical and honest debates with one another and subsequently reflect and contemplate on everything they have learned through that process. I get frightened by founders who cheerily agree with everything investors say. If the founder is indeed creating something new, or solving a widely-overlooked problem, there’s no way the average investor has considerable experience and expertise in that area – by definition the founder is “the expert”. I expect the entrepreneur to know far more than the average investor about what will work, what will not work, and why. Cheery agreement with everything an “ignorant” investor suggests acts as a red flag to me that perhaps this founder does not understand the problem she is solving, or her market, as well as is required to do what she says she wants to accomplish.
  4. My primary responsibility to investors in KEC Ventures is to be skeptical; Skeptical about myself, and what I think I know, and skeptical about the founders I meet and the claims they make. This is the only way I can minimize the chance that I pass on an idea that seems inconsequential at the outset, but goes on to form the basis for a transformative business. I hope another consequence of my skepticism is that I also minimize the probability that I am too eager to invest in startups that fail because they are built on ideas that are obvious. (Note: I also need to be optimistic.)
  5. Most startups fail. Let me rephrase that, the overwhelming majority of startups fail. My only task is to find those that will succeed before they become well known by other people. Further, we should not invest in a startup unless we believe that our investment in that startup can return our entire fund. One founder at the conference suggested he could “guarantee” a 10x return if KEC Ventures would invest $250,000 in his seed round. That would be great, if we were investing from a $2,500,000 fund.
  6. The type of startup I want to invest in is a very specific thing; it is a temporary organization that has been created to search for a profitable, repeatable, and scalable business model while it solves a problem that has been overlooked in a certain market. It is designed for fast growth once that solution is developed and the business model has been found, and if it succeeds it completely transforms and overwhelmingly dominates the market in which it operates before it moves into adjacent markets. ((This definition is a composite that combines elements from definitions other investors have used. It is primarily derived from a definition that Steve Blank and Bob Dorf use in The Startup Owner’s Manual.))
  7. Accepting the definition of a startup that I use as my guide, there are certain things that I listen for when I am speaking with a founder. Collectively, they are described as “Economic Moats” . . . Intellectual Property, Network Effects, Efficient Scale, Switching Costs and Branding. Even if these do not exist at the very outset, it has to be clear that they can be designed into the startup’s business model as it matures and that the founder has already been thinking about them. Also, I am not interested in situations where only 1 of those sources of an economic moat is present. I prefer 3 at a minimum, all 5 ideally. The durability of a moat is a something I worry about. Also, how wide or narrow that moat can be made is something I think about constantly. Essentially, I want to avoid the detrimental effects of competition.
  8. A venture capitalist does not provide capital to people who need it. A venture capitalist has a fiduciary responsibility to make the best effort possible to generate a positive return for investors in the fund.

Filed Under: Behavioral Finance, Entrepreneurship, Funding, How and Why, Investing, Pitching, Technology, Venture Capital Tagged With: Behavioral Finance, Conferences, Early Stage Startups, Economic Moat, Innovation, Investor meeting, Persuasion, Pitching, Presentations, Venture Capital

How an Investor’s Behavioral Traits Might Completely Derail Your Pitch – Part III

October 27, 2013 by Brian Laung Aoaeh

This post continues the discussion about how behavioral psychology might affect the outcome of a meeting at which a startup team is pitching to a potential investor. You can get caught up by reading part I and part II. My goal is to offer some advice on how entrepreneurs pitching to early stage investors might prepare to mitigate the problems that I have seen arise during some pitches because of the behavioral traits of investors.

Each investor has a unique psychological disposition that will affect how that individual will interpret the information that is presented during a pitch. In this post we’ll focus on emotional biases. ((I am focusing on those errors described in the CFA Institute’s Level III curriculum. There may be others not discussed here that are nevertheless worth studying and understanding.)) The cognitive errors I discussed in the first two posts in this series arise from constraints investors face as they process information that is unfamiliar. Generally, an entrepreneur pitching to investors should be able to develop a strategy to mitigate the potentially negative impact of cognitive errors on the outcome of a conversation with investors by making new and unfamiliar information easier to process, understand and interpret by the investor.

Emotional biases do not arise from our limitations in reasoning about unfamiliar information, instead they arise from our basic need to feel good about ourselves and to avoid things that cause us fear and discomfort. An investor’s cognitive processes may be over-ridden by that individual’s emotional biases depending on how the information presented during the pitch is framed, though there is evidence to suggest that some investors may be capable of modulating their emotional responses to informational stimuli in order to minimize the frequency with which they make sub-optimal decisions. ((Frames, Biases, and Rational Decision-Making in the Human Brain, Benedetto De Martino, et al. Science 313, 684 (2006); DOI: 10.1126/Science.1128356. Accessed online on Oct. 26, 2013.)) It is difficult to mitigate the potential negative impact of emotional biases, cognitive errors are easier to work-around by comparison.

Emotional Biases

  1. Regret Aversion: Regret Theory says the choices that investors make are affected by their anticipation of how much they will regret making those choices in the future. Fear of regret can cause an investor to behave unpredictably. Regret aversion is closely linked to loss aversion bias – in both instances the investor frames an investment in terms of gains and losses, and tries to avoid an anticipated future loss (regret) given the same level of current perceived risk. The concept of regret is critical in understanding how people behave in circumstances similar to gambling – high current uncertainty, and lack of insight regarding how to determine the likelihood of future outcomes. ((Consequences of Regret Aversion in Real Life: The Case of the Dutch Postcode Lottery, Marcel Zeelenberg and Rick Pieters. Organizationa Behavior and Human Decision Processes 93 (2004) 155-168. Accessed here on Oct. 27th, 2013))
    • Case 1: Andrew is an early stage investor. His investment process typically relies on relatively extensive background research and analysis before his fund makes an investment. He learns about an investment that is “closing as we speak” with every brand-name investor trying to get in. He is told there are mere hours before the allotment that is still open might be taken by someone else. He makes an investment without going through his fund’s typical process.
    • Case 2: Andrew encounters a startup doing some really interesting work. However, it is not using technology that he is familiar with. Also, the entrepreneur has not yet been able to get an introduction to any other early stage investors that Andrew knows or has heard of. He passes on the investment without studying the problem this startup is solving although it would otherwise fit the other criteria that he typically looks for – it has paying customers, is capital efficient, and has underlying IP. Andrew decides not to make an investment.
    • Analysis: In the first scenario, Andrew likely does not want to regret missing out on an investment which “every brand-name” early stage investor wants. In the second scenario he may not want to regret making an investment when no other early stage investor he knows seems to know about this startup. His fear of future regret is amplified because he is unfamiliar with the technology that the startup is using, and by the lack of social proof. ((Social proof or informational social influence happens when people operating under conditions of ambiguity and high uncertainty look for signals from other people about the correct decision. This phenomenon leads to conformity in large groups. There is a Wikipedia entry here.))
  2. Overconfidence Bias or Illusion of Knowledge: Evidence of this bias is demonstrated when the investor behaves in a manner that suggests that he believes he “knows it all” or that he is better at understanding and interpreting unfamiliar information than others, or that he possesses information and insight that no one else does. Illusion of knowledge leads to prediction and certainty overconfidence.
    • Case: Diana is an early stage investor. She is meeting with Alex who wants to tell her about a startup he and his co-founders are building. Alex finds the meeting highly frustrating because Diana does not let him get past the first few sentences describing what they are doing before she incessantly tries to convince him that what he and his co-founders are doing “will never work” because “I have seen it all in that industry and there’s no way that will work.” As a result Alex never gets to tell her about the traction that they are gaining with paying customers, nor could he explain why her assumptions were incorrect because of new discoveries and developments, which in turn make the innovation that Alex and his co-founders possible.
    • Analysis: Diana’s illusion of knowledge bias is preventing her from fully assimilating the information that Alex prepared to discuss. It is also preventing her from questioning the assumptions that she has come to accept about that industry.

There are other emotional biases worth studying. I am focusing on these two only to keep from writing a post that is needlessly long. It is important to note that one emotional bias might give rise to another behavioral trait that works against the interests of the entrepreneur pitching to an investor.

Here is one example. Regret aversion may lead to inadvertent in-group bias amongst early stage investors. ((What You Are is What You Like – Similarity Biases in Venture Capitalists’ Evaluations of Start-up Teams, Franke et al. Accessed online on Oct. 27th, 2013)) In-Group bias is the tendency for members of one social group to treat others they perceive as members of the same group preferentially than people they perceive as not belonging to that group. Here is another example. Regret aversion may also cause an early stage investor to inadvertently succumb to the bandwagon effect. The bandwagon effect is the tendency to think, justify or believe something simply because many other people believe and accept that thing. ((Here’s a video of Brad Feld from Foundry Group discussing venture bias.))

In this post I have decided not to suggest mitigation strategies for the cases I have created. Emotional biases are much harder to tackle in that manner, and I do not want to create the illusion that there’s a simple solution that will work every time with an acceptable level of efficacy. Nevertheless, every team that is building a startup and trying to raise funding from early stage investors should spend some time studying how emotional biases might affect the conversations they have with investors, and develop work-arounds that help them get past the communication barriers that could arise as a result.

One key first step would be to study the background of the investor before the meeting. That simple step might help the team anticipate where objections might arise from the investor solely due to cognitive errors, and emotional or social biases.

A process of experimentation is probably the best approach.

Filed Under: Behavioral Finance, Long Read, Pitching, Venture Capital Tagged With: Behavioral Finance, Early Stage Startups, Investor meeting, Long Read, Persuasion, Pitching, Venture Capital

How an Investor’s Behavioral Traits Might Completely Derail Your Pitch – Part II

September 21, 2013 by Brian Laung Aoaeh

This post continues the discussion about how behavioral psychology might affect a pitch. You can get caught up by reading part I. My goal with this series is to offer some advice on how entrepreneurs pitching to early stage investors might prepare to mitigate the problems that might arise due to the behavioral traits of investors.

The next set of errors I will discuss arise from investors’ inherent limitations in processing information that is complex and ambiguous. ((I am focusing on those errors described in the CFA Institute’s Level III curriculum. There may be others not discussed here that are nevertheless worth studying and understanding.))

Cognitive Errors – Information Processing:

  1. Anchoring Bias: This occurs when a prospective investor tends to use some experience from his past as an “anchor”, and then draws a direct parallel between that anchor and your startup. This anchor can become a strong frame of reference that dominates the remainder of the discussion and might become the single factor that determines the investor’s ultimate decision. ((My favorite example is the story Andrew Chen tells of his thoughts about Facebook after meeting the team in 2006. You should read it: Why I doubted Facebook could build a billion dollar business, and what I learned from being horribly wrong.))
    • Case: Steve is pitching Disruptive Technology Startup (DTS) to a well respected early stage investor. Steve is excited, and is really hopeful that the investor will say ‘yes’ because Steve believes that this investor will add a lot of value as an investor and as an advisor to DTS as it searches for a profitable, repeatable, and scalable business model. This investor has conceived and built a handful of startups in the past and Steve believes that the investor’s experience as an operator will be invaluable. During the pitch the investor quickly focuses on one aspect of the product DTS is bringing to market. He thinks that the absence of a specific feature is a fatal flaw in the product design, and he uses his experience from one of the startups he co-founded in the past as justification for his opinion. Steve disagrees with that assertion. Steve has studied the topic thoroughly. He and his co-founders have discovered that the feature in question is not considered critical or even important by the customers that are adopting the DTS product now and paying for it. Their product roadmap proposes adding that feature about 18 months from when they get funded. They are raising a series A round of financing that will allow them to start aggressively acquiring the enterprise customers that they have built the product for. So far they have built up a relatively large customer base with little marketing, public relations, or sales efforts. Steve never gets through his presentation, because the investor keeps going back to that feature. At the end of 90 minutes Steve leaves the meeting feeling frustrated because he did not get to discuss any topics that he felt were important for the investor to understand. He’s almost certain DTS will not get a positive response from this investor. He is right. Two days later the investor emails Steve to say he has decided to pass because of the issue he identified.
    • Mitigation: This is a tough one. If I were in Steve’s shoes I would not debate this investor’s opinions  about this specific feature too strongly during the first pitch. I would listen to their reasoning. Then I would ask that they table those opinions so that I can go through the rest of the pitch. After that, I would request a follow up meeting focused specifically on the objections the investor raised – presumably DTS has valid reasons for choosing the approach it chose. The second meeting will be devoted to “un-anchoring” the investor and hopefully getting them to see things as Steve and the rest of the team at DTS sees them. It may also be necessary to send some written documentation and some operational data that the investor can study independently in order to determine for himself that DTS should not be compared too closely to his past. This approach assumes that the investor is open-minded and willing to admit that he could be mistaken. If the investor is adamant, then may be Steve should move on. This investor may not be a good match for DTS.
  2. Framing Bias: This occurs when an investor interprets information about your startup in different ways depending on how the information is presented, or depending on who presents the information. In other words the same information presented in different ways or presented by different people leads the same investor to opposite conclusions about your startup depending on how, or by by whom, the information is presented.
    • Case: Hannah is an early stage investor. She has an engineering background, and  is meeting Alice, a co-founder of Super Disruptive Technology Startup (SDTS). Alice has a co-founder, Janice, who is SDTS’ CTO. Alice does not bring Janice with her to the meeting with Hannah. Alice leaves the meeting thinking that it went very well, and tells Janice she feels they will get an investment from Hannah. She is dismayed when Hannah decides to pass because she ‘did not feel confident about the technical side . . . ‘ Alice does not have a technical background. She studied philosophy for her first degree, and then she studied for a master’s degree in marketing, strategy, and management.
    • Mitigation: In this case Janice should have attended the meeting with Alice. Given Hannah’s background, they should have foreseen that she might be more interested in the technical aspects of SDTS than the typical investor. It is likely that Hannah did not feel convinced by Alice’s efforts to discuss the technical innovation behind SDTS. She may have interpreted the same information delivered by Janice more favorably than she interpreted it coming from Alice. Alice and Janice should both attend meetings with any investor that might make a large investment in the SDTS financing round, or who they want to win over because of the potential investor’s industry network or expertise.

There are other information processing errors worth studying; the availability bias and the gambler’s fallacy come to mind. Wikipedia’s entry on cognitive biases is here. Wikipedia also has a much more extensive list of cognitive biases here. If you have the time, you should invest in a copy of Daniel Kahneman’s ((If you purchase it through this link I will receive a small portion of the sales proceeds from Amazon to help me maintain this blog.)) Thinking, Fast and Slow.

In the next post on this topic I will discuss a number of emotional biases that an investor might exhibit during your pitch.

Filed Under: Behavioral Finance, Pitching, Venture Capital Tagged With: Behavioral Finance, Investor meeting, Persuasion, Pitching, Venture Capital

How an Investor’s Behavioral Traits Might Completely Derail Your Pitch – Part I

September 7, 2013 by Brian Laung Aoaeh

Many startup pitch meetings start out on a promising note, but things fall apart during the conversation between the startup and its prospective investor. Sometimes this could have been prevented if the startup team had studied a little bit of behavioral psychology beforehand. ((Any errors in correctly attributing work to my sources and references is entirely my fault. I’ll make corrections if you point an error out to me.))

Traditional finance theory tries to tell us how investors should behave, if they act as rational economic beings. Behavioral finance is based on the observed behavior of investors. Traditional finance is based on economic theory. Behavioral finance is based on psychology. Traditional finance assumes that investors make their decisions based on all available information, that investors are rational, and that markets are efficient. ((The efficient-market hypothesis (EMH) states that financial markets are informationally efficient and that the price of a publicly traded stock incorporates all available information about that stock.)) Even if you think this is true in public markets, you have to agree that it is not the case in venture capital. It is especially true that the market for early stage venture investments is highly inefficient, prone to extreme uncertainty and severe information asymmetries. Behavioral finance makes none of the assumptions of traditional finance.

In this post, I will describe a few behavioral biases that an investor might exhibit during a pitch meeting with the founder of a startup. ((I am basing the outline of this post on portions of the CFA Institute’s 2013 Level III readings on Behavioral Finance.)) I will describe how each bias might be exhibited during a pitch meeting. I will also suggest how the entrepreneur might attempt to mitigate each bias. Failure to mitigate a behavioral bias could mean that the pitch gets derailed, and the entrepreneur fails to communicate effectively with the investor about the startup. I have developed the examples on the basis of meetings at which I have been on the side being pitched by entrepreneurs, after-the-fact reports about investor meetings that entrepreneurs I know have spoken with me about, and also from meetings at which I have been on the side pitching an innovation to potential business partners, and investors for a startup that I have been helping to incubate since January 2011. ((I am not a psychologist, so my discussion of this topic will certainly fall far short of even very modest expectations. However, I hope that budding entrepreneurs find this discussion to be a good starting point for some independent work on this topic.))

The behavioral biases that I will cover in this post are categorized as cognitive errors. A cognitive error or bias stems from the inherent shortcomings people face as they try to process information that is unfamiliar and complex. Cognitive errors are further categorized as information processing errors or belief perseverance errors. This post will focus on a few belief perseverance biases. Behavioral biases generally can be grouped as cognitive errors, emotional biases, memory errors or social biases.

As you read the rest of this post you will notice that the lines between these biases is somewhat blurry – what one person sees as indicative of one kind of error could be seen by someone else looking at the same information as indicative of another bias. That seems to be the nature of those behavioral biases I have studied – there’s a lot of interconnection and it is difficult to assign an observed behavior to a single bias or error. More likely, the observed behavior arises due to a combination of biases and errors. That is why I think preparation beforehand is key. The entrepreneur can try various approaches to mitigating the observed bias until one approach leads to a break-through that restores the flow of ideas and communication between the entrepreneur and the potential investor.

Cognitive Errors – Belief Perseverance:

  1. Conservatism Bias: This occurs when a potential investor fails to revise his preconceived beliefs about your startup even when there is new evidence that suggests that his beliefs are incorrect. ((This can also be exhibited as a tendency to underestimate high-likelihood events and overestimate low likelihood events.))
    • Case: Steve is 20 years old. He has quit college with two of his classmates to focus on building a startup – Disruptive Tech Startup (DTS). He meets with an early-stage venture capitalist to describe the work they have done so far and their vision for the future. Steve does not realize that the investor believes that he’s too inexperienced and too young to accomplish what he wants to accomplish with DTS. More specifically, the investor does not believe that Steve is experienced enough to steer DTS so that the investor realizes the minimum 10x return that the investor’s investment thesis requires. Steve thinks the meeting went well, but the investor later tells him that the fund has decided to pass on making an investment in DTS.
    • Mitigation: Steve should spend more time discussing his background, what he has done to learn how to run the startup, and how he will learn what he needs to learn in order to run the startup in the future. He should explicitly tackle the issue about his youth and relative lack of experience, and openly discuss steps he will take, or has already taken to ensure that his investors’ capital is not put at risk because of his youth and perceived inexperience. He should offer references who prospective investors might speak to about his leadership potential as it relates to managing a startup. He should not assume that the investor will conclude that he will continue to succeed in the future after seeing what he has accomplished at DTS so far.
  2. Confirmation Bias: This occurs when the investor focuses on perceived negative aspects of your startup while ignoring and dismissing your attempts togive an explanation with evidence that will contradict that perception.
    • Case: Steve is pitching DTS to another early stage investor. She thinks that the technology they have developed is trivial after having listened to Steve for about 20 minutes, and she tells them as much. Steve gets frustrated because he feels she does not understand what DTS is about. The meeting is a disaster because she keeps focusing on the notion that “But isn’t this just a simple bot that scrapes the web for data? If I were a software developer I could do this with very little effort.”
    • Mitigation: This investor likely does not understand the full extent of the problem that DTS is solving. ((The unstated assumption here is that DTS is not solving a trivial problem.)) If Steve is stuck in “Demo Day Pitch” mode he likely has not considered that in a small meeting the dynamic is different. He should “put away the deck” and go into “professor mode” – in this mode he is educating the investor about the problem, about how DTS is solving that problem, and also about the opportunity that presents for potential investors in DTS, all in a conversational setting – like a professor teaching a student a new concept during office hours. He should expect to follow this up with further information for the investor to consider. ((See this post for an example.))
  3. Representativeness Bias: ((The Wikipedia entry for the Representativeness Heuristic is here. You should read it if you are building a startup and will be raising capital from investors.)) This occurs when the investor uses an if-then rule of thumb or mental shortcut toassess your startup because of the high levels of uncertainty associated with the decision the investor must make.
    • Case: Ademola is a Nigerian entrepreneur. He has been building an Internet software startup in Lagos for two years, African Technology Startup (ATS). He grew up in Nigeria and holds a master’s degree in computer engineering from the Obafemi Awolowo University of Science and Technology, one of Nigeria’s leading universities of technology. In order to grow ATS he has moved to New York and is raising capital from investors. ATS has customers from all over the world, and he believes ATS is solving a significant problem for them. Growth has been phenomenal. ATS has accomplished that growth on a shoe-string budget. Ademola has been building ATS with two other people, they are both co-founders of ATS as well. They will remain in Lagos to manage the technology and R&D efforts. Ademola is worried that many of the investors he will meet are ignorant about Africa. He is also worried that they may unconsciously harbor negative perceptions about ATS that they will not verbalize during a meeting.
    • Mitigation: Ademola has to work doubly hard to demonstrate his technical competence because the average early stage investor in the United States does not associate Africa with technical talent and competence. For example, investors might assume that ATS is relying on a contract software engineering consultant in Asia or Eastern Europe. If ATS is building its technology in-house, Ademola has to make that explicit. He has to talk about the technology in a way that demonstrates that he can fulfill the vision that he’s selling to his customers, and potential investors. He has to convince his audience that a software engineer trained in Nigeria can compete on the global stage. He has to remember that his accent could inhibit potential investors’ ability to understand what he is trying to communicate. ((Y Combinator’s Paul Graham inadvertently got embroiled in a pseudo-controversy over this subject. You should read what he has to say, and also read what others have said. Paul’s post on the subject is here. One response is here.)) Instead of hoping that they will ask him to clarify something, or explain something they do not understand he should practice speaking clearly and communicating effectively to people who have never encountered someone with his accent. He should avoid using colloquial terms and idioms that are used in Nigeria, but may not be commonly used elsewhere. Investors in NYC will not understand those terms. He should be friendly, but he should avoid the temptation to be unnaturally funny. His off-the-cuff attempts at humor could back-fire. The representativeness bias at play here could be “If ATS is an African startup then the probability that it is doing all this on its own is zero because all we ever see on TV about Africa is war, starvation, and political corruption and incompetence.” Ademola has to overcome that bias during his conversations. ((This blog post at 59 Ways is a clear, but brief explanation of this bias.))

An investor’s cognitive biases play an important role in how that investor will hear and interpret the information that an entrepreneur is trying to convey. Time spent understanding this phenomenon and how to mitigate any possible negative effects of a prospective investors behavioral biases will invariably lead to more productive pitch meetings.

Wikipedia’s entry on cognitive biases is here. Wikipedia also has a much more extensive list of cognitive biases here. If you have the time, you should invest in a copy of Daniel Kahneman’s ((If you purchase it through this link I will receive a small portion of the sales proceeds from Amazon to help me maintain this blog.)) Thinking, Fast and Slow.

Filed Under: Behavioral Finance, Case Studies, Funding, How To, Long Read, Pitching, Venture Capital Tagged With: Behavioral Finance, Investor meeting, Persuasion, Pitching

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