Innovation Footprints

What if . . . ?

Pitching

Question Everything; My Remarks At FOCUS100 2014

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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. 1I 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. 2This 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.

References

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.
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.

The Most Important Thing A VC Needs To Know About Your Startup

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Over the past 6 months I have been spending more time meeting many first time founders in New York City and elsewhere. One question has arisen over and over again. What are the most important things a venture capitalist wants to know about my start up in order to invest? I will attempt to answer that question in this post. 1Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained them.

To set the context, I am assuming that the potential investor and the entrepreneur are meeting one another for the first time, and that the startup is an early stage startup raising a seed or series A round of capital. There are still numerous questions to be answered, but the entrepreneur has made some progress and is well beyond just having an idea. There’s a product that is in a really early iteration and has had some user testing, but is still far from “perfect”. The startup has already raised some capital from friends and family, and subsequently from angel investors.

Some of my comments are directed towards startups building products for enterprises, but the same logic applies to startups building products for individual consumers.

First, as the potential investor, I want to understand the market in which you think your startup will exist. 2In this blog post from July 2007 Marc Andreessen argues that the market is the only thing that matters: http://pmarchive.com/guide_to_startups_part4.html I want to know as much about that market as possible. How many potential customers are there? How much did those customers pay in the past year for solutions to the problem you are solving? If this is a small but growing market, at what rate is that  growth occurring? How do we know that? If you are trying to convince me that you will somehow “grow the market”, how will that happen? How big is the market today? I would much rather bet on an entrepreneur building a product for a big market. The bigger the market the better. What is the current market structure? Who are the biggest incumbents in the market? How might they respond? What barriers to entry do you have to overcome? How difficult is it going to be for you to reach potential customers? 3In this blog post from December 2013 Rob Go describes why the choice of market is important: http://blogs.hbr.org/2013/12/great-entrepreneurs-pick-great-markets/

I want to understand the market because it is the most important factor in determining the success or failure of your startup. A great market is one in which customers will find you if your product works. They might complain that the product could be better and they might ask for more features, but if it works they will find you and they will buy your product. In a bad market your product is irrelevant. If you are selling to an industry with very thin profit margins, there may simply not be enough money available for additional expenditures on a new product. Also, it is very hard to displace a product that your prospective customers have learned to use and around which they have built their business processes.

Closely related to my questions about the market, I want to understand the problem that you are solving for that market. Too often I meet founders who are unable to succinctly and clearly describe the problem they are solving. In a typical week I speak with many founders about their startups. The startups I most easily remember are those that make it easy for me to understand the problem they are solving. It is important that I have a firm grasp of the problem the entrepreneur is solving. Why? My understanding of the problem will direct how I perform my independent research. It will also ensure that I study the information and data that I find on my own from a perspective that is congruent with the point of view of the entrepreneur.

Second, I want to know if the founder or founding team has an ability to learn. I am certain that the founder will encounter many unfamiliar questions in the future if the entrepreneur is building something truly unique and solving a problem that has not yet been solved by someone else. It is important that the founder is someone who can gather unfamiliar information, process it, interpret it and then make decisions about strategic and tactical choices. A founder who lacks the ability to process large amounts of unfamiliar information quickly but thoroughly is at an extreme disadvantage. Market structure changes. Regulations change. Consumer tastes and preferences evolve in ways that might escape notice till it is too late and business has deteriorated. Technology changes constantly. The economy shifts between upswings and downturns. Rivals and competitors enter the scene without warning. All this generates volumes of information and data. I much prefer to back founders and entrepreneurs who I believe possess an inherent ability to learn. It is equally important, that they can build teams around them of people who have this same quality. It is the only way that their startup will move from the early stages of its lifecycle and into the growth phase. 4In this blog post from January 2014 Brad Feld reflects on his strong preference for CEOs who are learning machines: http://www.feld.com/wp/archives/2014/01/invest-ceos-learning-machines.html

You will often hear venture capitalists say that they consider things in this order; market, product, team, and deal. Their analysis of the market and the product belong in the same category as the first factor in my preceding discussion – market. The question is this; is this a great market, and will someone pay to use this product in that market? Their analysis of the team falls under the second factor – is this a team that can learn what it needs to learn in order to succeed?

Every other question is simply an attempt to fill in the details.

 

References

Any errors in appropriately citing my sources are entirely mine. Let me know what you object to, and how I might fix the problem. Any data in this post is only as reliable as the sources from which I obtained them.
In this blog post from July 2007 Marc Andreessen argues that the market is the only thing that matters: http://pmarchive.com/guide_to_startups_part4.html
In this blog post from December 2013 Rob Go describes why the choice of market is important: http://blogs.hbr.org/2013/12/great-entrepreneurs-pick-great-markets/
In this blog post from January 2014 Brad Feld reflects on his strong preference for CEOs who are learning machines: http://www.feld.com/wp/archives/2014/01/invest-ceos-learning-machines.html

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

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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. 1I 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. 2Frames, 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. 3Consequences 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. 4Social 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. 5What 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. 6Here’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.

References

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.
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.
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
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.
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
Here’s a video of Brad Feld from Foundry Group discussing venture bias.

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

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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. 1I 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. 2My 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 3If 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.

References

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.
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.
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.

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

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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. 1Any 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. 2The 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. 3I 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. 4I 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. 5This 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. 6The 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. 7See this post for an example.
  3. Representativeness Bias: 8The 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. 9Y 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. 10This 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 11If 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.

References

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.
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.
I am basing the outline of this post on portions of the CFA Institute’s 2013 Level III readings on Behavioral Finance.
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.
This can also be exhibited as a tendency to underestimate high-likelihood events and overestimate low likelihood events.
The unstated assumption here is that DTS is not solving a trivial problem.
See this post for an example.
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.
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.
This blog post at 59 Ways is a clear, but brief explanation of this bias.
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.

What If Q&A: What Should I Do To Spread My Idea?

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Rajoshi Gosh in Chennai, India sent me this question via email; I am a startup founder in the developing world. 1She is the co-founder of 34Cross. Their first product, Owlink, is a browser extension that is now available for Chrome. Rajoshi tells me versions for Firefox and Safari are in the pipeline. We have known one another since 2011 when we worked together while she was a teaching fellow at the Meltwater Entrepreneurial School of Technology in Accra, Ghana. You can check out Owlink here. How should I go about making the right connections in the developed world for:

  1. A product that is global in nature?
  2. A product that is specific to the developing world?

I will paraphrase Rajoshi’s question, and try to outline an answer to a not dissimilar question; How do I help to spread my idea?

But, I digress. Because I know what Rajoshi has been working on, I know why she asked that question; Her startup is launching its first product, and she wants to generate some awareness.

Jason L. Baptiste, author of The Ultralight Startup, penned a great blog post that answers Rajoshi’s more specific question. 2Jason L. Baptiste, How I Pitched @TechCrunch and 13 Ways to Get Press When You Launch Your Startup, accessed at http://jasonlbaptiste.com on August 3, 2013. I suggest you read that post for an outline of the tactics that worked for him, and that you might use yourself. There are a few very minor bits of insight I would add, but overall Jason does a phenomenal job of laying out how one might go about solving the kind of problem that is confronting Rajoshi and her colleagues at this moment.

Now, back to the more general conversation about how one might spread one’s ideas. I will start with the general notion that ideas spread because people care about the ideas, and start talking about them to other people. Ideas are spread by people. Sometimes it is easy for us to forget that. In the following discussion I will use Rajoshi as my protagonist.

Epidemiology 3 I have adapted this description of disease transmission from the description provided online at http://www.epidemiologyschools.com/intro/index4.html which I accessed on August 3, 2013. Any similarities are deliberate. is the study of how disease outbreaks occur. An epidemic occurs when a disease outbreak exceeds what one might expect under normal conditions, within a relatively small area and group of people, over a given period. Disease causation, transmission and propagation need a number of factors. First, there must be an agent capable of causing the disease. Second, there needs to be a host that is vulnerable to the agent. Third, the agent and the host must meet one another in an environment that allows them to interact with one another.

The disease-causing agent must have three characteristics: infectivity, pathogenicity, and virulence. Infectivity refers to the agent’s capacity to cause infection in the host. Pathogenicity describes the capacity of the agent to cause an outbreak of disease in the host. Virulence describes with which the disease occurs, and the speed with which it spreads. 4It is not a coincidence that the term viral marketing and viral coefficient have been adopted widely.

Potential hosts too must have characteristics that are important to consider. A host might be immune, in which case the agent will fail in its bid to cause a disease outbreak in that specific host. A host might be already infected, in which case there’s no point for the agent to keep trying to cause the disease in that specific host. Finally, a host might be susceptible. This is the kind of host that every disease-causing agent seeks.

So how is this analogous to Rajoshi’s predicament? She is our agent. She has an idea that she wants to spread. Her first task is to find a small group of people who are already talking about the idea she wants to spread. This group of people represents the host. It is likely they are not having a discussion about the concept in a formulation that is exactly the same as Rajoshi’s expression of the idea. That’s okay. This group of people exhibits the quality of susceptibility. They are very likely receptive to listening to Rajoshi talk about her idea. This group is likely to engage her in discussion about her idea, and members of this group are also more likely to volunteer towards helping her spread the idea. Because Rajoshi’s idea is similar to the idea they have already discussed, it is likely that people in this group will talk to other people they know about Rajoshi’s idea without her knowing it. In other words, they are likely to become agents themselves, propagating her idea as they tell their friends about it.

So how does Rajoshi prepare herself to propel her idea once she finds this small group of people who are open to hearing her idea and engaging in an exchange with her about it? As it relates to her idea, how does she cultivate the quality of pathogenicity within herself? Jason says in his blog post that a startup should be prepared technically before it seeks PR. This is also true of Rajoshi. Before finding a group of people who would be receptive to her idea, she should prepare to discuss her idea in substantial detail. Ideally, by the time she does this she and her colleagues should have developed a list of frequently asked questions that they expect will arise when other people encounter their idea for the first time, and they should have prepared answers to the questions they expect to arise often. This is important because many smart people are skeptics at first. They will ask questions about how something works. They will ask about why an alternative solution to a problem was not used. They will challenge some of the assumptions that Rajoshi and her colleagues have made. If this happens, Rajoshi needs to have prepared well-thought answers. Her answers will prove that she’s thought carefully about what she’s doing and why she’s doing it. How she answers such questions can suggest that this is a solution that may indeed work to solve the problem she’s trying to solve, or may suggest that she is not to be taken seriously. No one I know wants to waste their time with something that will not last because the people who should be most invested do not care enough to develop answers to basic questions about what they are doing, why they are doing it, and how they are doing it. It will be easier for others to embrace her idea if they believe that it is an idea that will stand the test of time. If someone raises a question that she and her team had not considered, it makes sense for her to ask for help developing the skeleton of a possible answer. That gets the person that raised the question invested in solving the problem they have pointed out. Rajoshi needs to communicate her idea in a way that is persuasive and convincing if she expects other people to adopt her idea as their own and to spread it to other people who Rajoshi is unable to reach directly.

This brings us to the notion of virulence. How does Rajoshi make sure her idea is adopted and spoken about enthusiastically by other people?

Atul Gawande discussed this in a recent article published in the New Yorker. 5Atul Gawande, Slow Ideas, New Yorker, July 29, 2013. Accessed at http://www.newyorker.com on August 3, 2013 I will try to paraphrase the conclusions that he reaches in that article, but I urge you to read it for yourself.
First, Rajoshi must make her idea simple to understand and explain to other people. While it is okay if the underlying concept is technically complex, the way the idea is communicated must be devoid of unnecessary complexity. It must be simple, and easy to remember. Second, the primary benefits of the idea must be experienced by the group of people who Rajoshi hopes will adopt and then spread her idea. We are all inherently selfish beings. I find it easy to remember to excitedly tell my friend about how much a new app I have downloaded has made my life much easier. I find it more difficult to tell my friend about a new app I discovered which will make her life much easier. Third, for Rajoshi’s idea to gain massive adoption, assuming the first two conditions have been met, it helps if the cost of adopting her idea is relatively low. An app with a single step sign-on and registration will be adopted more readily than one that has a two-step sign-on and registration process. All else equal, an Internet product that allows a prospective user to try the product for free before signing up for a paid subscription for additional features will gain more adoption than one that does not allow a free trial of any kind. Fourth, if people are going to adopt and then spread Rajoshi’s idea she must get to know them and they must get to know her. Mr. Gawande describe’s a pharmaceutical sales rep’s practice of “touching a doctor seven times” in order to get the doctor to change from prescribing one medication to prescribing a new one that the sale rep’s employer wants to sell to the doctor’s patients. 6This might mean that one should not wait till the last minute before one engages with the people one would like to adopt and then spread one’s ideas in the future. Last, people respond positively to others that they consider “nice” – remember that spreading ideas is fundamentally about people. Mr. Gawande’s article ends with an interview between him and a birth attendant in India regarding the extent to which the birth attendant had adopted recommended practices that BetterBirth, an organization dedicated to improving maternal and infant care during childbirth, had introduced to her through a series of site-visits with a much younger nurse, who had only a fraction of the experience of the birth-attendant. As it turns out, contrary to expectations the birth attendant had in fact made a lot of changes based on her interaction with the nurse. The birth attendant said she made the changes suggested by the BetterBirth nurse because the nurse ” . . . was nice”,  among other things.

It is easy to think we should remain faceless, and rely on technology to spread our ideas. It seems easier to craft one email and send it to 500 people from our contact list all at once. It seems easier to simply send one tweet to our hundreds of followers, or to simply post a Facebook status update to our friends telling them about the idea we wish to spread. That assumption is not borne out by empirical evidence. In and of itself, technology is not enough.

Technology in the form of email, social networking, communication tools like Skype, Google Hangouts, etc provide the environment in which Rajoshi can communicate her ideas to other people. However, she must harness that technology in non-scalable ways at the outset – having one-on-one interactions with the people she identifies as most likely to be open to adopting her idea. As this process continues, the group of people who have encountered, accepted and made her idea a part of their world view will grow. They too will spread the idea to other people. As the process continues her idea will begin to spread and gain currency, with technology playing an enabling role.

To quote from Atul Gawande’s article;

“Diffusion is essentially a social process through which people talking to people spread an innovation,” wrote Everett Rogers, the great scholar of how new ideas are communicated and spread. Mass media can introduce a new idea to people. But, Rogers showed, people follow the lead of other people they know and trust when they decide whether to take it up. Every change requires effort, and the decision to make that effort is a social process.

 

 

 

References

She is the co-founder of 34Cross. Their first product, Owlink, is a browser extension that is now available for Chrome. Rajoshi tells me versions for Firefox and Safari are in the pipeline. We have known one another since 2011 when we worked together while she was a teaching fellow at the Meltwater Entrepreneurial School of Technology in Accra, Ghana. You can check out Owlink here.
Jason L. Baptiste, How I Pitched @TechCrunch and 13 Ways to Get Press When You Launch Your Startup, accessed at http://jasonlbaptiste.com on August 3, 2013.
I have adapted this description of disease transmission from the description provided online at http://www.epidemiologyschools.com/intro/index4.html which I accessed on August 3, 2013. Any similarities are deliberate.
It is not a coincidence that the term viral marketing and viral coefficient have been adopted widely.
Atul Gawande, Slow Ideas, New Yorker, July 29, 2013. Accessed at http://www.newyorker.com on August 3, 2013
This might mean that one should not wait till the last minute before one engages with the people one would like to adopt and then spread one’s ideas in the future.