Investor’s perspective: psychology of fundraising

“A compelling narrative fosters an illusion of inevitability.” 
― Daniel Kahneman

Most successful investors in the world have a good understanding of common human (cognitive) biases. Cognitive biases are ‘hard-wired’ in us, and we are all liable to take shortcuts, oversimplify complex decisions and be overconfident in our decision-making process. Thanks to these (intuitive or experience-based) insights, investors have a significantly better understanding of investment opportunities (founding teams and their projects) and are able to systematically use these (behavioural) insights for better decision making, thus improving their investment odds.

There are three aspects for investors to consider in order to select only the best investment opportunities:

  1. Identify and guard against biases in their own (investment-related) decision-making process
  2. Identify biases [paste link to the entrepreneur’s perspective post here] entrepreneurs may use (in their materials/deck/pitching process) to gain a more favourable view of their projects
  3. Identify and assess founders’ biases by observing how/what they pitch

Successful investor puts looks at opportunities via each set of lenses (from above three points) before deciding to invest.

1) Identify and guard against biases in their own decision-making process

  • Confirmation Bias + Loss Aversion. What is it: This is the tendency for people to favor information that confirms their preconceptions regardless of whether that information is true or complete. When layered in with Loss Aversion, it creates a deadly combination. How to defend against it: Because an investor is averse to losses, he is biased against any data that suggests that the initial investment decision was a mistake and will gravitate towards information that supports a follow-on investment. Confirmation-trapped people often seek out others who have made, and are still making, the same mistake.
  • Risk Seeking. What is it: Even if a company is really struggling, the following logic is very appealing: wouldn’t an investor be willing to spend $2M to save the last $8M he has already invested? Because investors usually buy preferred stock, they get paid first and so they only need the company to sell for the value of the preferred stock to get their money back. How to defend against it: As a result, you often see struggling companies raise inside rounds under this logic (often crushing employees’ equity in the process). Basically, investors avoid risk when their portfolios are performing well and could bear more, and they seek risk when their portfolios are floundering and don’t need more exposure to possible losses. This is largely due to the mentality of winning it all back. Investors are willing to raise the stakes to “reclaim” capital, but not to create more capital.

Other impactful biases include:

  • Delayed gratification (pressure to show immediate results)
  • Sunk cost trap (feeling lasting attachment to costs that cannot be recovered)
  • Oversimplification tendency (tendency to stay within your ‘circle of competence’ even when it is clearly counterproductive or destructive)

2) Identify biases founders use to gain more favourable view of their projects

As mentioned in the article, top biases that founders may deliberately use to gain more favourable view of their pitch and project are narrative bias (storytelling in deck and pitching), clustering illusion (that causes investors to observe appealing clusters of information and credentials), confirmation bias (founder shows the ‘right’ structure and contents to investors), pro-innovation bias (investors like to see innovative features and products), halo effect (founders show, via storytelling and credentials, a positive and likeable image or treat of themselves or their product, aiming for investors to think that the overall product and team are as good), zero-risk effect (founders pre-emptively show there are no risks or all potential risks are mitigated) and distinction bias (founders like to deliberately compare their product to one that is much inferior, thus highlighting the benefits).

3) Identify and assess founders’ biases by observing their pitch

  1. Anchoring Trap. What is it: We can be excessively influenced by a starting point or first impression. Psychologists have shown that when people make quantitative estimates, their estimates may be heavily influenced by previous values of the item. For example, it is not an accident that a used-car salesman always starts negotiating with a high price and then works down. The salesman is trying to get the consumer anchored on the high price so that when he offers a lower price, the consumer will estimate that the lower price represents a good value. Anchoring can cause investors to under-react to new information. How to defend against it: In order to avoid this trap, an investor needs to remain flexible in his thinking and open to new sources of information, while understanding the reality that any company can be here today and gone tomorrow.
  2. False Causality Bias. What is it: Many times, we falsely assume when two events occur together that one event must have caused the other. For example, founders are prone to show and quickly get credit for their previous success (exit or company sale). However upon careful analysis of the stated “success” (which a founder assumes to repeat with this new project) may show a confluence of external factors (such as technological development, favourable legislation, government support, etc), good timing and pure luck that were more important in the stated success. PayPal and Amazon are great examples, and founders of both are very careful not to claim full credit, but deliberate on more salient factors that weren’t in their control and how the sum total of their grit, perseverance and external factors helped in their eventual success. How to defend against it: Investors need to hear out founders’ stories but also conduct a thorough analysis of the context in which the previous success of the founder happened. Goal is to distill what really caused the success; was it mostly the hard work, visionary idea and perseverance despite or rather in addition to externalities?
  3. Fundamental Attribution Error. What is it: Whereby we attribute a person’s behaviour to an intrinsic quality of her identity rather than a situation she is in. For example, let’s say you were interviewing a financial advisor. He shows up on time, in a nice suit, and buys lunch. He says all the right words. Will he handle your money correctly? Almost all of us would be led to believe he would, reasoning that his sharp appearance, timeliness, and generosity point towards his “good character”. Dan Ariely’s book about situational dishonesty and cheating illustrates that we may give an appearance that is expected only to behave differently in a similar context. How to defend against it: Before and during the fundraising pitch, we need to dig deeper and put appearances and our expectation in a proper context, aiming to find out whether the founder and his team really have all the necessary attributes (industry knowledge, team skills, leadership, vision for the product) required to give them the best shot at successful growth and scale up of their product.
  4. Survivorship Bias. What is it: Our tendency to focus on successful people, businesses, or strategies and ignoring those that failed.  Because of this, we adopt opinions, structure businesses, and make decisions without examining all the data, which can easily lead to failure. A Google search of “Successful founders who dropped out of college,” will turn up some of the biggest names such as Steve Jobs and Mark Zuckerberg as examples of entrepreneurs who had an idea, took a leap and became successful. But by equating their success to hard work alone, we ignore a very important fact: for every successful college dropout, there are hundreds, if not thousands, who weren’t as lucky.
    The founders we put on pedestals worked hard, but there were also many circumstantial events that paved their way to success. In fact, research shows the majority of the United States’ most successful businesspeople graduated college – 94%, to be exact. How to defend against it: Look out for signs such as “In following legendary footsteps of XXX,” “We have some of the similar pedigree to YYY,” “Our team’s combined experiences in this industry are of ZZZ years”, etc which all have a common denominator of “based on previous success of such and such, we think we have a good chance at similar success.” Again, a more pragmatic assessment of team, product and market related to areas where the founder or his team claims some “heavy” credentials would help understand what the reality is.

In addition to the above, biases investors can look out for in founders include:

  • Information bias
  • Framing cognitive bias
  • Decoy effect
  • Choice supportive bias
  • Empathy gap
  • Illusion of control
  • Overconfidence and overoptimism
  • Scarcity priming

3 things today: psychological hacks of investor mindset

3 things today: investors (like other human beings) use mental shortcuts (called cognitive biases) in their decision-making process.

Top three shortcuts used include:

  1. confirmation bias (investors look for confirmation of their beliefs/values when evaluating startups and favour those with most “confirmations”)
  2. hindsight bias (investors think past successes of founders give them a good chance for a repeat success in future)
  3. bandwagon effect (investors jump on an investment opportunity that has other influential investors, advisors or founders with good track record).

Entrepreneur’s perspective: psychology of fundraising

The above quote is the truth. There is no one world – each of us lives in a world. And just like in anything, when it comes to money and fundraising for our projects, we live in our little world with our own idea of what an efficient fundraising process looks like. We do our research, then follow some steps we find convincing and voila! We fail. Generally speaking, startup fundraising is inefficient, lengthy and for most part fruitless, minus the few (statistical) exceptions. 95% of all startups launched die within the first 3 years, top second reason being shortage of capital. Capital is the oxygen to a startup, powering its launch and growth, and yet this oxygen turns out to be very hard to come by. 

Why do most startup fundraising efforts take long time and frequently fail? Two reasons: 1) founders don’t understand, let alone incorporate, behavioural insights governing investors’ decision making process into their pitch deck and pitching process; 2) investors fail to see salient points and potential of startups thanks to lack of their time and focus, and not in small part, lack of founders’ lack of investors’ decision making process and mindset. i.e. point 1 above. One fundamental insight helps solve both issues: most decision making (of investors and human being in general) is instinctively guided and controlled by mental shortcuts (called cognitive biases), without them even being aware of those.

What are cognitive biases? Cognitive biases are mental shortcuts. They are bits and pieces of human character and behaviours that evolved over thousands of years to help us survive, initially in the context of hunter-gathering against predators and in the wild nature. While much time has elapsed, these biases are still present with us in the modern world.

Broadly speaking, cognitive biases can be split into two types: information processing and emotional biases. Information processing biases are statistical, quantitative errors of judgment that are easy to fix with new information. Emotional biases are much harder to change or fix as they are based on attitudes and feelings, consciously and unconsciously. Both types can have implications when you are a startup founder trying to fundraise because they operate to keep you within your comfort zone. The underlying belief that you’ll be safer, more secure and more comfortable with less uncertainty and risk dominates decision making. To fundraise efficiently and effectively, we need to do the opposite, by going after investors and selling our story (narrative bias), showing our vision (confirmation bias, clustering illusion) and getting them to buy into our team (halo effect) and product (distinction bias, zero-risk effect, pro-innovation bias).

Top seven biases that are critical for successful fundraising cover all aspects of successful pitch and pitching process. Entrepreneurs would be wise to incorporate these insights into their pitch decks, giving them the best shot at achieving their fundraising targets.

  1. Narrative fallacy. What is it: humans (including investors) have a tendency to look back at a sequence of events, facts or information in a linear and discernable cause-and-effect way. Cause-and-effect morph into a story. How to apply: make your pitch deck – at least the beginning part talking about Problem, Opportunity and Solution – into an inspiring story, with clear causes, effects and inspiration.
  2. Clustering illusion. What is it: investors tend to observe patterns in what are actually random events. How to apply it: you must showcase your team’s credentials, previous or relevant successes of exiting (or failing) startups or a successful career in an MNC, which will create a clustering illusion in an investor’s head that your team has been on a roll, and your current project’s vision will be achieved based on your team’s previous success. Also when you show traction/data to investors, make sure your case is compelling enough, even with little data using the clustering illusion to your advantage, by citing trends as validation of your vision.
  3. Confirmation bias. What is it: investors believe what they believe based on experiences and expertise they have accumulated in startup investing. How to apply it: include all the main points investors expect to see in your pitch deck, resulting in an investor “confirming” that your project is commercially sound and to have a serious consideration of investment. Lastly, in your deck, show your present solution as consistent with investor’s prior beliefs (i.e. in line with the investor’s current former portfolio investment) and avoid contradicting any strongly held opinions of the investor during pitching. 
  4. Pro-innovation bias. What is it: novelty or “newness” are generally considered good by investors, hence showing a product innovation is a good idea. How to apply it: Pitch innovative features of your product and how they give you an edge over competitors, especially a competitive advantage. However, a caveat – investors know this well – is that you need to be very careful when pitching a business model innovation, as investors’ inclination is towards favouring business models that have proven track record, as opposed to completely new ones. 
  5. Halo effect. What is it: this is the psychological tendency many people (including investors) have in judging others based on one trait they approve of. This one trait leads to the formation of an overall positive opinion of the person on the basis of that one perceived positive trait. For example, people judged to be “attractive” are often assumed to have other qualities such as intelligence or experience to a greater degree than people judged to be of “average” appearance. How to apply it: show (in the pitch deck) or inform (during pitching) of achievements (former exit, speaking at a prestigious event, etc) in order to create a halo effect in an investor’s head, which will then colour his/her judgment positively for the overall project, and in conjunction with other factors, might lead to an investment. Also, if you can show a testimonial by a celebrity or a well-known business person of your product or one similar to yours, halo effect will do the rest!
  6. Zero-risk effect. What is it: this is a tendency to prefer the complete elimination of a risk even when alternative options produce a greater reduction in risk (overall). How to apply it: in your pitch deck, it is important to either not show potential risks (scale up or product) or show a risk with a full mitigation of it. This is one of the main reasons that investors might not speak out or question you, but also decide not to go ahead with investment due to perceived risks in your product.
  7. Distinction bias. What is it: this is a tendency to view two options as more distinctive when evaluating them simultaneously than when evaluating them separately. It can magnify the near meaningless differences between two very similar things to the extent they become decisive in which one we choose. How to apply it: in your pitch, compare your product with one or two competing products next to which yours has clear benefit. This comparison will clearly sway the investor to your product as a preference. 

more complete list of biases (excluding the ones mentioned above) affecting entrepreneur’s pitching ability can be found below.

  • availability heuristic
  • information bias
  • expertise trap
  • attribution error
  • framing bias
  • bandwagon effect
  • hyperbolic discounting
  • sunk cost fallacy
  • planning fallacy
  • omission bias
  • choice-supportive bias
  • illusion of truth effect
  • superiority bias
  • self-serving bias

Cognitive biases are particularly challenging for fundraising process as they have a profound impact on the creative right-side brain which is critical for creative ideas. Right brain thinking is more risky and prone to biases as it deals with abstract unknowns vs. left brain thinking which deals with more logical concrete knowns.

*This article was first published on WholeSale Investor