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January 27, 2009

Sway and Irrational VCs

I recently read Malcolm Gladwell’s new book, Outliers, with great interest and delight. Gladwell is a fantastic author:  always thought-provoking on human behavior and a quick, entertaining read.  But I confess this book did not resonate with me or strike me as relevant for the VC-entrepreneur dance in the same way his previous book, Blink, did (see:  VCs Blink).  It was intellectually interesting, but not professionally illimunating.

Instead, I have been even more taken by another book, which also analyzes human behavior in a thought-provoking way called Sway. Written by Ori and Rom Brafman, Sway was recommended to me by my friend and co-investor Howard Morgan at First Round Capital.  It is a fascinating analysis of why human beings naturally fall into irrational behavior.  The book has very relevant implications for venture capitalists and entrepreneurs, particularly in today’s environment, as VCs are likely to allow irrational behavior to seep into their portfolio management decisions in the coming years.

Sway points to three central psychological tendencies that cause human beings to behave irrationally, despite the preponderance of facts pointing in another direction.  The first is loss aversion, defined as our tendency to go to great lengths to avoid possible loss – even when it means taking outsized risks relative to the actual loss impact.  The second is value attribution, where we imbue a person with certain qualities based on our initial impressions (or desired impressions!).  And the third is the diagnosis bias, where we allow our initial assessment of a person or situation cloud any further judgment and, in effect, cause us to filter out any contradictory data.

As I look back on the good and bad investment decisions that we have made as a partnership, I see each of these three tendencies factoring into our discussions.  It is not uncommon for a polished, confident entrepreneur to benefit from value attribution, when in fact a deeper analysis of their skills and previous experiences as a result of exhaustive reference checking will reveal a very different prognosis.  We have tried to be more cognizant of identifying these tendencies in the partnership as we contemplate our future investment decisions with our (relatively) new fund.

As I look forward to managing the portfolio during the challenging times that we all face, I can see where loss aversion, in particular, holds sway in a VC partnership. Human beings prefer to avoid a loss, even if that loss is more costly than the price of continuing forward. One of the dangers in the coming years for the VC business is whether VCs are going to continue supporting companies in order to avoid admitting defeat and taking losses. In many partnerships, the culture may naturally encourage covering things up.  Many VC partners are eager to brag about their portfolio successes, but slow to admit when they have made mistakes or when they are in the midst of dealing with a poorly performing portfolio company. Further, partnerships as a whole are going to be loathe to admit problems and failures with their investors, the Limited Partners.  Without any malice, portfolio “cover ups” will be common throughout 2009 and 2010.

Loss aversion will thus cause VCs to throw good money after bad in 2009 and 2010.  Loss aversion will also cause VCs to report overly optimistic quarterly valuations.  I would estimate that many portfolios have valuations that are overstated by 20-30%.  And, as I have discussed before (see:  "Why 'Flat is the New Up' and VC Funds Are Under-Reserved"), it is also the reason why I think many VC firms are grossly under-reserved.  These factors will be exacerbated by most portfolio companies failing to attract outside financings in the coming years and VCs, loathe to admit losses, continuing to support them well beyond the length that a rational investor would.

To be clear, it is not only VCs who are induced into irrational behavior due to loss aversion. Entrepreneurs clearly suffer from this tendency as well, particularly when it comes to hiring and firing key executives. How often have you heard an entrepreneur say that they should have acted 6-12 months earlier in firing an employee that was not working out?  The reason – loss aversion. Entrepreneurs are loathed to admit their own hiring mistakes and are fearful of the impact and magnitude of losing even a poorly performing team member. I know I certainly fell into this trap when I was an entrepreneur, and I see it is repeated time and time again.

Thus, I think the lessons of Sway are ones that all VCs and entrepreneurs would benefit tremendously from when evaluating how they make decisions. In an upcoming blog I might dive into the question of value attribution and the diagnosis bias, which are also a thought-provoking concepts that drive irrational behavior in VC partnerships.  One entrepreneur identified another book for consideration on this topic called Predictably Irrational by Dan Ariely, which I have not yet read.

What are other examples can folks think of that fall into these irrational categories?


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It's really amazing how easily irrationality can creep into our decision-making. It is something I reflected on a bunch recently: http://bit.ly/3jDZ

BTW, I would second the recommendation for Ariely's book. I do think these pop econ books are getting a bit tiresome, but Predictably Irrational is a good one!

Jeff, another useful post. Thanks! Your statement, "...it is not only VCs who are induced into irrational behavior due to loss aversion. Entrepreneurs clearly suffer from this tendency as well, particularly when it comes to hiring and firing key executives." resonated with what I've seen in the ten companies I've run -- on an interim basis -- this last decade.

Though usually it's the VC who puts me into an under-performing company as CEO to figure things out, sometimes the founder himself has asked me in, usually in the role of COO. At one such company -- a $20 million global software venture -- at the end of the fist day the CEO's shoulders slumped when I told him, "Charlie, you know that we need to fire three of the six VPs I met today." Yes, he knew long before I arrived, but probably due to Sway's Loss Aversion he couldn't admit it until he had an independent "second opinion" (as well as having someone to do the dirty deed and to steer the company through the process of rebuilding the management team.)

And at another company, the VC was at fault. After 30 days, I sat with him to say, "You should not put the next mulit-million traunch into this company because it's going to take five times that amount to finish the turn around and the return is not worth it. He wouldn't hear of throwing in the towel and put the money in. Yes, we exceeded our revenue, P&L, and product goals for the year, and we were able to hire the "name brand" CEO we desired. Buy, three years on, the VC has in fact continued to put what I think is "good money after bad" to avoid telling his funders that it was -- and, frankly still is -- a bad investment.

Sway's Loss Aversion argument plays out in the real world.

I have posted my intuitive response at AlwaysOn without having read "Sway". Suffice to say that after having reading your post has highly motivated me to buy and READ this book.


As of this morning, I have deleted my online account at AlwaysOn, so I will leave a gist of what I thought here. In terms of value attribution I linked it to branding and how brand effects this attribution. I related diagnosis bias to paranoia, which seems intuitively the antithesis of what you described above. For Loss Aversion, I first deleted my AlwaysOn account and then linked it to personal confidence. Other than that, I learned much from your posting and I thank you kindly and look forward to lurking here in future. All the best. M.

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