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?