In early stage investing, uncertainties and risks are high. So how do angel investors assess the risk and decide which startups are worthwhile? Are choices instinctive and based on an emotional reaction? Or do angel investors employ more analytical and deliberate processes? Laura Huang, faculty member at Harvard Business School, has spent years researching behaviors of early stage investing. The conclusion: angel investors do rely on a so called, “gut feeling”, and to a degree that may be surprising. However, Huang is quick to emphasize that this gut feeling is actually a complicated combination of both instinctive and analytical decision making. Additionally, Huang states that knowing how much an investor relies on instinct can actually help entrepreneurs tailor the pitch, address biases, and ultimately forge a successful business relationship between an investor and entrepreneur.
What is really behind gut feeling?
In order to quantify this gut feeling, Huang assessed investing behavior using three different methods. First, hundreds of angel investors were interviewed regarding their investment criteria, key attributes they look for, and decision making process. From there, the team watched videos of pitch competitions and coded the entrepreneurs’ presentation based on the investor checklist. Although competitions pre-filter for a group of top entrepreneurs, the research team was able to study pitch content, the likelihood of receive funding, and performance level of the startup 3-4 years later. Lastly, Huang and the team conducted experiments by giving investors executive summaries and either changed the quantitative numbers to make the financial returns seem more attractive or emphasized personality attributes like determination and passion. Other entrepreneur characteristics – like name, photo, accent – were varied in order to understand effects of gender, attractiveness, and minority status.
Angel investors are influenced by subtle cues.
Huang’s research indicates that investors are influenced by relatively subtle cues and signals from the entrepreneur that they use to determine whether the startup itself is worth investing in. The results show a stronger correlation between positive perceptions of the entrepreneur and propensity to invest rather than the business plan itself. A startup with a weak business viability but a positively-perceived entrepreneur is more likely to be funded, and funded more in terms of dollar amount, than a negatively-perceived entrepreneur with a stronger business viability. Relying on subtle cues and signals also has a downside: it can perpetrate certain biases, such as gender biases or biases against people with an accent in the investment world.
Relying on gut feeling will not increase the number of successful investments in a portfolio.
There is a practical reason so many angel investors rely on their gut feeling, given the risk and uncertainties in early stage investing. They are usually the first external financing and little financial data is available. So many rely on this gut feeling that combines their prior investment experience and perceptions of the entrepreneurs.
Huang’s research shows that gut feeling will not increase the number of successful investments one makes, but it does help angel investors choose those that become very successful. Investors are willing to be wrong and 98 percent of the time they will never see a return on a particular investment. But relying on one’s gut could help an investor increase their likelihood of identifying that one extraordinary startup. Huang noticed two types of investors and how each incorporates gut feeling. Some have a standard check list of quantitative data to first assess the financials and markets, then lean on their feelings of the entrepreneur. The second group relies firstly on the rapport with the entrepreneur, looking for grit and passion, then verify their gut instinct with quantitative evidence. Both are ways to rationalize risk at this early stage and one isn’t necessarily better than the other.
For angel investors, knowing one’s decision-making type and reliance on gut can give confidence to choices. The knowledge can also help investors be aware of their own potential for biases and to combat those perceptions. Huang hopes the research will spark investors to think about the criteria they use and how investment decisions are made. For early investors, gut feeling can be helpful if judged against other sources. To entrepreneurs, Huang advises that knowing the signals to identify investor type can help tailor interactions to specifically address biases and areas of concern. Entrepreneurs can learn to either emphasize hard numbers early on or their passion and determination.
A question for further research is whether angel investors with a successful track record over time are equally likely to rely on gut feeling as their less successful counterparts. Huang’s results seem mixed here. It is possible that the majority of angel investors, who are overall not as successful, are more likely to rely on gut feeling, while a small minority of the ones that see most of the gains are more intentional about their investment choices. It has also been suggested by previous research that more experienced entrepreneurs make better angel investors; is it possible that that subgroup of investors is particularly unlikely to rely on gut feeling? Or does gut feeling mean relying on different cues and signals in their case?
Contributed by Janet Lin.
SOURCES:
Why Early-Stage Investors Tend to Trust Their Gut (Jan 2017)
http://knowledge.wharton.
PODCAST: This Week in Startups (June 2017)
https://www.youtube.com/watch?
Is “Gut Feel” A Good Reason to Invest in a Startup? (April 2018)
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