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Investor Psychology

// Zack Mansfield - VP, Early Stage + Pre-VC

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March 18, 2014
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Recently, I happened to be the third wheel of a conversation between two active angel investors who were talking about a particular company that was closing a round of funding (names will remain anonymous to protect the innocent). I was somewhat familiar with the company but not intimately; thus, I was able to listen to the debate –er, conversation – with a completely open mind.

The back and forth was particularly fascinating because the two gentlemen basically agreed on 98%+ of the facts related to the potential deal. They were in agreement that the two founders were fantastic entrepreneurs who had put the company in a materially better position than when they raised a seed round a year earlier. The product was fully built-out now, and they had serious traction (to the tune of thousands of customers for this B2B SaaS offering).

The one catch: to date the software had been offered for free and there had been no proof of what percentage of free users will convert to paying, and at what price. Both angels agreed that the next 3-6 months would be incredibly illuminating as to whether this company will scale into a real business.

What the two could not agree on was the price. But it wasn’t just a simple question of disagreement on the exact pre-money valuation. One of the investors was an existing shareholder, having participated in the seed round a year before. The other had already committed to the new financing round. It took a while to get there, but after a good 15 minutes of conversation it became clear that the reason for their disagreement was 100% due to whether they were already in the deal or not.

In the view of the existing shareholder, it was too early to settle in on a proper valuation. If the conversion to monetization went well, then he felt the company would be worth 50-100% more and wished the company would raise a smaller amount from existing insiders (and potentially save some of his stake via less dilution). Without this data, he couldn’t see how the new investors were justifying the current valuation. The new investor saw it as a chance to bet on a great team and to get in before the proof points – but that it was decidedly a “bet” on execution.

As the proverbial fly on the wall with no particular bias, I was able to instead focus on the dynamics of the decision making rather than my opinion. The first thing that jumped out at me was the impact that the investors’ unique individual perspective has on the psychology of a particular deal. They agreed on almost everything related to the company, yet had differing opinions on whether it was a good deal. Same facts, different perspectives. This is an important concept for entrepreneurs to understand as each potential investor will have a unique view based on preconditions that may or not be related to the entrepreneur’s company. Details such as size of an investor’s fund or a different portfolio company of the investor’s that may have gone bad in a similar industry are other examples of things that can influence decision making. That’s why it’s imperative to try and put yourself in the investor’s shoes to understand his/hermindset relative to investing, or not investing, in your company.

The far greater realization for me was this – in spite of articulate, impassioned, logical arguments from both investors about the merits and challenges of the company, the overarching reality is that neither really knows what in the world is going to happen. All the logic in the world from the investors won’t change the outcome for the company and the investment; the onus is ultimately on the entrepreneurs and execution. While it may be a bit of an ego deflator for an investor to admit he doesn’t know with any degree of certainty what is going to happen, this should actually be an admission that is freeing. The reality is that entrepreneurs don’t really know either – there are simply too many unknowns and too many known-but-unpredictable variables that are all interdependent. Yet, entrepreneurs and investors alike have to play the cat and mouse game of pretending that they can see over the horizon. Pitch decks are littered with product and market visions that in reality almost never play out according to plan. And investors will often wax poetic about their investment thesis on a deal and it can all make perfect sense – until it doesn’t. Or something changes (which it does every time).

The net-net on this is that we should all be ok with admitting that we don’t know what’s going to happen. For entrepreneurs, this may mean a little less complaining about investors who “just don’t get our business.” Perhaps they don’t, or perhaps they are simply admitting that they’re not comfortable with how much they don’t know. For investors, it’s ok to realize these are just best guesses and bets at their core (though maybe you don’t want to phrase it as such to your LPs :)). But both entrepreneurs and investors should be commended for partnering together on this quest into the unknown. It is the desire to go beyond the comfort of the known that creates the excitement that draws us all to the entrepreneurial world.

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