Emotional experience trumps outcomes

February 25, 2020

Regardless of how logical and unemotional we think that we are, a large majority of people make decisions based on emotional reactions. Think about it, emotion = e + motion. The emotion typically causes the action regardless of the logical implications.

When applied in the investment realm, emotional decisions cause cognitive biases that cloud decision-making. This typically results in a suboptimal allocation of resources.

I see these issues happening all the time for various levels of investors from angel investors in private markets to professional investors in public markets. Taking a few simple steps, such as; considering base rates, frames of reference, and thinking through the incentive structures would help improve the process for a lot of people.

How we think

Kahneman covered this concept in his book “Thinking Fast and Slow,” where we have two modes of thought: system one is fast, instinctive, and emotional; system two is slower, more deliberative, and more logical. People embrace system one and begrudgingly use system two. In start-ups, this means that people typically don’t care about the logical realities of a situation, they care about the story that they’re told.

They care about the potential of the idea and how the founders make them feel. A feeling is far easier to remember and digest than a bunch of abstract statistics. Cognitive psychologist Jerome Bruner suggests that we’re 22 times more likely to remember a fact when it has been wrapped in a story.

“I’ve learned that people will forget what you said, people will forget what you did, but people will never forget how you made them feel.” – Angela Mayalou

Stories and the feeling that you leave people with are more important than the underlying realities. If we want to ground our decisions in logic, we could look past the stories and feeling and consider base rates, frames of reference, and incentive structures.

Base rates

Back to abstract numbers, it’s important to look through the story and consider the base rates when looking at an investment. What’s the chance of success? On average a top quartile fund will generate an annualized return of more than 25%. Considering the power laws that are inherent in venture investing, only the top quartile will beat the market. The Cambridge Associates early stage index returned 9.5% p.a. over the last 10 years. The median returns for the whole asset class are mixed:

This means that the median venture capital fund will return around 10% p.a.. This is the base rate that investors should expect when they’re investing in a venture fund. Exceeding this benchmark would require exceptional performance because of the inherent power laws (a handful of names generate most of the value in a given year).

We’ll apply this in more detail below.

Frames of references

I’ve written about this before here. Here’s the situation, an idea generator (the stage before an incubator) is raising funds to invest in the companies that it’s generating. It takes a 30% cut of the investment that it pays out to the start-ups as a “program fee.”

If we consider that they’re generating/funding 20 companies in each cohort, this means that 17% of the total funding is going to the management company via the program fee. Should this be viewed as the “management fee” by another name or is it completely different? The management company also charges the fund a 2% management fee, a standard for the industry.

So, we could say that 17% of the value of investments is being allocated to the management company in one form or another. Put another way, at least 17% of the fund isn’t being deployed in investments.

All of this doesn’t include the money that’s paid to the founders as they decide on their idea and form teams for the first 3 months of the program ($5k/month for three months), which may or may not come from the fund (there are some intricacies which make the modelling difficult here). Considering that 100 founders enter the program, that means that $1.5m would be paid out in salaries ($5k x 100 founders x 3 months), which doesn’t convert to equity in the companies that are founded. It could be argued that this is a cost that allows the incubator to get the competitive valuations on the start-ups that it subsequently invests in. If not then 60% of the fund would be being deployed in activities other than investment.

This means that 17-60% of the funds raised aren’t being deployed in investments. Put another way, the fund will need to generate 120-250% returns to break even. This equates to 8.2% and 13.35% p.a. returns respectively. Therefore, the fund would require something closer to top quartile returns to breakeven before earning a return for investors. Hmmmm, when we reframe this situation and take the base rates into consideration, it doesn’t seem so promising.

The story that the idea generator is selling is, “Do you want to invest in start-ups at the ground level?” For a lot of people really do want to be involved with ambitious new companies that are trying to create the future.

However, if you peel back the onion, reframe the information, and consider the base rates that are inherent in venture investing, you can see that the fund is hugely reliant on having at a few slam dunks in each portfolio to get close to returning investors’ initial capital.

Incentive structures

It’s important to look at the incentive structures the are inherent in any business structure. In the above example, it’s simple to see how the idea generator is incentivized to generate more companies because it generates more fees with more “companies generated.” There are other operators out there that don’t charge significant fees on their funds or have reasonable hurdles to signal their confidence in their approach.

A recent example is Adventures, a permanent equity firm that focuses on mid-market private equity transactions in the mid-west of the US. Their recent newsletter highlighted the fact that they don’t take any fees on the capital that they raise but take a slice of the cash flow once hurdles are met to cover expenses. This results in an alignment of interests with the fund manager and the investors – both want to make investments that will generate cash flows.

Summing up

People don’t care about what you say, they care about how you feel. Those that are able to convey confidence and make potential investors feel like they’re on a journey to change the world through stories will have an easier time raising capital than people that betray an awareness of the pitfalls that they’re likely to face.

Investors that are aware that there are a number of unknown unknowns are likely to feel unsure where the less qualified will be full of conviction.

“The larger the island of knowledge, the longer the shoreline of uncertainty.”

This is a natural consequence of the Dunning-Kruger effect; as people learn more, they realise how little they know. Move forward with conviction but be aware of the base rates, frames of reference, and incentive structures that stand in your way.