Published in the San Diego Union-Tribune, February 13, 2017
It is no secret that I am not a fan of The Donald, but in the area of early stage angel investing, there is some data to support his theory about listening to your gut. I recently read “Managing the Unknowable: The Effectiveness of Early Stage Investor Gut Feel,” written by Laura Huang, Assistant Professor of Management at The Wharton School at the University of Pennsylvania.
Huang says, “I have heard stories of investors just saying, ‘you know, I invest because I rub my tummy and that’s how I make my investment.’” This is insanity in my humble opinion, but Huang has persisted in her effort to find out what investors actually mean when they say they invest based on their gut. It seems that market size, product fit etc. do play a role, but the nuance is that in the entrepreneurial context, investors are “willing to be wrong.”
She says, “in terms of their gut feel, it doesn’t actually make a difference in terms of being right or wrong on any one given investment — but it allows them to identify home runs.” Stop the madness. This makes no sense.
My favorite economist, Dan Kahneman, argues that “you should not take your intuitions at face value — overconfidence is a powerful source of illusions.”
Now of course this whole discussion centers around the “what” you are trusting in your gut — and on that point, I am all-in on only three things — the founder, the CEO and the team. Recently I did some consulting for a company with problems — and the core issue was the founder. I asked the board during my session when they sensed this problem, and they said it was months ago. They waited too long. They had history and data to suggest that this problem needed to be addressed earlier. Here, they ignored their gut.
Kahneman argues that we should be “wary of experts’ intuition — except when they are dealing with something in their past — where they have a data pool of experience to draw on.” This is critical. I can trust my gut in identifying the characteristics of a potential CEO since I have hired or interacted with more than two dozen. But where I have no real history, then trusting your gut is a fool’s gamble. The fact that you are a cyber expert should not give you comfort to invest in a robot company. That is why venture capitalists do due diligence. You know how to hammer a nail, but not every problem is a 2×4. You must have a checklist about the quality of the information.
Huang’s research suggests that for early stage investing — when not much can really be proven, when the science is too new or novel, then the gut trust thing might be effective. It favors the lucky risk takers. But the problem is that after “winning” a hand, you begin to think you actually know something, and that is when disaster looms large. Kahneman says, “I worry about leaders in complex situations who don’t have enough experience, who are just going with their intuition and not really thinking about it.” So do I.
One more element — can the entrepreneur game the system? Can he present himself in a way that reinforces a stereotype (resume, appearance, references) that then leads to a higher chance of investor bias — falling for fake authenticity?
I make my teams do an exercise. I ask, “What are all the things that can go wrong before one of them goes right?” Kahneman calls this a “pre-mortem.”
The angel investing racket has one immutable key component — extreme uncertainty. No matter how many deals you have seen, each new one does not necessarily build on a previous one. Investors think they can have nine dogs and then hit the home run. I do not subscribe to that theory. I am focused hard on the downside. I think home runs are very rare and that your gut is a lousy way to identify them — and even more to the point (which Ms. Huang totally misses) — you might see a home run, but not be able to get into that deal. The batting order is full. No room for novices.
My own model is to try for doubles. If a home run shows up, I know in my gut that I was the beneficiary of good fortune — not brilliance in identifying the deal.
Rule No. 497: Trust your gut, but take a map.