Risk? Real or imaginary? Ignore it at your peril…

How does human perception affect decision making? If a Business Angel or advisor is aware, how can they set expectations in order to reduce due diligence and transaction time? What are the real fears? What are the risks? Are they reasonable or based on instinct? How reliable is instinct? Dan Gardener’s book “Risk – The Science and Politics of Fear” is a useful reminder that Head should trump Gut when investing… this blog covers his key points.

Dan Gardner introduces the concept of the Gut versus Head in decision making. The Gut is fast, uses rules of thumb and automatic settings and results in us “feeling” the answer – ideal in the Stone Age. The Head is slow and evidence based and often needs to over-rule the Gut in the Information Age where input is more abstract. Dan reduces the concept to three rules:

  • The Anchoring Rule. This is where the last discussion can affect the next discussion in unexpected ways. Typically the discussion of one option can result in the incorrect estimate during a second discussion. For example, Dan relates an experiment with experienced Judges done by Strack and Mussweiler in 2006. By introducing a phone call mid-way through the deliberation on a written outline of a case asking if the sentence would be over three years or over one year, the average sentence was reduced from 33 to 25 months!
  • The Rule of Typical Things. This rule uses our knowledge of what “typically happens” to evaluate outcomes in the future, it “generally favours outcomes that make good stories or hypothesis”. However, what is typical varies between people, society and continents.  Plausible details can increase the apparent probability of the whole chain of events.
  • The Example Rule. This is where examples of past experience are used. The experience comes from a wide range of places (e.g. own experience, stories from others, films, newspapers, dreams, etc.), tends to be negative and have variable impact (depending upon how emotionally charged the event was, how vivid and novel it is). In the Stone Age these examples would preserve life but now they are not necessarily a good basis for a decision.

Dan Gardener provides many examples of Head v. Gut by taking “common” assumptions and researching the statistical background. The examples are enlightening so I’d recommend you buy the book to find out more (ISBN 978-0-7535-1553-2).

That’s the theory. So what can an Investor do to improve the speed of negotiation? Let’s take a few typical sticking points during negotiation:

  • What is value of the company? – Most entrepreneurs value their company using their “gut” resulting in a higher than the Business Angel (who is using their “head”). Knowing the Anchoring Rule, the Business Angel can talk about something else first (completely unrelated) with a low number before approaching the question of the value of the company. The result: a more realistic valuation.
  • Investee is concerned about the investment process. – Using the Rule of Typical Things, a Business Angel can recount a story of other “typical” investments (e.g. the size, time scale, questions asked, time required from entrepreneur, etc.) so that the Entrepreneur feels comfortable with progress.
  • What is the Exit plan? – Most entrepreneurs have not thought through how the investor will recover their investment. By giving a vivid, exciting and novel example of another entrepreneurs success, the Business Angel can use the Example Rule to help set expectations.

Given these few examples it is clear that experience (or borrowed experience) and preparation for meeting entrepreneurs is key. Know as much about the person as possible before you meet them to discuss next steps. If you found them through an Angel Network, ask the Deal Manager. And in the meeting, be prepared to tell stories!

It’s not what you say, it’s what you said earlier!

Leave a Reply

Your email address will not be published. Required fields are marked *