Photo credit: Maik Fechner and Jan Borowski

Foreword from Doreen Huber, Partner at EQT Ventures

Behavioral finance is the idea that markets are as irrational as the humans that comprise them. It asserts that rather than always and consistently being rational, people often make financial decisions based on emotions and cognitive biases.

In his talk at our Founder Day Berlin event, an afternoon of learning and networking for our DACH portfolio, Blacksquare Ventures’ Dr Daniel Smith delved into how to spot and manage these biases while fundraising. By acknowledging the irrational nature of human behavior, we can adopt strategies to improve communication and decision-making between founders and investors.

I’ve known Daniel since 2008, when we were both working together at SaaS business eKomi, and he taught me a lot about how to avoid falling into the traps our own minds set for us. I can’t think of a better guide through the weeds — or jungle! — of behavioral finance.

Take it away, Daniel.

Fundraising can sometimes be a big scary jungle. You don’t know what’s out there, and there’s no map. I can show you some of the tigers, some of the snakes and quicksand falls, but you’re gonna have to piece together the map as you go along. That’s all part of the fun.

Fundamentally, behavioral finance is about understanding human behavior — how our brains function, and how people think and collaborate in complex situations. And one crucial aspect of that is cognitive biases, which influence how we perceive and process information. As Carl Jung put it, ‘It all depends on how we look at things, and not on how things are in themselves.’

Have a look at the following picture — what do you see? At first glance, most people will see only an arrangement of squares and straight lines:

What usually isn’t obvious at all though is that the picture also contains a large number of perfect circles, hidden in plain sight — can you spot them? Go back and have another look, and if you still don’t see them, look at the picture below:

Cognitive biases are the mental equivalent of an optical illusion. We ​​latch on to some perceptions very quickly — and then it’s super hard to see things differently. For founders, the key is to leverage these biases to appeal to investors. Conversely, investors must be vigilant to avoid being misled by savvy pitches. You all just have to fight it out. But, ultimately, both sides need to be aware of these cognitive biases as they engage in the fundraising process.

The importance of framing

So imagine the US is preparing for an outbreak of an unusual disease that is expected to kill 600,000 people. Now, imagine that there are two programs that we can use to fight this.

* Option A: We will save 200,000 people.
* Option B: There’s a one-third chance we save all 600,000, and a two-thirds chance no one is saved.

Okay? Most people are going to go for option A. Now let’s try another two options.

* Option C: 400,000 people will die.
* Option D: There’s a one-third chance no one dies, and two-third chance that all 600,000 people die.

Now, if you were paying attention, you’ll notice that these are the same options. Option A and C are the same, and options B and D are the same. So, logically, if you like option A, you should pick option C, or if you prefer B, you should also choose D. But if you present the options like this, most people will pick A over B, but D over C.

In other words, how you ask the question is often more important to the outcome than what question you ask.

So when you’re pitching to someone, take a step back and think carefully not just what options you’re presenting, but how you’re framing those options, because that will determine how your audience reacts.

And when you’re presented with a choice, ask yourself ‘Why did they frame it that way? What are they actually putting forward, and is there a different way to look at this?’

What are the trade-offs?

If you only take away one thing today, take away this question: ‘What are the trade-offs?’ If I do X, this happens. If I do Y, that happens.

And this might seem super obvious to everyone. Like, duh, of course I think of trade-offs, that’s what I do as a founder or investor. But you’d be surprised how often entrepreneurs, especially, fall into the trap of not thinking through the complete set of trade-offs.

One of the most common examples I see in fundraising contexts is adjusting EBITDA. When founders first hear they can make adjustments, they often go ‘Okay. Let’s make ALL the adjustments.’ But you need to think about the trade-offs. If you do zero adjustments, you have 100% credibility — it’s just the ground truth. But as you start making adjustments, your credibility drops.

The first couple of adjustments are not going to tip the scale very much. But a lot of people underestimate that when you make that first adjustment, there’s a drop of something like 20%. It’s like driving a brand new car from the dealership; just that first drive off the forecourt means the car is no longer brand new. There’s unadjusted, and adjusted.

The sweet spot, of course, is going to depend on your exact context and audience, but it’s important to think in these terms and have that discussion. I would much rather have $3m EBITDA unadjusted, than $3.1m with a footnote, no matter what that footnote is — it’s the fact that there is a footnote at all that’s the problem.

Or think about it in terms of forecasts. If you give a very low forecast, you might lose the investor’s interest. If you give a forecast that’s too high, you’re probably going to miss it — and that’ll be perceived as a loss. Because of our bias for loss aversion, the pain of losing is psychologically about twice as powerful as the pleasure of gaining. So you want to lean towards a conservative estimate, reducing the scope for loss.

If I had an hour to solve a problem…

‘If I had an hour to solve a problem, I’d spend 55 minutes thinking about the problem and five minutes thinking about solutions.’ Even if Albert Einstein, to whom that quote is commonly attributed, never said it, it’s true.

People, especially in a group, tend to jump straight to solutions. In two hours, they’ll spend 30 seconds thinking about the problem, and then spend an hour, 59 minutes and 30 seconds advocating for the first solution that pops into their mind.

If you step back first and just spend time discussing ‘Okay, what’s the problem? What are we afraid of? If we do this, it’s going to be more of that but less of that. Or we could do…’, before talking solutions, you’re going to outperform by a factor of two or three.

Just carve out the first 20 minutes — even just five minutes — so everyone’s on the same page. You’ll see that the discussion afterwards is going to be very different, because now you’re actually talking about, say, how much credibility you lose with each additional EBITDA adjustment versus how much extra value you’d get out of making that adjustment, rather than just fighting for the first two adjustments that they could think of.

This is really important when you’re pitching. I’ve seen so many companies in the fundraising process constantly change their pitch or their equity story according to the last three discussions they had. Obviously, you need to incorporate feedback, but you need to consider both the positive discussions you’ve had and the rejections. Consider the whole spectrum of experiences and data points when refining your message. That way, you’re just fine tuning your pitch, instead of always overemphasizing the last meeting.

People cannot let go of numbers

The last bias I want to talk about is anchoring — where you become highly attached to the first piece of information you see. This is dangerous in a fundraising situation. You might spit out a number, and I can guarantee you that this number will be the benchmark until the very end; it’s crazy — people cannot let go of a number as soon as you’ve told them one.

I think in four of the last five exit processes I’ve gone through, the very first initial business plan, the first thing we presented, in one way or another became part of the final agreement. It just wasn’t changed, even though it was still a very early suggestion from the beginning of the process. And everyone has a story of their initial guess becoming the business plan for the next three years. The first number you put out there, it’s going to stick. So just state it; if you have to give a number you’re not sure about, make people aware of the problem: ‘I’m just telling you now, but don’t hold me to it.’

When dealing with any of these biases, the key is to avoid making subconscious, snap judgments. The big danger lies in inadvertently falling into these cognitive traps. Take a step back, think through how you’re presenting — or being presented — the information, the trade-offs for each potential action, and how much you’re being influenced by some number you saw earlier. Try to go back to first principles. Even just taking that minute to think makes all the difference. It’s still a jungle out there, but you can make sure you’re not going in circles.

It’s going to take longer than you think — always

One of the biggest points where people often tend to fall into the same trap over and over again is when it comes to the question “how long will this take?”. Whether it’s product release cycles or the fundraising process itself — time and time again, people vastly underestimate how much time something is going to take.

There’s a famous experiment on this, where a group of students were asked how long they thought it would take them to finish their master’s thesis; more exactly, before they started, they were asked to give an estimate of at what future point they were 50% sure they’d be done, 75% sure they’d be done, and 99% sure. You can probably guess what actually happened: only 13% of them actually managed to get it done by the point that they’d previously given as “50% sure I’ll be done by that time”, a mere 19% of them managed to hit their own 75%-certainty estimate, and only 45% got it done by their own previous 99% certainty estimate:

Think about that again — at a point where people themselves had upfront estimated that they’re 99% certain they’d already be done, less than half of them managed to actually be done. This is something that happens in so many different areas, and it’s a big recurring problem in so many fundraising processes. Even when they think they’re being realistic or even conservative, people are actually almost always over-optimistic about how long something as complex as a fundraise will take.

The best advice in this regard that I can give to any founder is: take whatever you currently think is a realistic expectation of how long your fundraising process will take, and double it. If actually taking that long would mean you’d be in deep trouble with the runway you currently have, you’re actually already in trouble — you just don’t know it yet.