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How VCs Think & Act: Influences of Intuition, Bounded Rationality, Cognition, and Biases

This article summarizes insights from extant literature about how venture capitalists think and act in the course of making their investment decisions. It is relevant to my PhD research for two reasons – comparing my own observations from interviewing 16 Canadian VC investment managers with those of other researchers (e.g. for consistency, divergence, or novelty) and to provide context for practical recommendations from my research for VC investment managers (primarily in Canada). Therefore, I review perspectives in the debate over VCs’ espoused ('theoretical') decision factors vs. in-use practices and summarize what extant research has suggested about VCs’ thinking and behavioural influences such as their intuition, bounded rationality, cognition & learning, and biases.

Much of extant research into VCs' investment decision-making process claims that VCs are "conspicuously successful at selecting new ventures", implying they must be experts. While I expect some are, on the basis of my estimate of lacklustre broad industry performance (where less than half of VC investments make any money at all) and other researchers' claims, there is likely room for improvement in VCs' knowledge, judgment, and decision processes. Accordingly, researchers in this field should design research to deliver phronetic contributions to VCs about their complex decision process.

Some renowned researchers in this area also claim that: what VCs say they do differs from what they actually do; VCs do not have a strong grasp of their own decision-making processes; and, VCs are limited in what they can process (which is an issue because of both the complexity of venture investing decisions and their information-laden nature). I analyze and critique these claims. Researchers in both the US & Canada have suggested VCs decision quality could benefit from using actuarial models and other decision aids. However, this assertion was based on research about VCs' screening process and not the more complex evaluation process. While I present a complex model of VCs' entire Investment Decision Process, I also propose that VCs may be able to handle this complexity through a combination of stage-wise or modular decision-making and the use of decision aids (such as those already suggested and also boundedly rational heuristics supporting each stage). Further research is required in this area.

Intuition: I provide the reader with insight into the concept of intuition by describing its 2 forms (judgment and insight), 6 characteristics of intuitive knowledge, 2 stages of the intuitive process, and distinguish between expert intuition and entrepreneurial intuition - both of which are needed by VCs. Two small studies (one being Canadian) explored VCs' intuition and concluded that VCs are diverse in their thinking models and tend to exhibit low cognitive complexity in their decision-making. This means they tend to make their investment decisions on the basis of only a limited number of dominant factors which usually includes 'Management Capabilities' plus one other (which varies among VCs). Unfortunately, other research indicates that VCs are not particularly adept at evaluating the intangible of human capital. So, VCs need better assessment methods/aids in that regard. Another conclusion is that VCs' expertise represents personally-constructed knowledge, suggesting experience plays a role in decision-making.

Cognition & Complexity: I present a comprehensive model of VCs' Investment Process which suggests there are as many as 13 factors VCs ought to consider in the combination of their screening and in-depth evaluation of prospective investments - an obviously higher level of inherent complexity than prior research indicates VCs typically process. While other research argues that decision complexity and cognitive/information loading represent challenges to VCs that lead them to boundedly rational decision approaches (which is not necessarily a bad thing), I argue that the complexity of the investment decision taken as a whole may not be a relevant perspective. This decision is not simply invest or don't: rather it is a process of sequential stages where the decision at each stage is whether to advance the investment opportunity to the next stage or not. In this context, each decision stage deals with a much reduced set of factors (from 1 to 6) which many VCs can likely handle. Some of these decision stages (e.g. screening, as other researchers have noted) would lend themselves to AI-based actuarial models. Others, like assessing 'Management Capabilities', appear to need innovation and development to improve VCs' competence & judgment. And, in other cases, decision aids may be better heuristics based on collective intuitive insights to use in a boundedly rational approach. A last consideration about VCs cognition is that their learning cycle is long because of the time required to obtain feedback on initial decisions due to long investment holding periods.

Bounded Rationality: The results of boundedly rational decision approaches are frequently as good or better than theoretical optimization approaches. However, as decision complexity and information loading increase, humans in all decision-making contexts face cognitive limitations and seek ways &means of balancing the trade-offs between the time & cost of decision processes (including searching for additional information) and the incremental quality of the decision. But, too much reliance on heuristics as norms can limit the scope of decision behaviour and reduce the search for alternatives. In some cases (particularly when information is scarce, such as for investments in the exploration/innovation stage), the combination of bounded rationality using heuristics and intuition developed over years of experience makes sense (subject to controls for certain biases identified below), particularly given the volume of such decisions most VC firms face. But, in other cases (such as investments in the exploitation/commercialization stage, which may have relevant performance track records), perhaps a more comprehensive & rational approach evaluating more factors would improve decision quality - whether that results in acceptance or rejection.

Information Availability: Most decision makers claim to prefer more information to less. But, this is not supported by research and most people typically do not analyze all the information available. VCs’ emphasize different evaluative factors according to the type of information available. They seem to have an affinity for market information; if that information is scarce (often the case involving innovation/exploration or under certain conditions of information asymmetry), VCs shift their evaluative attention to the entrepreneur-leader to assess his/her capabilities for achievement. In my own research, this was consistent with VCs seeming to prioritize assessments of 'TPM Opportunity' over 'Management Capabilities' considering the significant proportion interested in exploration-type investments.

Experience: My own and extant research both indicate that VC experience matters in investment decisions, particularly when assessing exploration opportunities and my research indicates that the proportion of VC firms pursuing those early-stage investments is much higher than 20 years ago. I note that experience has two implications in investment decision-making: (i) there appears to be a structural allocation of assessment components between more- and less-experienced VC investment managers with the former taking on more cognitively complex issues, often when less information is available and more judgment is essential; but, (ii) the making of intuitive judgments is often made with low cognitive complexity and may be subject to various biases, both of which may persist in more-experienced VCs.

Biases: Biases can impede VCs' decision-making and subsequent introspection. Extant research has identified several biases that VCs have exhibited including availability bias & the halo effect, recall bias (emphasizing successful investments and overlooking the characteristics of unsuccessful ones [also a problem I perceived in the scholarly research designs]), and overconfidence. Overconfidence is particularly prevalent and its consequences include reduced information search, inhibited learning & potential improvements in the decision process, and possibly errors of commission (funding inappropriate ventures). It is corelated with the extent of information availability, resulting in an inverse relationship between more information and lower decision accuracy. An important question is 'Why?'. It could be decision-time available vs. the volume of opportunities to screen or evaluate, managing the overall complexity as aforesaid, consistency of information framing with VCs' extant thinking models, or issues of competence with particular evaluative factors (like 'Management Capabilities'). Some researchers have offered suggestions for how to reduce VCs' overconfidence, but more research is required on this key issue - particularly if VCs want to improve their portfolio returns.

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