The Angel Investor’s Mind Tricks

When startups and angel investors negotiate the valuation of an early-stage business, sometimes what they’re really talking about is putting a price tag on nothing more than an idea. But how much exactly is an idea worth?

Even in those early days, some dreams cost more than others to buy into. Most people would give a few dollars to Elon Musk in exchange for shares in his next company, without even asking what it might do. And equally, if I came up with the idea to put someone on Mars, nobody should give me a dime for it—that spaceship has sailed, so to speak.

So how do you put a price tag on somebody’s dream? That question is a billion-dollar business today. Investors look for signals to predict the future, but often “signal” is just a fancy way of saying “feelings.”

What angels want

In a way, start-up valuation is all in the mind—and the mind is the easiest to change. For a founder to be successful, they need to be good at a whole bunch of things, and selling someone on joining their journey is high up on the list.

The number one reason a startup shuts down does not actually have to do with running out of money, as most would believe. Startups fail when the founder gives up. In one experiment to identify which start-up characteristics are most important to investors, the research showed that nothing is as important as the founding team.

And as Jason Calacanis, one of the earliest investors of unicorns such as Uber writes in his book Angel: “When someone tells me they have a founder they want to introduce me to but they’re worried because the person is a wild card, I set that meeting up for the next day. Angel investors are looking for wild cards, because the best founders are typically inflexible and unmanageable, pursuing their visions at the expense of other people’s feelings.”

Minding the mind tricks

For someone reading my posts, it won’t be a surprise to read that human behavior and psychology play an important part in an investment, even if it sounds like they shouldn’t. Investors are only human, and that’s true even for the institutional ones. Oftentimes decisions are made first, then rationalized using applicable facts from statistical models and technical analysis.

In essence, a founder wants to look like a solid investment. For that, they need a decent idea and a team that seems like they can deliver. It also doesn’t hurt to come across as the kind of person who’s unstoppable.

Founders can use behavioral biases to their advantage, although some of them will be easier to leverage than others.

• Fear of missing out, or FOMO for short, is one that founders notoriously try to exploit but get wrong. A founder might send an email to an angel saying that the investment round is closing, and they must decide within a week—which is all well and good until the same investor finds out about the same round being open half a year later.
• Anchoring is much easier to deploy. Founders have to know their competition in and out: which similar companies secured investment, by whom, and on what valuation? Including some of the more flattering metrics in a pitch is a must. Startups can use a comparable company with a high valuation to make their cheaper offering sound like a “discount,” or use a higher valuation to signal a more “premium” product.
• Familiarity bias might work if the investor shares similarities with the founder or with the company in some way. Are the parties from the same hometown? Are the companies based in the same state? Might be worth pointing those similarities out.
• Venture tends to work like an assembly line in which Series A and later-stage investors are looking at companies that angels have invested in, and angels are looking at whether a startup is coming from a well-known incubator or not. As a new startup, getting incubators is pretty easy compared to getting seed investment, so first-time founders should consider this option.
• Press releases and social following can be important factors. A somewhat related 2006 study found that individual investors are more likely to buy stocks that catch their attention. Any advertiser could tell you: People buy what they remember.

Because they told me so

There’s nothing new under the sun; startups already know to include anchors and credentials in their pitches, and they often try to appeal to an investor’s fear of missing out. Whether they do all of this consciously or just because someone told them to, the result will be mostly the same.

And for angel investors, it’s important to know that they are only human, and people tend to overestimate their own abilities. The successful poker player Isaac Haxton once said that the most important skill of a professional player is to know exactly how good they are: Overconfidence will bankrupt a person if they keep sitting at poker tables, going against better players.