Loss Aversion vs. Gains Maximizing

Note: this post is one of several drill-downs on the topic of why angel investing and early-stage venture investing are not just different in scale, but different in type.

Most angel investors I know don’t consider their early-stage investments to be integral components of their personal investment strategy.

Instead, they’re more often viewed as “off balance sheet” allocations of discretionary funds — in effect, like (very) expensive consumer purchases, where the “thing” being consumed is both a low-cost, high-risk investment (similar to a lottery ticket), and an experience: the opportunity to participate vicariously in the entrepreneurial journey of a young company.

Because the good being purchased is both an experience and an investment asset, angel investors tend to value each of their early-stage investments intrinsically — a significant component of the “value” to the angel investor is their ringside seat on the startup action — and the possibility of making a significant return on their investment is a fun and exciting enhancement to the core value proposition, but often not the primary focus.

Angels with a small number of personaldiscretionary and experiential angel investments will tend to be powerfully influenced by loss aversion — a distaste for deals that have a reasonable chance of losing all their investor’s capital.

A loss averse investor will tend to favor opportunities that balance a reasonable chance of producing gains with conditions likely to mitigate losses, factors like:

  • Conservative spend and raise plans
  • Near-term focus on revenue and profit
  • Experienced, senior leadership in sales and marketing roles
  • Niche opportunities less likely to attract larger competitors
  • Strategies that cater to the needs of wealthy incumbent players (i.e., those that have the capacity to pay more for the company’s product or service)

(For more on the psychological drivers behind loss aversion, I highly recommend Daniel Kahneman’s excellent book, Thinking Fast and Slow)

Contrast this with the view of the professional venture investor

When you raise a venture fund, you undertake a set of personal and professional obligations that sharply define the roles of both the fund investor (Limited Partner or “LP”) and fund manager (General Partner or “GP”).

In the case of the LP, the allocation of capital to a fund triggers a fundamentally different set of evaluation rules than an angel investment.

Instead of buying an experience — the ringside seat to one team’s startup journey — the fund investor is buying a service — financial performance within a specific asset class. The “loss” of the ringside seat and individual control over investment selection and management is traded for the anticipated “gains” of: (1) access to better deals; (2) diversification across a broader pool of deals; and (3) improved financial performance, even allowing for the fund’s overhead (fees and carried interest charges).

For the GP, raising a fund means pledging to reciprocate the LPs expectations for the life of the fund (typically 10 years). As soon as the fund closes and the money hits the fund account, you are now a contracted fiduciary, legally and honor-bound to manage your LPs money with “the highest standard of care” to maximize gains and minimize losses within the parameters of the asset class you represent.

As a professional money manager, the GP’s decision framing is not the experience-valuing, personal loss aversion typical of individual investors, but the risk-adjusted gains-maximizing framing of modern portfolio theory, in which each individual investment position is valued for its potential contribution to overall return.

The professional investor’s focus on returns-maximizing investing is powerfully reinforced by the incentive structure of a venture capital fund. 

In a traditional “2 + 20” fee structure, fund managers are authorized to draw 2% of fund capital annually to cover operations, but have a right to 20% of fund returns in excess of contributed capital. Particularly in smaller funds where basic operating expenses fully consume the 2% annual draw, a majority of the GP’s expected compensation comes in the form of profit participation, commonly referred to as “carried interest”.

It should come as no surprise that professional investors who…

  • have a legal and moral responsibility to maximize returns, 
  • whose compensation is largely dependent on maximizing returns, and 
  • who have made a long-term commitment to operating under these restrictions (typically a minimum of 10 years per fund raised) 

…will do everything in their power to maximize returns.

Why is “returns maximizing” different from what angel investors seek to do?

In the software industry, the ability of agile, high-performing teams of digital creatives to create new product categories and / or fundamentally alter the competitive dynamics of existing industries has never been greater.

The most explosive value creation in software over the past 10 years has been wrought by companies pursuing digital disruption. And as the cost of starting a software business continues to fall, the appetite of both consumer and enterprise end-users to consume new, software-powered solutions (think iPads, smartphones, apps, etc.) has accelerated beyond most analysts’ wildest expectations.

In this environment, a returns maximizing early-stage investor with the capacity to assemble a portfolio of high-quality investments will tend to seek deals with a radically different profile than those preferred by our “typical” loss-averse angel investor.

The returns-maximizing software investor will tend to favor companies that:

  • Have aggressive spend and raise plans
  • Pursue rapid growth at the expense of near-term profitability
  • Are led by hackers who may lack traditional business experience but possess extraordinary digital creative skills
  • Seek to attack major segments of the economy dominated by established players
  • Seek to steal share, undermine pricing power and otherwise annoy (rather than support) the incumbents in their sector
Venture investors are hired to do a very specific job: putting capital at risk with a goal of producing “asymmetric” returns — where losses are finite but gains can be many multiples of the capital at risk.  Many (perhaps most) of the investors hired to do this job will fail to deliver acceptable returns to their LPs. They will not be paid for their work, and will be unable to raise capital for future funds. 
And that is as it should be.