Potemkin Village Ventures

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Last week, at a meeting of an organization that provides pre-seed financing to start-ups with high growth potential, I was talking to several entrepreneurs about their efforts to obtain their “A” round of financing from venture capitalists and angel groups.

Once again, I heard the common refrain from the entrepreneurs that they have trouble attracting any investors to finance their companies until one of the investors becomes interested. But as soon as one investor becomes interested, many others soon follow.

This pattern – which I have heard reported many times – makes perfect sense if you apply a little social psychology to understanding how people make decisions about investing in start-ups. When things are uncertain – which high growth new ventures certainly are – people look to the behavior of others to figure out how to judge the value of something.

The social psychology of decision making under uncertainty gives us the following rule about how investors figure out whether to finance new businesses: If other people think a new venture is a good investment, then it is. If other people don’t think a new venture is a good investment, then it isn’t.

The psychological principle behind investor behavior suggests to me that public policy makers interested in encouraging high growth entrepreneurship in their region should set up “Potemkin Village Ventures”. Named for the Russian minister who erected fake villages to fool Catherine the Great, this government-led venture fund would express “fake” interest in financing new companies. As a result of this fake interest, the real venture capitalists and business angels would become interested and finance the companies.

Obviously, Potemkin Village Ventures could never happen. Not only would investors figure out what was going on over time, but government entities wouldn’t want to engage in an activity with such shady ethics.

But the idea of Potemkin Village Ventures illustrates my point. Much of what investors do when deciding which potential companies to finance is to look to what other investors are interested in to figure out what they should finance. Their decision making process involves a lot more group psychology and a lot less rational economics than many people think.

Entrepreneurs, investors, and policy makers should recognize the psychology behind investing in start-ups rather than always trying to rationalize it.

5 Comments ▼

Scott Shane


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

5 Reactions

  1. Scott,

    That’s a great way to describe investor’s behaviour! :)

    I can’t agree more – I myself do just what you write in your post – I wait for other investor to make the first move. My assumption is, that the first investor well-researches the company to invest in. So, in addition to my own investigation, the first investor’s research is actually my first screen on opportunities.

    Thanks for the great post.

    Cheers!

  2. Martin Lindeskog

    Why this “follow John” (follow-the-leader) mentality?

  3. Anita Campbell

    Scott,

    This post seems to be getting emailed quite a bit. I suspect some out there may be seriously considering taking your advice. Of course they have to keep it in stealth mode. :)

    Anita

  4. Anita Campbell

    Hi Scott, this reminds me of a related issue: the “follow the leader toward a bad business model” behavior of investors.

    A friend of mine who has been running venture-backed companies for years has privately talked about how investors are lemmings — they just follow the crowd to certain doom.

    For instance, even when a business model makes little sense, they insist on it. A perfect example right now is how most investors are going ga-ga over advertising based business models, as if advertising is right for every product or website.

    Just because “everybody else” is going after advertising, investors are pushing these startups toward advertising — even if the business makes more sense as a subscription-based software-as-service model, or a partner-channel model, or some other model.

    The problem is, it’s not just that the advertising-based portion of the model will fail because they can’t generate enough page views or don’t have a targeted enough audience to command decent CPMs. Rather, the problem is that most people seriously underestimate how hard it is to make substantial money from advertising (unless you have millions of page views monthly and can rely on AdSense). — and what a distraction it will be for the startup.

    Advertising models sound SO easy. But the result is, the startups have to invest precious time and money and staff trying to sell advertising in vain and pumping up pageviews, when they could have invested that in making a success of a different business model.

    It’s kind of sad to see these companies pushed into the “advertising model” when they would be much better off focusing exclusively on a different business model.

    Have you seen evidence of this yourself in your travels with investors and entrepreneurs?

    Anita

  5. When you are talking about franchising, you have to remember that it is the franhiSOR who is the entrepreneur and the franchiSEE is the resource for the entrepreneur who helps the franchisor to get private investors. Under federal regulatory policy, franchisees seem to be premeditated and expendable resources for startup franchisors who may be able to beat the odds of startup failure of small business organizations because they can “overseed” and not share in the failure of the franchisees in the overseeding process in the startup phase, and even later, when they have attained visibility in the economy. (See Startup Failure Rate Statistics by Scott Shane of Western Reserve University, Cleveland, on a Google Search.)

    Franchisors cannot qualify for government guaranteed and subsidized loans because they are a form of a legalized pyramid sales scheme that cannot qualify for an SBA loan —(mostly paper and no tangible assets) but, of course, franchisees, under the myth that a franchise is a business of one’s own, can qualify for SBA subsidized and guaranteed loans because they do purchase the hard assets that serve the franchise system by way of contract. This fact does help franchisors to attract private investors to back franchisors because they know that brand advertising has been very successful for the “brand” in the franchisor-franchisee union and some startup franchisors do beat the odds and stand for some period of time in the economy with guaranteed profits from system sales encouraged by “brand advertising.

    I think the business community should stop refering to the franchisee as the entrepreneur and, instead, use the term “self-employed” to describe the retail franchisee in research and Internet hype.

    Do you think franchisors could attract private investors if franchisors were required under law to disclose UNIT performance statistics to new buyers of the franchise?

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