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.