No bridging: Why €10k probably won’t rescue your €100k investment!

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Aug 10, 2023

It’s a dilemma a lot of angel investors face: After the exciting angel round, the situation becomes cloudy and in the following months the founders run out of money and ask for a first, second or even third bridge. While bridging is part of the game and sometimes necessary, it’s also a moment to make a new investment decision.

Especially, when already a lot of money went into the startup, often investors actually don’t make a conscious decision, but rather aim to protect or recover their already made investment. In a way, they are falling prey to the infamous sunk cost fallacy.

Why do we fail to rationalize sunk costs?

The sunk cost fallacy refers to the tendency to continue investing in a project because of the resources already invested, regardless of the likelihood of success or failure. It leads people to overly consider past costs that cannot be recovered as the main decision criteria, which can cloud their judgment and prevent them from making rational choices. The fallacy revolves around the misconception that the more you invest, the greater the obligation to continue investing.

In an easy example, this means that after 30 minutes of watching a movie, you realize you dislike it and get annoyed by the main character. Still, you continue to watch for another 60 minutes, because you already started watching it. In fact, nothing would hinder you to stop the movie and leave, but most often this is not even a considered option.

Also in a world of numbers (or maybe especially so), you as an investor are prone to irrational behavior. Even if you consider yourself being a rational investor, you are very likely to be affected by subconscious biases that for example lead to falling for the Sunk Cost Fallacy. Let’s have a look at the underlying effects.

We overvalue consistency (Commitment bias)

Both individually and socially, we as humans feel guilt and regret, if we don’t stick to our decisions. This is of course due to the fact that we have to admit a bad decision retrospectively in the first place, but also with our perception of being judged by members of our society. Intuitively we tend to justify bad decisions of the past, with bad decisions in the present, by changing our attitude towards the outcome. In case of an investment, this could mean: Let’s pump in another €10k with a 2x Liquidation Preference so that I maybe can at least get 50% of my initial investment of €100k back.

This cognitive dissonance arises when we face conflicting beliefs (e.g. past decisions and present beliefs). It often leads to maintaining the status quo and “saving face”, by justifying the past decision through repeating it. Obviously, instead, we should try to reflect on our past behavior and admit mistakes, to enable personal growth and better business decisions.

Losses “feel” more powerful (Loss aversion)

As we saw already, even though the former investment in a startup should be regarded as sunk cost, investors still aim to protect it and prevent losses from happening. If times are turning and believe in a startup is shrinking, loss aversion kicks in. Instead of maximizing returns for the future (and following the principle of balancing risk and return in the investment portfolio - read more here) investors start trying to reduce their losses.

Loss aversion describes that the psychological (negative) impact of losses, weighs heavier than the psychological (positive) impact of gains. Hence, we feel losses more than gains, which is another reason why we tend to focus more on mitigating losses instead of following through on a portfolio-wide strategy of finding “fund returners” and maximizing returns.

Even considerate decision-making is difficult

Once you get to making a more conscious decision about a follow-on investment, there are more fallacies. Even when you think you make a more considerate choice, by being aware of your aforementioned fallacies, some additional effects kick in.

Seek the good, forget the bad (Confirmation bias)

When you are making a difficult decision, you have the tendency to seek, interpret, and remember information in a way to confirm our preexisting beliefs (and previous decisions). This psychological fallacy is called confirmation bias. With regard to a startup, this could mean that you unconsciously remember the one lonely success story, the formerly positive business case calculation or the strongly dedicated founders, instead of the 100 lost leads and the failed targets along the business case.

Hence, even when you are trying to make a more conscious decision (e.g. by listing pros and cons), you will end up favouring the pros and downplaying the cons of a “bad” follow-on investment.

We feel that we know better than the rest (Overconfidence bias)

In addition, angel investors (who are often entrepreneurs themselves) have a tendency to suffer above average from another related psychological bias, namely the overconfidence bias. Research suggests that entrepreneurs tend to be more overconfident than non-entrepreneurs, leading them to underestimate risks and overestimate their abilities to succeed. [1] This bias can contribute to an unwarranted belief in a startup's potential, even when faced with a changed situation and sliding beliefs.

Read more: https://thedecisionlab.com/insights/society/pacman-ghost-torpedoes

What can you do about it? Improve your decision-making!

To make more informed and rational investment decisions, it is essential to overcome the sunk cost fallacy and mitigate other biases. Here are a few strategies that we try to deploy:

Focus on reasons not to invest: When it comes to the actual decision, instead of solely looking for reasons to invest, take a critical approach by identifying and evaluating reasons not to invest first. This approach helps reduce the influence of confirmation bias and encourages a more balanced assessment. In addition, this is also a helpful strategy at the initial investment, when excitement and rush take over.
Loss in the moment of investment: The goal is to consider each investment as an independent decision, disregarding the previous amount invested. View each subsequent investment as starting from zero, evaluating the opportunity solely based on its merit and potential for future returns. This is why we work with risk-adjusted values that incorporate a discount depending on the startup’s stage in our portfolio XLS. For example, after the first round, we would apply a discount of 75% and a discount of 25% for later stages. Even though this is only a calculatory issue, it makes potential losses more visible and therewith helps to overcome loss aversion.
Consider your entire portfolio Startup investments are a game of the power law and diversifying risk with the number of investments. Hence, it helps to look at the entire portfolio and tolerate losses in accordance with your gains. With a failure rate of around 65% in the JVH Ventures portfolio, we still managed a Multiple on capital invested (MOIC) of >3x, driven by 4-5 startups of around 40 in total. Hence, losses always will be part of the calculation.

Conclusion

In conclusion, it is crucial for angel investors to avoid falling into the trap of the sunk cost fallacy when making investment decisions. The tendency to continue investing based on past investments rather than future potential can cloud judgment and hinder rational choices. By recognizing and overcoming this fallacy, investors can make more informed and objective decisions. Additionally, being aware of other biases such as confirmation bias and overconfidence bias can further enhance decision-making.

By employing strategies like evaluating reasons not to invest and taking a portfolio-wide view, investors can mitigate these biases and optimize their investment outcomes. Ultimately, making rational and informed decisions is key to successful angel investing in the dynamic world of startups. And of course, sometimes it absolutely makes sense to do a bridge and “rescue” a company.

Sources

[1] Incorporate why entrepreneurs are more prone to overconfidence: Simon, M., Houghton, S., and Aquino, K. (2000) 'Cognitive Biases, Risk Perception, and Venture Formation: How Individuals Start Companies,' Journal of Business Venturing, Volume 15, Issue 2, March 2000. (Available here.)

Are you a founder and don’t know how to think about your valuation?

Hit us up, we are happy to give feedback: www.jvh-ventures.com/pitch