Measuring Gut Feel on Venture Investments

What's the role of gut feeling in venture capital investingCollective wisdom. Crowdsourcing. “Two heads are better than one.” We have no shortage of words and expressions to convey the idea that when it comes to making decisions, there is strength in numbers. Except research tells us that that’s not always the case.

Wharton Ph.D. candidate Andy Wu researches the role of organizational structure in entrepreneurial finance decisions. Specifically, he’s studied how choices made by individual partners stack up next to the investment decisions of their venture capital firm as a whole. Surprisingly, Wu finds that individuals often outdo the group in selecting investment opportunities that perform well, despite characteristics that initially make them appear weak.

These findings raise important questions for firms: When is it better to let a group vote on a decision, and when is it preferable to let an individual make the choice? And what procedures can firms put in place to help improve the quality of group decision-making?

Wu discussed his research in an interview with the Mack Institute. The video of the interview appears below. A transcript follows.



My current work focuses on the role of partners of venture capital firms who make angel investments on the side. What that allows us to do is compare organizational decision-making to individual decision-making. In this work, we find that individuals acting alone are able to process private information that they have that their organization doesn’t have, and allows them to make investments in firms with observably weaker characteristics, such as younger founding teams, less-educated founding teams. Nevertheless, these individual investors are able to generate the same financial return as their employing firms.

Dick Kramlich was a founding partner at New Enterprise Associates. When he first started out, he was evaluating a possible investment into a firm called Forethought, founded by Rob Campbell. At the time, Forethought was undergoing some major technological and financial challenges. And in particular, a lot of people didn’t like Rob Campbell either.

Dick Kramlich really liked the company and really wanted to pursue the investment. So he went back and asked his partners, “Can I go ahead and invest in Forethought myself?” And the partners said, “Sure, but we think it’s not a good idea.” Dick went ahead and did it anyway. The story goes, Dick goes back home. He asks his wife to stop work on the house: “We’re gonna need to mortgage the house and then put money into the company.” And he goes ahead and takes all the money out, invests in Forethought, even though everyone else thinks otherwise.

The moral of that story is that Forethought eventually renames itself. It changes its name to PowerPoint, gets acquired by Microsoft and then the rest is history. This story illustrates an example of a case where you can have organizational disagreement between the partners of a firm. And in this case, one of the partners had additional information about the company, which he was unable to share with the other partners—not because of malicious intent but because it’s information that isn’t easily transmitted.

So in this work, we identify a distinction between two different kinds of information: public information and private information. But this might be more intuitively thought of as explicit versus tacit information. Explicit information is information that within a group, the individuals in the group can easily transmit and explain to each other. That includes hard data, descriptive characteristics and other kinds of information that I could easily say, or something that I could send to you via email.

On the other hand, there’s a whole category of tacit information that a person can easily understand if they already haven’t but may be costly to acquire. For example, there’s emerging research done here at Wharton looking at the role of gut feel and investments.

The one issue there is that I can’t credibly express to you my gut feel. There’s no reason for you necessarily to believe in my gut feel, and I can’t explain how strong my gut feel is. As a result, that kind of information is limited.

We find that the partners of the VC firm individually pursue investments that appear weaker on observable characteristics. What that means is they choose to invest in firms that are on average, have weaker founding teams, with less education, who are younger, who have less entrepreneurial experience. Nevertheless, even though they appear weaker, they end up performing equivalently well on financial characteristics.

If there are differences in private information, tacit information between the members of an organization, then some of the members will have that tacit, private information and be able to act on it, whereas other parties will not. In organizations where the organization has to jointly make a decision–for example, by voting–then the partners of the organization who don’t have that private information won’t be able to act on it. This will thus reduce the decision quality of the organization as a whole.

For example, a board of directors governs all corporations in the United States. What this work can help show is that a board of directors, because of the nature of the structure of the board and the fact that they need to vote, errs toward certain kinds of decisions, like where there’s very strong public information about a possible opportunity. [They also vote] against opportunities where there’s low public information and where they require a major private information component that’s not evenly distributed among the board members.

One possible mechanism to improve group decision-making quality in entrepreneur finance is to require a stronger way for the individual partners to signal that they have additional faith or gut feel, or private information about a possible investment. One way they can do that is by putting in additional money of their own. If they’re willing to co-invest their personal money along with the VC firm, then that represents a very strong signal of their own private information.

We find that there’s a role for organizations in decision-making, and there’s also a role for individuals in decision-making. It’s not clear we should always revert to a committee to make decisions. Sometimes, that committee can underperform individuals acting alone. So the challenge here is being able to design the right mechanisms in order for us to understand when organizations outperform individuals, and when we should ex ante assign individuals to go ahead and make the decision on their own.

Editor’s note: This post originally appeared on the Mack Institute website on Oct. 22, 2015.


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