Angel Investors Rely on Gut Feel Over Data

New research shows that early-stage angel investors rely on instincts over data when looking for their next home run.

 

L aura Huang

Laura Huang, assistant professor of management and entrepreneurship

As the first source of external financing for most entrepreneurs, angel investors play an important role in the success of burgeoning startups. But investing in young businesses is always a risk. So what convinces an investor a venture is worth betting on—the product? The market data? The confidence and charm of the entrepreneur?

According to research by Laura Huang, assistant professor of management and entrepreneurship, the answer might be found in an unexpected place: the gut. In her paper “Managing the Unknowable: The Effectiveness of Early-Stage Investor Gut Feel in Entrepreneurial Investment Decisions,” coauthored by Jone L. Pearce, a University of California, Irvine, management professor, Huang examined the ways in which angel investors make decisions. When she was speaking to investors for her research, she says, one theme kept turning up: “They would talk about the size of the market; they would talk about the product. But they kept coming back to: ‘Well, then I rely on my gut feel,’ or, ‘Then I invest based on my gut feel.’”

Huang says most entrepreneurial investors are willing to be wrong, and they know they’ll be wrong often. While gut feel doesn’t necessarily help them determine which investments will bring a return, it does give them a better chance at identifying the “home runs.” “If we think about it in terms of baseball averages,” she explains, “if your goal is to have a very high batting average, your gut feel might not be as effective. But if you’re willing to have a really low batting average but hit more home runs, then perhaps you want to rely on your gut feel.”

This strategy works precisely because the ventures these investors are funding are still in development. “You’re at this stage where you perhaps may have a prototype, or maybe you just have a glimmer of an idea,” Huang says. “You’re not exactly sure what the market is going to look like. There may not even be a market out there.”

One investor said, “Sometimes I can tell within five to 10 seconds of meeting somebody whether or not I’m going to invest in them.”
At this stage, most of the numbers entrepreneurs bring to the table are just estimates, which aren’t as reliable to investors as their own experience. This, says Huang, is where gut feel takes over: “We had one investor who bought the house he lives in now in Malibu off of one investment that he made. He said, ‘You know, sometimes I can tell within five to 10 seconds of meeting somebody whether or not I’m going to invest in them.’”

 

Huang says one of the key takeaways from her research is that early-stage decision-making takes place in an uncertain environment, so angel investors play by a different set of rules. She also sees the importance of recognizing how investors make decisions that aren’t driven primarily by economics. “There are different types of data out there,” Huang says, “and the investors’ gut feel is actually trumping the data behind business viability—the hard data. So [information about] financials or market size, or product—their gut feel was a more important consideration to them than some of these other things … It’s not to say those things don’t matter… [but] we should consider these behavioral and micro-level influences.”

 

  • hitesh pant

    @Laura- Nice article. I would like to share some thoughts.
    All investments come with a factor of risk. Although I agree that most of the VCs(unlike those in India) bet their money based on their gut feelings, but there is always a ‘is it really worth’ sentiment behind every penny investment.
    After all the intention is to make money from money otherwise people would have donated that money to a charity or other philanthropic causes.
    Now what do they look for: the entrepreneur or the product or the market. For me the answer is all three. And most importantly every person associated with the idea be it the founders to the people in marketing& sales to technology play equally important role in making the initiative a success.
    It can never be a single factor that can determine a future of an entity.

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