A LACK OF INSIGHT - DO VENTURE CAPITALISTS REALLY UNDERSTAND THEIR OWN DECISION-PROCESS

What decision criteria do venture capitalists (VCs) use to make their investment decisions? This question has received much attention within entrepreneurship literature (i.e., Wells 1974; Poindexter 1976; Tyebj ee and Bruno 1984; MacMillan, Seigel, and Subba Narasimha 1985; MacMil lan, Zeman, and Subba Narasimha 1987; Robinson 1987; Timmons et al. 19 87; Sandberg, Schweiger; and Hofer 1988; Hall and Hofer 1993; Zacharak is and Meyer 1995) for a number of reasons. First, VC-backed ventures achieve a higher survival I ate than non-VC-backed businesses (Kunkel and Hofer 1990; Sandberg 1986; Timmons 1994). Second a better understa nding of the decision process may lead to even better survival rates. Finally, entrepreneurs seeking venture funding benefit if they underst and what factors are most important to the VC. Although past research has greatly contributed to our understanding of the decision, it may b e biased and somewhat misleading. The majority of past studies rely on post hoc methodologies (e.g., interviews and surveys) to capture the decision process. Post hoc methods assume that VCs can accurately rela te their own decision processes, but studies fr on cognitive psycholog y suggest that people, in particular experts, are poor at introspectin g. Introspection is subject to rationalization and post hoc recall bia ses. Using social judgment theory and the associated lens model as a f ramework, the current study investigates how well VCs introspect about their own decision process and, by extension, whether the past resear ch efforts are biased. The current research uses policy capturing, a r eal-time method common in cognitive psychology, to capture the VC's '' actual theories in use'' versus their ''expoused thoeries'' (Hitt and Tyler 1991). Policy capturing requires that VCs make a series of real- time decisions based on various information factors. Regression analys is of each VC's decision captures how important each of the informatio n factors is to her/his actual decision process. After the VCs make th eir decisions, they provided a weighting of how they believe they used the information factors. Comparing the captured decision policies to stated decision policies provides a measure of VC insight. The finding s suggest that VCs are not good at introspecting about their own decis ion process. Even within the confines of a controlled experiment, whic h greatly reduces the amount of information considered, VCs lacked str ong understanding of how they made decisions. Most decision-makers wou ld like to have all relevant information available for their decision. However, as more information becomes available, insight diminishes. F inally, this study finds that VCs are very consistent in their decisio n process, even though they do not necessarily understand how they mak e their decisions. VCs face a plethora of information when making an i nvestment decision (i.e., business plan, outside consultants, due dili gence, etc). It may be difficult for VCs to truly understand their int uitive decision process because of all the noise caused by this inform ation overload. This lack of systematic understanding impedes learning . VCs cannot make accurate adjustments to their evaluation process if they do not truly understand it. Therefore, VCs may suffer from a syst ematic bias that impedes the performance of their investment portfolio . The methodology used in this experiment can be modified and used as a training tool for active VCs. In addition, the consistent nature of VC decision-making (even if they do not have a strong understanding of that process) is favorable to the development of decision aides. Deci sion aides can minimize the danger of salient information (e.g., the l ead entrepreneur is a winner) clouding the VC's judgment. Past researc h also needs to be interpreted in a new light. Although VCs undoubtedl y use some of the information cited in past studies, the relative impo rtance of that information needs to be reevaluated. VCs may not, for i nstance, rely most on the background of the entrepreneurial team. In a ddition, it is likely that the past studies provide more information f actors than VCs actually use. People have a tendency to overstate the information they believe they relied upon and to use far less informat ion (typically three to seven factors) to make a decision than they ac tually think they use. The methodology used in this experiment has the potential to identify the more relevant information factors cited in previous work. Even though VCs are experts in the new venture funding realm, their decision process has room for improvement. Almost 40% of all backed ventures fail to provide a return to the VC. Considering th e billions invested each year, a modest improvement in the failure rat e can have a substantial impact on venture portfolio returns. That imp rovement starts by better understanding the decision process. This stu dy is a step in that direction. (C) 1998 Elsevier Science Inc.