Venture Capitalists come across thousands of business ideas every year. But how do they make their investment decisions? Do cognitive biases influence them, or is there something more systematic present? Jessica Livingston, a co-Founder of Y Combinator, has an expert take on this subject. According to her, the VC herd mentality is one of the dominant factors when deciding which startups to invest in. Investors often follow trends or other VCs’ opinions rather than making decisions based on their own research or data-driven intuition. I’ve long argued that doing so may expose them to reputation risk and subpar fund performance—unless it is managed adequately.
In this post, I identify VC herd mentality’s advantages and disadvantages, explore where it comes from, provide advice to Founders who want to use it as an opportunity to raise funds, and offer guidance to VCs on how to manage their herd reflexes without damaging their business.
In This Post
How Does Herd Mentality Manifest Itself In Venture Capital?
In finance, herd mentality refers to Investors succumbing to prevailing market sentiment rather than making independent decisions. It could be influenced by factors such as media coverage of certain businesses or technologies, or peer opinion within their network. It’s an instinctive behavior that leads Investors to follow others blindly without thoroughly diligencing potential investments.
Examples of investment decisions based on herd mentality abound:
- Airbnb: Most investors had trouble understanding the startup’s value proposition, even sophisticated ones such as Fred Wilson (in a documented exchange with Livingston’s co-Founder Paul Graham) and Chris Sacca (who feared criminal acts would be committed)
- Coinbase: Garry Tan makes an eloquent demonstration of why he was the only one to say yes when everybody else said no
- Google: Bill Gurley explains why he and other VCs couldn’t get past red flags in Google’s series A round
These are all examples of errors of omission (read more about this type of mistake, which I call “the capital sin of VC” here).
VC herd mentality also occurs when Investors all jump on the same bandwagon. An analysis recently shared by the All-In “Besties” showed how concentrated VC portfolios are. To make matters worse, VC firms tend to invest in each other, compounding the concentration risk.
Everyone’s fingers are in everyone’s pies.
Laconia Capital (Source: Enmeshment in VC)
When it goes well, everybody wins. “Everyone is an investor in Facebook” was often heard when the company went public in 2012. Even I was an investor in Facebook in 2009 through a Goldman Sachs feeder fund.
When things don’t go so well, outsiders are left wondering: “What the deuce did [they] want to go in that galley for?” to borrow from Molière’s theater masterpiece The Impostures of Scapin. Think of Theranos, FTX, Quibi, and many, many more.
These are clear errors of commission. The herd mentality in Venture Capital is not, contrary to what many believe, a bulletproof way to avoid costly mistakes. Data shows that, on the contrary, outperformance comes from unique—even contrarian—bets that very few Investors are mentally equipped to make.
Where Does VC Herd Mentality Come From?
I’ve long researched the business, psychological, and even evolutionary roots of humans’ herd mentality. It’s paramount to first understand the causes before addressing their consequences.
Given the inherent uncertainty and risk in funding startups, Venture Capital is a fertile ground for such behavior. Investors must interpret weak signals to make investment decisions, often over-rely on intuition, and operate in a high-stakes activity. Given the power law distribution in VC, missing a few great opportunities could make it challenging for a VC firm to raise the next fund.
VC herd mentality is also reinforced by the unique nature of the business, which relies heavily on relationships and trust. I’ve mentioned in another post the evolutionary roots of the groupthink phenomenon in Venture Capital. Here, I link it to the evolution of the VC industry over the last five decades.
A Change In The VC Trade
I believe VC herd mentality lies in how the industry has changed since the “second coming of VC” in the 1970s. Venture Capitalists were maverick, risk-taking individuals who would help build the companies they invested in. Over time, as the asset class proved itself and matured, the nature of Venture Capitalists themselves started to change. Many Investors today are glorified asset managers who try to make safe bets with other people’s money.
This can lead to herd mentality, with Investors following each other’s lead instead of doing proper due diligence to validate an investment thesis. “Proxy due diligence“, as I call it, is the natural consequence of such behavior.
We’ve hired an entire generation of investors that do not map to those who have generated the best returns in the industry.
Chamath Palihapitiya (Source: All-In Podcast)
In a recent episode of the All-In podcast, Chamath Palihapitiya describes findings from his team’s stunning research. They explored which Venture Capitalists had made at least one $1-billion-dollar exit through a single investment and found that 20 such people existed—Fred Wilson, Mike Moritz, Peter Fenton, and Bill Gurley are among them.
The common point between them? The overwhelming majority don’t have a VP Product, Design, or Engineering background. They are exceptionally commercially oriented. I haven’t seen Chamath’s data, but it corroborates our findings from a similar analysis on the 2019 cohort of The Forbes Midas List.
I would add that these people, and other highly successful VCs that have proven their worth, are mostly promotion-focused Venture Capitalists. They focus on what can go right, are not afraid of breaking mental models honed by years of experience, and tend to make bets that are not obvious to most.
I don’t mind a 90% chance of failure if there is a 10% chance of making 100x and changing the world.
Vinod Khosla – Khosla Ventures (Source: Bloomberg Wealth)
Vinod Khosla, Peter Thiel, Chris Sacca, and others perfectly embody a recommendation from Oaktree Capital’s Howard Marks: “You have to be right and contrarian.”
As the VC industry goes through a period of readjustment, many young investment professionals who have only known an upcycle, rarely come across turmoil in their portfolio, and have banded with everyone else on the same companies are likely to find themselves “swimming naked when the tide goes out,” to quote Warren Buffet.
However, one group may benefit from the herd mentality endemic in Venture Capital: startup Founders.
How Founders Use VCs’ Herd Mentality To Raise Funds
Raising funds from Venture Capitalists isn’t easy. Herd mentality can sometimes make it even harder, especially if the startup’s idea is not apparent or mainstream enough. In addition, VCs will generally prefer to invest with people they know and trust. VC firms are often reluctant to back first-time entrepreneurs or those coming from outside their network.
This often results in protracted fundraising processes where no Investors are committing first.
Working to convince those first few investors can be really demoralizing. It’s a grind. […]. The median investor is a herd animal.
Jessica Livingston – Y Combinator (Source: Her awesome blog)
I often tell Founders I train for or advise on fundraising—especially those who must convince Investors in 45 minutes on a TV show I take part in—that they have to make herd mentality work for them, not against them.
There are two effective ways to accelerate a funding process by playing on psychological levers:
- Identify and convince a promotion-focused VC first, who tends to make decisions based on first principles and their own analysis. They will then attract prevention-focused Investors, who rely on the “Who else is investing?” question to be swayed. More on this tactic in the Killer #3 point of my webinar 7 Startup Fundraising Killers (use the Chapters button on the player bar to navigate the video)
- Create FOMO to entice said herd Investors to send a term sheet. In her post, Livingston illustrates the “free option” strategy most VCs employ to jump on the bandwagon once a startup’s process starts picking momentum. Most herd Investors will delay a decision until this happens, then send a term sheet out at lightning speed. More on how to create Fear of Missing Out in my webinar 3 Effective Methods To Contact Investors (it’s the first point I make)
Here are two world-class illustrations of this tactic at work.
Elizabeth Holmes: Using FOMO on the DeVos Family Office
Court depositions in the Elizabeth Holmes trial show how she leveraged FOMO to convince the DeVos family to invest money in Theranos.
Holmes was able to garner a $100 million investment despite inadequate due diligence on the family office’s part. She crafted a narrative that painted her company as an innovative force in the healthcare industry. She discussed how competitors were investing heavily in the company and that failing to do so would leave the DeVos family on the sidelines.
I think that the Fear of Missing Out is endemic in our species, especially in uncertain likelihood, high-return possibilities. Creating FOMO is part of the entrepreneur’s job.
Bryan Roberts – Venrock (Source: The Dropout podcast)
In my webinar Why Venture Capital Due Diligence Fails, I play the portion of the lengthy trial reported in the excellent podcast The Dropout, which details how Holmes expertly used FOMO to attract Investors to her company.
Elon Musk: The $1-Billion Text Message To Finance Twitter’s Acquisition
Another court exhibit, this time in the Twitter vs. Musk (short-lived) kerfuffle, shows how Elon Musk masterfully utilized FOMO to attract big-name Investors when attempting to acquire Twitter.
Text messages released as part of Exhibit H describe how he proposed a plan involving him investing heavily in the acquisition and followed this up with an ultimatum. If they chose not to invest, he suggested they could only watch as others took advantage of the opportunity while they missed out on possible gains. Musk relied on scarcity and time pressure, two components that influence us in purchasing decisions.
As Hoffman, visibly pleased, asked how much would be acceptable to invest, Musk casually texted back: “$2B?”. Done deal.
I’ll soon write another post dedicated to Musk’s fantastic ability to raise billions like others sell lemonade stand tickets. Subscribe to my newsletter to get the info first!
These are two visible illustrations of Founders creating FOMO to benefit from the VC herd mentality. To conclude this article, I want to turn to how VCs can limit collateral damages from what can be perceived as an excess of it.
How Venture Capitalists Can Avoid Damaging Their Reputation Despite Herd Mentality
I want to clarify again that I don’t see this type of investing as inferior or to be avoided at all costs. I’ve studied enough psychology (an ongoing endeavor) and have met enough VCs to know that changing one’s mentality on this front is no easy task.
Instead, I try to help the VCs I train accept their investment style while avoiding being stigmatized for it. Likewise, I help Aspiring VCs better understand who they are so they can apply to the right type of firm. Being a prevention-focused Investor requires a different skill set than promotion-focused VCs.
One such advice I offer is to be open and transparent with fundraising Founders. Instead of delaying an answer to keep the investment option open, prevention-focused VCs should make clear early that the investment opportunity is not evident to them, but that they know other Investors who are experts and whose opinions could sway them.
Making warm intros to other VCs on an opportunity you are not hot about is a hard sell. Besides, nobody likes a free rider. However, just as Venture Capitalists cultivate a network of peers to co-invest with as part of their syndicates, they should also establish relationships with proven promotion-focused VCs to refer investment opportunities to them. It is another type of win-win relationship.
The right type of Founder will remember the gesture and extend an invitation to invest when their process gains momentum.
Conclusion: tl;dr
Herd mentality is a phenomenon that affects many decision-making processes, including Venture Capital. It comes from a combination of factors, including fear of missing out (FOMO), risk aversion, and peer pressure. FOMO is mighty as it creates an environment where people feel they must act quickly or they will miss a chance at success. Similarly, risk aversion can lead individuals to follow the herd to mitigate potential losses. Finally, peer pressure can create a sense that everyone else is going in one direction, leading to conformity and the acceptance of group norms.
Herd mentality is difficult to change, as it has deep evolutionary and psychological roots. In Venture Capital, professionals exhibiting such traits have considerably increased as the asset class matured. However, instead of being a force shielding Investors from mistakes, herd mentality tends to increase the likelihood of both errors of omission and commission in an industry relying on a few extraordinary winners to make all its returns.
By using FOMO to create an atmosphere of urgency and importance, Founders can take advantage of the VC herd mentality to attract attention and get the funding support they need.
On the other hand, VCs should be cautious in artificially delaying their investment decision to follow the herd. To avoid damaging their reputation, they should make peace with that personality trait and help Founders who contact them by introducing them to promotion-focused colleagues at other firms.
