Source: Billy Fink, AxialMarkets
A market downturn, skewed valuations, skeletons in the closet — there are hundreds of factors that can derail an otherwise perfect opportunity. While some of these disruptors are truly factors out of your control, there are other risks that you unknowingly may be bringing to your deals.
Cognitive biases are defined as “mental errors caused by our simplified information processing strategies.” In other words, they are the ‘human’ errors that can derail any negotiation or deal. These risks are particularly dangerous because we are not even aware we are committing them. Some believe they even contributed to the 2008 financial crisis.
While entirely avoiding these biases is nearly impossible, you can mitigate their consequences by keeping them top of mind. Below is a brief review of some of the biases likely to impact your next deal.
Early in the Deal:
Cognitive biases can begin impacting your deal even as you source new opportunities. Factors including when and how you interact with a specific intermediary may significantly impact your valuation of a specific investment opportunity. Here are a few to keep an eye out for:
- Framing: Do you view the glass half-empty or half-full? As it turns out, the answer might not be entirely up to you. Framing — or the context in which a situation is presented to you — can significantly impact your impression of an opportunity. If a situation is framed in a positive manner, it can make you more interested and risk tolerant. Make sure you are not avoiding risks — or unnecessarily attracting risks — just because of how the deal was presented to you. Also look to see that your initial reaction to the deal is purely based on the quality of the deal, not quality of presentation. A helpful trick might be to present the opportunity to another member of your firm as objectively as possible.
- Anchoring: Anchoring, or the tendency to rely on the first piece of information offered in a conversation, can be particularly impactful on negotiation around valuations. Most people tend to use an initial piece of data as a reference point — or “anchor” — for the entire conversation. For example, if a banker initially suggests that a type of company values at 6.5x – 7.5x, the conversation will likely remain somewhat pegged to those numbers. To avoid succumbing to the effects of anchoring, run your own estimates before meeting with the intermediary and try to weigh all pieces of information equally. If you are selling a company, be careful not to anchor higher than the market will allow.
Note: Anchoring does not only pertain to numbers or statistics; it can also affect your impressions of an individual. First impression of personalities are also notoriously hard to shake.
Later in the Deal:
As you move past LOI and into a full-fledged deal process, you expose yourself to a whole new set of cognitive biases and fallacies. As you conduct later stage negotiations and due diligence, be wary of:
- Confirmation Bias: Confirmation bias, or the tendency to favor information that confirms existing beliefs or hypotheses, can become particularly problematic during the due diligence process. The bias can cause you to seek out and selectively remember information that supports your initial hypothesis — if you think the opportunity is strong, you will seek out evidence to support its strength. Your biased approach could result in incomplete due diligence or primed questioning. One of the best ways to avoid confirmation bias is to hire third parties to conduct effective and complete due diligence. Relying too heavily on those involved in the deal — on either side of the table — can yield biased results.
Note: Even hiring a third-party for diligence does not necessarily guarantee the data will be interpreted correctly. Conservatism bias, another risky bias, causes individuals to inappropriately interpret — or completely ignore — new information in an effort to defend their initial hypothesis.
- Cognitive Dissonance: If your initial hypothesis becomes challenged, you may quickly experience cognitive dissonance, or the distress felt when you simultaneously hold two contradictory beliefs. In the deal process, the bias most often appears when a disappointing realization develops — like when you discover a risky skeleton in the closet of an otherwise perfect company. You can either satisfy the dissonance by believing that the skeleton is not that bad, or by backing out of the investment. Make sure you are fully aware of impact of skeleton if you choose to stay in the deal.
- Groupthink: Unfortunately, cognitive biases can emerge from within your firm as well. Groupthink, or the tendency for an individual to adopt the mindset of a larger group, most often occurs intra-firm rather than inter-firm. The pressure of conformity and the desire to fit in can often drive those with minority opinions to silence their doubt. Because of this bias, certain doubts and issues around the viability of a deal may be left unquestioned. One of the best ways to counter groupthink is to allow individuals to express their initial opinions in smaller, more personal settings. If you are a leader in the organization, allow others to voice their opinions before announcing your own.
After the Deal:
Even after successfully closing a deal, cognitive biases may cloud your key takeaways.
- Hindsight Bias: Hindsight is always 20/20. But, beware this old adage for it has the risk of skewing the valuable lessons offered by past successes or failures. Hindsight bias, or the tendency to interpret events as being more predictable than they truly were, can falsely depict a deal as being simpler than reality. You can counteract hindsight bias by keeping a careful log of the deal process while it is happening in order to remember the variety of factors that impacted each stage of the deal.
- Outcome Bias: The outcome bias, while similar to the hindsight bias, is the tendency of an individual to remember an event solely based on its outcome. In other words, it asks “Do the ends justify the means?” Such focus on the result of a deal can risk the development of bad deal practices and techniques. Just because something worked once does not mean it will work again. It is important to always adhere to deal best practices to ensure success.
About Scale Finance
Scale Finance LLC (www.scalefinance.com) provides contract CFO services, Controller solutions, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, business valuations, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance LLC has offices throughout North Carolina including Charlotte, Raleigh/Durham, Greensboro, Wilmington, and Southern Pines with a team of more than 45 professionals serving more than 120 companies throughout the region.