Friday, 27 March 2009

Search theory and business investment

I visited a networking group yesterday which brings entrepreneurs and investors together to try and matchmake them.

At the end we had a conversation about how to make the group work best. One of the persistent concerns about investment networking events is that each investor just stands there while a hundred entrepreneurs swarm over them, trying to get their money.

This is unmanageable for the investor and doesn't serve the entrepreneurs very well either. Most of them get nothing and it is so competitive that those who might get an offer, get screwed down on terms.

What's more, the facades that people (particularly entrepreneurs) erect make the search for worthwhile matches difficult. Even though investors will nearly always get to the truth before providing and money, the results of search theory mean that they will have to spend more time, and will find worse matches, than if the entrepreneurs were honest (although there may be behavioural phenomena that counter this - back to that later).

This reminded me of something: the discussion of marriage competition in Tim Harford's Logic of Life. A small reduction in the number of men relative to women results in an intense competition for husbands which hugely damages women's interests. The remaining men benefit at their expense, but probably not enough to increase total utility (let alone considerations of natural justice). Of course the same applies if there's a shortage of women, though the form that the competition takes is likely to be different. To be simplistic, if there's an excess of men they may commit more violent crime, while an excess of women may become more submissive and sexually available.

A related phenomenon is this one: given that men are biologically inclined to be promiscuous, whose idea was it to form mostly monogamous relationships? Despite the intuitive answer, it's in men's interests to run society on a monogamous basis. Wikipedia has a discussion of this. Again it's about competition - if men can have multiple wives, the high-status and rich men will have four or ten each, and lots of other men will lose out.

Now the investor-entrepreneur relationship is not the same as the dating and mating game. There are naturally more entrepreneurs than investors - it isn't trivially obvious that this should be the case, but consider that there are always some ideas that won't be fulfilled; but rarely is there any money that can't be put somewhere. This implies at least that the business plans in the market at any time are requesting more money than is available to invest. Coupled with the fact that most companies request less money than the average investor has available, there must be more entrepreneurs than investors.

Thus, without some kind of intervention, the overcompetition problem is inherent in the market for investment. Entrepreneurs will always compete with each other and drive down their returns in the fight to win money.

However, this inference is based on angel investors specifically; if you include the entirety of people with savings, it may no longer be true. Indeed one of the factors in creating the distinctive startup landscape of the late 1990s was a broadening of the range of people willing to invest in private companies. This hints at a possible way to solve the imbalance.

Another reason that this market is not like the dating market is that investors can put money into several companies; a company can also have several investors; and there is a wide range of levels of commitment available. So competition might not necessarily drive down entrepreneurs' returns across the board, but instead lead to a reduced amount of money received by each.

There is a further way out of this trap: to transcend the zero-sum game. If investors are offering something more than scarce resources - knowledge, for example - then the scarcity equation becomes very different. Entrepreneurs themselves can offer knowledge too; and thus the players in the market can benefit from each other in a way that does not diminish the resources of either party. It's not obvious how to measure this economically, except to assert that if 4 investors and 16 entrepreneurs each come into a room with three things of value to offer the others, everyone in the room can go away with something worthwhile. Whereas if they only come in either offering or seeking money, most of them will probably end up unsatisfied.

And finally on the search theory point: while investors will eventually get an accurate picture of their investees through due diligence and other information gathering, the delays in doing so mean that they cannot meet as many entrepreneurs and won't find as good a match as if they had the right information up front. In a purely rational world, this does not serve the interests of the entrepreneur any more than the investor. There is still, however, an incentive for entrepreneurs to misrepresent themselves: the anchoring effect and confirmation bias. Once an investor decides she likes you (even if it's on false information) she will evaluate future information through a filter, seeking out the facts that confirm her impression rather than those which falsify it. This will offer you some advantage in pricing or competition against other entrepreneurs. Thus entrepreneurs who do not do it will lose out to those who do. But collectively, entrepreneurs don't gain from this process; they only win at each other's expense.

So how could an investment network help to serve the interests of all its members? Two primary actions would resolve the key economic problems.
  1. Provide pre-checked information about entrepreneurs to present a more accurate picture to investors in advance
  2. Balance the amount of investment sought with the amount of money available in a given group, to control overcompetition
And two secondary actions which would support the process:
  1. Reduce search costs further by providing a more efficient filtering and selection process than the investors and entrepreneurs could manage themselves
  2. Encourage advice and other value to be generated within the group, but outside of the pure investment proposition
This is in both parties' interest because of one simple exchange: entrepreneurs get to avoid the overcompetition problem, and in return, investors get to reduce their search costs.

The entrepreneur should be willing to pay the cost of validating their information - there is a "due-diligence ready" service available from lawyers Nabarro which for a fixed price helps a company to answer all of an investor's likely questions in advance. This costs around £5000 and is possibly too much for a speculative purchase - but it would be possible to design a lower-cost version of the service that could be used to prequalify entrepreneurs for the network.

One of the distinctions between economics and the other social sciences is that it lets us not just determine that a phenomenon exists, but also measure its magnitude and cost. Search theory gives us the tools to measure the benefit of this service and thus work out if it is commercially viable to provide it.

One final note: this is exactly the justification for making the provision of home information packs mandatory. In that case, the number of houses and the number of people to live in them are about the same, so the overcompetition problem is less. Thus the seller's direct benefit from the pack is less than in the investment case - which is possibly why they have complained so much about the imposition of these rules. But since nearly every seller is also a buyer of another property, they gain from the reduced search costs when buying.

Buying and selling businesses is quite like buying and selling houses - so we could all benefit from creating a "company information pack" to streamline the process.

Update: Then again, independent ratings on debt investments have been available for ages, and we have seen what that led to.

1 comment:

OldNick666 said...

Having been an entrepreneur I am now therefore able to be an investor. I see the need for two questionnaires. One for the entrepreneur and the other for the investor. If carefully devised these would allow each to set out their stall in an efficient way. A piece of software that asked the questions in a structured way and only printed those answers that were relevant would help. The aim should be to prompt thinking as much as provide a large volume of data. The fee for professional advice is probably much too high for entrepreneurs who are after all seeking finance. Maybe someone with appropriate programming skills could manage a shareware project and take input from interested parties.