Disruption and Investors’ Fear of Missing Out
- A new study from UC Riverside and the Rotterdam School of Management finds that fear of missing out motivates investors to give money early to startups with a disruptive vision.
- Many early backers are reluctant to invest too much in unproven ideas that might not take off. Disruptive startups are more likely to raise money, but receive smaller amounts than less-threatening ventures.
Entrepreneurs and business developers set themselves apart using 2 primary strategies.
The 1st involves emphasizing the track records and past accomplishments of the entrepreneurs and the executives they hire to run the new business and/or its unique resources.
The 2nd sees them touting what the venture will become and what the entrepreneurs will achieve. Disruptive visions fall in this category.
Disruptive innovations are those that introduce a fundamental change, disturbance, or re-ordering of the ways in which organizations, markets, and business ecosystems operate.
Netflix (NASDQ:NFLX) transformed the video-rental industry and TiVo changed the way we watch TV.
The startup world has a love affair with the concept of disruption, as evidenced by entrepreneurs like Elon Musk, who wins investors by communicating disruptive visions: one where humanity explores Mars, such as SpaceX, and another where the world transitions quickly to sustainable energy, such as Tesla (NASDAQ:TSLA).
To find out how successful disruptive visions were at attracting investors, Professor Sood and his colleagues at Rotterdam School of Management, Timo van Balen and Murat Tarakci, studied 918 startups in Israel seeking a 1st round of funding.
Israel has more high-tech startups per capita than any other country and has produced a number of highly lucrative ventures. The researchers collaborated with Startup Nation Central, a nonprofit that offers an exhaustive platform for the Israeli startup ecosystem to gather detailed data.
They found that a small increase in the disruptiveness articulated by the startup’s communications improved the odds of receiving a 1st round of funding by 22%. Surprisingly, disruptive visions gathered 24% fewer funds in the 1st round. A disruptive vision caused the typical Israeli venture to lose $87,000 in the 1st round and $361,000 in the 2nd round.
“Why might investors be so positively biased toward disruptive visions, yet opt for investing for so little?” Professor Sood said. “Our research reveals that talking about disruption can be a 2-edged sword.”
The researchers recruited 203 people with previous investment experience in exchange-traded commodities or funds, government bonds, stocks, unit trusts, angel investing, private equity funds, venture capital funds, options, or crowdfunding to answer questions about 2 fictitious vision statements, identical except for the degree of disruptiveness they expressed.
Each respondent was given only 1 of the statements, along with other company information, and asked questions about the kinds of investment decisions they would make.
The results of the experiment matched what the researchers had found in the Israeli database; investors funded disruptive startups eagerly but less generously.
The Big Q: What lures investors?
The Big A: Expectations of making extraordinary returns is what entices investors to fund the self-claimed disruptors.
A small increase in the amount of extraordinary returns investors expected made them 4X more likely to fund the venture.
Nonetheless, investors do not follow the enchanting promises of those disruptors blindly. They are aware that young companies with daring, untried ideas or products stand a high chance of failure. Investing a small amount at an early stage is like buying an option to invest more at a later stage when doing so might be less risky.
The study concludes that a disruptive vision can attract investors who wish to obtain extraordinary returns and join a celebrated group of early investors in Unicorns. But it can also deter investors from making large, speculative investments into the venture because they prefer to hedge risk Vs wait.
“For entrepreneurs seeking early stage investments, we have the following simple but important advice: carefully craft the message,” Professor Sood said. And, “If you are looking to acquire large sums of money, perhaps you should keep your disruptive plans quiet.”
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