Trust your selves – both of them.
Trust your selves – both of them.
The Role of Conscious and Subconscious Cognitive Processes in Soft Due Diligence.
TL;DR:
Assessing an Investment Opportunity is not a purely rational activity, and it does not have to be. Rather the reverse!
Our brain provides us with more than just rationality, and according to the founder of Analytical Psychology C.G. Jung, there is even a completely separate entity inside our mind that can be hired for the job.
In this article we explore some cognitive concepts borrowed ruthlessly from science and bent into a shape that allows us to dig deeper into Soft Due Diligence. No psychologists have been harmed during the writing of this text.
Soft Due Diligence is the process of gathering and assessing information about the non-financial and non-legal aspects of an investment opportunity. Researchers are clear about the importance of doing so, the evaluation of “soft data” in Venture Capital (VC) and Mergers & Acquisitions (M&A) is clearly a factor for success and helps limiting the chances of failure of a deal.
The relevance of Soft Due Diligence is obvious in situations where little tangible data is available, e.g. early-stage Venture Capital investments or capital allocations to First-Time Funds without a track record. Even later stage VC investments or M&A deals, typically involving more mature companies, benefit from increased attention to soft factors.
M&A deal teams who evaluate soft factors intentionally, systematically and with a structured approach increase the chances of post-deal synergies in a significant way (1) and a study by the University of Chicago (2) found that VCs who focus on soft factors are also more likely to make successful investments.
But how does that work? Is it an entirely rational process, like financial and legal due diligence?
The answer is: yes and no. Soft Due Diligence clearly benefits from that intentional, systematic, and structured approach: knowing where to look is important, and trying to get a complete picture by planning ahead helps. Also, Soft Due Diligence should contribute to organisational learning and growth, and understanding in depth how to perform it helps making the process reproductible and the results comparable, and to a certain degree quantifiable or measurable.
But not everything in Soft Due Diligence is rational, and that’s ok.
It is even more than ok: non-rational approaches are rather an asset for success in this field than an obstacle to effectiveness. Becoming aware of how our mind works in these situations can improve our ability to collect data and take decisions, and also to better understand how other people take their decisions.
In a number driven world with a tendency to believe that everything can be expressed and understood through quantifiable data, using one’s full cognitive capacity helps to see also the data that is not necessarily quantifiable, but none the less relevant.
Venture Capitalist’s Magical Powers.
Let’s take Venture Capitalists as an example: very proud of their professional capabilities, they almost define themselves through their ability to hunt down the next good deal. Most of them, however, do not have a clue about how they are doing it: according to research (3), most VCs do not understand their own decision-making process (and they are perfectly fine with that).
“Gut Feeling” is the most cited resource when it comes to explaining how to distinguish a good deal from a bad one. It sounds like a mythical, magical capability, that escapes rationality and logical explanation. It provides an additional aura of “you just got to have it” to the bearer, and the luxury of not having to explain anything. No surprise here because research (4) also found that VCs are notoriously bad at introspecting.
But research also comes to rescue when trying to understand what this “Gut Feeling” really is: Laura Huang, after examining investor’s decision making (5), finds that it is a complex process that involves both emotions and cognition. More than pure magic and divine inspiration, “Gut Feeling” actually combines investor’s accumulated treasure trove of experience combined with their creative ability to recognise patterns and draw conclusions from them.
Our Brain runs on two Systems.
Nobel prize winner Daniel Kahneman’s research gives us another model that provides insights into the cognitive mechanics at work here. In his book “Thinking fast and slow” (6) he explains that our mind is split into two systems: System 1 and System 2. System 1 is a collection of stored and pre-configured routines that we use regularly and often. Nobody has to stretch her or his mathematical skills to find the solution to the equation “1+1=?”. The answer is instantaneous, given without hesitation and few people feel they have to think hard in order to find it.
Asked to solve “178.262/512=?”, however, most of us will fall silent, our lateral vision narrows, our iris focusses, blood is diverted into the brain, amid many other physical manifestations that happens when we concentrate.
This is System 2 kicking in.
System 2 is there to solve problems that are not pre-configured in System 1, and that need bespoke thinking. System 2 is doing proper hard work, and it feels like that: when we solve complex problems with our System 2, we feel the strain and it drains our energy. When we’re done with System 2 thinking, we sit back and sigh deeply, in dire need to replenish our batteries.
When we use System 2 often enough for one particular type of task, our brain considers that it is worth creating a shortcut to the solution. The experience gathered from using System 2 on this task is packaged for use in System 1 and from now on available for quick, effortless deployment when necessary.
The Limitations of thinking fast.
This is part of learning; however, it is also part of how biases are formed. By creating a shortcut, our brain allows us to go faster when triggered by something we know. But how closely related is the actual situation that triggers this fast response to the one we think we know? There is a margin of similarity that allows us to use System 1 in situations that resemble the ones we experienced and that made our brain create that shortcut in the first place.
Using System 1 is comfortable and saves energy: it is doing what we are used to do. Following a routine and acting according to our habits feels safe. We have a tendency to match the unknown with the known, and that can give us the false impression that we are actually dealing with something we know. It’s all about saving energy and keeping that saved energy for moments where System 2 is required to do the hard work.
And we make mistakes doing that: “I have seen this 1000 times, I know what to do” means that we use our experience to solve a problem, but it can also mean that we look at a problem in a way that allows us to solve it with the tools we have. Paraphrasing Abraham Maslov’s “law of instrument”: if all you have is a hammer, everything looks like a nail.
Cognitive Dissonance to the Rescue.
But how does our mind recognise that something needs the big guns of System 2? One possible explanation is the concept of “cognitive dissonance” developed by Leon Festinger (7): our mind usually cruises along, keeping all vital systems going while saving energy by relying mostly on the efficiency of System 1. As long as everything going on around us “makes sense” we stay in this state of “running on autopilot”, effortlessly navigating our reality.
That is what happens for example when driving a car on the motorway. Most of the time, we are not actively and consciously checking what is going on around us, and sometimes we “wake up” and ask ourselves what happened during the last 20km and how we managed not to crash the car while apparently driving unconsciously at high speed.
In reality, we were totally capable of keeping our vehicle under control, our System 1 taking care of most of the driving.
Novices would not be able to relate to this, as they will have to drive mostly using System 2 because every situation is quite new to them. Driving as a novice is exhausting and requires a lot of energy. Things that would not even catch a confirmed driver’s conscious attention are a trigger for novice drivers, keeping them in a state of constant alert.
This “catching the attention” is what cognitive dissonance is about. According to Festinger, cognitive dissonance happens when “inconsistency among beliefs or behaviours causes an uncomfortable psychological tension”.
Staying in our motorway scenario, as long as nothing unusual (i.e. anything that System 1 cannot deal with) happens, we continue cruising. As soon as something happens that does not fit the expected scenario, we enter a more or less intense state of alert, and we fire up System 2 to assess, understand and react to the unexpected event. The intensity depends on the difference between the scenario we were expecting, and what we are observing in reality. A car slowly changing lanes will trigger us less than one that zig-zags uncontrollably in front of us.
It looks like there is part of our mind constantly monitoring the reality that we perceive through our various senses, and that checks it against a dynamic reality that we expect. Cognitive Dissonance happens when these two do not match.
Our two selves.
What is this part of the mind, that is doing such a great job – without us even noticing – until our conscious intervention is needed?
Well, it seems a completely distinct and autonomous personality lives inside us. Early 20th century psychologist C.G. Jung found that we have at least two personalities, our conscience, and our subconscious. Some of us might have more than one conscious personality, one for private use and one for professional use for example, but C.G. Jung draws the line at two. If you have more than two, go and consult the psychotherapist of your choice, he advises.
C.G. Jung describes the subconscious as an actor distinct from our conscious mind. For him, the subconscious draws from an individual’s personal life experience, but also from intergenerational and collective experience. Basically, our subconscious links us to our lineage of ancestors and at the same time to humanity as a whole.
This theory unsurprisingly raised some controversy, and research in psychology in the past 100+ years certainly had something to say about Jung’s propositions. But for us it comes as a useful model to understand decision-making in Soft Due Diligence. Perhaps our subconscious is this part of Laura Huang’s “Gut Feeling” that is informed by our personal experience, and according to Jung, also by the experience of our forefathers and foremothers, and humanity or society at large.
Based on Jung’s developments, our subconscious might also be the “monitoring instance” mentioned before, capable to alert us in case cognitive dissonance happens. This instance, sort of background process of our mind, seems to come from the dawn of our species, mediating between the necessity to save energy and the need to ensure survival.
Palaeolithic example: from the edge of our vision, we perceive a rustle in the leaves of a bush, and the subconscious nudges us to watch this area a bit closer, in case there is a sabre-tooth tiger waiting for us to become his lunch. At that moment, probably just a little more adrenaline in the bloodstream, and a feeling of slight unease. Perhaps not even consciously noticing where this is coming from, just like what Festinger calls psychological tension.
But once the sabre-tooth tiger jumps out of the bush, all our systems are powering up, and we go into fight, flight, or (not recommended) freeze mode.
Restoring Consonance.
What does all this have to do with a Venture Capitalist assessing an investment opportunity?
Everything.
When evaluating a new venture, we have a certain idea of what we are looking for. We want a scalable business model, a product with a “huge” market, and a capable team to bring all this to life. We see presentations, perform due diligence, talk to people, and we try to find out if this particular venture corresponds to our criteria for an investment with potential.
But when the facts don’t add up, we experience cognitive dissonance: these financial projections do not make any sense considering the roadmap the team is presenting to us. We were expecting something different. Why is that so? Let’s go and find out!
Cognitive Dissonance leads us to pay attention to this inconsistency in our perception that served as a trigger. Festinger describes what happens then: we try to reduce the dissonance by changing enough of the inconsistent elements that triggered us in the first place. Here, changing can mean for example that we try to rationalise the situation in order to understand what happens and what the potential consequences are.
The rustle in the leaves was just a furry peaceful mammal, and the startup founders have a very convincing rationale explaining why the financial projections and the roadmap actually correspond. Alert is over.
Festinger explains that cognitive dissonance prompts us to become active, and either reduce the dissonance or add consonant elements to restore consonance.
Harnessing the Power of the Subconscious.
In the above example, cognitive dissonance was triggered by a rational assessment: what is the rational link between the roadmap and the financial model? Based on my experience, I can estimate the financial needs for this venture’s go-to-market strategy, and if this is inferior to the budget they put aside for that purpose, I see a problem.
In Soft Due Diligence, however, we rarely deal with hard, quantifiable data. Rather squishy, fuzzy information that allows multiple interpretations. It is not objective data, and any interpretation will always be subjective by nature.
Terrible news for our analytical conscious mind looking for rationality, but the good news is: we are not alone. There is a second personality inside us that deals very well with these less rational aspects.
We feel that something is not right with the story that we are being told. Something does not add up. In French we say “Je ne le sens pas, ce truc …”, I don’t feel this thing, literally. We can’t say why, but we just know that something is wrong here.
That feeling is located somewhere in our body, very often in our belly, right? Here we are: “Gut Feeling”!
Instrumentalising Cognitive Dissonance.
Now how can we instrumentalise this? How can we use all this in our professional (even personal) life? How does this potentially improve our assessments , and helps us make better investment decisions?
First of all: we need to listen.
At least in our “western” societies we are so focussed on rationalising everything, that emotions are totally underrated in terms of producing valuable insights. Everything has to be demonstrated by hard data, if there is not a number or a hard fact supporting something, it did not happen.
By taking our emotions and feelings into account, we add another, equally rich layer of information to our assessments. Remember, C.G. Jung told us there is a whole second personality in our brain that we can recruit to assist, and to provide us with a totally different point of view. As with anybody else’s opinion, we can take it or leave it, but it might be worth listening, and giving it a thought.
In order to take advantage of this additional source of data, we must learn how to access it. Sometimes the emotion is obvious and manifests itself loud and clear. At times, however, querying our emotional state requires to take time, to take a break, to step back and ask ourselves: “how do I feel about this?”. We need to pause to engage in a conversation with this other instance in our mind to be able to draw from its particular insights.
Then follow your “Gut Feeling”, but consciously.
Try to figure out where the “psychological tension” came from. Is it linked to something that you read or that somebody said? Have a critical look at the situation, the people, their behaviour, and also at what has been said, then try to understand what made you feel like that. Sometimes it is obvious, but in other cases it might be an emotion that you cannot clearly associate with anything tangible, yet.
Let your mind wander: for example, retrace your steps and replay that conversation in your head to see if you can link that emotion to a particular part of it. Often, this works best in situations where you are not sitting at your desk, straining your mind to concentrate on something. Take a walk, have a coffee, stand in front of the window, and let your mind freewheel, while staying attentive to where your thoughts are going.
This is not very different from the creative processes employed by artists and designers. You might be surprised where your “Gut Feeling” takes you when you let it take the lead, and how many surprising, yet valuable insights will come out of it.
Make it Intentional!
In Soft Due Diligence, we want to develop a holistic understanding of an investment opportunity. We want to use all the data we can access and draw conclusions from an assessment that validates the coherence of what we see. To develop a truly holistic view, we need to use all the means at our disposal, and we have seen that there are more than what we systematically use.
We live in a world that privileges rational thinking, and our socialisation, education and schooling has trained us to approach anything we do from that angle. But we can learn to harness the other resources we have available, just as much as people can learn and embrace creative approaches, that combine cognitive and emotional faculties of our mind.
The clue, in our opinion, is in the intentionality. It is not about flipping the whole thing upside down, and discard rational, analytical thinking. It is not about some new-age hippie thing. It is about benefiting from the best of both worlds. Considering where we come from culturally, it is not a surprise that taking into account the non-rational faculties of our mind does not come naturally. We need to train ourselves to use them systematically and intentionally.
Note: The content provided in this article is for informational purposes only and does not constitute financial or investment advice.
(1) Warter, L., & Warter, I. (2015). Cultural Due Diligence as Advantage in Cross-Border Mergers and Acquisitions. Bulletin of the Polytechnic Institute of Iasi, Romania, 59-71.
(2) Soft Factors Matter: The Role of Human Capital in Venture Capital Success by Brad Feld, Ethan Mollick, and Michael Pratt. Journal of Business Venturing, 2011, 26(4), 439-451.
(3) Shepherd, D. A. (1999). Venture capitalists' assessment of new venture survival. Management science, 45(5), 621-632.
(4) Zacharakis, A. L., & Meyer, G. D. (1998). A lack of insight: do venture capitalists really understand their own decision process?. Journal of business venturing, 13(1), 57-76.
(5) Huang, L., & Pearce, J. L. (2015). Managing the unknowable: The effectiveness of early-stage investor gut feel in entrepreneurial investment decisions. Administrative Science Quarterly, 60(4), 634-670.
(6) Kahneman, D. (2011). Thinking, fast and slow. Farrar, Straus and Giroux.
(7) Festinger, L. (1957) A theory of Cognitive Dissonance, Stanford University Press, Stanford, CA