The winner’s curse and the contingent contract.

 The investors should consider adopting what’s known as a contingent contract, which, in effect, allows founders to bet on what they say they believe about their company.

It is common for businesspeople to make excessively rosy predictions of their prospects for success. When entrepreneurs offer overly optimistic forecasts, their investors end up disappointed. But investors can contribute to this problem by encouraging founders to be optimistic. Venture capitalists often push founders to set big, hairy, audacious goals. When potential investors demand a promise of glorious revenues in five years, founders often oblige.

Let’s consider the dynamics created by these incentives. For simplicity, imagine that one investor (an individual investor or a venture-capital firm) is considering dozens of potential start-ups for a single $1 million investment. Using the information provided by the entrepreneurs, the investor assesses the expected value of each investment option. Now think of each assessment as having two parts, signal and noise. The signal is the expectation that arises from an objective evaluation of useful information. In addition, there is also noise or error that comes from the optimistic bias of the entrepreneur, their selective provision of information about uncertain events, and potential exaggerations and other distortions provided by (some) founders. The investor chooses the start-up with the highest apparent expected payoff. The start-up with the most grandiose profit projection is likely to have been biased upward by noise, leading the investor to overestimate its value.

Now let’s turn things around and imagine a start-up founder who manages to start a bidding war between potential investors. The founder is seeking $1 million and wants to give up the smallest percentage of the firm possible in return for the $1 million. You are one of ten potential funders. Due to your willingness to accept the lowest percentage of the firm in return for your $1 million, the founder agrees to the investment terms that you offered. Should you be happy?

We suggest that you should limit your celebration, because you may have just become the most recent victim of the “winner’s curse.” When many parties bid on a target of uncertain value, the winner typically pays more than the target is worth. Winning is thus more of a curse than a blessing. Not only is the “winning” investor in such an auction likely to be the one who placed the highest valuation on the firm, but they are also likely to be the one who most overestimated the value of the firm. If this happens to you, you may ultimately end up cursing both your misfortune and the biased signal that fooled you into overestimating the benefits of winning.

People typically fall prey to the winner’s curse when they fail to take into account the information present in others’ bids. The very fact that other interested bidders are not willing to pay as much as you are suggests they reached lower estimates of the target’s value. If those cautious bidders have useful information, then outbidding them is dangerous, because it increases the risk that you will overpay. The more rivals you outbid, the more likely you are to have paid too much. Winning against a large number of well-informed rivals strongly suggests you have overpaid. Thus, bidders on uncertain commodities competing against many other bidders should lower their bids accordingly. However, most people ignore this consideration, or even bid more aggressively as the number of bidders goes up.

Newly minted MBAs compete fiercely for jobs at venture capital firms, lured by legends of outsized returns from early tech investments. VCs closely guard the decision-making strategies they use to identify those few startups whose fortunes will land in the long right tail of the distribution. Yet a 2012 study by the Ewing Kaufmann Foundation found that the average venture capital fund barely broke even. Why is actual performance so weak? The winner’s curse provides part of the answer: Venture capitalists tend to invest in the most extravagantly overoptimistic start-up founders. Collectively, investors reward founders for providing low-quality, upwardly biased forecasts.

Even if skeptical investors discount entrepreneurs’ forecasts, they will have difficulty knowing the extent to which founders have exaggerated their claims. Access to better information would enable VCs to make better investment decisions. How can they get it?

One idea, used too rarely, allows founders to bet on their forecasts. Professional gamblers challenge each other’s improbable claims with the invitation “Wanna bet?” Negotiators call this wager a contingent contract.

To illustrate, let’s return to the case of the startup seeking $1 million in funding on a valuation of $5 million. A standard contract might provide the $1 million for 20% of the firm. Assume that the founder has made some quantifiable and measurable forecast based on revenues, profits, or future valuation within a specific timetable. As the investor, you could then make an offer in which the percent of the firm that you own for $1 million depends on the founder’s ability to meet their claims.

For simplicity’s sake, imagine that the founder predicts the company will be worth $10 million in two years, at the next round of funding. Instead of offering $1 million now for 20% of the start-up, you could offer $1 million in exchange for:

1. Fifteen percent of the firm if a new round of funding leads to a valuation of $10 million or more within two years,
2. Twenty percent of the firm if a new round of funding leads to a valuation of $8-10 million within two years, or
3. Thirty percent of the firm if the firm’s valuation does not exceed $8 million within two years.

Notice that when the founder believes her claim, this offer will be more attractive to her than an offer of $1 million for 20% of the firm. But if the founder has exaggerated the estimate, she will become less interested in your offer. Her reluctance reveals valuable information. If the founder declines your contingent contract in exchange for someone else’s more generous investment offer, you can feel good that you have reduced your exposure to the winner’s curse.

More broadly, leaders can think about how to create an environment that will lead others to provide accurate information by allowing people to bet on what they say they believe. This same solution can apply to internal funding. Too often, leaders reward employees for their optimism rather than holding them accountable for their predictions. Establishing incentives for accuracy can be a useful tool for helping others reduce bias. The result is better decisions—for leaders, employees, the organization, and the broader society.

by Alessio De Filippis, Founder and Cheif Executive Officer @ Libentium.

Founder and Partner of Libentium, developing projects mainly focused on Marketing and Sales innovations for different type of organizations (Multinationals, SMEs, - Start-ups).

Cross-industry experience: Media, TLC, Oil & Gas, Leisure & Travel, Biotech, ICT.