Fake it until you make it?! How to separate the good from the bad (in start-up investing)

Extreme Number 2

At the same time, some frightening headlines reach us from Silicon Valley: the healthcare start-up founder Elizabeth Holmes just got sued on several accusations with fraud being the main one. What happened? Well, she was basically lying about the effectiveness of her product, blood tests, to her investors while they poured in money in good faith based on wrong assumptions.

Sure, we can hardly compare those two companies based on company stage. But the point is that looking at those two extremes gives light to the ambivalence of start-up investing: it can be highly profitable or likewise very risky. What we want to cover today is looking at the cause for an investment scenario like the one with Elizabeth Holmes’ Theranos and how to prevent you from taking on investments that turn out to be a painfully wrong decision for your investment performance.

“Fake it until you make it!”

In Silicon Valley it is a common practice for pre-seed until early-stage start-ups to be very optimistic about their product towards investors – sometimes even a little too optimistic. “Fake it until you make it” is an aphorism that suggests that by projecting confidence or competence as well as an optimistic mindset, a person or a company can realize those qualities and achieve the results they seek. In real life, this could mean giving out a slightly better KPI on the effectiveness of a novel drug or, let’s say, a blood test, even though you might not be there yet.

What Elizabeth Holmes called “faking it until I am making it!”, Investors now call fraud and a lie. Thin ice.

While optimism generally speaking is something to aim for in life, in business you should be careful not to mistake reasoned optimism with boundless optimism – sadly, in the start-up world, the latter is usually taken into account.

Information Asymmetry

This leads us to the main cause of bad investment decisions in healthcare start-ups: a phenomenon known as information asymmetry that some of you might recall from some distant microeconomics session back in business school. Information asymmetry describes the misalignment of knowns between, in our case, a start-up and an investor: while the start-up founder usually knows every inch of his business and his sector (at least that should be the case), investors are most times just scratching the surface – they can’t understand the background of every business they invest in because it is a life-time challenge to become an expert in more than one field. Now, this is leading to a dangerous scenario where the start-up can “sell” their company as a more than decent investment opportunity with half-truths and optimistic outlooks regarding their product while the investor can’t do anything else but nod and believe. In the context of business, all the explained above is also called “adverse selection”.

Moral Hazard and the Monopoly of Knowledge

From adverse selection we get to more principles in just a few more strokes of thought: Moral Hazard occurs as soon as someone takes on increased risk because he does not personally bear the full consequences of that risk. As a start-up founder, it can quickly happen that your company starts to belong to investors more than it belongs to yourself – at this point, founders might start to either unintentionally or even deliberately take on risks with a Moral Hazard component.

Going further down the rabbit hole, in a Monopoly of Knowledge only a few selected individuals are presented with the necessary information to understand a situation fully while a broader group of people then must make a decision with limited information. In start-up investing this happens for example when investing through a middle-man and investment specialists that do not provide a solid due diligence process of the start-ups they invest in.

Steps for making better investment decisions

1. You yourself should intend to understand as much of the business you are investing in as possible: investment material like business plans, pitch decks, or exposés should be read carefully.
2. Get to know the founders, either personally or through research, to know who stands behind the business you are about to invest in.
3. Look for skin in the game: what do the founders have to lose? Is there any of their own money in their business? If you are investing through an investment specialist or a platform, ask yourself the same question: what do they have to lose from keeping informations and being responsibe for bad investments?
4. Eventually, in healthcare investments, you should be either an expert in the field by yourself or if not, you should definitely look for an investment specialist to invest along with.

How Aescuvest is aiding in diminishing Information Asymmetry

As a healthcare investment specialist with a focus on digital health, Aescuvest has the needed capacities to evaluate healthcare start-ups properly and understand businesses at least as good as the founders themselves. Like this, no one can nose around Aescuvest into poorly made investment decisions. Furthermore, our investment committee consisting of many international, external healthcare experts, breaks up the Information Monopoly by screening a start-up thoroughly and communicating results openly with Aescuvest. Finally, making investment decisions is Aescuvest’s job – this means, the Aescuvest team has a responsibility to make proper investment decisions that won’t hurt the company’s reputation in future. Aescuvest is here to stay and therefore intends to make sustainable decisions with the investors best interest in mind.

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