In a bid to be more efficient and expend less brain power the mind has developed cognitive biases. Simply put, these are essentially lazy assistants that often filter out the details and funnel us into habitual thinking. Biologically speaking, it’s a great way for brains to burn fewer calories. But when it comes to deal making, these biases can slip below the radar, forcing you towards poorly considered decisions and missed opportunities.
At a time when the value of mid-market deals between in North America January at May 2016 slipped 10 per cent year-over-year to US$56.9bn and the volume of those deals has fallen from 896 to 655 according to the Q2 2016 mid-market report, the buyer’s market dynamic make its critical that dealmakers are on their game.
As Jeff Cleveland, Managing Director of investment firm D.A. Davidson so eloquently put it in the report; mid-market companies looking to sell are going to need to be aware of their biases.
“You need to be as critical looking at your own assets as you would be looking at someone else’s,” he says. “I call it the ‘mirror syndrome’ – companies often look in the mirror and see everything as beautiful, but when they look at something else through the window all they see is warts.”
Cleveland’s so-called mirror syndrome is the byproduct of several cognitive biases. But the only way to overcome them is to identify them within yourself and your organization’s decision-making team. We take a look at some of the cognitive biases that can hinder your deals and suggest some ways to subvert them.
Otherwise know as focalism, anchoring refers to our predilection to rely too heavily on the first piece of information offered when making decisions. In the case of mergers and acquisitions, the second firm tables a bid, an anchoring value in created. As both parties work through the deal, that anchoring value can influence the seller’s perception of what their company is worth, even if that value was supremely lowballed off the bat. To flip it the other way, look at the tech sector. Sky-high valuations of tech startups lacking in true value pushed perception for a number of years causing larger firms to pay exorbitant amounts for businesses they perceived to be worth more than they were. The best way around this is to strive to understand where that number came from and get an independent valuation before moving onwards in the process.
Confirmation bias is a big one, especially on the buyer’s side. This particular predilection comes into play when you give more credence to perspectives or confirming evidence that fuels your pre-existing view while ignoring contradictory facts or opinions. In some ways, this is a key bias in the “win at any cost” approach where the buyer has tabled a publicized bid and becomes obsessive about the positives that can come out of the deal. You may even find yourself referencing media articles touting the bid while shoving those that question it to the side. In some cases, this can lead to the buyer overpaying. It also can come out heavily in the preliminary due diligence process where the goal is to put together an enticing letter of intent with an attractive price range to get the deal moving. According to an article in the Harvard Business Review, this can lead dealmakers to use “current market multiples as evidence to confirm the wisdom of a deal, in lieu of a compelling business case.” The key to protecting against confirmation bias: dig in on the disconfirming evidence and pitfalls, solicit counter-opinions and genuinely hear them out.
Everyone knows it takes gall to run a company so there’s no abundance of hubris in the boardroom. Unfortunately, the c-suite’s “we can do it” attitude and overconfidence can sometimes lead to them overestimate their ability to create value in mergers and acquisitions. Overconfidence can send you down the path of a failed merger, which ultimately destroys shareholder value. Research by Matthew T. Billett and Yiming Qian found that acquirers often experience “significantly more negative announcement effects” in second or higher-order deals compared to their first deals. They also noticed that while acquisition likelihood increases in the performance associated with previous acquisitions, that previous positive performance doesn’t necessarily protect them from poor showings in future deals. One way to avoid overconfidence is to examine comparable deals in the sphere – known as reference-class forecasting – and their success rate then sees where the current deal fits amongst comparable deals and how they turned out.
Silicon Valley has proven a certain expertise when it comes to pro-innovation bias with a steady stream of so-called “life-changing apps” failing to prove value. Essentially, this cognitive funnel occurs when an innovator is so in love with their creation that they overvalue its usefulness. It comes full circle back to the discussion on sky-high tech valuations versus the reality of worth. Pro-innovation bias can often lead a business owner to ignore the limitations of their product. Much like overconfidence, acquirers can avoid falling into a pro-innovation bias by specifically picking out why a particular startup or innovative company could be a bad purchase for you. It also helps to examine other innovation mergers and figures, look at valuations and down-valuations and decide if this is a sphere you seriously want to delve into.
Bringing it full circle is Cleveland’s ‘mirror syndrome’ where everything looks rosy in your camp; the flaws are with the others. Unfortunately, it’s a lot easier to pick up on other cognitive biases than it is to pick up on your own. Don’t be ignorant to your biological predilections, study them and know how to counteract or they could cost you a deal – before you’ve even realized.