Company Valuation Psychology: Emotional Biases in Investing Decision-making
Advanced mathematical techniques and high-quality data analysis often give us confidence that the company valuations we came up with are rational and accurate. However, when we value companies, we are often required to make certain assumptions and decide whether certain ideas, hypotheses or information is relevant or not. These decisions can often be influenced by our human biases.
So, to get an accurate picture of company valuations, we must understand the psychology behind valuations.
To help you remove biases from investor decision-making, in this article, we will explore how emotional factors affect company valuation decisions. Towards the end, we will even visualize a couple of scenarios where biases are likely to affect investor decision-making.
How emotional factors affect company valuation decisions?
To understand how emotional factors can affect company valuation decisions, we will study them in parts. First, we will address the biases on both sides of the table, i.e. buyers and sellers. Then, we will explore the biases a professional valuator has to fight against. Then, we will finally discuss cognitive biases that all parties involved may need to deal with.
Biases of buyers and sellers
Emotions interfering with investor decision-making are easiest to understand when the root cause of the inaccuracy is the motivations of each party. Everybody wants to get a better price. In any transaction, the seller will want to get a high valuation whereas the buyer will prefer a lower valuation.
In fundraising rounds, investors will be wary of unreasonably high valuations while founders will want to make sure that the valuation is not too low. Also, whether a transaction is executed or not depends on the initial company valuation put forward. This is referred to as the anchor since all counter-offers will be anchored around this valuation.
The responses to anchors are different among buyers and sellers.
An article published in the Journal of Behavioral Finance suggests that buyers are less likely to proceed with a transaction when presented with a low anchor (low company valuation). This is probably because they may become confident about negotiating lower valuations. Or they may feel that the seller is not confident about the equity they are selling.
On the other hand, sellers are likely to proceed with a transaction when presented with a high anchor (high company valuation). This is probably because sellers are typically at the end of their investing journey and just want to make a profitable exit. So, when they are presented with a high valuation at the start, they are less likely to drop out or make futile efforts to get a better company valuation.
So, we see that a high company valuation connects to transactions being executed.
Engagement bias
When a company valuation professional is hired, they are likely to present a company valuation that reflects their client’s concerns. The same company valuation professional will present a higher valuation when they represent the seller in comparison to when they represent the buyer.
Company valuations are also required for tax purposes when you issue stock options. To attract employees and offer better incentives to existing employees, companies will want a low valuation since it reduces the immediate tax liability of their employees and helps them capture more of the company’s growth. In such a situation, the hired company valuation professional may err on the lower side.
However, to best serve their clients, company valuation professionals must fight against this bias and provide company valuations that are as accurate as possible.
Cognitive biases
We like to think of ourselves as rational beings, however, the human brain often takes shortcuts or makes assumptions to simplify various tasks. These shortcuts and assumptions are the reason why optical illusions like crazy diamond and the Jastrow illusion exist and we see things inaccurately sometimes.
Ilda Cairns, Vice President at VCA Software, emphasizes the importance of mitigating emotional biases in decision-making, whether in company valuations or claims management. ‘Just as emotional factors can cloud judgment in investment decisions, they can also influence the way claims are handled and evaluated,’ says Cairns. ‘With the use of data-driven tools and transparent processes, we can help ensure that decisions are based on facts rather than biases, leading to more accurate outcomes and greater trust in the process.
Investor decision-making is also affected by such cognitive errors. Sometimes we put more weight on recent information than on old information even if the new information is not credible. Sometimes, we are over-influenced by how information is presented to us. These are all cognitive biases.
We have listed some cognitive biases relevant to investor decision-making in the table below:
Cognitive bias | Effect |
---|---|
Recency bias | Trusting new information over old information without verifying it |
Confirmation bias | Trusting old information even when new evidence suggests otherwise |
Anchoring bias | Negotiations being unreasonably tied to the initially proposed company valuation |
Overconfidence bias | Being so overconfident in your ability to value a company that you do not consider the points put forward by other people (both, on your side and the other side) |
Availability heuristic | Being overly influenced by readily available information instead of conducting a comprehensive analysis |
Loss aversions | Being overly cautious to avoid future losses and undervaluing the company in the present |
Framing effect | Being easily influenced by how information is presented and not diving deeper to test the suggested company value |
Exploring Company Valuation Psychology Through An Example
Let us see a company valuation psychology example with the following parties:
- Seller
- Buyer
- Company valuation professional
Scenario 1: Low initial valuation
The seller wants to sell their tech startup. The buyer is cautious because of recent negative market trends. The buyer engages a company valuation professional.
Initial valuation
The company valuation professional proposes a low valuation based on conservative estimates.
Buyer’s reaction
- Recency Bias: The buyer is influenced by recent negative trends in the tech market. So, they are cautious about overpaying.
- Confirmation Bias: The buyer looks for information that confirms the low valuation they have in mind.
Due to these biases, the buyer asks for a lower valuation.
Seller’s reaction
- Loss Aversion: The seller does not want to take a loss or accept a low return. So, they are reluctant to accept the proposed valuation and will consider it an undervaluation of their startup.
- Status Quo Bias: If the proposed valuation is lower than the previous valuation of the startup, the seller will prefer to maintain the current valuation in hopes of getting a better valuation from someone else.
Biases of both parties lead to a stalemate and the transaction is not carried out.
Scenario 2: High initial valuation
The company valuation professional is now representing the seller and proposes a high valuation based on optimistic estimates.
Buyer’s reaction
- Anchoring bias: Influenced by the high initial valuation, the buyer perceives it as a fair starting point for negotiations.
- Framing Effect: The buyer views the valuation positively because it is framed with optimistic projections and potential future growth.
At this stage, because of their biases, the buyer is already interested in the company and will make counter offers only to see if they can get a better price.
Seller’s reaction
The seller is likely to proceed with the transaction since their belief of the company being highly valued is already validated.
Fate of the transaction
In such a scenario, the transaction will likely be executed since both parties are confident in the company’s valuation.
Company valuation professional’s role
In such transactions, the company valuation professional will likely be biased towards their own clients. After all, they are the ones paying the professional’s fees. However, the company valuation professional must also note that if they propose an unreasonable company valuation, neither party will consider it as a fair starting point for negotiations. This will not only hurt their clients but it will be less likely that either party will hire them in the future.
Conclusion
In this example, we saw how a pessimistic buyer is likely to exhibit recency and confirmation bias. At the same time, we also saw how sellers may drop out of transactions because of loss aversion bias or status quo bias. When high valuations are proposed, buyers become susceptible to anchoring bias and the framing effect.
Get unbiased company valuations with Eqvista!
Whether you are a buyer, a seller, or a company valuation professional, you are not completely immune to biases unless you train yourself. Whenever you are approaching a company valuation, you must zoom out and take a look at the bigger picture. You should understand the purpose of the company valuation, your role and the biases that come with it, and the roles of other parties and the biases that come with their roles.
This will help you identify when you or someone else is making a biased decision which is the first step towards finding the true company value.
At Eqvista, we are aware of these biases and have protocols in place to address them. For instance, sometimes one of our valuation professionals will take the opinion of a team member who doesn’t know which party we are representing. This collaborative approach allows us to best align company valuations with client needs while maintaining accuracy.
This makes our company valuations easily defensible in tax audits and highly trusted on negotiation tables. Contact us to know more!