Fairness As Winning Long-Term Strategy

Recently a startup that was on the brink of a new funding round with nearly $10 million in annual revenues was forced to shut down.

Who forced it to shut down: Its existing investors!

Why?

Because these investors had previously invested at a much higher valuation and would rather shut down the company than accept a down round, sending the strongest possible signal to management and new investors of their disapproval of the turn of events.

The clue to this quite irrational action is the insight uncovered by psychologists and behavioral economists in the famous Ultimatum Game experiments:

In this simple experiment, one player, the "proposer," decides how to split a sum of money with another player, the "responder." If the responder accepts the split, both players get the money as proposed. If not, neither player gets anything. The players that end up with any money after the game are those that split the money more or less evenly, even though rationally a responder should accept any amount of money offered.

What we learn here is profound: people place a high value on fairness, even at a cost to themselves. Once a player suspects another player of being unfair, they would rather walk away from money than have the unfair player gain anything.

Ultimatum Game teaches that we punish those who don't treat us fairly, even if that punishment costs us.

This instinct for fairness over mere gain offers a powerful lens to view investor and entrepreneur dynamics in the startup world, especially as many startups struggle to maintain the high valuations of venture rounds closed in 2021 and 2022.

Fairness Overrides Immediate Gain

Investors, like all humans, are influenced by their perception of fairness. They react not only to financial outcomes but also to the emotional and ethical implications of those outcomes. A lower valuation in a future round might not just mean dilution of their stake—it also creates a precedent and may also be a reflection that they were more or less treated unfairly in the prior round.

Navigating Investor Psychology:

So how should entrepreneurs use this insight? Here’s what you can do:

• Transparent Communication: Keep the lines open. Before you get to the negotiation table, make sure your investors understand the trajectory of the company and the rationale behind it. Help them understand why your prior valuation was fair, even if today's valuations are lower despite your progress.
• Anticipate Emotional Reactions: Understand that decisions can be emotional. Prepare to address not just the logical aspects of your proposals but also the emotional responses they might elicit.
• Offer Creative Solutions: If facing a down round, consider alternative deal structures. Could you offer warrants, or perhaps a better deal on future dividends? Can you allow your prior investors (especially those that came in at highest valuations) to invest above their pro rata)? Sometimes the key isn't changing the game but changing the stakes.
• Beware of High Valuations: High valuations are not always a sign of success. They can set you up for failure downstream (a topic I will explore in detail in my next post). So, when you are negotiating terms, understand what other criteria besides valuation you need to optimize for.

Long-Term Relationships Over Short-Term Gains:

Remember, a relationship with an investor is not a one-off game but a series of interactions. Building trust through fairness and understanding can often outweigh the benefits of any single deal.

?? Fairness isn’t just a moral choice; it's a strategic one. Understanding this can change not only how you negotiate but potentially the very success and survival of your startup.