The Game of Investment

Understanding human relations are complex and no mathematical model can still understand how and why we make decisions. Nevertheless, in some closed environments, we can build a strategy based on the last movement of another person and their motivations behind it, always taking into consideration that we are rational people (act to maximize their utility), pretty much like playing a game, sometimes finite, other times infinite, this will be the theme for this Biobusiness issue, Game Theory. In the representation below we can see the set of different scenarios and the outcome of each player's cooperation or defect.

According to the?Stanford Encyclopedia of Philosophy, game theory is “the study of the ways in which interacting choices of economic agents produce outcomes with respect to the preferences (or utilities) of those agents, where the outcomes in question might have been intended by none of the agents.” In other words, game theory models are about strategy interactions, which means that there are decisions involved, which means that human judgment is involved.

Game theory models are dynamics; they depend on human perception of situations, context, previous experiences, and mental models to decide and take action. Such analysis can be used for investment strategy investors face different scenarios, and they need to analyze, compare and decide if A, invest, or B, do not invest. The decision is not static and brings new decision scenarios over time depending on other players' strategies.

The development of option games has become a popular topic in the field of decision-making analysis. This approach has been implemented in various valuation models; for example, real options models in which we consider the probabilities of different scenarios to determine a company’s future value. The option games approach is a new valuation tool that combines real options and game theory to value flexibility and commitment.

Imagine a scenario where founders and investors are negotiating a deal. This could happen in a cooperative manner where they do a fair deal, benefiting both parties equally (a non-zero-sum game), or become non-cooperative and try to exploit and get a better deal for themselves at the expense of the other (a zero-sum game). A zero-sum game ends in a lower valuation or zero funding for a startup, pretty much what we are seeing right now on the private and public markets. Now, The Nash Equilibrium for the scenario occurs when both companies value themselves below true value. After initial negotiations, the next set of decisions would be taken on prior experience, and therefore strategies would be adjusted accordingly. There is a strategy in game theory, namely “tit for tat”, which clearly explains this type of situation.

There are 2 potential strategies that a VC and Founders may follow, both with a different outcomes:

When VCs and Founders mutually defect

First, let’s observe what happens when both entrepreneurs and VCs ‘mutually defect’. This can occur when an entrepreneur becomes aware of new opportunities that have a higher probability of success like competing offers, new ideas, etc. and the VCs are constantly looking to maximize their financial return (Sounds familiar?), which incentivizes defecting to end the relationship. In this instance, ‘defecting’ would mean disallowing financial support. In the case of entrepreneurs defecting while VCs remain steadfast in the relationship, we see that withholding technical details, and critical information about the startup (full disclosure is often necessary for cooperation to occur) may serve as a short-term strategy that benefits the entrepreneur but hurts the VC. On the other hand, if the VC does not provide enough capital or show confidence in the team afterward and pressurize the startup, that would hurt the startup.

When they co-operate

To get the maximum profit, VC and startup have to cooperate. To cooperate, Communication is key. Having a vision, and being able to dazzle people with your idea is just as essential to a good relationship as the idea itself, which may time a long time to achieve. That is, the probability of a cooperative relationship rises with the frequency of their communication. The probability of a successful relationship increases when there is perceived power equality between entrepreneurs and VCs.

So, how can your type of game and decision influence your company valuation?

In terms of valuation, game theory applies in many ways; what is a good number for both founders and investors? Since there are many valuation methods, the lack of information makes it hard to use and trust them, so in the end, still being more art than science. Human judgment plays a vital role in the founder-investor interaction. Several questions appear on the table, and there are no easy answers; the best solution is to think of them as a game. A complicated game, but if founders or investors learn to play, they can have an advantage.

Investors, as a player, have an advantage because they play the game thousands of times, learn, improve, and master the game. Entrepreneurs sometimes are involved in a new and unknown game. They need to understand how to play and where are the hidden rules. That initial step brings a lot of mistakes. Fundraising can be played as a game. In each conversation, founders and investors become wiser about the other and adjust the strategy.

“Ignore the blonde, the best result will come from everyone in the group doing what’s best for him and the group.” - Russel Crowe on Beautiful Mind

Business is an infinite game so we need to have loyalty and trust in our customers, employees, and stakeholders. A founder should know why he started what he started in the first place. In order to win or to get funds in this context, one should cooperate. So, a leader needs to inspire and cooperate rather than manipulate and defect.

Are you using Game Theory in your daily work? Leave a comment below

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