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Idealab, a Pasadena (Calif.)-based technology incubator, has formed 75 startups in the past 15 years, selling or taking public 30 of them. More than a dozen are currently in development or operating privately with advice—and in some cases, investment—from Idealab. From highs such as Overture.com to lows like EToys.com, the incubator’s founders have learned valuable lessons about what makes a startup succeed, says Douglas McPherson, vice-president of corporate development and general counsel at the company. McPherson and Andres Castañeda, Idealab’s director of recruiting, spoke about making better business decisions at an entrepreneur roundtable at Idealab’s offices in June.
Here are some of the "thinking traps" Idealab tries to avoid:
• Confirmation bias: Rather than being purely rational actors, research shows that individuals often unknowingly fall into gaps in their reasoning, McPherson says. One of the strongest is confirmation bias, the tendency to favor data that confirms our preconceptions or hypotheses. "In business, teams have to fight the temptation to take new information and see it as fitting into certain sets of facts," he says.
When choosing which companies to work with and fund, Idealab is not afraid of entrepreneurs who have experienced failures in the past. Success after success is wonderful, but often it leads to confirmation bias that a lucky chief executive officer with good timing is a golden leader who can do no wrong, McPherson says. "Adversity is a crucible that tempers people. We have one CEO who has threatened to quit multiple times during a difficult startup. He came from a big company and never had to handle adversity. With a successful CEO, you want to know whether they just rode the escalator up or ran up it faster than it would otherwise have gone."
• Fundamental attribution error: We too often attribute people’s behavior to their fundamental character rather than to the situation they’re facing. "Most people’s behavior is driven by context. If you can understand that, you can better understand the person and the positions they take in things like negotiations," McPherson says.
Recently, a CEO at one of Idealab’s startups who had initially been collaborative became oppositional and testy. Rather than writing him off as difficult, his collaborators at Idealab recognized that his behavior was due to the stress of a financing event, something this CEO had never before led, McPherson says. "He was not comfortable. He felt he was not in control, and those feelings were coming out in all sorts of ways." Rather than assume that the CEO was acting maliciously, McPherson says, he considered advice he’d heard from Indra Nooyi, CEO of PepsiCo (PEP), and chose to "assume good intent."
• Loss aversion: Because we all strongly prefer gains to losses, it can be difficult emotionally to declare a venture a loss. "At Idealab, we think about this quite a bit. We’re the founder and only investor in our companies and we have the tendency to think all of our babies are beautiful," McPherson says. With very early stage companies, it is particularly hard to pull the plug. "There’s a temptation to think maybe the business model isn’t quite formed or the competitive landscape is still evolving. Sometimes we think that if we change the pricing, it’ll take off."
In order to counteract loss aversion, Idealab looks for external validations of a company’s success or failure. "If we can’t recruit A+ people to commit a couple years of their lives to this, that’s a sign the idea isn’t as good as we think it is. The same goes for outside investors," Castañeda says.
• Limited self-control: Research shows that people perform less effectively on physical and mental tests after they have been asked to resist temptation, such as a platter of warm cookies. Recruiting for Idealab’s startups can be difficult because the company looks for technically skilled engineers who can collaborate in a highly creative environment.
Frequently the company’s open office is too stimulating for people who become distracted easily, losing focus. Others find that the set-up entails too much scrutiny of their work. "During the onboarding process, we do constant checks with new employees—at 30, 60, and 90 days—to keep them on task," Castañeda says. The company also screens specifically for people who can adapt to change and are comfortable with ambiguity, since startups involve a great deal of uncertainty and management must often pivot quickly on a new product or focus.
• Recency bias: People tend to give more weight to recent events and believe they are predictive of future events. This is why investors fall prey to financial bubbles and miss a natural regression to the mean when it is occurring, McPherson says.
Within a business, managers often base annual performance reviews on recent job performance, which may be adversely affected by outside circumstances, he says. "People may do great work for years in a company, but something happens on their way out—they become overly greedy or react badly if the company is sold and they’re not ready for the transition," says McPherson. "It isn’t fair, but years of good effort can be erased by the memory of how someone leaves."