“Mirror, Mirror, on the Wall – Who Is the Greatest Investor of all?” Effects of Better‐than‐Average Beliefs on Venture Funding

Date01 June 2020
Published date01 June 2020
DOIhttp://doi.org/10.1111/emre.12363
AuthorSonja Sperber,Christian Linder
Mirror, Mirror, on the Wall Who Is the
Greatest Investor of all?Effects of Better-
than-Average Beliefs on Venture Funding
CHRISTIAN LINDER
1
and SONJA SPERBER
2
1
Management Department, ESCP Europe Business School, London Campus, 527 Finchley Road, London NW3 7BG, UK
2
Management Department, ISM International School of Management, Frankfurt Campus, Mörfelder Landstraße 55, 60598,
Frankfurt/Main,Germany
Agency theory considers information the most decisive elementin investorentrepreneur relations. Building on the
notion of better-than-average (BTA) beliefs, we investigate the extent to which information asymmetries between
investors and entrepreneurs may also emerge on paths other than the self-interest or opportunistic behaviour of
rational actors. Based on a data set of 176 investors from 23 different German financial institutions, we conduct a
conditional process analysis that indicates approximately 30% of all professional investors hold unjustified BTA
beliefs regarding their abilities to identify flaws in new venture ideas, which leads to inaccurate financing decisions.
We further find evidence that investors generally tend to underfund start-up projects if they perceive little similarity
with the founders, but overfund projects if interpersonal similarities are high. Moreover, we demonstrate that high
BTA beliefs facilitate engagement in competition with peers for the best investment option.
Keywords: principal-agent theory; better-than-average; interpersonal similarities; uncertainty tolerance;competitive
behaviour; new venture funding
Introduction
Agency theory comprehends investors as principals and
entrepreneurs as agents (Arthurs and Busenitz, 2003),
while information is seen as the most decisive element in
investorentrepreneur relations (Jensen and Meckling,
1979; Arrow, 1985; Jensen and Smith, 1985; Foss and
Stea, 2014; Bosse and Phillips, 2016). Information not
only allows identification of the hidden intentionof the
entrepreneur and hidden characteristicsof the venture
beforethe investment decisionis made, but also the control
and monitoring of the agents b ehaviour during the
investment period (Ross, 1973; Jensen, 1994; Shapiro,
2005; Bendickson et al., 2016; Seth, 2016). In associated
theories, information is treated as a commodity and its
most important aspect is that it has a cost and can be
purchased (Eisenhardt, 1989; Shapiro, 2005). Yet,
information has a further, critical dimension for
entrepreneurial financing decisions (Eisenhardt, 1989;
Arthurs and Busenitz, 2003; Casamatta, 2003; Courtney
et al., 2017): it needs to be interpreted by the investor.
Specifically, all information largely receives its meaning
from the unit that interprets it (Linder and Sperber,
2017). Such interpretation is a subjective, meta-pragmatic
act based on the idiosyncratic experiences, expectations,
values, cognitive frameworks and self-perceptions of the
interpreting unit (Daft and Weick, 1984). This raises
questions regarding the quality of interpretative acts
(Rasche and Chia, 2009); something not elaborated on in
agency theory, since the unit of analysis is the contract
and not the unit interpretingthe particular contract.
To explain the quality of interpretative acts, a subfield
within behavioural finance literature has emerged that
investigates investorentrepreneur relations by treating
both actors as not fully rational (Fairchild, 2011) and
embraces an understanding of decision making as
potentially infectedby overconfident, over-optimistic,
exuberant and other non-rational behaviour (Glaser
et al., 2004; Thaler, 2005). Consequently, information
asymmetries may also emerge on paths other than the
self-interest or opportunistic behaviour of rational actors.
Notably, there is a long tradition of past research
showing that the self-perception of an actor affects how
Correspondence: Christian Linder, Management Department, ESCP
Europe Business School, London Campus, 527 Finchley Road, London
NW3 7BG, UK. Phone: +44 20 7443 8884; E-mail
chlinder@escpeurope.eu
DOI: 10.1111/emre.12363
©2019 European Academy of Management
European Management Review, Vol. 17,
407 426, (2020)
information is interpreted (Macmillan et al., 1985;
Malmendier and Tate, 2005a; Larrick et al., 2007;
Malmendier et al., 2011; Itzhak et al., 2013). While the
potential of these insights is not fully exploited in
entrepreneurship research, some of the theories suggest
there is a significant bias between the personal and
objective rating (Forbes, 2005; Landier and Thesmar,
2008). In other words, there is a pervasive human
tendency to estimate oneself as better than the average
person the so-called better-than-average(BTA) effect
which causes people to believe they are superior in a
broad variety of dimensions (Alicke et al., 1995; Alicke
and Govorun, 2005).
This provokes the question of whether perceptual
asymmetries in i nvestorentrepreneur relation may be
caused by the unjustified BTA beliefs of an investor
who interprets information about the entrepreneur against
a biased self-pe rception. One result of an unju stified BTA
belief about the personal ability to identify promising
business ideas is that the investor may invest in a new
venture that has serious flaws. Against this background,
we investigate the extent to which an investorsBTA
belief accounts for evaluating their own ability to identify
promising business ideas as higher than their peers, while
simultaneously failing to spot flaws in business ideas
more often than a reference group. To investigate this
phenomenon, we ask, in our first research question,
whether possi ble biases in an i nvestors self-per ception
have the potential to foster perceptual asymmetries in the
investor-entrepreneur relation. Further, we are interested
in perceived interpersonal similarities or dissimilarities
to a referential other individual, which in the case of
investors is entrepreneurs, since BTA belief may affect
the way investorsperceive the characteristicsand qualities
of others. Specifically, we are interested in whether
unjustified BTA beliefs affect control efforts with regard
to risk tolerance and attitudes towards competition. For
example, biased investors may believe they are able to
control the risk inherent in the investment because they
overestimate their abilities (Broihanne et al., 2014). Thus,
we further ask if unjustified BTA beliefs consequently
lead to the acceptance of a disproportionate number of
low-quality applicants for funding. In other words, we
are interested in the mechanisms through which these
BTA beliefs affect an investors financing d ecisions by
a biased interpretation of the new venture and the
entrepreneur.
Buildingon a data set of 176 investorsfrom 23 different
German financial institution s, we employ conditi onal
process analysis to test a set of hypotheses. Our findings
provide several contributions to a better understanding
of start-up fundingdecisions by highlightingthat the real
or objectivequality of a business opportunity may be
subject to biased judgments based on the unjustified
self-beliefs of investors.
Specifically, we contribute be demonstrating how
entrepreneurial finance may benefit from considering
outside conceptslike BTA effects. Agencytheory is based
on assumptionsthat do not involve the cognitiveprocesses
of the investor and entrepreneur. Instead, it assumes the
bias-free processing of information, which is a strong
and questionable assumption. A number of authors
contend that the evidence supporting principal-agent
theory in entrepreneurship lacks clear predictive relevance
because the results to date are mixed and weak (Bruton
et al., 1997; Arthurs and Busenitz, 2003; Bitler et al.,
2005). Others claim agency theorys insensiti vity to
temporal issues in investorentrepreneur relations are
decisive for limited explanation power (Arthurs and
Busenitz, 2003). Some further authors identify basic
assumptions,like goal congruence that is, agencytheory
is silent in cases where goals between investors and
entrepreneurs align (Davis et al., 1997; Eddleston et al.,
2012) as a questionable theoretical basis for
entrepreneurial finance. To make agency more applicable
to entrepreneurial financing, we add a new dimension to
the discussion by contesting the assumption of investors
as fully rational and unbiased actors (Malmendier and
Tate, 2005a). Byturning the focus away from the contract
as a unit of analysis and towards the interpretation of
contracts, we demonstrate that investorsdecision making
is potentially infectedby unjustified BTA beliefs, which
affects the investor-entrepreneur relation through the
interpretation of information and signals (Cable and
Shane, 1997;Zacharakis and Shepherd,2001). Our overall
contribution is the demonstration that entrepreneurial
financing may be better explained if a more complex
cognitive perspective on investorsperception processes,
such as BTA beliefs, is considered instead of relying on
simplified assumptions. Thus, we show that the classical
agency model can be effectively enhanced by including
this perspective.
A further contribu tion is made in extending the research
(Zacharakis and Shepherd, 2001). While the existing
literature demonstrates the cognitive differences of
venture capitalists, such as overconfidence, which
negatively affects decision accuracy, we expand this
notion by linking decision making to the human
propensity to compare ones own capabilities to the
perceived capabilities of others (Festinger, 1954; Buunk
.et al., 1990; Kruger and Dunning, 1999; Buunk and
Gibbons, 2007). While overconfidence is linked to the
tendency to overestimate the likelihood that ones
favoured outcome will occur(Zacharakis and Shepherd,
2001), BTA beliefs are rooted in a comparative view.
Hence, decision accuracy is not only biased through the
type of information available to the investor, prior
experience and learning from past investment projects
that is, availability biases(Zacharakis and Meyer,
1998; Zacharakis and Shepherd, 2001; Shepherd et al.,
C. Linder and S. Sperber
©2019 European Academy of Management
408

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