— Lessons from Narrative Economics in Venture Capital

Human beings tend to comprehend the world through stories; we learn about the Trojan War from Homer and view the Napoleonic Wars through Tolstoy. We are inherently susceptible to the influence of narratives. When a compelling story captivates us, it can turn us into believers or skeptics, leading us to overlook critical facts and even selectively seek data that supports our preconceived notions.

As a General Partner of a venture capital fund, our responsibility is to consistently anchor our assessments in hard data and objective analysis, rather than relying on narratives.

That’s why, when I recently read Narrative Economics by Nobel Laureate Robert J. Shiller, it resonated with me. In this book, Shiller masterfully explained how economic events and behaviors are significantly influenced by the spread and dynamics of popular narratives. Shiller argues that these often simplistic and emotionally charged stories can profoundly affect individual and collective economic decisions. He suggests that narratives can propagate through society like epidemics, gaining momentum and shaping significant economic outcomes.

Numerous lessons and parallels can be drawn from Narrative Economics with the venture capital (VC) world. As General Partners at Golden Section Venture Fund (GSV), we are often susceptible to the stories that founders present for us, or narratives we formulated about a company.

In the investment process, the narratives surrounding companies can drive investment decisions. It's all too easy to become enamored with a compelling founder story or a disruptive vision, which can lead us to overlook critical operational issues. This convergence of narrative influence in economics and venture capital illustrates the powerful role that stories play across different spheres of decision-making. Which is something we need guard against, always let the facts and data be the guide.

Consider a scenario where one of our General Partners had an inspiring conversation with a charismatic founder. The founder's vision of their company as a future unicorn, a market disruptor, and a thought leader can be incredibly persuasive. This narrative can quickly become contagious, spreading through the associates and analysts and influencing the opinions of associates and other partners. As the story takes hold, the team may begin to overlook warning signs such as product development issues, inadequate market traction, or customer churn. These narratives can cut both ways, potentially leading to both false positives and false negatives.

WeWork serves as a stark example of the dangers of narrative-driven investment. The company was heralded as a paradigm shift in the coworking space, with its visionary founder Adam Neumann captivating investors with his grandiose vision. However, the narrative overshadowed the underlying financial and operational issues, leading to one of the most notorious investment disasters in recent history.

In our own investment committee (IC) meetings, we strive to ensure that narratives do not eclipse rigorous analysis. It is essential to challenge the stories we tell ourselves about our portfolio companies and potential investments. This means diving deep into the data, scrutinizing financials, market conditions, and operational metrics, and maintaining a healthy skepticism towards overly optimistic or negative narratives.

To avoid falling into the Narrative Trap, we must implement several strategies:

1. Encourage Diverse Perspectives: Foster an environment where diverse viewpoints are valued and dissenting opinions are heard. This can help counterbalance the influence of a single, compelling narrative.

2. Implement Rigorous Due Diligence: Ensure that our due diligence process is thorough and data-driven. This includes conducting detailed market analysis, financial modeling, and operational assessments.

3. Regularly Reassess Narratives: Periodically revisit and reassess the narratives we have built around our portfolio companies. This helps us stay grounded in reality and adapt to changing circumstances.

We need to challenge the narratives we formulate ourselves or are being told, ensuring that our judgments are anchored in data and metrics. This requires a disciplined approach where we critically evaluate some narratives against hard evidence and quantitative analysis. By doing so, we can mitigate the risks associated with narrative bias, avoid being swayed by emotionally charged or overly optimistic/negative stories, and make more informed, objective investment choices. This approach helps us maintain a clear focus on the underlying realities of a company's potential and performance, leading to better investment outcomes.

We love great good stories, but the truth is often messier, so, do let the facts get in the way of a good story.

By Isaac Shi
May 16, 2024