There are many articles these days about young startups raising tons of money. There is also an increasing number of articles about well-funded startups suddenly struggling or shutting down. Every time a new story comes out, there’s a chorus of comments about how a failing company was doomed from the start, or how the VCs investing at huge valuations are dumb, or how the founders of a company don’t know what they’re doing. Sometimes these comments are accurate, but much of the time they’re ill-informed. These comments also reveal two common biases: the tendency to underestimate others (and overestimate oneself), and the tendency to draw conclusions from present data without considering what data might be missing. These are dangerous biases – especially when used by founders to hastily dismiss the quality of their competition.

Underestimating others

The startup ecosystem is interesting because of its extremely capitalist nature. Everyone wants to make the world better or disrupt this industry or that industry, but eventually money flows toward the most promising investments. Investors back the strongest founders with the most compelling ideas. Funds of funds support the venture capital firms with the best track records. The system isn’t perfect, but it rewards competence and punishes incompetence. If you are a great at building companies or producing investment returns, you’ll have access to more and more capital. If you grossly mismanage your employees or your product or your investing dollars, then capital will quickly dry up.

Why is this important? Because it means that the founders and investors involved in each company you read about are generally smart people who believe in what they’re doing, believe they’re taking the best approach, and have been vouched for by other intelligent folks. The system makes mistakes, but those mistakes are the exception, not the rule. If you see a lot of supposedly smart people doing something that looks dumb, it’s more likely that you’re missing something and less likely that everyone involved is missing something.

Letting yourself believe that you are smarter than everyone else is especially dangerous for founders. I often hear people discount competitors with comments like: “We’re doing bottom-up customer acquisition. Our main competitor is going top-down, and they just don’t realize that’s an inferior approach.” Really? Are you sure? First, your competitor probably says the same thing about your approach. Second, your competitor is smart, and if that’s the case, then how do you know their approach is inferior? What if your approach is the inferior one?

Ignoring lack of context

Along with overlooking that other people are smart, it’s also easy to forget that what you read in a news story or blog post might not cover all of the relevant info. Maybe it seems crazy that a two-year-old car insurance startup just raised $100m. OMG #bubble, right? Maybe. Or maybe the company has an exclusive not-yet-public contract to insure all of Uber’s drivers. Or maybe they’re about to become the preferred insurance partner for AAA. Either of these things would be huge, but might not be public knowledge yet.

Here are two thought experiments that demonstrate how not having enough data can be misleading:

Thought Experiment #1

Let’s say a company has the following revenue trend. Would you invest in it?

Looks pretty bad, right? It seems like business is declining steadily.

Well, what if the actual revenue breaks down as follows?

This is actually pretty great! It’s indicative of a business that was largely based on consulting services and is now transitioning to a SaaS recurring revenue model. This is a healthy transition because SaaS revenue is easier to scale and often higher margin. A company with this revenue trend could be a great investment, even though it looks bad on the surface.

Thought Experiment #2

How about the following revenue trend? Is this company doing well?

It sure looks like it! But the data becomes worrisome if you show profit along with revenue.

Now the business looks less healthy: it’s growing quickly, but profit margins are shrinking just as quickly. That doesn’t bode well.

Or maybe it does bode well. Maybe the company is Amazon and is intentionally depressing margins and funneling all of its resources into growth. Public market investors have liked that strategy for the last 15 years.

Or maybe it doesn’t bode well because retail competition is heating up, and Amazon will never have the chance to increase margins like it someday hopes to.

Clearly the conclusion you draw is heavily based on the data and information that you’re exposed to. Don’t jump to conclusions when you don’t have enough data.

Critical Thinking FTW

The lesson here is to think critically. When you see a founder or investor – or anyone else! – doing something that makes little sense to you, deciding that person is dumb is lazy thinking. You might be right, but there’s little value in being right. There’s much more value in assuming you’re missing something and trying to work backwards. For example, what missing data could help explain a startup’s valuation? Why would someone smart follow a strategy which seems suboptimal on the surface? What do they see that you might not be seeing?

If you respect the other players in the game, and you analyze their decisions diligently and patiently, you’ll learn things that help you build your own business more effectively.