Investment Jaws

January 18, 2013 BY danariely

I have recently gotten hooked on ABC’s Shark Tank (based on the original Dragon’s Den), a reality show in which rookie entrepreneurs seek investments from wealthy self-made investors. These investors are the titular “Sharks,” who receive investment proposals ranging from a folding guitar company to a business in cat toilet-training kits. Once a sales pitch is made, Sharks can offer to invest, and will sometimes compete with one another for the opportunity. At times, the entrepreneurs leave with nothing, and occasionally they are laughed off the stage.

One lure of Shark Tank is the way it puts the psychology of negotiation on display. When entrepreneurs enter the “shark tank,” they put forward an offer, asking a specific amount of money in exchange for a percentage of equity in their company. (Dividing the dollar amount by the percentage stake provides an estimated valuation of the company.) This offer serves as a powerful anchor for both parties, which can exert a dramatic influence on the subsequent negotiations.

In spite of their own appetites for money, when an entrepreneur presents an inflated valuation of their company, Sharks often pass up the investment opportunity. For instance, if an entrepreneur asks for $100,000 in exchange for a 10% stake in her company, but the Sharks estimate the company’s worth at far less than a million dollars, they may back out brashly rather than make a lower offer. Although an inflated valuation may indicate poor business sense on a contestant’s part, it often seems that the Sharks’ decisions to pull out in scenarios like this are based on emotion rather than business savvy.

On the other hand, sometimes a Shark’s initial offer appears to bias an entrepreneur against considering other options. An offer that demands double the equity for the same cash investment may appear unfavorable when, in fact, the initial valuation was off. When a Shark offers to buy a business outright and pay the founder royalties, entrepreneurs tend to reject the proposition, even if it makes financial sense. The entrepreneurs clearly have more invested in their ideas and products than dollars and cents.

The show exposes some interesting contradictions. The Sharks are personable, yet they attack at the first scent of weakness. Kevin O’Leary, the bombastic Shark known as “Mr. Wonderful,” claims that “it’s all about MONEY,” but at times even his emotions seem to cloud his judgment. In other situations, a compelling performance by a contestant is enough to sway the Sharks’ minds, even when the sales figures don’t.

Then again, perhaps letting emotions factor into negotiations is not such a bad idea. It would probably be unwise to go into business with someone with an established negative rapport. A waffling sales pitch may indeed predict wishy-washy behavior in future negotiations, which might seriously hinder business prospects. And perhaps an entrepreneur’s “gut” is actually guiding him in the right direction when he rejects a Shark’s offer. It is, of course, impossible to know for sure, but it is this fascinating blend of calculation and emotion that keeps me swimming after this show’s bait!

~Heather Mann~

Saving By Spending

May 31, 2012 BY danariely

Camera store salespersonThis week, I visited a camera store to order two enlarged prints as a gift.  I don’t order photo prints very often; in fact, I’m not sure that I have ever ordered prints aside from graduation photos.  As I was making my purchase, the friendly, middle-aged woman who had been helping me asked whether I wanted to become a store “member.”  I learned that for only 13 dollars and change, I could save 10% on purchases at the store for the next year, including around five dollars on the order I was purchasing.  (I asked whether this discount applied to cameras.  It did not.)  After fleeting consideration, I explained that I did not think it was likely that I would be buying more prints in the next year, and hence membership was not a worthwhile purchase for me.

To the friendly saleswoman, this did not seem be a satisfactory answer.  She continued to push the membership offer, emphasizing the five dollars that I would be saving.  “I don’t know about you,” she said, “but I’m someone who likes saving money.”

As I walked from the camera store to my car, I couldn’t help but contemplate this saleswoman’s comment.  Did she actually believe that purchasing a camera store membership would benefit my bank account in the long run (as she appeared to), or was she simply a loyal store representative, eager to make additional sales (which seemed more likely)?  Either way, her comment reflected a “save by spending” mentality that permeates modern-day America.

Membership programs and customer reward programs that charge an initial fee are prime examples of the “save by spending” creed.  The customer is presented with various opportunities for future discounts, provided he or she coughs up money for a membership.  As in my camera store situation, the membership offer is usually presented right before purchase, and the amount saved on the purchase itself is highlighted by the salesperson.  The customer is forced to decide on the spot whether he or she would like to join.

Membership programs are rather curious in light of the established research finding that, in general, people will settle for less money if they can have it immediately – a tendency psychologists refer to as temporal discounting.  (Think Money Mart loans or pawnshops.)  In contrast, joining a membership program means foregoing money now for the possibility of earning that money back later on.

There are several reasons these programs may work.  First, they force the consumer to project the likelihood of future purchases in a biased setting.  People are notoriously bad at predicting the future; when buying an enticing summer novel at Barnes and Noble, surrounded by other books, one is more likely to consider spending money on books than on the variety of other products out there.  Second, when presented with the membership program, people may experience mild social pressure from the sales associate.  Third, if people are making their purchases with credit cards, they’ll be more willing to slap on an additional membership purchase; research attests that using credit cards makes people spend more, compared with cash.

Last but not least, the feeling of saving money is just plain rewarding.  We know that money is valuable.  At the same time, we don’t want to save by foregoing that sparkly new iPhone accessory.  Membership programs offer us the opportunity to have our cake and eat it too – to experience the joys of saving and spending at the same time.  And I’m guessing this makes companies pretty happy too.

Of course, membership programs aren’t the only example of our tendency toward saving by spending.  Who hasn’t relished in the experience of buying a product at 50% off, focusing on that 50% that they have magically “earned”?  I know I have.  This may be part of the reason that the average American has half as much personal savings as personal debt.

Thank you, kindly saleswoman, but I will simply pay for my photo prints this time.

~Heather Mann~