Just recently, the concept of social proof as a reason for investing has come up again. It first came up when I was giving the Angellist guys some feedback on their referral system. In their emails, there is a prominent section dedicated to social proof and details the other usually-prominent investors and advisors who are investing and have endorsed the startup. But I complained back that in my experience, social proof can be a dangerous reason to invest in a startup, as much as it can lend support to an idea.
Here are some reasons why social proof can be a great thing:
1. Presumably, if a smart investor has committed funds to a venture, then he has researched it and think it is something he can make money with, or else why would he toss away his funds on something that won't?
2. Previously mentioned smart investor might be someone who has more experience than you, so you rely on someone else's expertise to help you decide. Or it may be an area where you may have no experience in, but you want someone who does have experience to endorse it.
3. If a lot of smart people invest in something, then the additive effect of a lot of smart people agreeing can lend support to a particular venture.
Now here are some reasons why I hate social proof:
1. Investors like to invest with others that they like. So they tend to travel in packs and herds (ie. think "herd mentality"). Thus you may have a lot of smart investors, who hang with other smart investors normally, who just invite their friends into a venture. The only thing is, sometimes these smart investor friends just trust their other investor friends to bring them worthwhile ventures and they may not have thought through exactly how good or not good a venture is. Given this, it may mean that item 3 in the positive aspects of social proof is an illusion because the group of smart investors endorsing it may actually all be following one or two of them.
2. There are a lot of guys out there who are angel investing that are more rich than you or me. To them, $50K or even hundreds of thousands of dollars are mere blips in their wealth; it's like if I pull out a $20 bill and give it to you and not really care if I get it back. When your mindset is driven by the fact that you can give out large amounts of money and not have it affect your lifestyle in the slightest, it can really alter your decision process on how you pick startups, and how rigorous you may be. It can very well mean that you're just happy getting involved in some really cool thing and want to have bragging rights, more so than being really focused on monetary return. It can also mean that there is huge entertainment value realized from being involved, and that they just want to be a part of something cool. How do reasons like that match with your strategy of investing?
3. Following on 2, this can apply to venture funds even more so. They have tons of cash to deploy and are perfectly willing to take on risky ventures since it's their core business. A fund does not have to have positive outcomes in many of its startups in order to have a sizeable turn for the fund itself. So they can and will take chances on ventures that could be hugely risky across a wide set of measures and be OK if it dies. But where will we be if the investment fails...?
4. If you follow someone’s investment, you really have to be wary of WHY THEY ARE INVESTING. I have encountered the case where I saw a prominent venture fund individual put his money into a startup. The entrepreneur touted that fact and it did seem to lend some credence to the venture. However, when I talked to the prominent venture fund individual about the investment, I found that he invested mostly because he knew the guy personally and wanted to support him so he invested mainly because of that...and also because that item 2 above enabled him to invest a seemingly large part of the small round and he was OK with that. Do you want to co-invest alongside someone who is in reality just supporting someone he is close to and not really thinking as deeply as he should about the business and the opportunity?
5. By the way, it can often seem like because there are smart investors in a round, that when the startup needs help they will jump in to lend a hand. However, I have also found that this is not necessarily true. Many smart investors are very busy people. They may have many companies in their portfolio. Their time is very tight and they may not have time to help in depth with all their startups. They may be forced to focus on only those that are the winners and everyone else doesn’t get much attention. Or worse, if a venture starts going downhill, I’ve also seen them just be left to die; after all, if this one dies, these guys still have many others who can benefit a lot more from their help versus trying to spend your time rescuing those who will die and for little return on their time investment. It is ruthless, but true; sacrificing the losers will mean that focus on the winners will mean they will make back their money and then some. However, if you haven’t invested in every startup that a smart investor has invested in, you may end up investing in a lot of losers and that sucks!
So while it may seem social proof can be beneficial, and in many cases it can be, it is also very bad to invest blindly using only social proof. My advice would be to do your own homework into those startups you want to invest in, and don’t just follow the herd. The herd you’re a part of may turn out to be a herd of wild, strong mustangs led by a dominant horse who can lead you to safety and success....or your herd could suddenly transform itself into a herd of lemmings about to follow the leader right off a cliff.