Anyone who has studied pricing knows that we commonly perceive value based on the most readily available reference points. In a practice known as “price anchoring,” fashion and luxury stores have been exploiting this psychological glitch for years by showing us the highest priced products first. Once we see a $1,500 suit or a $2,000 handbag, everything else seems like a good deal. This is how we get fooled into thinking a $50 t-shirt at the Armani store is a bargain while down the street Target is selling a six-pack of t-shirts for $10. At the Armani store, the starting reference point is $1,500, while at Target it’s a $2 tube of toothpaste. In comparison to the available price references, Target’s t-shirts seem expensive.
In the tech world, it appears this practice of price anchoring to an absurd reference point has become the new way of valuing investment rounds. Take for example the recent rumor that Path was approaching a $1 billion dollar valuation. I’m no expert on venture funding, but I can’t see any reason how such a valuation has basis in reality. But consider the timing. On April 22nd, Fab announced they were raising a round at a $1 billion dollar valuation. Then in early June, word gets out that Snapchat was raising at close to a billion dollar valuation. A week later, multiple sources tell Techcrunch that Path is raising at a similar valuation.
This could be a coincidence, or it may have been deliberate. Either way, the effect is the same. We need only look as far back as the dot com bubble for a massive historical case study into the effect of price anchoring.
Once Fab and Snapchat had anchored our perception to a billion dollars, it made perfect sense for Path to plug itself into the same valuation category. Never mind that Fab is generating well over $100 million in annual revenue, and Snapchat is seeing growth rates that Path can only dream about. The anchor price was set at a billion dollars and, just as we think any suit with an Armani label is worth somewhere north of $1,000, we think all “hot” companies must be justifiably priced in that range,
The fact that Path’s actual funding valuation has since moved lower still doesn’t negate the effectiveness of the anchoring strategy. Like a $100 Armani t-shirt on sale for $50, investors are much more likely to think they’re getting a great deal at a $500 million dollar valuation instead of realizing they’ve been price anchored to the ludicrous $1 billion dollar number.
But surely VCs aren’t that stupid, are they?
I don’t want to be too hard on VCs, so instead of calling them stupid, let’s just say they’re human.
Humans are extraordinarily gullible. If you say something enough times, a large portion of the population will start to believe it, and people rarely bother to ask questions. Consider the Mona Lisa. Everyone knows it’s a famous masterpiece, but few people bother to ask why. Even art critics fabricate reasons for its value. The truth is, the Mona Lisa was just another quality renaissance painting until it was stolen in 1911. Overnight it was in all the newspapers and by extension the public eye. From that point forward it was hailed as a masterpiece and became one of the most famous paintings in history. Everybody drank the Kool-Aid.
If anything, this type of unquestioned fame as a result of random exposure has become more rampant. For example, the entire Kardashian family is famous because Kim made a sex tape with Ray J. Clearly this is a terrible reason for women to buy her shoes, copy her fashion, or try to emulate her, but most people have already forgotten what launched Kim into the public eye and they allow themselves to be influenced by her meaningless notoriety.
If valuation by notoriety worked for such disparate things as the Mona Lisa and Kim Kardashian, it stands to reason that it should work for startups as well. Add in the psychology of price anchoring and you have a brilliant new strategy for suckering VCs out of their money.
For the record, I have absolutely zero insight into whether or not this valuation anchoring strategy was intentional, but if Path did time their announcements and press leaks to closely follow those of Fab and Snapchat, then it was truly a masterful stroke of subconscious influence. For the VCs reading this, remember, you’re human with the same blind spots and biases as the rest of us. Don’t get fooled by the Jedi mind trick and don’t let the tail wag the dog.
[Illustration by Hallie Bateman for Pandodaily]