A lot of founders are optimistic people by nature…you kind of need to be in order to be willing to put your hand in the ring of entrepreneurship and deal with the countless challenges that may come your way. They are glass half full type of people and they are believers that the future for their business is generally always bright.

The challenge however is that their belief of a bright future may not always be grounded in reality. Small positive indicators are seen to be strong positive signals and although the founder can be right (meaning they are actually a highly positive occurrence for the future), they are also exactly the type of bias that causes real issues in M&A.

By definition, optimism bias is our tendency to overestimate how likely good outcomes are and to underestimate how likely the bad ones are. We assume the plan will land, the risk won’t materialize, and the future will bend in our favour more often than the evidence actually supports.

Why optimism bias becomes a problem in M&A is actually multifaceted.

At its most basic level, optimism bias will cause founders to believe that next year will be a breakout year and as such selling their business now would be foolish versus waiting a year when that big event happens, the big new customer signs on or the new technology is finally launched…but although they may be true, most founders believe the impact will be stronger than it generally is. From my experience advising hundreds of clients, most businesses grow and win by consistent growth versus these big one time events. So rather than capitalizing on the business they have built up, they focus on the future and both expose themselves to more risk (owning a private company is fraught with risk) while delaying a potential sale until a later date. And for mid-market M&A, that sale is never a guarantee. I’ve talked to many sellers who have shared this exact story. Let me wait a year or two and my business will be on a fundamentally different plane and when that happens, it will be time to sell. The problem is that few founders actually achieve these types of results. Yes, they may grow but now not at the paradigm-changing pace they anticipated and thus their future outcome is far from what they expected.

The bias shows up again in how founders read the market. Optimism bias can cause founders to believe that the market valuation of their company (meaning what people actually are willing to pay for the company) is flawed as it does not capture the amazing growth potential of the company. I’ve seen this more times than I care to share, wherein a founder has a great deal on the table and pushes it off because they believe it is undervalued only for years later that deal to have actually been a really strong deal that they should have otherwise taken. And perhaps what’s even worse is when founders use their optimism bias to anchor an exit value they feel the company is worth even though the market reality can be otherwise. For example, we deal with a client who believed his company was worth $12m as he received a valuation for his company by a big four accounting firm six years prior. Unfortunately during the time when he received the valuation and spoke to us, the company performance dropped and his company was worth less than $10m…however he was unwilling to recognize that the value could be anything other than $12m. His rationale was tied to, you guessed it, his perceived value in the future of the company…ie optimism bias.

The most damaging version, though, is what the founder communicates to a potential buyer. They use their glass half full mentality to sell a positive future for the company that may actually not be tied to reality. They provide proformas that are far beyond stretch goals, they sell confidence in outcomes that don’t deserve said confidence and they otherwise create a scenario where the buyer can use this to a) underpin any contingent structures and b) create a situation where the buyer expects they are buying a business with a Ferrari level take off when really they are buying a jeep (or something not as fast…I’m not a car girl). Why this matters is that they unknowingly set themselves up for failure, for expectations that they can’t possibly achieve and they expose themselves to serious financial and litigation risk. We once sold a medical business for $40m wherein our client was convinced he could expand into the US and triple his business within a short period of time. He felt so strongly over this that he agreed to an earn-out that was so aggressive that we warned him it would never be paid out. After close, the buyer began the expansion into the US as per his plan. Soon after it became evident that his plan was sizably flawed and wouldn’t work as quickly or as significantly as expected. It left the buyer unhappy and our client out millions of dollars in contingent payments.

The major issue with optimism bias in M&A is that most founders (including myself) are highly conditioned to think this way. In many ways, sheer ignorance surrounding the optimism that one can get through anything is a big reason that founders end up building companies of scale…because more logical minds would perhaps give up prior to ever being in the ring. But this bias is problematic in M&A, which needs to be more pinned to reality, actual performance and verifiable data and outcomes.

The way to address it is actually simple. The first part is to undersell and over deliver, both to external parties such as buyers and internally to yourself. Shoot for 15% growth rather than 35%, and if you achieve 25% you have a strong outcome where all parties walk away happy. The second part is to run weighted average scenarios on what could actually play out. What would it look like if the company doesn’t grow as quickly, and how likely is that to happen? The key to this exercise is to be incredibly honest with yourself. Do that, and you can look at your business through a more accurate lens, one anchored to reality rather than to the future you hope for.

Reece Tomlinson is the Founder and CEO of RWT Capital Corp. and the author of Uncommon Capital.

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