Published date:  14 October 2024   |  5-Min Read

Whether it’s a deal stuck in due diligence or a project awaiting closure, incomplete tasks tend to occupy more mental space than those we’ve successfully wrapped up. This psychological phenomenon, known as the Zeigarnik Effect, explains why unfinished business dominates our thoughts and compels us to seek resolution.

Named after psychologist Bluma Zeigarnik, this cognitive bias shows how our brains prioritize incomplete tasks, a pattern that extends well beyond daily to-do lists—it also has profound implications in alternative asset investing.

In the world of venture capital, the Zeigarnik Effect subtly impacts how investors assess startups, manage portfolios, and make investment decisions. It fuels an innate desire for closure, leaving investors fixated on unresolved matters until they’re addressed.

For fund managers, this cognitive bias can significantly influence their approach to due diligence, portfolio engagement, and even how they revisit past investment opportunities.

This reinforces the importance of data-driven decision-making and caution when a company is underperforming.

The belief that ‘things will get better’ can lead to significant losses if investors are not realistic about the compounding risks in the venture capital landscape.

1. Unfinished due diligence: a cognitive trap

During the due diligence phase, VCs typically initiate a thorough evaluation of a startup’s financials, market potential, and team dynamics. However, once the due diligence process begins, the Zeigarnik Effect can cause a preoccupation with incomplete tasks, creating a sense of unresolved tension.

This often drives VCs to prolong the assessment, even if early findings suggest the startup may not be a strong candidate for investment, ultimately delaying decisions and consuming valuable resources.

Recent research conducted provided further insight into how due diligence timelines affect deal outcomes. The study defined the due diligence period as the time between a virtual data room (VDR) opening and the public announcement of a deal.

It found that deals with medium-length due diligence processes are more likely to be completed efficiently, with a lower average premium and better long-term returns.

These „Goldilocks“ deals achieved a 4% higher return over 12 months compared to deals with shorter or longer due diligence periods, which posted negative returns.

However, the trend toward longer due diligence periods appears to be accelerating, with the average length increasing from 189 days (2013–2020) to 247 days (Bayes Business School) in recent years.

Factors such as:

• The increasing complexity of regulatory requirements
• The rise of ESG considerations
• The vast volume of data have contributed to these longer timelines

While VDRs and evolving technologies provide more robust tools for conducting due diligence, they also highlight the ongoing challenge of balancing thoroughness with efficiency.

In the context of venture capital, this trend aligns with the Zeigarnik Effect, as the drive to complete unfinished due diligence can lead investors to continue processes longer than necessary, potentially missing out on other opportunities or delaying crucial decisions.

 

2. Active monitoring of early-stage portfolio companies

VCs may also find themselves paying disproportionate attention to portfolio companies that are still in uncertain stages of development, as opposed to stable, high-performing ventures.

Early-stage companies inherently require more oversight due to their higher failure rates and lack of established product-market fit.

Research shows that early-stage startups, which often face greater risks, consume more resources and demand frequent check-ins from investors, as VCs work to guide them through critical growth phases Blue Future Partners, Alumni Ventures.

This phenomenon, driven by the need to bring these companies to their full potential, can lead to deeper engagement and a psychological preoccupation with resolving the „incomplete task“ of ensuring success.

In contrast, stable companies typically require less involvement, allowing VCs to focus more on underperforming ventures or those still in early development AC Ventures.

 

3. Lingering over missed opportunities

The Zeigarnik Effect also comes into play when VCs pass on an investment opportunity.

If the startup later gains traction, the „interrupted“ evaluation can stay top of mind, causing investors to second-guess their initial decision. This mental engagement can even lead to revisiting past opportunities, driven by the desire to close the loop on missed deals.

 

4. Pushing for exits: the need for completion

In some cases, the Zeigarnik Effect can accelerate a VC’s desire to push portfolio companies toward an exit—whether through acquisition or IPO.

After years of engagement and capital deployment, VCs often feel the pressure to bring investments to a close. This need for closure can result in pushing for exits earlier than optimal timing, driven more by the psychological drive to finish the investment cycle rather than the company’s market readiness.

The story of Jawbone, a once-promising tech company that received over $900 million in venture capital, is a classic example of how the Zeigarnik Effect can keep investors trapped in a cycle of over-investment.

Despite repeated product failures and intense competition from Fitbit, investors continued to pour funds into the company, likely driven by the desire to complete the „story“ of their investment with a successful exit.

Ultimately, Jawbone liquidated in 2017, marking one of Silicon Valley’s most significant failures.

The relentless need for resolution, coupled with ongoing funding rounds, kept investors locked into a failing proposition, unable to disengage from their sunk costs and failed strategies.

Key Metrics:

• Funding Raised: Over $900 million from top-tier VCs, including Sequoia Capital and Andreessen Horowitz.
• Competitive Pressure: Jawbone held only a small fraction of the market, significantly outpaced by Fitbit, which captured 85% of the U.S. fitness tracker market by 2014.
• Legal and Financial Troubles: Jawbone faced extensive litigation and product failures before liquidating.

 

While the Zeigarnik Effect can foster diligence and persistence, it can also have downsides in venture capital. The drive for completion can cause investors to stay overly fixated on underperforming portfolio companies or rush toward exits before a company is truly ready.

In hindsight, the Zeigarnik Effect likely played a role in keeping investors engaged, as the psychological need to finish what they started overshadowed the mounting evidence that a successful exit was unlikely.