The Stroop Effect and Private Company Reporting

Born as the second youngest of six children on a small farm in Tennessee in 1897, John Ridley Stroop was not expected to survive as an infant, let alone become the creator of one of the tools most valued by cognitive psychologists. The Stroop effect, first published in the December 1935 issue of the Journal of Experimental Psychology, would go on to be replicated by over 700 studies and continues to be a foundational test in the field of cognitive psychology when it comes to attention and interference. Let’s put ourselves to the test now to understand the Stroop effect. Take the next few seconds to name the following colors:

That should have been fairly straight forward! Now try and name the colors of the  following words (you’ll notice they don’t match the words!):

If you took a lot longer or made mistakes, don’t fret; this is the exact observation John Stroop published in 1935. He found that the mean time for responses increased by 74 percent in the second scenario when the brain felt a “semantic interference” due to incongruent stimuli from the ink color and word being different. This effect is significantly reduced when your brain can’t understand the words. Try this again now to name the colors with the words in Tamil (my mother tongue and hopefully a script you don’t understand): 

The Stroop effect is a good example of how the left brain uses language as a tool for interpretation, sometimes misleading us away from reality. In his book The Master and His Emissary: The Divided Brain and the Making of the Western World, psychiatrist and author Iain McGilchrist describes the central role of the left brain as a cartographer of reality, and language as the pen with which the left brain draws this map. In fact, the left brain has two primary tools it uses to interpret reality – language and categorization. Unfortunately research proves that when it comes to beliefs and interpretation, the left brain can sometimes have little regard for reality. The left brain sometimes confuses the map for ‘territory’ (more on this topic here) and language becomes a tool that ‘uses’ you by creating a story that isn’t real.

So why is this relevant to us as founders or managers? Let’s look at how we end up falling prey to the left brain’s ability to use language and categorization to mislead us into not seeing the reality presented by hard numbers. Welcome to the world of private company reporting and investor jargon!

Private company reporting

In the startup world, we talk about things like unit economics, contribution margins, adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), Customer Acquisition Costs (CAC), Payback on CAC, etc. Metrics like these help investors understand the quality of a business and its potential profitability better – it’s our ‘map’ if you will. But some of the more creative definitions of these metrics (or even a focus on the wrong metrics) may give us a false sense of business progress and value creation – the ‘territory’ – that in reality may be less sanguine or even downright terrible (i.e. confusing our ‘map’ for the ‘territory’).

As an extreme example, WeWork talked about Community Adjusted EBITDA as a way to define profitability of their business, when in fact the real profitability was highly questionable. While this may have been an exception and, at that point, appeared to be a way to market the WeWork story and justify its high burn rate, we often find that the use of language, or rather ‘creative metrics’ can obfuscate reality, often unknowingly; given the power of the left brain’s storytelling capabilities once the right language is used.

One such metric that is often used to denote profitability is the Contribution Margin. Contribution Margin usually refers to the profits made after accounting for the cost of goods sold and other variable expenses linked to selling a product, but before fixed overheads. Usually, it’s a metric used internally by management. Increasingly, we see the use of multiple levels of Contribution Margin – CM1, CM2, CM3, etc. – being used as a way to measure progress towards profitability in their reporting to investors. We have even seen this go all the way up to CM6! While defining detailed metrics is a good thing, we’ve seen some risk in the definitions of how costs are categorized. Founders should be aware that having complicated metricization gives them a false sense of what is really going on in their startup and potentially obfuscates the real economic picture of the business. CM2 breakeven is not profitability, and metrics like city or country-level EBITDA, or ‘profits before technology and corporate overheads’, are not signs of an enduring business if it’s still burning hundreds of thousands of dollars a month. Beware of being fooled by your own left brain’s storytelling capabilities!

The Stroop effect equivalent in the startup world can come from defining euphonious profit metrics, which over a sustained period unfortunately hide the real economics of a business. This is because the brain gets trained to use these metrics to measure progress and hence becomes slow to respond to the inherent conflict between the rosy metrics and the high overall burn! In addition, over reliance on such metrics, which may have served one well in the early days, may distract teams from what they should be moving toward as the company grows – which is to report with the discipline of a publicly-listed company, with focus on overall profitability, a healthy balance sheet and strong free cash flows.

Remember: A spreadsheet of metrics is not your business. It is simply a representation of your business. It is just a map of the territory; and even the best maps are approximations of the actual territory. You navigate the real territory and not the map. Never confuse language for reality itself when it is expected to be merely a representation of reality. For founders, managers and investors, the best advice is to keep things simple – focus on the cash; free cash flows and profits after tax.

Recommended Reads

Here are two articles I read over the last few weeks that I found interesting and a movie/documentary on Netflix that I loved watching:

In this column, titled “How to Become Wise”, Irish Institute of Korean Studies director Kevin Cawleyis sheds light on the tenets of Korean philosophy, which generally has a lower profile globally compared to other Eastern traditions like Buddhism or Taoism. In Korean philosophy, which is practical and largely agnostic, the onus is on the individual to develop themselves, without recourse to the divine or the supernatural. This article explores the idea that if you change the patterns that have become ingrained in how you think, you will begin to live differently.

I really enjoyed reading this piece on how YouTube is bringing viral fame to small retailers in Chandni Chowk, one of Delhi’s oldest markets. Built in the 17th century by the Mughal emperor Shah Jahan, Chandni Chowk is home to a wide array of stores selling everything from traditional clothes to spices that are often so small they don’t even have a street sign. In the last few years, a number of wildly popular YouTubers have started working with shop owners to showcase their products, bringing visibility to these small retailers and, in many cases, changing their fortunes. It’s a wonderful ‘old meets new’ story that highlights the impact of India’s digital revolution in a historic corner of the country’s retail landscape.

One of the most compelling pieces of content on Netflix right now is a documentary made by actor Jonah Hill about his therapist, Dr. Phil Stutz. This comes at a time when the world is becoming more aware about mental health issues, and even the most conservative societies in our region are now much more open than they were five or six years ago to discussing and tackling issues like anxiety and depression. Throughout this documentary, we get a peek into Hill’s own mental health struggles; something he’s been very candid about in recent years, and come away with practical tools and techniques that Dr. Stutz uses. This is a film that anyone and everyone can benefit from in their personal growth journey.

If you have time for a longer read, here are two books I’d like to recommend. 

The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, by Michael J. Mauboussin 

Some of you may have read my earlier writing on serendipity. I found Michael’s book, which dives into this topic, deeply fascinating and educational. The book makes the point about how consistency of process over a period of time allows investors the best chance of harnessing the power of  luck.

Empire of Pain: The Secret History of the Sackler Dynasty, by Patrick Radden Keefe

A long but interesting read about the history of one family which had quite a substantial impact on the US drug industry. I learned a lot about America’s pharma industry, how money corrupts people and divides families, and about the unstoppable drive of founders with a fire in their belly.

Do write in at gv@peakxv.com if any of my interests intersect with yours! Click here to read more articles on Peak XV’s blog. For more editions of Connecting the Dots, click here. I’m also on LinkedIn and Twitter.