Sunk Cost Fallacy

I highly recommend The Economist article noted below, it concerns what is known as the sunk cost fallacy.   That’s the phenomenon describing individuals who throw good money after bad, funding failing projects because they cannot bear to lose their already invested money.  This behavior, while universally observed, is epidemic in the startup world.

First, some background.  We’ve all seen the startup failure statistics; I’ve cited them in previous posts.  According to the US Census Bureau, over 50% of all startups will succumb within four years of incorporation.  Looked at dispassionately, that failure rate represents a lot of lost money.  Whose lost money?  Mostly that of the entrepreneurs themselves or of their friends and family.  Smallbiztrends.com notes that over 80% of all startups are self-funded and/or rely on the largesse of relatives and close friends.

One could hardly create a more perfect petri dish for propagating the sunk cost fallacy phenomenon.

Without the discipline imposed by banks, venture capitalists or other institutional players, self-funded entrepreneurs are left to pursue that ever elusive national account, that viral posting.   Success is always just around this corner . . . or, surely, the next one.

But, wait. Isn’t that the corner of Bankruptcy Street and Lost Friends Avenue up ahead?

I know this behavior because I’ve worked with and attempted to advise “sinkers.”  The pattern is insidious.  Decisions are made not on a long term, strategic timeline but, rather, on a daily, incremental basis.  Funding one more week or month seems sensible because, after all, one has plunked down mucho dinero already.

Yet, there may be more to this phenomenon than the misplaced optimism of inexperienced founders.  The Economist article below details a Carnegie Melon study that demonstrated that individuals are more likely to keep chasing a bad investment if they believe others have sunk costs in it.  In other words, the very fact that friends and family have invested in an entrepreneur’s bad business idea may contribute to his/her pouring more money down the drain.

If ever there was an argument for having an active Board of Directors, a trusted business coach or a close advisor, this study provides it.  Entrepreneurs, burdened with daily tasks and buffeted by unexpected problems, have a distorted business perspective. They need someone free from these quotidian distractions to step back and properly evaluate their businesses.  The results can change one’s point of view.

Over time, one might even view business failures in a new way:  Normal failures versus sinker failures.  Consider, for instance, that very short-lived restaurant, the one that opened where those other restaurants had come and gone.  Every town has such a spot.  Why did the owner choose to open there?  A bad idea, yes, but a “normal” failure.  The restaurateur stopped the bleeding quickly.  At least he/she didn’t sink and fail.