The Entrepreneur and the Sunk Cost Fallacy

May 25, 2018 Change, Entrepreneurship Comments (0) 79

If you’re an entrepreneur and you’re not familiar with the term “sunk costs” you may have a problem.

A “sunk cost” is any past cost for something that you’ll not be able to recover. Typically, sunk costs are not included when making forward-looking decisions because those costs will remain the same regardless of what you may choose to do. In manufacturing, for example, a sunk cost might be the cost of equipment because it is a cost that has been incurred which will remain constant regardless of whether that equipment produces any product.

Think of it this way: It’s money you needed to spend that you’ll never get back.

The problem for most of us is that our forward-looking decisions become too tied to those sunk costs. We often become emotionally invested and the more investment we make, the harder it becomes to divest ourselves from those costs. In these situations, it is difficult to consider the pros and cons objectively. Instead, we try to recoup sunk costs, which makes us do irrational things.

Researchers Hal Arkes and Catherine Blumer argue that when we continue a behavior or work because of our previous investments of time, money, or effort, we fall victim to what has become known as the sunk cost fallacy (Arkes & Blumer, 1985). We place such a high value—either monetarily or emotionally—on those investments that we irrationally behave when faced with a decision that devalues those prior investments. Moreover, we look for ways to justify our choice rather than accepting the sunk costs as what they are—money we can never recoup.

Let’s look at it a more personal way.

Say you bought a quart of your favorite yogurt at the grocery store. It’s been in the fridge for a few weeks unopened, and putting away the dinner leftovers you spot it and realize that yesterday’s date is the “use by” date on the package. Concerned that it will spoil, you open and eat as much of the yogurt as you can—maybe even all of it—even though you’ve already had dinner because you’d rather do that than “waste your money” on food that will spoil.

The money for the yogurt was gone several weeks ago. You’re not going to get it back. But you’re emotionally invested with your favorite yogurt and your money. So, you chose to load up on the yogurt, which you didn’t enjoy as much this time. You only felt bloated and uncomfortable in the end. You made a decision that left you uncomfortable because of your emotional tie to money and your yogurt.

Make sense?

Consider another example. If you’re an artist, you invest a lot of time and energy in creating art. You might even have an MFA, so you have those education costs and maybe student loans to pay back. The time and energy to earn the degree, and the cost of your education are sunk costs. You will never get that time, energy, or money back. And still, you may be inclined to factor all those costs into the sales price of the art you create because you’re emotionally invested in those costs. But in doing so, your art rarely sells, or sells very slowly, because trying to recover the sunk costs will likely price your work out of range for your market. What you should really be doing is setting the price for the art based on the current market value of the art and perhaps the incremental costs to create it—paint, brushes, canvas—rather than all of the costs—sunk and incremental—you have invested in the artwork.

It.’s important to remember that sunk costs can occur in any situation where what is invested cannot be recovered in any way. Sunk costs can be the 30 years we spent in an industry that has since evolved beyond our experience, skills, and perhaps relevancy, for example.  Or trying to prove you are right about something when being right doesn’t matter. Maybe even ending a partnership that has long outlived its usefulness to all parties, but you keep hoping things will improve. Or maybe, doing everything you can to save a failing business because you’ve invested so much in it, hoping that things will turn the corner if you don’t quit. Those decisions are all based on the sunk cost fallacy and will become one of the causes of failure.

Making decisions about the future by basing them on backward-looking decisions of investments time, money, or effort, do not move the business forward. And many of us are guilty of spending too much time in the past for fear of wasting our investments. Psychologist Robert Leahy suggests that human beings fundamentally hate the idea of wasting anything. We have a desire to prove we’re right, we fear regret, we don’t want to feel bad, and we are unable to anticipate the positive side of giving up on the past or how others may view us if we chose to give up (Leahy, 2014).  I would argue that for entrepreneurs, this is all about overcoming the social stigma of failure, a risk that every entrepreneur faces when he or she steps into the ring.

No one likes to fail. But it takes many entrepreneurs a long time to admit that they are failing, or have failed, especially if that failure is not public. Even in the midst of a failing business, many entrepreneurs don’t seek the help they may need, often for fear of judgment. Failure suggests you didn’t do your homework—you misjudged the market, the opportunity, the customers. Perhaps it suggests you didn’t manage your budget well, or couldn’t keep your employees motivated. Those things could be true, but it is just as likely that you have been—conciously or not—making forward-looking decisions that factor in your sunk costs. And putting sunk costs in proper perspective can make all the difference between swimming with the sharks, or being eaten alive.

References

Arkes, H. R., & Blumer, C. (1985). The psychology of sunk costs. Organizational Behavior and Human Decision Processes, 35, 124-140. Retrieved May 24, 2018, from https://pdfs.semanticscholar.org/e456/4b88ca2349962a707b76be4c75076ad6bd43.pdf

Leahy, R. (2014, September 09). Letting Go of Sunk Costs. Retrieved May 24, 2018, from psychologytoday.com: https://www.psychologytoday.com/us/blog/anxiety-files/201409/letting-go-sunk-costs

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Image source:  GEORGE DESIPRIS from Pexels

David Harkins is a serial entrepreneur with significant experience in branding, strategy, licensing and marketing.

In his spare time, he consults, coaches, speaks, writes, hikes, explores, and creates art. Although, not necessarily in that order.

Connect with him on social media below:

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Stop focusing on your product and start focusing on your customer

February 19, 2018 ENT670 – Adv. Entrepreneurial Strategy, Entrepreneurship Comments (0) 284

The most common definition of business suggests it is the “organized effort of individuals to produce and sell, for a profit, the goods and services that satisfy society’s needs” (Pride, Hughes, & Kapoor, 2013). In a manufacturing-driven society, this definition might be valid, yet it arguably emphasizes an outward-in approach to product and service development and in doing so has potentially set a generation or more entrepreneurs off on the wrong foot. So many entrepreneurs believe that the “thing”—the product or service—they have created will “satisfy society’s needs” without giving enough thought to understanding what society needs, values, and expects. The focus on the thing poses one of the most significant long-term barriers to success for entrepreneurs.

Entrepreneurs devote too much time and energy to the perfect execution of the product or service at the outset. In fact, many entrepreneurs invest—maybe even over-invest—in the thing before they understand if there’s an actual market for the thing. Not long ago, I spoke with an entrepreneur who had an idea for a new technology product and a pool of funds to develop the product. He was searching for a developer to help get this product off the ground but had not thoroughly researched the market opportunity for what he was about to create. Moreover, he had done little more than cursory research on his target customer. His focus was on product execution, rather than customer understanding. Unfortunately, this approach is all too common with startup entrepreneurs. A good product or service—one that meets a customer's desires—will be far better than a great product or service that misses that mark.

Steve Jobs once said, “Customer’s don’t know what they want until we have shown them” (Isaacson, 2011). To Jobs’ point, when new ideas for products and services are solicited from customers, those ideas tend to mirror competitive products in the marketplace or be derivations of products or services already available (Furnham, 2000). However, this should not suggest that knowledge of the target customer and customer input is without value. In fact, one might argue that Jobs and his team developed their products based on a clear understanding of the needs, values, and expectations of their target customer. Apple’s customers, for example, have come to expect the most innovative products, of the highest quality, that enable a short learning curve, efficient use, and support the simultaneous engagement with other products (Hyungu, 2013). Apple’s focus on delivering products to that target customer, and then taking care of that customer with committed customer service, elicits profound loyalty to the company and its products.

Customers are the only thing that matter to a business. Regardless of the product or service offered, if there are no customers, there is no business. It is surprising how many entrepreneurs start their business with an idea of a product or service and a detailed plan for execution of that offering, without a clear understanding of the customer. The customer’s needs, values, and expectations are never thoroughly researched, and the thing, as developed, misses the mark with the intended audience.

All of this is not to say that the thing—the product or service—is not essential. It is. However, a product or service is only relevant in the context of the customer’s needs, values, and expectations. A product and service placed at the center of the business, particularly in today’s business environment, may work in the near term but is not sustainable. The customer must be at the center of the enterprise for a business to have long-term success.

Perhaps a more appropriate definition of a business for our current environment might be “the organized effort of individuals to satisfy society’s needs, by producing and selling goods and services, for a profit.” Changing this definition might encourage entrepreneurs to focus first on the customer, and make product execution and delivery the second step in the business development process. Putting the prospective customer first might well make all the difference between success and failure of the next entrepreneurial venture.

What do you think? Should the customer needs, values, and expectations trump sheltered product development?

 

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References

Furnham, A. (2000). The Brainstorming Myth. Business Strategy Review, 11(4), 21-28.

Hyungu, K. (2013, September). To Be A True Industry Leader: Apple Inc. and Microsoft Corporation in Consumer. Leadership & Organizational Management Journal, 2013(3), 114-130.

Isaacson, W. (2011). Steve Jobs. New York, NY, USA: Simon & Schuster.

Pride, W., Hughes, R., & Kapoor, J. (2013). Business (12th ed.). Cengage Learning.

 

David Harkins is a serial entrepreneur with significant experience in branding, strategy, licensing and marketing.

In his spare time, he consults, coaches, speaks, writes, hikes, explores, and creates art. Although, not necessarily in that order.

Connect with him on social media below:

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8 Shark Tank Takeaways for Entrepreneurs

October 10, 2017 Entrepreneurship Comments (3) 615

The new season of ABC’s Shark Tank started a few weeks ago. If you are not familiar with the show, it’s a business “pitch show.” Each week several entrepreneurs pitch their businesses to a group of investors (also known as “Sharks”) hoping to secure funding for their venture. Although it is dramatized, like all reality shows, I am a fan because it aligns with my own experience as an entrepreneur and I believe aspiring entrepreneurs can learn a few lessons from the interactions those pitching on the show have with the Sharks.

Here are just a few of my Shark Tank takeaways for aspiring entrepreneurs and those looking to grow their business through outside investment:

 

1. Know your true opportunity.

Too many entrepreneurs go into business chasing what they perceive to be a market opportunity only to learn that the market is not significant enough to warrant an investor’s interest. Think about where the business could go, without being too unfocused, to grow. But be realistic. Just because there are millions of dog owners in the market does not mean you will sell every one of them your new dog product.

It is also critical to have a keen knowledge of your competition. You should consider how easy it might be to knock-off your product or service offering, or otherwise, move into your market. This is especially true if your competition is larger than you and the market opportunity is right. Competitors with deep pockets can be a startup killer. It is essential to understand how your business is realistically different.

Keep in mind that, investors want to maximize their returns. If you’re targeting a market that has limited potential, there’s little chance you’ll be funded if the investor doesn’t see a market opportunity you may be missing. Invest the time to understand the true opportunity before seeking outside investment.

 

2. Live and breathe your numbers.

Your business financials are the lifeblood of your company. Investors will want to know your financials inside and out. Your customer acquisition costs, cost-of-goods, operational costs, cash flow, inventory turn, and revenue growth are all key. You should also understand where improvements can be made within the operation that will increase revenue and profitability.

Investors want to know you are intimately associated with your money before they will invest theirs. They will also want to know how and when they might see a return on their investment. Often, they will ask “What if” questions about your financials and financial projections to look at the best case, the probable case, and the worse case business scenarios. With tools to run these scenarios in place, and having run various scenarios yourself, will not only help the investor understand the possible outcomes, but it will help you gain a better understanding your business financials.

 

3. Sales. Sales. Marketing. Sales. 

Sales will tangibly show an investor that your business may be a viable investment. If your company has sales, it demonstrates that there is some market opportunity for the product and services your business offers.

Sales numbers can also tell an investor a lot about a business. If a company has been operational for two months, for example, and sold 50,000 units of a $19.99 item, it might suggest that the entrepreneur has found the right market for the product. Conversely, if those 50,000 units were sold over three years, there could be many different underlying problems that would likely to give the investor pause.

Marketing is essential, too. Knowing how to reach your target market best and demonstrating it by consistently driving new customers to the business is vital. Keeping the customer acquisition cost low and the sales conversion high should get the attention of investors.

Know that few investors will invest much in an unproven idea. Investors want to see that the business has sales and steady growth. Operations can be improved, and costs can be reduced, but sales are necessary to keep the company going. Investors want to invest in winners and sales provide one measure of possible long-term success.

4. Be realistic with your valuation.

Most of us overvalue our businesses when seeking investment. Not everyone has $1,000,000 valuation. In fact, few startups do. There are many ways to arrive at a business valuation and the more common formal method discounts the cash flow over a period and then compares the ROI of the investment with a risk premium to the safest investment in the market. It can be complicated to calculate, and few entrepreneurs take the time to learn how to best value their company.

Too often entrepreneurs opt to look at sales numbers and factor some fuzzy math. Some might argue, for example, that steadily increasing sales from $250,000 to $800,000 over the last three years and being “on track for $1,500,000 this year” puts the value of the company at $1,000,000. Maybe, but highly unlikely. The cost of goods and operating costs need to be factored into the valuation.

Investors consider risk and opportunity in the valuation of a company. If the opportunity is excellent, but the risk is high, the investor will often want more equity to offset the associated risk. This includes those situations where the investor will need to invest not only money but time and energy into the business to see his or her return. The risk-reward factor is important, but financial fundamentals are the baseline measure for any entrepreneurial investment.

5. Understand how to scale.

Many entrepreneurs think having a product or service that they are selling is, in fact, a business. While in the strictest sense of the word this might be true, investors are looking for a “business operation” in which to invest, not a corporate structure. It is not enough to have chosen to incorporate and have made a few sales.

It is important to remember that most investors seek opportunities where the business has some structure that will enable it to scale. Scalability is key to maximizing an investment return. Investors look for companies that already have, or are implementing, systems and operations for scalability. For this reason, many investors will not invest in service businesses because they are more difficult to scale than, say, an online retail store, or maybe even a manufacturing business. Scalable companies not only have the potential to reduce costs, but they might also increase revenue and, in turn, profitability.

6. You are your pitch.

Having a solid business pitch is essential, but it’s about more than just the business. Clearly and succinctly communicating your business operation, what products and services it offers, how those products and services are delivered, who the customers are, and what problems your offerings solve for customers is essential. Equally important is your background and experience as it relates to the business, and what the company has accomplished to date. And, as mentioned above, your knowledge of the business financials are an essential part of the pitch. But investors value other things, too.

Keep in mind that when pitching, you are not only pitching your business, you are pitching yourself. It is good to be professional and prepared, but don’t come across as aloof or too argumentative. Have passion, but be realistic. Tenacity is good, within limits. How you conduct yourself in the pitch, and in “real life” will factor into the investor’s decision, too. Be humble, kind, and honest. Listen and be coachable. And be personable. Investors are investing in you, particularly in the early stages. You need to be as investable as your business.

7. Know your own limitations.

An entrepreneur’s passion generally drives the startup idea. Quite often that passion is driven by a desire to solve a problem. Yet, sometimes those who are motivated to solve a problem may not be or have the desire to be, a great business person. You may have created a great product, but you may not have the business knowledge or experience to grow the business opportunity. If an investor sees the value in the product, he or she might choose to invest; however, the equity ask might be 50% or more. The higher equity asks stems from the investors understanding of what needs to be done to turn your idea or product into a business. Such offers are always worth considering.

Investors willing to make an investment in you to help you build structure and sales of your product likely deserve a higher equity stake. In such situations, investors may well be bringing more to the table than you might be. In these circumstances, it is essential to consider your strengths, weaknesses, and interests, and then determine the real value you bring to the opportunity. This is the time, to be honest with yourself. Don’t forget that 40% of a company making money is worth a lot more than 100% of a company that is not making money.

 

8. Investors bring strengths and weaknesses.

Each investor will have his or her own strengths and weaknesses. They know them, and you must know them, too. Whenever possible, learn more about an investor, his or her likes, and dislikes, how they have invested in the past, what they’re looking for in an investment, and what they feel they can bring to the table. Knowing this will help you choose the best investor match for your business, and enable you to tailor your pitch to the investor.

As an entrepreneur, it is just as important for you to how you might leverage the strengths and downplay the weaknesses of a given investor in your venture. Choosing the wrong investor can be the kiss of death for an entrepreneur. Finding the best match is critical for success.

 

Although not every investment pitch will be made to a Shark like those on the show, entrepreneurs can learn from watching others pitch and listening to the questions asked by the investors. I watch little television these days, but I do try to catch Shark Tank each week, and when I’m traveling, I am guilty of binge-watching reruns of the show on CNBC. I am so surprised when I hear entrepreneurs tell me they have not seen the show. I think they’re missing out. I learn something every time I watch Shark Tank. If you’re an entrepreneur, I know you will, too.

 

P.S. In my personal opinion, sometimes Kevin “Mr. Wonderful” O’Leary is right. Licensing is the answer. But then, I’m a licensing guy, too. 🙂

 

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Featured Image Source: Getty Images/Phillip Faraone

 

David Harkins is a serial entrepreneur with significant experience in branding, strategy, licensing and marketing.

In his spare time, he consults, coaches, speaks, writes, hikes, explores, and creates art. Although, not necessarily in that order.

Connect with him on social media below:

Continue Reading