by Vincent DeFilippo, PhD, author of “Braking Point: How Escalation of Commitment Is Destroying the World (and How You Can Save Yourself)“
It takes a special person to be an entrepreneur. In addition to having self-confidence and a vision, entrepreneurs have a cognitive ability to explore new possibilities and opportunities. They hurtle headlong into new ventures, investing significant energy and resources. Yet, ironically, these are the same qualities that make them vulnerable to escalating their commitment even when they’d be better off cutting their losses and letting go of their project.
Research shows that although four out of five entrepreneurs believe they have a good — if not certain — chance of success, 74 percent of new start-up businesses fail, most often due to overconfidence and loss aversion. Further, according to research teams Staw and Ross, as well as Kahneman and Tversky, decision makers tend to escalate their commitment even when knowing they’re in a failing course of action. This speaks to the inherent optimism and confidence of most entrepreneurs. These same characteristics — overconfidence and fear of loss, also tend to foster an irrational escalation of commitment (EoC) when an entrepreneurial enterprise begins to fail.
Several theories regarding EoC behaviors offer insights into why entrepreneurs choose to escalate their efforts in shoring up a project that shows signs of failing.
These include:
1. Self-justification.
This theory is centered on the social pressure of saving face. It involves the entrepreneur’s need to legitimize investments. When an entrepreneur is surrounded by others with high expectations of their abilities, self-justification pressure mounts. As the entrepreneur faces an increased need to justify past choices, self-justification undermines innovation and adaptability and leads them to escalate their commitment to a losing cause.
2. Prospect theory and loss aversion.
Entrepreneurs who allow their passion and boldness to run wild without oversight have fallen victim to prospect theory. Prospect theory refers to how entrepreneurs make decisions, often driven by emotion, fear of losing, reference points, and framing. While they’re often willing to pursue their vision despite traditional norms, when these entrepreneurs meet with situations where their business is failing, they feel an inherent need to invest more and push harder so as not to lose to the competition. This aversion to loss drives them to take on additional risk despite evidence suggesting that they shouldn’t.
3. Sunk cost fallacy.
This EoC behavior is motivated by waste avoidance, and also involves a social component. Two mountaineering expeditions in 1996 illustrate this theory. Both mountain climbing companies were guiding clients to the top of Mount Everest. One company was led by an entrepreneur, Rob Hall, the other company was founded by entrepreneur Scott Fischer. As both set out on the journey with their clients, each had a contingency plan should their groups fail to make adequate progress. In both cases, the parties persevered in opposition to their original plans. In an unfortunate series of events, five people lost their lives in a major blizzard during that climb, including Hall and Fischer.
Neither guide wanted to squander the time, effort, and energy it had taken to plan, organize, and pursue the climb. But sunk cost fallacy encouraged them to push ahead, costing them their own and other’s lives. To avoid sunk cost fallacy, a keen awareness of what’s at stake should weigh more heavily than prior resources invested.
4. Attribution theory.
In this case, entrepreneurs have an exaggerated sense of their abilities. Such overconfidence affects how they interpret feedback. It can lead them to only consider evidence that supports their views, while ignoring information contrary to their views. Kenneth Lay and the Enron scandal exemplify how attribution leads to escalation of commitment. Lay was CEO of Houston National Gas Company when, in 1985, his company merged with energy pipeline company InterNorth, creating the new company of which Lay was CEO, Enron.
The company collected and traded natural gas at a much lower cost than companies having to drill for the resource, and profits quickly skyrocketed. Lay attempted to implement a similar strategy in other commodities, yet these endeavors failed to produce similar profit margins. Unwilling to admit defeat and ignoring internal warnings, he used “unusual” accounting to hide the failed deals from investors. Lay continued to maintain excessive confidence and refused to consider contradictory evidence. Ultimately, Enron’s failures were made public and the company was forced into bankruptcy in 2001. Twenty thousand employees lost their jobs and investors lost billions.
Because aspects of the entrepreneurial mindset often lead to an escalation of commitment to unrealistic visions, entrepreneurs must:
- Closely examine motivations and reasons for making additional investments into their ventures
- Listen less to their hopes and emotional attachments than to the voice of analysis and reason
- Adopt a more sound and rational decision-making approach
- Pay attention to history and learn from the mistakes of others who have tried and failed to tread the entrepreneurial path to success.
Entrepreneurs who challenge their own assumptions about why things are happening, and are aware of their cognitive biases and irrational tendences, stand a greater chance of making better decisions.
Dr. Vincent DeFilippo, DBA, MBA, is a professor in the School of Accounting and Business at Monroe College. Prior to that he was CEO of a private equity fund in Hong Kong, raising several billion dollars in venture capital for entrepreneurs and publicly traded companies throughout the Asia Pacific Region. His new book is “Braking Point: How Escalation of Commitment Is Destroying the World (and How You Can Save Yourself)“.
