How Good are Entrepreneurs at Cutting Their Losses?
One of the entrepreneur’s toughest jobs is recognizing when a startup should end. Economists say delaying the decision to close shop drains financial resources, yet researchers are just beginning to get a handle on what influences people to pull the plug on failing firms.
Research by Olin’s Anne Marie Knott and Daniel Elfenbein “begins to open the black box” around why entrepreneurs delay their exit from bad businesses: financial incentives that drive them to go into the business may blind them to the reality of their firm’s prospects.
When entrepreneurs have skin in the game — either through cash from the company, stock, or options — their belief in the firm’s prospects is fundamentally changed. “The big surprise is that incentives shape beliefs, not just behavior,” Knott said. “Managers and entrepreneurs frequently destroy significant value by failing to shut down underperforming businesses in a timely manner. To address this problem, we must understand the mechanisms causing exit delay.”
The research also showed that entrepreneurs react slowly to bad news, but rather quickly to good news. In contrast, advisors to a company, who have no financial incentive in its success, make better decisions about pulling the plug on a foundering business. In fact, they might even be too quick on the trigger. “Entrepreneurs have to be really, really convinced,” Knott said.
The researchers reached their conclusions through a series of simulation games with 137 participants. Some participated as entrepreneurs, others as advisors. Twice, they walked through a detailed computer-based simulation showing quarterly results for a fictional company. Only the “entrepreneurs” could gain rewards for their decision to exit or stay in business. Each quarter, entrepreneurs could shutter the business; advisors could recommend doing so.
Why is this important? It's really costly for the entrepreneur to exit too late," Knott said. "But first, we have to understand how they make exit decisions."
KEY TAKEAWAYS for Managers
- Those with a financial incentive in a company — and the power to make an exit decision — react slowly to bad news about its prospects.
- The incentives actually shape the entrepreneur’s belief in the company’s prospects.
- Those without financial “skin in the game” tend to correctly evaluate bad news.
Daniel Elfenbein and Anne Marie Knott presented their research to alumni and friends in the business community on November 8, 2018.
“Equity Stakes and Exit: An Experimental Approach to Decomposing Exit Delay,”
Authors:
Daniel W. Elfenbein, Associate Professor of Strategy, Olin Business School, Washington University in St. Louis
Anne Marie Knott, Robert and Barbara Frick Professor of Business, Olin Business School, Washington University in St. Louis
Coauthors: Rachel Croson, Michigan State University
Publication:
Strategic Management Journal, Volume 38, Issue 2, February 2017.
