The Dilemma of Sunk Costs in Venture Capital
Last week, I bumped into a buddy who runs a fairly large venture-backed company. I asked him how things were going. Rather than getting the common response, “everything is great,” he explained that he had spent the last few quarters developing a new product only to discover the customer response has been lukewarm. He said this experience stung because countless hours and hundreds of thousands of dollars were spent building the product. He had also used up significant political capital with his Board. He asked me what I thought. I simply replied, “Don’t let the sunk costs get in the way of deciding what’s best for the business.”
A sunk cost is a cost that has already been incurred and cannot be recovered. We all experience sunk costs in our personal and professional lives. They can include money spent, time, effort and energy. Sunk costs play a big role in startups and investing. Startups and investors are faced with a barrage of sunk costs on a regular basis:
- Spending huge sums of money to develop a product only to discover there isn’t a market for it
- Hiring a key executive only to discover he or she isn’t a fit
- Making a big promotion only to realize the employee isn’t set up for success
- Naming your company and buying a domain only to find another company has the trademark
- Launching a large advertising campaign that doesn’t produce results
- Hiring expensive recruiters or consultants that don’t deliver
- Investing in a company that doesn’t perform relative to expectations
A lesson I learned in school and throughout my career: valuing and harping on sunk costs often leads to poor decisions. It is human nature to try to salvage an investment of time, money, energy and effort. Avoid the trap. They are counterproductive when making forward-looking decisions. They are often an illusion. Don’t let them get in the way. Treat the money, time, energy and effort as gone forever. I realize moving on can be painful and feel barbaric but it can also be liberating.
Whenever sunk costs are influencing decisions, I always recommend coming back to this question: ‘what’s best for the company going forward?’
As an investor, this often presents a dilemma. Investment theory suggests that any incremental dollar invested in a company should be evaluated separately from the initial check. I typically subscribe to this principle. It is sound and responsible. But what happens if a company is in a tight spot and needs additional investment to get to that next critical milestone or achieve an outcome? Is declining an investment in this situation truly in the best interest of the firm? I would argue that most often it’s not.
Venture, especially seed investing, is a human-driven and long-term business. My reputation is all I really have. If I don’t step up in times of need, I’ll eventually develop a bad reputation and founders won’t want to work with me. Being a supporter in tough times is not only the right thing to do from a human and karmic perspective but I also believe it will result in better returns over the long run.
Dealing with sunk costs isn’t so black and white after all. There are grey areas that ultimately challenge our values. If you just focus on what’s best for the company in the long-term you can’t go wrong.