Today on MBA Mondays we are going to talk about another form of costs; Sunk Costs.
Sunk Costs are time and money (and other resources) you have already spent on a project, investment, or some other effort. They have been sunk into the effort and most likely you cannot get them back.
The important thing about sunk costs is when it comes time to make a decision about the project or investment, you should NOT factor in the sunk costs in that decision. You should treat them as gone already and make the decision based on what is in front of you in terms of costs and opportunities.
Let's make this a bit more tangible. Let's say you have been funding a new product effort at your company. To date, you've spent six months of effort, the full-time costs of three software developers, one product manager, and much of your time and your senior team's time. Let's say all-in, you've spent $300,000 on this new product. Those costs are sunk. You've spent them and there is no easy way to get that cash back in your bank account.
Now let's say this product effort is troubled. You aren't happy with the product in its current incarnation. You don't think it will work as currently constructed and envisioned. You think you can fix it, but that will take another six months with the same team and same effort of the senior team. In making the decision about going forward or killing this effort, you should not consider the $300,000 you have already sunk into the project. You should only consider the additional $300,000 you are thinking about spending going forward. The reason is that first $300,000 has been spent whether or not you kill the project. It is immaterial to the going forward decision.
This is a hard thing to do. It is human nature to want to recover the sunk costs. We face this all the time in our business. When we have invested $500,000 or $5mm into a company, it is really easy to get into the mindset that we need to stick with the investment so we can get our money back. If we stop funding, then we write off the investment almost all of the time. If we keep putting money in, there is a chance the investment will work out and we'll get our money back or even a return on it.
Even though I was taught about sunk costs in business school twenty-five years ago, I have had to learn this lesson the hard way. Most of the time that we make a follow-on investment defensively, to protect the capital we have already invested, that follow-on investment is marginal or outright bad. I have seen this again and again. And so we try really hard to look at every investment based on the return on the new money and not include the capital we have already invested in the decision.
This ties back to the discussion about seed investing and treating seed investments as "options." Every investor, if they are rational, will look at the follow-on round on its own merits and not based on the capital they already have invested. But the venture capital business is a relatively small world and reputation matters as well. Those investors who make one follow-on for every ten seeds they make will get a reputation and may not see many high quality seed opportunities going forward. Our firm has followed every single seed investment we have made with another round. In most cases, those investments have been good ones. But we have made a few marginal or outright bad follow-ons. We do that for reputation value as much as anything else. We measure that value and understand that is what we are doing and we keep those reputation driven follow-ons small on purpose.
When it is time to commit additional capital to an ongoing project or investment, you need to isolate the incremental investment and assess the return on that capital investment. You should not include the costs you have already sunk into the project in your math. When you do that, you make bad investment decisions.
“We do that for reputation value as much as anything else. We measure that value and understand that is what we are doing and we keep those reputation driven follow-ons small on purpose.”So do you factor those into your PR budget then Fred? 😉
You beat me by 2 minutes to copying and pasting this very sentence.My question is: won’t people realize what you’re doing? And haven’t you undone a little bit of that value by making this public? I realize that there’s no obvious delineation between big and small investment the second time around, but still…All of this signalling talk is interesting because it’s very real-world and not the sort of thing that academia teaches.
There are two parts to this which Fred can elaborate on.1] All projects for start ups are guesses. Usually your working on something new. There is no exact science that would tell you how much it will cost to succeed. In the initial seed round part of the VC’s role is to review expected costs and seed money is technically an approval. Of course the VC’s often have other projects as benchmarks and probably even factor the potential for error (not on success but funding needed to succeed). So if you do not give follow on seed money your reputation would be to start ups that even if your project stays promising if you don’t nail it with first round your left looking elsewhere for funding. (meaning support from this VC will be automatically gone). This would lead to lack of future opportunity or poorer investment terms.2] Fred doesn’t the follow on funding mean an increased ownership stake? Thus increasing return should the project pay off?If my second point is true this reduces what you might think the value of making this public. Its not free money. It has strings. But those strings do mean continued support.
I’m curious about this as well… do your portfolio companies know you’re following on to defend your reputation?
I’m guessing that it’s part, but never the whole reason. I’ll bet some stragglers surprise often enough.
I think that by making this public Fred might actually be increasing the signalling value of the “reputation round”; rather than any negative effect because everyone knows what they’re doing, it ensures that USV will continue to have a chance to invest in way more than their share of the top companies in the space going forward. You know you’ll have a fair shot at making it big when they invest in your startup- also I suspect there might be some value in learning how these entrepreneurs behave when things didn’t go as they had planned, but USV is willing to see if given a bit of extra funding they might be able to carve out some sort of a positive exit- if the entrepreneur manages this situation well it would likely give the VC additional confidence and the inside track to invest in their next venture?
you read my words correctly jared
not often unfortunatelygiven our strategy, i wish it was more often
I would love to hear your thoughts on this, Fred. To me, it implies that trajectories hold more often than not. If you were to divide projects into ‘those that pivoted’ and ‘those that held the course’, would you find any difference amongst the two?It seems that those late stage decisions that might make the difference would really turn on the essence of the project that piqued your interest in the first place, -whether it lie primarily in the team, the core function, or a combination of things.Even in the early stages of a project, I find that when we can sit down, and get reflective on our project in a calm and causal way, we often find ourselves casting off some of our latest and greatest plans as we reacquaint ourselves with the essence of what we are doing. After these meets, we walk away clear-headed. But it’s funny, that part needs nurturing. I’m finding it’s one of the most important things we do, -it’s almost religious.Do you nobly ride the essence into the ground, or do you even cast that aside when every one knows where the train is headed? As an investor, do those second round require answers to these kinds of questions?
Founder note to self, “when courting money, position startup in a place that defends the reputation of investors”.
we don’t explain our investment rationale to anyone other than ourselves (and our blog readers when we blog about it)you and they will just have to guess why we are investing
What about the LPs? I’m not sure I’d like the prospect of my money being put to work in marginal or even bad follow-on deals just to preserve the reputation of the fund manager (I know LPs benefit from a fund manager that has high quality deal flow, but that impact is long term and may actually benefit LPs in the next fund).I always rationalised option seed deals as being a form of DD for a larger round – you put in a bit of money and give the team a chance to prove itself and its product. Of course, this means that you don’t go on to back a sizeable proportion of the pool of companies, but at least that decision is based on genuine knowledge.(I do agree though that a firm has to go into each of these option deals with the intention of following them all the way, and the resources to do so if they prove themselves. Firms which do 10 deals knowing full well that they can only ever fully support 3 or 4 deserve to lose their deal flow).
From the simple position of a VC – option seed deals make all the sense in the world. throw more spaghetti on the wall – and eat what sticks – discarding everything else.Of course, this only works in a highly capital constrained world – where founders / entrepreneurs have to take your money.In a competitive environment – you lose your reputation as someone who sticks by your companies – and are seen as a dilettante – and as you say – lose your deal flow.
Instead of investors did you mean founders/entrepreneurs?
yes. fixed the problem. Thanks for the catch.
you think it’s an entrepreneurs market, not a VC market? that seems true to me only if you already have a reputation and connections.
I think there are 2 markets out there right now. For those with “reputations and connections” – i.e. serial entrepreneurs with a history of success – it is a sellers market. they can pick and choose. Anyone with traction to some degree can pick and choose. Look at the coverage of the Foursquare financing. However, if you are not in these positions – then it is much more difficult – and you will likely have to take whatever deal is on offer if you want to pursue your project.This makes sense to me when I put my public market hat on. VC’s for the most part are thematic and momentum based investors. So pick a hot theme – build some momentum – and it becomes a bit easier to pick and choose your partners.
it is most certainly an entrepreneurs market in web/tech and has been for almost a decade
once the LP commits to our fund, they are giving us the right to invest their capital as we choosethey have no control over how we do thatthey can, of course, choose not to invest in our next fundwe had 100% re-up in our second fund
that’s a sweet stat right there.
i make most everything public, particularly our approach to investing and working with entrepreneurs
we don’t have budgets for anything. we don’t spend cash on PR, but we do manage our reputation. i am doing that right now.
what no budgets? ….but this is MBA Monday! 🙂
we have one budget actually – the total amount of money we spend each month, quarter, and yearand that is spent about 90%+ on people
Great point and an important lesson to put into business practice (and life). Taught in all finance and economics courses, this is a concept students find reasonably easy to understand by one that is very very difficult to put into practice.I explain it often by through the age old proverb “dont cry over spilled milk!”
If the emotive nature of money makes it hard for you to accept the concept of sunk costs and deal with them rationally – just transpose it for something far less emotional like, erm…love.If a relationship isn’t working out – you don’t decide whether to stay or go based on historic time and effort put in – you base it on how you foresee the future panning out.You wouldn’t stay in an emotional relationship based purely on money already spent on it – why would you a financial one?
You wouldn’t… but lots of people do stay in relationships because they’ve spent lots of time together and time = money.Love and loss aversion make people do very irrational things.
Irrational, but predictable.
🙂 Lately you are always able to compare everything with love and marriage! I think that your comparison is highly relevant. I see a lot of couples fighting for something which obviously doesn’t work. They do it because “we’ve been though so much together”, just like the business guy too reluctant to admit it was a bad investment.
just trying to add a little humour to a monday morning
Darling, even some marraiges are a bad invement. I also wonder if the followup rounds are the VC equivalent of good community investments. Bad for the firm, good for the ecosystem. There are tradeoffs just like divorces (there are marriages that stay together for community appearance sake, aka the ecosystem that they take place, and it keeps strength in that community going)
Try to marry someone for whom the marriage vows are neither prose nor poetry but truth. This is kind of old fashioned but it is timeless. Because you will have tough times, I promise it.When you say “for richer or poorer”, make it stick and make it work. You will emerge stronger.If you can work it out, marry your best friend. Because you will likely need as much friendship as love.
i did that. it worked out pretty well. she still is my best friend
Thanks JLM. I mean it. : Still looking for a best friend that way. Don’tthink I’m grown up enough to find that person. Sounds wierd, it’s justsomething that I know.And I’m old fashioned enough to agree with you.
i have for a long long time compared the relationship between a VC and an entrepreneur to dating and marriage. i think there is even a blog post on AVC a long long time ago on that subject
I’m going to respectfully take the con on this one.I think when it comes to something that has emotion such as relationships with human beings “sunk costs’ count.The future does depend on the past. As Fred points out they make some follow-ons because it makes people want to take Fred’s seed money when they see the follow-on support. I always leave the field with the team I came in with. Meaning I could “dump” some person but I don’t think that’s right. You’ll never stay married if you don’t work through the tough times.When it comes to a purely financial decision: i.e. I bought this unbelievable disk array for a ton of money but now solid state makes it obsolete you make sure you don’t give one damn about past events (money spent)
perhaps my analogy isn’t accurate – apologies.for me the whole concept of sunk costs boils down to looking forwards and not backwards. -i’m not saying you shouldn’t work through the hard times, i’m saying you don’t decide to work through them based purely on effort put in to date. you always factor in positive future returns – and if you don’t think there are any – the fact that you’ve worked at it in the past shouldn’t swing your decision.
No apology needed. For a much more eloquent writeup of my viewpoint see Daniel’s link.
Money is intensely emotional, it’s why it’s one of the top issues that couples fight (or avoid talking) about
That’s what I was saying. If money was too emotive a subject to think rationally about transpose it with something less emotive. For comic purposes I chose love but it clearly backfired.
I don’t mean to stay on this but I can’t think of a topic less emotive than money, kill a project, not throw good money after bad, dump a stock that you’ve lost a ton of money on.What’s hard is personal relationships. Let’s say an employee is getting divorced from a spouse or even worse has a spouse that is going to die from cancer and they have young kids. I’ve been there.Sunk cost theory says the investment you’ve made is sunk, they aren’t going to be at the top of their game for the next year when you need them. The reality is you’d be better off firing them and hiring a new person. Throw them over the side of the boat they’re a sunk cost.
I think money is highly emotive. But appreciate it’s not universally so and probably depends on your upbringing and personal circumstances.I’m not talking morals or ethics I’m just trying to extrapolate the theory.
I think you have great comments….and I think you are right it does depend on upbringing and circumstances…that is where you are totally right in that people need to separate the money and the emotions.
Hmmm, in the business of hiring, inspiring and firing people I would be careful not to overlook the ROI in dealing with people with just a touch of humility and nobility and empathy.I have had the great pleasure of working with lots of good people through the years. I love them all. I have lost a single employee that I regretted at the time out of literally thousands.One time one of them — a real estate broker — got his ass in a huge financial crack and was about to lose his house. Posted for foreclosure. Painfully embarassing, humiliating. Two kids in school and getting ready to go to college.I am not exactly sure why but I wrote a check for $366K, paid off his mortgage, no written agreement, just a handshake and a smile and my asking him to do the right thing when he got back on his feet.I liked the guy immensely, trusted him but more importantly I thought — there but for the grace of God go I. I truly could feel his pain and embarassment. I made it as easy as possible for him to take that assistance knowing I just might never see the money again. I could afford it.That guy brought me several deals thereafter before anybody else saw them and I literally made a fortune on them. He also paid me back and though I asked him to keep it quiet, he did not. The goodwill this generated in the industry was worth millions more.Most important thing, I got a kick out of helping him in addition.I once paid for the son of one of my execs to go to drug reform, rehab school in Idaho. It was damn expensive. I never told him how much the bills were and I covered them as they came in. I wanted his mind clear because he needed the diversion. He was a trade school grad and had flown a couple of tours over N VN. I owed it to him.Just remember something simple — when you CAN help, it may be because that is the way God worked it out. He put YOU right where you could be tested and could make a difference in the world. He gave YOU the power to change the world.You can only eat so many tacos. When you can help a friend, do it. Make your brand of friendship something special in an otherwise shitty world. Cause guess what, it’s the right thing to do.
For the second time in this post somebody else has described why you can’t deal with people the same as you would money much better than I.I would also add that the Lord also tests you on strangers and it can be small as well as big. A simple act of kindness like dropping a twenty when you see somebody in line who is obviously in need, and explaining it fell out of their wallet, is a small act of kindness.
This behavior is the one that stops you from taking a cab after you spent 20 minutes for a bus, thinking that you’d be pissed if it came right after you leave.Or again, the exact same behavior that makes you want to keep gambling to “get back” the money you’ve just lost.Manipulation theorists call it “engagement”.
The bus/cab scenario is a relative of loss aversion, http://en.wikipedia.org/wik….
The book “Sway” is a quick and interesting read on loss aversion.
Thanks! I’ll have to check it out.
“How We Know What Isn’t So” – good overview of various heuristic shortcuts and fallacies that lead us astray – http://www.amazon.com/How-K…”Influence” – how “manipulation theorists” (I like that expression) take advantage – http://www.amazon.com/Influ…
I always appreciate book recs. Thanks.
On sunk costs- don’t get Influences followup, it’s a repeat of the same material. (i have sunk costs in that book)
Great example of this concept in real life Mohamed!
Sunk cost is a very difficult concept to adapt – unfortunately it applies to everything in life & not just project costs. Education, relationships, careers etc all have critical junctures where a decision is required. Letting go is a very hard concept and its intrinsic in human nature to try and salvage something from every investment.Mark Suster has a post where he talks about decisions by indecisions. The key problem with sunk cost is that we usually end up making a decision by indecision on it.The crucial point is about recognizing that managerial decisions need to be made. In the VC world, those decisions have a much more explicit form ( investment rounds) whereas in other aspects of life, they are much less obvious.Is there a secret sauce?
Here’s the link to Mark’s post in case anyone’s curious and hasn’t read it: Avoid decision by indecision
I usually don’t comment on these Monday Morning MBA posts – but this is an important one to understand.Sunk costs in investing are very close to the phenomenon knows as “anchoring.”If you buy a stock at $10 – and it sinks to $5you are faced with 3 choices: 1. buy more at a lower price – average down, 2. sell your loser, 3. do nothing and hope it rises phoenix like back to your cost basis.All of these decisions will be made with sunk costs and anchoring involved. If you buy more you may think that you should get back to your cost basis – and the fact that you already have an investment at $10 will fixate you on that level. You will think “I can double my money on the new investment and break even on the original” You are dealing with the sunk cost – and you have anchored yourself to the $10 price tag.Similarly, if you decide to do nothing – you may just be waiting for the company to get back to where you started. You are anchored at the original price.Only the sale at a sure loss is a decision where you have weighed the sunk cost – thrown off the anchor and moved on.In hedge funds and personal accounts – this is a somewhat easier decision to make – because you can recycle the capital easily and move on.In venture firms, it is much harder for a number of reasons.Firstly, venture investors mark their books – usually at the last round of financing – so down rounds are a no – no. It makes it seem like the company is not doing well – and makes it harder potentially to raise the next fund.Secondly, venture investments are illiquid, so simply calling a bad investment a sunk cost is more akin to calling it a permanent loss of capital. If it is a small company and not going in the right direction – it is very hard to get anything back.Thirdly, there is the reputation or signaling issue to deal with. If you abandon the investment as a VC – what signal does it send to potential other investors? What does it do to your reputation with potential partners in the future?Finally, and I think this is the biggest one – since venture funds do not recycle capital – any investment – no matter how bad it is going, always has an option value. Think of it as a lottery ticket. It doesn’t happen often, but if a company successfully pivots and becomes a winner – you want to hold onto the lottery ticket. In the public markets – you can sell back your lottery ticket. In venture, you buy it, you keep it. So why give it up?Of course this last point leads to a highly skewed return profile for venture investments – generally, they are either home runs or strike outs – with very little in the middle. Public markets are exactly the opposite – because there is neither institutional anchoring nor a sunk cost problem in the public markets – but these are structurally built into the VC model.
That anchoring concept is very useful. Thank you.
If you have bought a security or made an investment subject to reasonable due diligence and thoughtful consideration, then the opportunity to buy more at a reduced price is a bargain. If you “like” a stock at $10, you should love it at $5.One of the comforts you may make is that it is not YOU who is valuing the security, it is the “market” and the market is never stable. It is either heading up, down or pausing to make up its mind.One of the considerations you have to take is whether you believe your own judgment to be sound. Never, ever take counsel of your fears.Every day we all make the decision to buy, sell, hold or abandon ship — sometimes by doing something but often by doing nothing. Perhaps more often by doing nothing. Because doing nothing often means we are happy with our original investment — or it could also mean we have lost our focus but that is a different story.The other great variable is time — because many investments ultimately prove out but not in the time period we desire them to perform. Time is a heartless wench but if you have enough time most things work.
Enjoyed the comments.In order to be successful as an investor you need the mental ability to be alone and wrong.Being the 20th VC into a Groupon clone is not likely to produce a lot of success – but will give you a lot of cover if you lose.The best investors I have ever seen are confident in their analysis and willing to stand by themselves, if necessary, and for quite a long time in order to be proved right.The more people piling in, the less the chance that the price you are paying is a bargain.
great comment harry
Putting reputation value aside for a second, by the logic of the final paragraph of this post, it would seem like a bridge loan is a bad investment nearly all the time. If it’s a bridge to an exit, then it’s a textbook case of falling into the sunk cost fallacy (as you’ve defined it here). If it’s a bridge to a financing, then you’re putting in money without knowing the valuation and thus you can’t really assess whether or not it’s a good investment. And it’s a bridge to nowhere, then that’s bad any way you cut it.
A bridge to help a company with a good product and market position get over a period of low cash can be a good investment. A bridge to help a company that has a bad product dress itself up for the next investor (Lipstick on a Pig) is probably not the best thing to do. Making sure you have a realistic view on which scenario you are dealing with and not letting sunk cost get in the way of the analysis is key.
Smacks precisely of Mark Suster’s take on why bridge loans are bad for entrepreneurs and vcs.
i think you are right andrew with the exception of the bridge to a financing you know is going to happen (might even be an inside round) but you are doing a bridge for some other reason (like to allow an M&A discussion to play out)i guess same is true of a bridge to an M&A event you know is going to happenthinking out loud here so forgive the rambling nature of this commenti guess bridges to uncertainty are bad ideas (leaving reputation value aside)
Do you think that there is a cultural difference in how sunk costs are perceived? I’m thinking about the differences in the perception of taking risks (such starting a business) in Europe, where it’s considered a bad thing, vs. the US, where it’s not considered as bad as in Europe. I guess, either way, we shouldn’t let it affect our future decisions…
I think there is a difference. Usually in Europe failing is perceived as something really terrible and it can be more difficult to recover, so cutting losses is usually avoided more than in the US.
Follow-On investment is required most of the time.But follow-on to follow-on and so ON without magnetization is bad.
Thank you for this. This is something I’ve often thought on, but never had a term for it.Reminds me of one of the ‘Daniel Strong’ tenants of the movie ‘Search and Destroy’: “The past is pointless.” 🙂 Maybe taking it a bit too far, but it’s was only funny because there is some truth to it.
Company A has invested $100,000 sunk costs invested in R&D and you had developed a great product.Company B spent an additional $50,000 ($150,000). In addition to a similar product it has a patent, marketing report and a prospective customer list.I guess what I’m saying is that the incremental investment is a function of the quality of sunk costs.
CPL,Just clarifying this concept. Sunk cost is always sunk cost. You should never consider it for rational decision making. (doing it to maintain reputation, etc is another debate going on here). Your decision should be made on future cash flows (future operating earnings or exit sale) only!What you are talking about is investments that have some value which is recoverable in some form. Those should be considered. Typically their value is baked into the future cash flow because those assets (including patent, marketing report or prospective list) are causing the cash flows. These also figure in the alternative case when you consider the question ‘if I pull the plug now, what will be my cash flows (sale of patents. customer lists, etc).
I have heard that women investors tend to get out earlier than men from investments into which they have “sunk costs”. Men stay invested and try to recoup the loss, from pride perhaps, whereas women tend to simply cut loose bad investments, from practicality perhaps. I wonder whether this is a myth. I wonder how much of the third world micro loan business, with women as a much higher recipient group than men, bears this out.If it is not a myth, then I would think there is a double argument for getting more women into investing, and entrepreneurial ventures as mentioned in the XX Combinator post.
Third world micro-loan works mostly on women for 2 reasons i) because they are not crooked and defaulters as much the men are (in the third world i belong to… no degrade meant). ii) many are taking micro loan to support their family hunger than making money and again women takes more responsibility here than third-world men (at least in the very-low income group )
Nifty seeing the value of reputation trumping sunk costs for seed investments.How do I reconcile reputation with seed only angel investors? They never follow on(*) and instead look forward to companies surviving on their own.As a founder I’d prefer clear expectations up front instead of rep followons. If at all possible I’d do everything I could to repay investors any sunk costs into a business I run if it doesn’t pan out, to protect my own rep.* = If an angel or fund follows on even once it follows on
As business school students, we are definitely taught to ignore sunk costs and focus on marginal costs and revenues when making decisions. It’s true that these concepts are the foundation of correct financial investment decisions.However, I’m not so sure that these principles can be imported and used as effectively in ‘life’, at least not all of the time. As one of my favorite profs at school, Clayton Christensen, points out- applying the ‘marginal cost fallacy’ to one’s life can have disastrous consequences, because it causes people to stray from their long-held principles. Take a look at his piece here: http://hbr.org/2010/07/how-…
This was of course a much more elegant way of expressing my view in the comment above. I would tell people to read the whole article…but appreciate your link to the relevant part for this post.
i wish i could have studied with clayton. he is an inspiration to me
I wasn’t going to post a comment, but I figured after spending so much time reading the article, it would be a waste if I didn’t say anything.
I think that’s a mistake, there’s no way reading it was a waste 😀
I think you should invest the additional time to re-read it.The original reading was a sunk cost that you should ignore and re-read it, but this time re-read every second sentence because maybe, just maybe, this time you’ll get something out of it!
Looks like Fred learnt his lesson well. He isn’t commenting on this post even though he sunk the time to write this one. 😛
not true. i was busy yesterday
Was trying to be funny. I guess it didn’t work. 🙂
if only others would feel the same. about one in a hundred readers leave a comment
Well, thats a good percentage I should say (not considering stupid spam-bots)
Can’t you also think of sunk costs in in a positive way too? For example, I’m getting my MBA and there’s 27 people in the class. The school has already sunk X dollars into putting on the program already (which is already covered by having 15 people enrolled), and there is room for 40 people in the room before they need more chairs.Since they have already sunk X dollars into putting on the program and since that amount has already been covered, it would be in their best interest to fill each class with as many people as they can until they would have to spend more money on bigger rooms, chairs, etc.Kind of a simplistic example, I suppose…
That’s what airlines do (and many other businesses with a high percentage offixed costs). The problem with that approach is that you show the marketthat the product can be obtained at a reduced price, so next time they willwait and you’ll have fewer customers willing to pay full price. Also, whenyou increase the number of customers service can suffer (same number ofteachers or flying attendants for more people).
Exactly, you are talking about “yield management” rather than sunk costs.
I have a hard rule on “sunk costs”.This is a term I’ve known for years – because I was forced to learn it the hard way. I think the only lessons you ever actually learn in life are the ones you pay for. I call this ‘tuition’, and it rarely comes with a diploma, and it almost always costs a lot more than ‘just money’.My rule is this – Once I realize that a project is in trouble – not doomed, but just in trouble – I assess what has gone into the project thus far, trying to tally every asset (Time, Cash, Labor, Relationships, etc.) invested. At that point, I evaluate the reasons for why I made the original commitment and try to establish if they are still true. If the original reasons are still valid, I put the concept on life-support, and try to revive/redirect. I am willing to invest 1/3 of the original investment during this life-support phase.The project (and the manager in charge) has a firm finite limit in terms of time, dollars and company resources to be able to solve the problem.Thoughts on this approach?Michael LainePresident, LiftPort Group – The Elevator to Space Companies
Tuition — a brilliant analogy. I often think of “tuition” in almost everything I do which is associated with failure. It is part of the “learning of life”.I have made massive amounts of tuition bear fruit in a future endeavor. I have learned a lot more from failure than success.
Thanks for your comments. I’ve posted some additional response earlier.I find it especially interesting that every person that responded to my comment, focused on my “tuition” comment, and most people didn’t have a lot to say about my “life-support” concept for dealing with sunk costs.Like you, I’ve made ‘tuition’ bear fruit many times… Walking REQUIRES falling – a lot. There is simply no other way to do it.Take care. [email protected]
great approach and great commenti reblogged part of it at fredwilson.vc
Thanks a lot. Sincerely. Posted a response over on FW.VC. Take care. mjl
I don’t think I agree with this approach.I feel as though putting projects on ‘life-support’ can actually work as a disincentive to staffers/partners by placing too much negative focus on the past and too much angst around a shaky, unknown future.i.e., we better figure this out OR…i.e., we don’t have his help like we did before, SO….i.e., it’s this way because we screwed up!That entire philosophy seems to basically aim to motivate through fear, implied threats, lack, imminent danger concepts. And while I’m sure that motivates some people and achieves some results, I haven’t seen data, and it is not my experience, to show that it is optimal in a 21st century workplace.I’m a fan of weighing the current pros/cons of Now and giving 100% support to Now with the full-on belief that the project will and deserves to succeed. If it works, fantastic. If it doesn’t work, fantastic. We’ve learned something. If we need to discontinue, we discontinue. No ‘life support.’
Interesting perspective on motivation. I can remember times when my approach ‘tanked’ a project. And other times, the project revived nicely. I think it was about 50/50%. You are right, my approach absolutely affected morale every time I implemented life-support measures. The times when the projects succeeded, I’d say were worth the risks/setbacks of the times that we failed. Maybe this philosophy stems from my first ‘job out of high-school’, was that I was a United States Marine. I know I operate with a ‘Boot Camp-like” mentality sometimes. I’d say that overall, it’s been an asset, but yes, sometimes it’s a problem. Thanks for your feedback. [email protected]
However, on a mostly unrelated note, the ‘tuition’ concept was great.
Thank you. I posted a response to Fred, here: http://fredwilson.vc/post/8…I have a pretty atypical past. (I’d guess that most people reading AVC.com also have atypical experiences!) And as I grow my particular vision of the future – and Elevator to Space combined with a Venture Capital company that nurtures precursor technologies – I have been reflecting a lot on ‘what went wrong’. I do a lot of ‘After Action Reports’ (again, training from the USMC) and the concept of learning lessons is generally expensive keeps coming up. The “tuition” model will be a sub-chapter of my book/software tool.
It’s all about pot odds. If the pot has $75(sunk cost) and it’ll cost me $25(additional investment) to see the river(exit) and I think I have an equal or better than 3:1 chance to win the hand(return at least my money or better) I call (make the investment), if not, I fold and move to the next hand. That’s the way I think about almost everything in life.
poker will get you a long way in businessbut not all the way
Only our government can throw good money after bad and spin it into some type of win scenario.
@fredwilson: “Those costs are sunk. You’ve spent them and there is no easy way to get that cash back in your bank account.”What’s the hard way to get that cash back in your bank account?
build a great product and sell a lot of it
It’s interesting, a large amount of the discussion surrounding the past two MBA mondays have been around keeping ones emotions in check. I wonder what the keys are about handling ones emotions are so that one can see with clear eyes?I mean, we’ve talked yoga, but even I know its a tad more complicated than that.
Some say sunk costs are solely a business decision. I don’t. Sunk costs are also a character decision as portrayed here http://www.youtube.com/watc… which is Danny Devito’s explanation to his question “Do you have any character at all?” Shana, IMHO “clear eyes” stem from such regret (the emotional sunk cost).[v.o.M.]
One other thing I took away from reading a mishna on “True Love” this morning http://www.torah.org/learni… that if there is emotional dependence on something, it isn’t a sunk cost. Then we are living in the “what if’s” and “only if” kind of world. So I think of sunk cost no different to the Beatles did http://www.youtube.com/watc… which is “Let it Be”.[v.o.M.]
How interesting that this was found by a cross-posting at Silicon Alley Insider, a blog that has been ignoring this very principle when lambasting Microsoft for killing off Kin.
The good thing about sunk costs is, you learn to let go, realize the value of that circumstance, and become wiser with future strategies. Great experience is what you get; and maybe a good future investment not to make the same mistake.
i didn’t become a good VC until i had taken a few big losses and realized i could still look at myself in the morning
Jesus, I’ve never seen such amount of gray nmatter applied to such stupid arguments. So you have invested money in the past and your investment has not given the expected results. Now you’re faced with the decision of keepi investing on it or not. And you talk about “emotions”, “attachment” and such things? Please, you’re supposed to be business types. You should talk about possibilities, future projections and business plans. That’s what should drive your decision to keep investing or not.That MBA folks are still trying to understand so simple concepts says a lot about what is wrong with current business mentality.Repeat with me: sunk costs as a concept does not exists. The existence of this concept is a mere excuse to write off bad past decisions. Period. So please do not elaborate more over the simple fact that you may decide at some point that your past decisions were wrong.
Looks like Fred learnt his lesson well. He isn’t commenting on this post even though he sunk the time to write this one. 😛
In poker this is called being “pot-committed”–justifying your decision to stay in the hand based on having already “come this far” rather than the actual odds presented to you. A huge mistake and yet a really easy one to commit.
“…you should NOT factor in the sunk costs in that decision…”I wish you were around when my clients try to justify the price they want to list their home at based on what improvements they have and the money spent!
there is only one price, the market pricei feel for you Joe
In real estate, the most irrelevant pieces of data are — what you have in it, what you want for it and what it sold for 5 years ago.The market is a merciless but true bitch and she will reveal the most important piece of data — this is the offer we have for it.
This analysis is similar to the decision whether to hold or sell a publicly traded stock (although there a decision to sell doesn’t result in a total loss of value). What you paid for a stock should have nothing to do with your decision to hold it or sell it; the only relevant information is where you think the stock is going. Most investors sell their winners too early and hold on stubbornly to their losers, hoping to get back to break even. When I learned to do the opposite, my investment returns improved dramatically.
This pre-supposes we can determine when something is throwing good money after bad. What I see often is an investment with over-optimistic assumptions (1 year for proto’s, 5 beta customers, revenue in 1.5 years, break even in 3 years, etc.). After 1.5 years the product is late and you have one potential tier 2 beta customer (maybe) waiting for samples and you need more money. Good investors (internal and external) need to understand that the original plan was over-optimistic (which is okay or even good). And if the original rational still exists then I would expect that nearly always (absent extreme changes (cost 5 to10x what you though or whatever)) you would complete the investment to beta or some later stage to really assess customer traction. Most experienced managers/investors understand sunk costs although dealing with it is tougher in reality then you think. However, I also often see companies and investors that lack the stomach to see complex projects through to revenue and that is a problem as well.
how much do you think these kinds of decisions are a failure to objectively and unemotionally evaluate sunk costs…..and how much is the fact that it usually means someone has to take responsibility for the past decision and the consequences of it being perceived as a mistake?personally, i think blame and failure avoidance are huge factors – we are wired to avoid them by any means necessary. a strong team culture with an explicit acceptance of ‘fail fast’ might be the best cure to sunk cost mistakes.
good stuff. happy to have applied this way of thinking when web designer #1 told me we hit budget. choice was keep digging, or start over with new designer, happy to have made choice despite initial pain of decision
edit error, please delete comment
Hi Fred,Could you in the future write something about Real Options? I believe it’s a strong factor in financial decision making but also difficult to quantify as such.Thanks,Vincent
In all honesty, I’m applying this business concept even to my personal relationships.Folks often stay in things based on a history VS based on what is on the table, now.Gracias.
Great post and comments. One thought and one (perhaps dumb) question:1) On the subject of sunk costs in love/relationships vs. business: You know there’s a psychological difference if you have ever felt the tug-o-war between a spouse who loves a regular paycheck and a beloved but starving startup. It’s much harder to ignore the sunk costs in the latter if you have a lot of sunk costs in the former. 2) I had a business plan to get to breakeven based on a certain upfront investment of time and money. No surprise, it will take more time and money to get there, but the initial investment has produced a viable product as planned with some online sales proof points. Now I need to decide whether and how much more to spend. I’m reminded of the saying, “The temptation to quit will be greatest just before you are about to succeed.” You’re all saying, forget the original breakeven plan; look forward only, do the math on a go-forward basis and consider the past investment “sunk cost”. Or does that apply only when the sunk costs are someone else’s money? Because otherwise, I (and if not I, certainly that spouse I was referring to) do wonder, how do we ever calculate an ROI ?
I think we have to be careful not to let sunk costs influence decisions too much (one way or the other). There are so many hidden costs that get glossed over when decision-makers overcompensate against the sunk cost fallacy, imo.
A good idea is to set up-front, scheduled milestones or benchmarks for a project during which you assess the project/business. If it doesn’t meet the benchmarks set out or the market has changed, company policy should dictate that the project be killed. It is advisable that this be done along with someone that is removed from the project as emotions play a huge role in this process. Private equity firms are notorious for this and have it down to a science. Ultimately if the discounted future cash flows of the project do not exceed the amount of money required for continued investment in the project then it’s unwise to continue.
LOL…How about Safeway as a way to go… Forget the sunk cost – it is already sunk… And how about mnogo shamarki for your great ethics and good intentions, Dear Mr F RED!
Though I have yet to read it, I believe this is the concept behind Seth Godin’s “The Dip.” Great post, Fred.
“You should treat them as gone already and make the decision based on what is in front of you in terms of costs and opportunities.”This is why managing scope creep is incredibly important, to reduce the “sunk costs”.Still, it’s very reasonable to utilize this information – no need to scrap a project that’s 75% complete but reached it’s budget if the project is on track, or better, than previously projected…
How do you measure the likelihood of a young hot seed pairing with you, based on those follow-on investments?