Most conversations involving new ventures talk about the importance of founders or leaders having ‘skin in the game’ – a term first coined by renowned investor Warren Buffett referring to a situation in which high-ranking insiders use their own money to buy stock in the company they are running. Today it’s used a bit more generously and it refers to leaders having a stake in a company or a stake in the outcome of a new venture. And this stake isn’t limited to just a dollar investment; it can also refer to a time investment or even an investment of one’s professional reputation.
If you step back a moment and think of ‘skin in the game’ in terms of behavioral economics, then it becomes quite similar to the concept of sunk costs which can greatly affect the decision-making process of those involved. The most powerful aspect of this behavior is that individual’s with ‘skin in the game’ (and thus sunk costs) tend to display an overly optimistic bias as to the probability of success of the start-up. Now at first glance, there may be nothing wrong with having optimistic leaders running a new venture; optimism is certainly preferable to the other extreme of having overly pessimistic leaders which will certainly doom most new ventures.
But when you dig a little deeper, that overly optimistic bias as to the probability of success of the start-up can get you into trouble if things go south. Here’s how: An overly optimistic bias can lead to non-rational economic decisions when it’s time to make that critical decision of whether to ‘cut your losses’ and shutdown the new venture. How many times have we been in similar situations where sunk costs are incorrectly factored into go / no go decisions for a project or start-up? It’s the same thing here. It come’s under the heading of loss aversion and it’s what prevents most of us from taking losses on our own portfolios (stocks, real estate, etc.) – we would rather wait until the price (or outcome) gets back up to a certain level (usually the level of the ‘psychological purchase’) before we sell. And it’s not just that we prefer to wait; most people actually believe–sometimes beyond rational hope–that things will improve enough to get back to that psychological break-even point. In the end, it’s destructive behavior that typically leads to bad business decisions.
Heres the takeaway: Skin in the game can be a double-edged sword for management participation in start-ups. Embrace the positives, but be keenly aware of the negatives.
