Earlier this week, I got involved in a LinkedIn Group discussion regarding start-ups and the concept of skin in the game. The original question centered around the plusses and minuses of joining a start-up management team with your own cash. The subsequent discussion trail focused on the financial aspects of pre-funding compensation, sacrificing salary as a substitute for providing equity to the operation, and investor expectations.
I then jumped in and made the point that there was more to this than just financial considerations, and made the analogy that ‘skin in the game’ was pretty much the equivalent of sunk costs. And with sunk costs, some powerful psychological forces come into play. Here’s part of what I said:
If you think of ‘skin in the game’ as equivalent to sunk costs. then some very powerful aspects of behavioral economics come into play. Two in particular are that (1) individuals seem to display more personal responsibility for the success of the start-up and (2) individuals tend to display an overly optimistic bias as to the probability of success of the start-up.
At first glance, it appears that both these aspects are all positive for the start-up. I mean, who wouldn’t want someone on the management team who displayed both more personal responsibility and an overly optimistic bias for success of the start-up.
But when you dig a little deeper, the second attribute – that individuals tend to display an 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 operation. 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 prevent 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. 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.
Reader feedback is the lifeblood of this blog – whether you agree or disagree with what you’ve read, please feel free to post your opinions in the comments section below.
