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This morning I had a typical encounter with the ‘sunk-cost trap’ and I thought it might be useful to share it with you.
About two years ago a young entrepreneur, his name is Pim, asked me and his dad to invest € 10k each in his e-commerce start-up. After looking at his business plan we decided that it had a good chance to become a successful business, so both his father and I invested the 10k and each of us obtained a 25% stake in the company.
Unfortunately, after a not too bad start (break-even) in the first year, the company started losing money in the second year mainly due to external factors that almost made the heart of the business model obsolete. Pim, as the entrepreneur, was to blame for not seeing it coming. Of course, Pim, after first juggling on his own to keep the creditors at ease, turned to us, his shareholders, for cash to keep it floating. That was yesterday.
Pim called me first before talking to his father. I told him I was not prepared to put one more penny into the company, because it is clear that this business model is dead.
Pim’s father called me this morning, quite agitated, to tell me that he could not believe that I was just turning my back on our mutual investment and on his son.
After calming him down I asked him the following two questions:
Upon answering the second question he did not get any further than some computer hardware and software that can be bought for a few thousand euro’s.
Pim’s father clearly fell into the ‘sunk-cost’ or ‘throwing good money after bad money’ trap. Because he had invested € 10k in the company he felt that he had to ‘protect’ that investment by putting in more money almost blind.
The two (or three) simple questions that I asked him made him realize that he would just be sinking more money.
My attitude towards investments in new projects is to evaluate the potential and the risks of such a project as good as possible before making the decision to invest. Once I decide to invest (we’re not talking about huge money) I mentally write-off that money from the day it leaves my bank account. In my experience this is the best way to invest in start-ups and young companies, which remain intrinsically risky anyway. It eliminates the irrational urge to ‘rescue’ the investment by throwing more money after it without looking at the attractiveness of the business case at that point in time as if it were a completely new project.
About two years ago a young entrepreneur, his name is Pim, asked me and his dad to invest € 10k each in his e-commerce start-up. After looking at his business plan we decided that it had a good chance to become a successful business, so both his father and I invested the 10k and each of us obtained a 25% stake in the company.
Unfortunately, after a not too bad start (break-even) in the first year, the company started losing money in the second year mainly due to external factors that almost made the heart of the business model obsolete. Pim, as the entrepreneur, was to blame for not seeing it coming. Of course, Pim, after first juggling on his own to keep the creditors at ease, turned to us, his shareholders, for cash to keep it floating. That was yesterday.
Pim called me first before talking to his father. I told him I was not prepared to put one more penny into the company, because it is clear that this business model is dead.
Pim’s father called me this morning, quite agitated, to tell me that he could not believe that I was just turning my back on our mutual investment and on his son.
After calming him down I asked him the following two questions:
- Given what you know today about the viability of the business model and the specific market would you invest in a new start-up with that business model?
- What tangible and intangible assets did our previous investment pay for that are worth or in need of rescuing by putting in more money? And will that money actually rescue it?
Upon answering the second question he did not get any further than some computer hardware and software that can be bought for a few thousand euro’s.
Pim’s father clearly fell into the ‘sunk-cost’ or ‘throwing good money after bad money’ trap. Because he had invested € 10k in the company he felt that he had to ‘protect’ that investment by putting in more money almost blind.
The two (or three) simple questions that I asked him made him realize that he would just be sinking more money.
My attitude towards investments in new projects is to evaluate the potential and the risks of such a project as good as possible before making the decision to invest. Once I decide to invest (we’re not talking about huge money) I mentally write-off that money from the day it leaves my bank account. In my experience this is the best way to invest in start-ups and young companies, which remain intrinsically risky anyway. It eliminates the irrational urge to ‘rescue’ the investment by throwing more money after it without looking at the attractiveness of the business case at that point in time as if it were a completely new project.
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