Esclalation of commitment for VCs by Christian Jepsen

Escalation of Commitment in the Venture Capital Context

Summary of study results Prof. Dr. Malte Brettel / Dipl.-Kfm. Dominik Steink端hler Aachen, April 2009

Overview of this report‘s content and structure

Theoretical Theoretical background background Escalation Escalation of of commitment commitment leads leads to to delayed delayed terminations terminations in in sequential sequential investment investment decisions decisions -- Delays Delays in in termination termination due due to to escalation are irrational escalation are irrational -- Irrationally Irrationally delayed delayed terminations terminations incur incur high high opportunity opportunity costs costs and and claim claim resources resources that that could could be be better better deployed deployed elsewhere elsewhere

Structure Structure of of respondents respondents 177 177 valid valid responses responses were were included included in in the the analysis analysis Wide Wide country country and and industry industry coverage coverage assures assures representativeness representativeness of of results results Of Of the the responding responding VCs VCs -- 65% 65% invested invested more more financial financial resources into the failed resources into the failed projects projects than than projected projected -- 64% 64% invested invested more more effort effort into into the the failed failed projects projects than than expected expected

--- 1 ---

Survey Survey results results Sunk-cost Sunk-cost effect effect as as strongest strongest cognitive cognitive driver driver of of project project escalation escalation Self-justification Self-justification with with significant significant influence on all cognitive influence on all cognitive biases biases Political Political behavior behavior as as strong strong driver driver of of project project escalation escalation in in group group decisions decisions Countermeasures Countermeasures should should focus focus on on most most significant significant drivers drivers of of escalation escalation

Escalation of commitment leads to delayed terminations in sequential investment decisions Introduction to escalation of commitment

Sequential investments

Many organizational investment decisions take place sequentially and provide the option to continue or abandon projects at several decision points This flexibility provides significant value because it allows decision makers to acquire more information about projects‘ prospects by continuing to invest resources The realization of this advantage critically depends on the decision makers‘ effectiveness in terminating unsuccessful projects based on the updated information

Escalation of commitment

In such sequential investment contexts decision makers may fail to terminate unsuccessful projects and instead continue to invest resources (e.g. money, time, effort) Escalation of commitment describes the fact that individuals become overly committed to a course of action and persist beyond the point where an economically rational analysis of the project would indicate termination. Hence, project escalation leads to irrationally delayed project terminations

Delayed project terminations

Prior research has confirmed a systematic tendency of delayed project terminations in a multitude of different contexts and business situations. In some areas they are even the rule rather than the exception1 Because delayed project terminations incur high opportunity costs and claim resources that could be better deployed elsewhere they are of significant practical relevance

The Venture Capital industry provides an attractive setting to study escalation of commitment VCs routinely decide whether to continue investing resources so the potential for escalation is commonplace VCs are considered “expert decision makers“ who are experienced and incentivized to maximize profits. Accordingly, results from the study of escalation in the VC context may represent the upper bound on the quality of decisions and should therefore be generalizable beyond the VC industry © 2009 Lehrstuhl Wirtschaftswissenschaften für Ingenieure und Naturwissenschaftler

--- 2 ---

In the VC industry escalation of commitment leads to overinvestment in unsuccessful ventures with negative consequences for portfolio return Delayed terminations of staged venture capital financings Theory

Reality

Staged capital infusion as potent mechanism for controlling ventures - Allows the monitoring of progress thus reducing uncertainty in follow-on financings - Based on updated return estimations, VCs can determine whether the ventures should be cut off from new financing By focusing on the most promising ventures and terminating engagements in unsuccessful firms, portfolio return can be maximized

Empirical studies show the influence of escalation of commitment on venture capital decisions: - VCs systematically ignore new, incoming information about their portfolio companies2 - VCs exhibit a tendency to sell winners too early and stay with losers too long3 - VCs tend to continue investing in companies even when prospects of success are declining2 “In short, VC firms do not behave so as to maximize profits in sequential investment decisions”4

Relevance Since VC investments are inherently subject to uncertainty, investments that may perform worse than anticipated are unavoidable. Every VC portfolio includes both successes and failures. Accurately evaluating ventures’ prospects and terminating investments in unsuccessful companies is key to the overall portfolio performance Empirical evidence shows that VCs do not differ in their management of successful companies but in their capability to terminate investments in unsuccessful ventures.5 High performing VCs distinguish themselves from the rest of the industry in their ability to terminate unsuccessful investments earlier than others This termination capability is also a significant predictor of overall long-run venture capital firm performance © 2009 Lehrstuhl Wirtschaftswissenschaften für Ingenieure und Naturwissenschaftler

--- 3 ---

Several different non-economic factors may drive escalation of commitment Overview of escalation drivers In the VC context different reasons have been proposed for delayed project terminations, e.g. fund-life cycle, contractual pressure from co-investors, investment norms which penalize termination through the syndication network, etc. The above factors may lead to suboptimal termination decisions with regard to single projects (project level) which would represent escalation of commitment. However, it could also be argued that they quite rationally influence continuation decisions because they constitute external pressures to which the VC firm (firm level) adapts to meet its long-term economic interests The present study will focus on internal psychological and cognitive mechanisms leading to irrational persistence that cannot be explained by rational-economic considerations, neither on the project nor on the firm level. An overview of these factors is given in the table below:6 Escalation drivers

Description

Self-justification

Decision makers develop the motivation to reaffirm the correctness of past investments by increasing resource allocations. They want to protect their internal positive self-image and avoid the psychological cost of failure as well as save face to protect their external reputation

Perceptional deficits

Perception thresholds and selective perception of decision makers lead to incomplete/inadequate assessment of the decision situation and consideration of alternatives

Sunk-cost effect

Resources that have already been irrevocably committed are emphasized in the project evaluation and/or unconsciously influence the assessment of the situation and lead to risk seeking behavior

Overoptimism

Decision makers tend to systematically overestimate the probability of good and underestimate the probability of bad performance. Assessment of success and return potential is positively biased

Regret aversion

Decision makers anticipate the regret they would experience when the options not chosen would have made them better off than the chosen option. This “regret potential“ is included in the evaluation of alternatives and influences decisions because decision makers try to minimize it

Political behavior

Decision makers in a group have different preferences and act to serve their self-interests. Political behavior leads to less effective decisions that are not oriented toward organizational goals

--- 4 ---

Escalation drivers have been studied based on a European sample of VC investments from different industries Overview of sample The influence of the different escalation drivers on delayed termination of venture capital financings has been studied based on a European survey on venture capital investments that have to be considered as a failure 177 valid responses were included in the further analysis. Wide country and industry coverage assures representativeness of results. The results presented on the following pages constitute an abbreviated summary of the empirical analysis of the study and are based on the entire sample. Several control variables were considered but did not materially affect the results

Country distribution of respondents

Norway 3%

Industry distribution of investments

Other 16%

Energy and environment 7% Consumer

Austria 4%

Life sciences 26%

products, service and retail 7%

Germany 45%

Sweden 5%

Chemicals and materials 7%

France 6% United Kingdom Switzerland 12% 9%

Business and industrial products and services 13%

Total: 177

Communication 16% Computer and consumer electronics 15%

Total: 174*

Other 10%

--- 5 ---

Escalating projects consume resources that might be better deployed in more promising ventures Evidence of escalation in failing venture capital investments Financial resources invested 21% 1%

31%

30% 25%

21% 13%

6% 7%

-3 -2 much less than expected

Man-days / effort invested 21% 18%

5% 0% 2%

-1

0 +1 as expected

+2 +3 much more than expected

-3 -2 much less than expected

-1

0 +1 as expected

+2 +3 much more than expected

Comparison of rounds and months invested 5

45,4

4,1 40

4 3

2,3

Months

Rounds

30,5

Although the investments eventually failed, 65% of the responding VCs indicated that they invest significantly more financial resources than initially projected at the initiation of the project Additionally, 64% of the responding VC professionals invested more effort into the failing projects than expected

A comparison of the “Worst 10%” of failed projects that show the highest degree of irrational escalation with the “Top 10%” that show the lowest degree suggests that escalation leads to significant overinvestment:* - The “Worst 10%” received on average 1,8 more rounds of financing from the responding VC - The “Worst 10%” remained on average an additional 15 months in the portfolio of the responding VC during which they received support

0 Rounds invested

Months invested

* Because most VCs are reluctant to disclose data on investment volume in specific ventures, it was not possible to determine the financial loss from escalating engagements --- 6 ---

4 of the 7 escalation drivers have a direct influence on project escalation. Self-justification is a strong driver of all cognitive biases Causal relations of escalation drivers Model of the influence of the different escalation drivers*

+++

Selective Perception

+++

Perception Threshold

+++

Overoptimism

Comment

The escalation drivers included in the model explain 15% of project escalation

As mentioned earlier termination decisions may be influenced by a lot of aspects including considerations that induce the continued support of a failing venture but still serve the long-term economic interests of the VC firm

SelfJustification

Project Escalation

+++

Sunk-Cost Effect

+++

Anticipated Regret

* The plus signs indicate whether the influence is strong, medium or low. Dashed paths without a plus sign do not have a significant influence © 2009 Lehrstuhl Wirtschaftswissenschaften für Ingenieure und Naturwissenschaftler

Political Behavior

++ --- 7 ---

R2: 15%

Since the psychological and cognitive mechanisms considered here are not founded in economicrational considerations, these results imply that this 15% of project escalation is due to irrational persistence that cannot even be explained by firm level considerations This irrational persistence could and should be avoided by taking appropriate action

The findings which will be detailed and generalized beyond the VC context on the following pages can be summarized on two levels Summary of escalation countermeasures for the VC practitioner

Strongest impact

VC Company Level

Individual Project Level

“Change the organization” to avoid selfjustification Require consenting votes from front/back office Establish work-out groups for problematic projects Improve reward system - consider quality of the decision process - reward “successful terminations” Have publicly known stopping rules

Learn from sunk-costs but ignore them in future decisions Label sunk-costs as irrelevant for future Have adequate evaluation methods and mandatory expert support where necessary Discuss opportunity costs and contrast continued investments with new projects

Manage political behavior by making decision process rational Appoint supervisor who controls objective information gathering/analysis and decision making Incorporate politicking as negative factor in reward system

Transparency helps to cope with biases Create awareness of individual biases among decision makers Always consider termination as a valid option Improve information system - Prepare clear project reports that highlight progress and obstacles - Establish “decision circles” and reward messengers with critical but important information Appoint an “advocatus diaboli” where possible

--- 8 ---

The findings on the causal relations of the escalation drivers can be generalized beyond the VC context Interpretation of the causal mechanism driving escalation of commitment When a decision maker is subject to self-justification pressures, his actions will be influenced by the need to rationalize prior investments The mechanism to achieve such rationalization proposed by classic escalation research would be to simply persist in the prior course of actions, i.e. to continue investing However, in “expert contexts” such as venture capital this direct mechanism does not affect project escalation. Still, the strong influence of self-justification on the cognitive biases confirms the important role of self-justification and suggests that there may be a different causal mechanism that accounts for the influence of the need for self-justification on project escalation: the decision makers engage in a variety of cognitive “defense mechanisms” that eventually transmit the influence of self-justification and influence the decision to continue a project - When a decision maker feels self-justification pressure, he may be prone to narrow his information search. He may selectively perceive information that reinforces prior beliefs and which is in favor of project continuation. While he should attend to the whole pattern of information, he ignores contradictory information or discredits its reliability and relevance - Moreover, the decision maker will (unconsciously) pay more attention to the invested sunk-costs to lessen the “attractiveness” of project termination. Similarly, despite setbacks he may overoptimistically continue to believe in the bright promise of future gains and exaggerate the desirability of a positive outcome to justify continuation The allocation of responsibility and the structure of the decision process has an influence on how this causal chain may unfold - In conditions of high unquestioned freedom to make decisions the self-justification pressure has a strong influence on the cognitive biases and escalation because the decision maker may easily yield to the self-justification pressure that blurs his assessment of the situation and eventually leads to continued support of a project - On the other hand, in conditions of low freedom to make decisions, the need to self-justify shows much less influence on project escalation because individual decision makers that feel self-justification pressures are not free to act, for example because they need to substantiate their decisions in detail © 2009 Lehrstuhl Wirtschaftswissenschaften für Ingenieure und Naturwissenschaftler

--- 9 ---

Research has suggested a plethora of countermeasures to reduce escalation. However, a practically feasible selection should focus on the most significant drivers identified Countermeasures against escalation of commitment 1

Self-justification as significant driver behind the cognitive biases Elimination of the need for self-justification by separating responsibility for initial and subsequent decision making - Similar to the segregation of voting in bank lending business according to the Minimum Requirement for Risk Management (MaRisk): lending decisions require consenting votes from front and back office - Establishment of work-out groups who are assigned problematic projects and have no ties or commitments to prior decisions Reduction of the self-justification pressure by diversifying the evaluation criteria for competent decision makers - Include in the reward system a focus on the quality of the decision process instead of solely considering the actual outcome. In high risk environments, the outcome of decisions is impossible to control. By rewarding decision makers for the way a process is carried out makes them attend as much to the quality of analysis and decision making as to the final results. They are thus motivated to reorganize problems and deal with them instead of trying to turn their projects into a success, whatever the cost - Reduce the risk of failure for decision makers. Termination of projects should not tarnish the reputation or career of decision makers. Instead, reward systems should not only consider success but also “successful terminations” (e.g. “Perfect Failure” system at Heinz which rewards calling a quick halt to failing projects) Disrupt the causal mechanism between self-justification and escalation by limiting the unquestioned freedom to make decisions of decision makers that might suffer from self-justification pressure - Open declaration and discussion of objectives of responsible decision makers and discussion of how certain decisions contribute to the achievement of these objectives may prevent decision makers from following self-justification motives. Similarly, predetermined, publicly known stopping rules and clear milestones limit the discretion of individual decision makers

--- 10 ---

Sunk-cost effect as strongest cognitive driver of project escalation Explicitly label sunk-costs as irrelevant for future decision making. Challenge projects that simply continue due to their “inert force” Provide decision makers with adequate evaluation methods and expert support (for application of decision making tools and rational decision making methodology) Discuss opportunity costs (e.g. other projects that cannot be funded or receive less management support) to stimulate thought about future possibilities rather than regret for lost past investments

Political behavior as strong driver of project escalation in group decisions Political behavior is an inherent factor in group decision making and hence it is difficult to avoid / control Political decision processes are unlikely to be based on complete and accurate analysis of available information because they are not oriented toward organizational goals but instead revolve around the self-interests of individuals who may refrain from vetoing each other’s projects in order to gain advocates for their own concerns While such behavior may be individually rational it most certainly will not be collectively so because political behavior is detrimental to overall firm performance7 To assure effective decision making it is necessary to take a negative view of politicking. Decision makers should focus on common goals, putting the organization first and incorporating this orientation in the individual reward system It is necessary to ensure that decision making processes follow a certain procedural rationality which involves the collection of information relevant to the decision and the reliance upon analysis of this information in making the choice. A designated decision-making process sponsor may be appointed to ensure that involved decision makers follow such a rational process and refrain from political behavior

--- 11 ---

Biased / overoptimistic assessment of prospects Explicitly advise decision makers that they may be biased toward escalation and that they should keep this danger in mind. Instruct them that termination is a valid option that should always be taken into consideration Prepare clear project reports that regularly provide decision makers with an overview of project progress and obstacles. Clear criteria for success and failure and quantitative information help to recognize relevant information among the ambiguous plurality of feedback Obtain objective assessments of projects, for example by convening regular “decision circles” in which fellow employees offer honest evaluations of the hurdles projects face and their prospects. Encourage subordinates to re-evaluate decisions and establish explicit rewards for messengers with extremely critical but important information Introduce controlled conflict through an “advocatus diaboli” who raises objections to favored alternatives, challenges the assumptions and goals of individual decision makers, and possibly points out alternatives to prevent coming to conclusions without sufficient consideration

--- 12 ---

Findings on escalating commitment entail ramifications that can be applied to a variety of topics Examples of topics where escalation findings can be applied 1

Negative macro implications The individual psychological and cognitive drivers of escalation introduced in this study are clearly related to irrational decision making. However, there may also be external influences which have to be taken into account on the firm level (in the VC context e.g. fund-life cycle, contractual pressure from co-investors, etc.). By avoiding termination decisions, firms eschew the consequences of non-compliance with such constraints Accordingly, even though each firm may act to maximize its own interest, the overall economic result may be far from optimal. Companies and their capital providers incur opportunity costs on the whole by foregoing better investments in favor of existing projects In the VC context for example, the pattern of holding on to unsuccessful investments may have adverse implications for the allocation of capital to the most promising entrepreneurial opportunities in the overall economy

Danger of real option logic Whereas a sequential investment approach to project portfolio management undoubtedly has certain benefits, its success depends on implementation Accounting for the real option value of flexibility may justify investments that would have classically been rejected. Indiscriminately embracing sequential investment practices may be perilous, since the value of these investments critically depends on the capability to terminate unsuccessful projects at the right time However, due to escalation of commitment the challenges associated with abandoning projects can be greater than those associated with initiating them and firms may fail to adequately exercise their options to abandon failing projects

Termination capability as success factor When a project is doing well, firms seem to follow similar decision practices. This may be due to the fact that continuation is a relatively easy decision since the project is performing according to milestones However, when the performance of a project is uncertain or declining, decision makers need to exercise significant discretion in continuing or terminating projects. It is at this point where companies may differ. Given the number of unsuccessful projects in a typical company, managing these projects seems to be a valuable capability Firms with a distinct termination capability invest fewer resources in unsuccessful projects and may thus be able to gain a competitive edge and improve their long-run performance

--- 13 ---

Endnotes & Quoted literature

ÂŠ 2009 Lehrstuhl Wirtschaftswissenschaften fĂźr Ingenieure und Naturwissenschaftler

--- 14 ---

Endnotes

See e.g. Keil 1995; Lange 1993; Mahlendorf 2008; or Meredith 1988

Birmingham et al. 2003; Guler 2003; Ryan 1994

Birmingham et al. 2003; Valliere & Peterson 2005

Guler 2007: 275

Guler 2003

For a more detailed description of the escalation drivers see Dean & Sharfman 1996; Zayer 2007; and Zeelenberg & Pieters 2007

See e.g. Dean & Sharfman 1996; Eisenhardt & Bourgeois 1988; Elbanna & Child 2007

ÂŠ 2009 Lehrstuhl Wirtschaftswissenschaften fĂźr Ingenieure und Naturwissenschaftler

--- 15 ---

Quoted literature Birmingham, C., Busenitz, L. W., & Arthurs, J. D. 2003. The escalation of commitment by venture capitalists in reinvestment decisions. Venture Capital, 5(3): 218-230. Dean, J. W. J. & Sharfman, M. P. 1996. Does decision process matter? A study of strategic decision-making effectiveness. Academy of Management Journal, 39(2): 368-396. Eisenhardt, K. M. & Bourgeois, L. J. 1988. Politics of strategic decision making in high-velocity environments: Toward a midrange theory. Academy of Management Journal, 31(4): 737-770. Elbanna, S. & Child, J. 2007. Influences on strategic decision effectiveness: Development and test of an integrative model. Strategic Management Journal, 28(4): 431-453. Guler, I. 2003. A study of decision making, capabilities and performance in the venture capital industry. Dissertation, University of Pennsylvania, Philadelphia. Guler, I. 2007. Throwing good money after bad? Political and institutional influences on sequential decision making in the venture capital industry. Administrative Science Quarterly, 52(2): 248-285. Keil, M. 1995. Pulling the plug: Software project management and the problem of project escalation. MIS Quarterly, 19(4): 421447. Lange, E. C. 1993. Abbruchentscheidungen bei F&E-Projekten. Wiesbaden: Deutscher Universitäts-Verlag. Mahlendorf, M. 2008. Eskalation des Commitments bei scheiternden Projekten: Eine empirische Untersuchung kognitiver Eskalationsfaktoren und verhaltenswissenschaftlich basierter Controllingmaßnahmen. Vallendar: Inst. für Management und Controlling. Meredith, J. 1988. Project monitoring for early termination. Project Management Journal, 19: 31-38. Ryan, P. M. 1994. Escalating commitment: A study of contrasts in the venture capital industry. Dissertation, University of Texas, Austin. Valliere, D. & Peterson, R. 2005. Venture capitalist behaviours: Frameworks for future research. Venture Capital, 7(2): 167-183. Zayer, E. 2007. Verspätete Projektabbrüche in F&E. Wiesbaden: Deutscher Universitäts-Verlag. Zeelenberg, M. & Pieters, R. 2007. A theory of regret regulation 1.0. Journal of Consumer Psychology, 17(1): 3-18. © 2009 Lehrstuhl Wirtschaftswissenschaften für Ingenieure und Naturwissenschaftler

--- 16 ---