Thursday, July 15, 2021

Entrepreneurship Failure: Poor Skills or Bad Luck?

We spend way too much time focusing on success. How much space in popular press is spent on the centi-billionaires and the firms they founded? How much academic research is drawn from successful enterprises, those who founded and financed them, and the CEOs currently leading them? Let’s talk about failure for a little while.

We understand that entrepreneurship success, the founding of enterprises that survive and grow, in most cases has a big skill component, though luck is needed too. Is the same true for entrepreneurship failure? Probably not, as Diego Zunino, Gary Dushnitsky, and Mirjam van Praag point out in research published in Academy of Management Journal. Skill is so important for success that we can be pretty sure it is present along with some luck. But by the same token, bad luck can sink an enterprise regardless of skill, so failure does not mean that skill is absent. It does, however, raise the possibility that skill is absent. 

Why is this important? Well, the successful entrepreneur often does not form any new enterprises because managing growth and ensuring continued success is already plenty of work, and it is rewarding work too. Failed entrepreneurs often wants to form a new enterprise, because they naturally believe that they are highly capable and just got unlucky. After all, entrepreneurship does go along with a high self-image and willingness to risk other people’s money, and these days “serial entrepreneur” is something of a badge of honor.

But what about the investors who are asked to fund enterprises? Do they look at the track record of the entrepreneur? How do they assess it? First, we need to understand that very few investors face the situation of those who were asked to help fund Amazon. Jeff Bezos told them that they had a 70 percent chance of losing their money, which is fairly realistic (actually the percentage is higher). More importantly, he had no past failures because he had never founded an enterprise – he had been an employee. Most entrepreneurs asking for funding will have a short or long track record of dead or moribund enterprises.

One simple and incorrect decision rule is to view any failure as a sign to stay away. Clearly that will exclude many skilled founders and promising enterprise. Another is to ignore past failures. Clearly that means not seeding out some entrepreneurs who really ought to get a job instead. But can potential investors thread a reasonable middle path?

Fortunately, the researchers found that they can. When assessing a potential venture investment, how promising people found it and how much they could be willing to invest was influenced by past failure, but not so much that past failure ruled out investment. Instead, past failure made the potential investors more sensitive to clues about whether they entrepreneur had skills that would help the venture. So, neither of the simple and incorrect decision rules are at work, but instead some form of middle path. This is what we want to see.

So, does that mean all is well? Not quite. We have to remember that the research shows average investor reactions, and averages are usually smarter than individuals when making judgments like this. This means that entrepreneurial failure does not cut off funding for new ventures. It does not mean that all individual investors avoid the simple and incorrect decision rules. Good news for entrepreneurship, less so for investment. 

Zunino D, Dushnitsky G, Praag Mv. 2021. How Do Investors Evaluate Past Entrepreneurial Failure? Unpacking Failure Due to Lack of Skill versus Bad Luck. Academy of Management Journal forthcoming.