When to Hold ‘Em, When to Fold ‘Em

Loss Aversion and the Sunk Cost Trap in Venture Capital

In the high-risk world of venture capital (VC), balancing the tightrope of innovation and risk is a key skill to master. Knowing when risks have reached their limits can mean the difference between cutting losses and doubling down in hopes of a future payoff. This is where two powerful psychological biases—loss aversion and the sunk cost fallacy—often make that balancing act even trickier (you can find many fascinating articles about both biases on our page, check for example this article on loss aversion and enhancing the efficacy of teaching incentives or this one on the interchanges of climate change and the sunk cost fallacy out). Let’s uncover the fine line that venture capitalists face between losses and sticking it out in hopes of a future payoff.

First, a quick dive into the theory: Loss aversion is understood as the tendency to experience losses more acutely than gains (Hornero & Montalván, 2021). In VC, a loss can be perceived as exiting a failing investment—a decision that may feel unthinkable, even when it’s objectively the most rational choice. The sunk cost fallacy, on the other hand, is the bias of throwing good money after bad money. Past investments in time, energy, or money create a psychological stickiness, making it harder to walk away from an underperforming venture. In VC, where investments are often made in stages, each additional funding round can reinforce this fallacy, encouraging investors to back startups beyond their prime simply because they’ve already spent so much to get them there (Hogrebe & Lutz, 2024).

Both biases can be seen to be deeply ingrained in VC culture and have been examined as follows in academic literature. For instance, loss aversion is magnified when there’s a strong personal connection to the startup’s founders or mission (Mallik et al., 2017). The relationship VCs build with founders often amplifies the emotional stakes, making it harder to walk away without feeling a personal sense of defeat.

Coming back to venture capital’s multi-round investment structure: In each funding stage, VCs might find themselves increasingly locked in. For example, a VC might back a startup through two funding rounds and then hesitate to pull out in the third, even if metrics suggest a downturn. This commitment escalates when VCs believe they can fix the problem by stepping in more aggressively. This illusion of control—the sense that one more round of funding might turn things around—often leads VCs to invest further in struggling ventures, even as returns dwindle (Khanin & Mahto, 2013).

These biases play out in complex, high-stakes scenarios. Look at how decisions are made within the sector: Purely data-driven decision-making can be challenging in VC, as valuations and projections often rely on estimates, hard-to-quantify market trends, and qualitative factors such as team quality. Additionally, VC is known for its close-knit networks, and personal relationships frequently influence investment decisions. With this personal connection to the founders or a stake in the startup’s mission, the pain of potential losses understandably deepens, and VCs may become overly optimistic, investing more to avoid the emotional toll of quitting (Mallik et al., 2017).

Interestingly, certain fund characteristics can make these biases even stronger. Newer funds or those with ample unallocated capital are more susceptible to sunk-cost thinking, whereas more mature funds facing liquidity constraints tend to scrutinize investments more critically (Hogrebe & Lutz, 2024).

These biases prompt tough questions. Is it best to trust the, decisively shaky, numbers, or does gut instinct—emotional and otherwise—ought to have a key place in these decisions? After all, some might argue that this feeling, informed by experience, is as valuable as any metric, especially when dealing with the inherently uncertain future of a startup. On the other hand, rigorous decision-making frameworks and oversight committees might help us in shaking these biases. If VCs were to re-evaluate each funding round as though it were the first, disregarding prior investments, might they avoid the traps of loss aversion and sunk costs? Can intuition and objective metrics be balanced in a way that honors both financial prudence and the high-risk nature of the industry? In a field driven by both innovation and risk, recognizing the impact of these biases is essential‒not to make decisions driven by loss aversion or the sunk cost fallacy but to increase the chances of investing in the solutions of tomorrow.

Bibliography

Ceballos Hornero, D. and Mongrut Montalván, S. (2021) The entrepreneurial social discount rate: risk premium and loss aversion in new ventures, Revista Mexicana de Economía y Finanzas, Nueva Época. Volumen 16 Número 4, Octubre – Diciembre 2021, pp. 1-24. Available at: https://doi.org/10.21919/remef.v16i4.610 (Accessed: 06 November 2024).

Aziz Mallik, K., Munir, M.A., and Sarwar, S. (2017) Impact of Overconfidence and Loss Aversion Biases on Investor Decision Making Behavior: Mediating Role of Risk Perception, International Journal of Public Finance, Law & Taxation, Vol. 1, Issue 1, pp. 14-15. Available at: https://www.eurekajournals.com (Accessed: 06 November 2024).

Khanin, D. and Mahto, R.V. (2013) Do Venture Capitalists Have a Continuation Bias?, The Journal of Entrepreneurship, 22(2), pp. 203–222. Available at: https://doi.org/10.1177/0971355713490818 (Accessed: 06 November 2024).  

Hogrebe, F. and Lutz, E. (2024) Sunk costs and venture capital follow-on decisions: The role of financial flexibility, Journal of Corporate Finance, 86, p. 102589. Available at: https://doi.org/10.1016/j.jcorpfin.2024.102589 (Accessed: 06 November 2024).