Throwing good money after bad money

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:

• 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?

His answer to the first question was a clear ‘no’.
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.

Excellent post! Thanks for sharing. Some speed.

Thank you.

Great post.

I think Pim himself would benefit a lot by trying to answer those questions. New businesses will fail and it's important for an entrpneur to recognize when it's time to move on.

Thank you for posting this story. I've seen it again and again!

One of my rules is to look at each cash infusion as a brand new investment. Reassess the deal. Knowing what you know now, would you invest in this company? If the answer is "no" then forget about the past and move on.

The biggest mistake business owners make is not because of lack of opportunity, it's because they fail to cut their losers quick. (And that includes bad partners, bad products, bad marketing, bad employees - cut it quick and move on)

It's one mark of a real investor...to know when to take the loss and let it be what it is. I think it's very astute of Diane to mention that she wrote this sum off at the *beginning*. That's why she was able to keep a level head while others went blind.

uh, Diane didn't post the story. HenkHolland did. what's wrong with me today the point remains though. rock n roll!

Excellent post, Henk.

Getting into the fastlane is one thing.

Staying there requires an entirely new set of skills.

Rep speed. ++

-Russ H.

Great post and hopefully there were lessons learned for young Pim. Speed +.

I enjoyed reading this one! What Diane posted is great as well! Speed ++ to you both!

It is amazing how often we chase something we should just let go (applies to so many aspects in life, to old flames or significant others, investments, jobs, etc.). Sometimes life gives you "advice" or direction in mysterious ways, and the old saying "everything happens for a reason" is often true.

Thank you Diane. This is so true! Rep++

With a bit of exaggeration I dare to say that in many companies the 80/20 rule appears to be applicable to this. They spend 80% of their resources to fixing things not worth fixing and only 20% to develop areas of opportunity.

All of you thanks for the comments and speed.

My tip of the day: Don't invest anymore money. Pim's father should also let his son deal with this mess.

My question to you and Pim's father. What where you thinking?

-Did this guy have a proven business idea? No
-Did this guy have a proven brand (repeat business)? No (probably no if stage 1 wasn't even a "Yes").
-Did this guy have any proven CEO running it? I don't know, did he? If Pim where running the shop, then what is his experience running a company? If he had no experience, then why didn't you, the investors demand an experienced CEO running it from the get-go?

Excuse me for saying this, but both camps has done a serious error in evaluating this deal. As one famous dealmaker ones said (maybe someone may remember his name when you read this line of wisdom. I think his name is Herb Cohen): "You gotta know when to hold'em and when to fold'em". This is a fold, gentlemen. I wouldn't invest a dime more until Pim had a lot of customers, long term prospects and a smart and passionate CEO running the shop. Then he would get more money from me. Without question or doubt from my part.

The best way to start a company and make money if you are pretty broke yourself (as a Founder) is by printing up a lot of business cards and then hand them around to the right crowd. And then prey. There is not a lot more you can do, really. If you are lucky, you will get a fish or two. If you are really lucky you will get a fat, big fish. That is a start-up in it's essence. You will fail 99,9% of the time, why then waste all your money on one aim and risk to miss everything? Business cards is one of the cheapest ways to reach out. These days it may be smart to have a nice looking website too (elegant, not high tech).

One thing I have learnt is. If no one in your own city or village wants your service, then how likely is it that anyone else in the world would like your service? See it as a quick test of viability. I have just saved you a lot of cash.

Let the fish come to you and then bag the elephant. Pim should do just that. If he can't do that, then he just have to admit the idea wasn't as good as he thought. Many ideas are not that good in a commercial sense. Sorry, but that's reality.

Hold your money HenkHolland. Find another start-up with a proven business model and a proven CEO running the place. Then, if Pim do prove he was correct, then you may continue financing him. Otherwise, keep away.

Fanocks, thanks for the comments. You don't need to excuse yourself for pinpointing the truth.
Indeed I have made a mistake at the moment that I stepped into the first-round investment in Pim's start-up.

I have found the rule of "cutting your losses quick and moving on" to be true 100% in the past few years. When I was first learning how to invest in the stock market, there were quite a few times I lowered my stop-loss on a stock I had just purchased, and watched it fall further. Rather then pulling out and accepting it as a play that didnt work out, i remained stubborn, SURE that the stock would come back up and I would make the money I had planned. Meanwhile, the opportunities I missed while WAITING for that to happen may have made me my money back in half the time.

As Kenny Rogers said, sometimes you gotta "know when to fold em"

Always risky with start-up financing. Though, those 3 steps, if they are well taken care of, minimises the risk a lot. It can still fail, but the risk is much lower than if you didn't have a foundation for the company and investment to build on.

I do think you took a good step forward in your development though.

Great post Henk!! Speed+++++++++

This brings up an interesting side topic to this ...

When is it time to quit?

I remember in my naive days of MLM, the cult leaders would always espouse that "NEVER QUIT!" mantra -- which to most, seems like good advice.

I think the "NEVER QUIT" strategy is bad advice.

If I NEVER QUIT the MLM's or the various other schemes I tried to perpetrate, I'd be dead or living under a train track on Halsted Ave. I wouldn't be where I was today.

One must make distinctions between "quiting" and "changing directions".

Agreed. Gotta be willing to cut your losses. Closing my last "business" required an entire overhaul of my life, and it was really scary to quit. But sometimes you just have to decide that you're worth more than what you're getting, cut your losses and go build something better. I think that decision is when I started my transformation from salesman to entrepreneur. It's a tough journey but I believe will be quite worth it.

Thank you MJ.

A thread with experience and advice on how to know when it is time to quit or time to change directions could be very helpful for many of us on this forum.

it's a hard one to balance in your head too, especially when you have invested time and some energy into a concern.

I bought part of a company that makes plastic parts. It's a good business, but the ownership (myself now included) really haven't gotten it off the ground.

There are so many other opportunities out there, it gets me to thinking.
If I continue to invest tons of time, money and energy into this business, will it suceed?

Yes, no, maybe.... but probably a bit, sure.

But, what ELSE could I be doing with my time and energy.
Opportunity cost is one thing to consider, the other is what other people have mentioned. Invested capital in many cases is a sunk cost. Not worth dwelling on as long as you did your homework before investing.

Things work out and don't work out... as long as we live and learn, it's all part of the deal.

For me, this last investment isn't panning out as quickly or as profitably as I would like, maybe it's time to cut and run, I'm going going to get my initial money out any way you slice it