Entrepreneurs discuss a common side effect of a failing business - "chasing losses"

In a recent New York Times op-ed piece, Kai Ryssdahl, host of NPR's "Marketplace," and Megan Larson, the show's producer, profile several entrepreneurs whose early attempts ended in failure ("Following Your Bliss, Right Off the Cliff"). [Note that the web URL hints at an earlier, more interesting title: "The Painful But Liberating Lessons of a Career Failure."]

One theme of the piece is that failures are often made worse by our tendency to "chase losses" - meaning to stick with a failing proposition for too long and therefore lose more than was necessary. This concept is covered nicely in Tim Harford's book "Adapt: Why Success Always Starts with Failure." Here are a few observations from Ryssdahl and Larson on chasing losses:

But even when the future looked grim, [boutique owner Michelle] Tyree hung on. In fact, she dug in. She bought more inventory for the racks and threw celebrity-fueled parties at the store to generate buzz.

"Your gut says this could be a problem, but your head overrides it because you have just put in this huge investment," she said. "You are hanging on to not just the dream, but you are hanging on to the sweat equity and what you put into it financially."

Human beings, by nature, don't like to turn their backs on what are called "sunk costs," said Craig Fox, who teaches decision-making at the University of California, Los Angeles. When a lot of money is put into something - the dream of a small business, stocks or even an education - and it can't be recovered or is otherwise "sunk," few of us can just walk away....

Back in the '90s, when [Michael Dearing] was fresh out of Harvard Business School, he, too, sank a lot of money into his dream of owning his own store.

The Industrial Shoe Warehouse had five outlets in Los Angeles that sold work boots (think back to the Dr. Martens craze). "It had a vibe of, like, Urban Outfitters - concrete floor, high beam ceilings, all the stock was on the floor," said Mr. Dearing. "We had a really good business for awhile."

But, in the end, he said, "It was what you would call a splat-against-the-wall failure."

Mr. Dearing said the economics of running a shoe store were tougher than expected. Plus, the business grew too fast. Then Mr. Dearing's business partner wanted out.

He struggled to keep the business afloat because, he said, it felt dishonorable to let it go. "I personalized the outcome to a degree that it was unhealthy," he said. "I thought failure was total and permanent - and success stamped me as a worthwhile business person."

I discuss a way of managing the urge to chase losses - the concept of "affordable loss" - in Chapter 5 of the Mistake Bank book. If you're going to put your heart and soul into a project, you would do well to establish and manage to an affordable loss, so that your commitment and ego don't cost you in the event of a failure.

"Affordable loss" concept helps reduce the cost of failure

Affordable loss is a concept defined by Prof. Saras Sarasvathy of the University of Virginia's Darden School. The website effectuation.org provides a very concise definition of the concept:

Affordable loss involves decision makers estimating what they might be able to put at risk and determining what they are willing to lose in order to follow a course of action. Using the entrepreneur’s new venture plunge decision, this article combines insights from behavioral economics to develop a detailed analysis of the affordable loss heuristic. Specifically, we develop propositions to explain how individuals: (1) decide what they can afford to lose; and (2) what they are willing to lose in order to plunge into entrepreneurship.

This video from Professor Stuart Read of the IMD business school elaborates on the idea of affordable loss. Rather than sketch out a long-term vision and quantify potential, competitive strategy and define target customers, launching with affordable loss is done by defining a crucial first step (or steps) and deciding to invest a fixed amount (money and time) in it. If that step achieves its goal, it would justify more investment and the next step can be taken.

Affordable loss helps an entrepreneur know when something is not working and gives a signal that an effort should be stopped or redirected before too much money and time is spent. It's also discussed in two recent business books, Peter Sims' "Little Bets: How Breakthrough Ideas Emerge from Small Discoveries," and "Just Start: Take Action, Embrace Uncertainty, Create the Future," by Leonard Schlesinger et al.

Here's a quote from an entrepreneur who is interviewed in the video, Kevin DeWhitt, founder of Agilyx, a maker of alternative fuels:

The primary key was a wife who understood me. And when I came to her and said, "Honey, I think in a year's time if I develop a model and a story, I think I can get this project funded, and from there we can move on our way." In reality it took 2 years, and that was 2 years of a scientist not generating any income. There were 5 kids in the house, and a wife that was supporting everybody, that's a little hard. That vision, though, that she and I had together and she allowed me to pursue was really key in getting it launched.