The implications of optimism

Why investors shouldn't overlook an entrepreneur's outlook

May 01, 2004

Recent research suggests that investors should factor in the optimism of an entrepreneur when designing financing packages.

Launching a company is a risky business, with about half of all newly created companies folding within four years of their creation. It would therefore seem that entrepreneurs are world-class risk-takers.

However, what drives entrepreneurs to launch companies is not their attitudes toward risk but their perception of risk, say management scholars and psychologists. Simply put, many entrepreneurs overestimate their odds of success.

In the recent study "Financial Contracting with Optimistic Entrepreneurs: Theory and Evidence," Augustin Landier, an assistant professor at the University of Chicago Graduate School of Business and David Thesmar of École Nationale de la Statistique et de l'Administration Économique (ENSAE) and Centre de Recherche en Économie et Statisique (CREST) in Paris, use a dataset of French businesses to examine entrepreneurial optimism and its effect on capital structure and performance.

Landier and Thesmar looked at the differences in beliefs between entrepreneurs and investors. In addition, they determined which characteristics of entrepreneurs tend to be related to optimism.

In conducting their study, the authors merged two data sources. The first was a survey conducted by the French Statistical Institute of new businesses launched in 1994 and 1998. This survey provides information on entrepreneurs' demographics and expectations for company growth. The authors also used accounting data compiled from French tax reports covering firms' balance sheets, profit accounts, and employment from 1994 to 2000. Approximately 23,000 firms were included in the sample.

The authors compared entrepreneurs' growth expectations with actual growth. Different levels of optimism among entrepreneurs play an important role in whether those entrepreneurs select long-term or short-term financing. They find that optimistic entrepreneurs prefer short-term over long-term debt, and prefer inside rather than outside financing.

"Our message to investors is that contracts have to be designed to take into account the optimism of the entrepreneur," says Landier.

The Determinants of Optimism

The authors find that the degree to which an entrepreneur is overoptimistic depends on several characteristics. "Real" entrepreneurs who are launching a new venture tend to be more optimistic than heirs or family members who are simply taking over the reins of an existing entrepreneurial venture. In this sense, optimism among entrepreneurs is related to "the winner's curse" effect seen in auctions. Auction winners tend to be the most optimistic among the bidders and therefore pay too much for the item they are bidding on.

"If you inherit a business from your father, you didn't choose to inherit it, so the winner's curse isn't in effect," says Landier. "But if you have left a job to start your own company based on your own idea, something like the winner's curse is in play. In that case, you became an entrepreneur precisely because you're enthusiastic about the idea behind the business."

What are the other factors that encourage entrepreneurial optimism?

The authors find that as educational level and career experience increase, entrepreneurs are more prone to overoptimism. Because entrepreneurs must possess strong positive feelings about their ventures to put aside excellent jobs elsewhere, those who have more education and experience are likely to be more optimistic.

Male entrepreneurs also tend to exhibit more optimism than their female counterparts. Additionally, those who have already launched other firms are more optimistic than those who are launching a firm for the first time.

Entrepreneurs who have some expertise in the industry of their start-up tend to be more realistic, whereas those who became entrepreneurs to implement their own idea or because they needed more autonomy are significantly more optimistic.

Optimism and Debt Preferences

For most entrepreneurs, using short-term financing would appear to be a very risky course of action. However, approximately half of the debt entrepreneurs take on is short-term.

Short-term and long-term debt contracts involve trade-offs for entrepreneurs. Short-term debt comes with lower interest charges attached. However, an entrepreneur generally must produce positive results within a year or two. If these results don't materialize, the entrepreneur may default on the loan.

In contrast, long-term debt gives the entrepreneur more time to make his or her company successful and pay back the debt, with the trade-off being higher interest payments.

"The type of contract a more realistic entrepreneur accepts does not sound like a good deal for an optimistic entrepreneur," Landier explains. "Optimists believe the interest rates on long-term contracts are too high, while realistic entrepreneurs believe the contract the optimist finds attractive is far too risky."

Optimistic entrepreneurs aren't likely to abandon their dreams quickly or easily. The authors find that entrepreneurs with optimistic views at the start of their business ventures were still holding high expectations three years later. Even if it becomes apparent that their business will not succeed without abandoning some portion of the business plan, adapting it, or scaling back the business, optimistic entrepreneurs' strong belief in their venture may prevent them from adapting to early feedback.

"The enthusiasm of optimistic entrepreneurs is their strength and their weakness," says Landier. "They work hard, but are reluctant to adapt their initial idea."

For this reason, investors are well advised to offer optimistic investors short-term financing that shifts control and ownership rights to the investor if early results aren't up to par. The investor can afford to charge the lower interest rate on short-term debt because the investor will gain control if the entrepreneur cannot repay the money. The investor will then be able to force the entrepreneur to adapt the business to the reality of the marketplace.

When the business doesn't perform as well as it should, it is crucial to revise the business plan and adapt the product to customer demand. The optimistic entrepreneur is unlikely to make these changes without the pressure of an outside investor, notes Landier. In these cases, short-term debt is a powerful disciplining device, because it gives control back to the investor. The results show that optimistic entrepreneurs financed with short-term debt tend to perform better.

When an investor is dealing with a realistic entrepreneur, the best financial contract for both parties is a long-term contract.

Realistic entrepreneurs realize the chances of cashing in early on their fledgling businesses are small, while the odds of losing money in the early stages are much larger. For them, short-term financing is a risky bet. Long-term debt, on the other hand, smoothes income allocation across all possible results, and in essence, provides the realistic entrepreneur with a form of insurance. Moreover, the disciplining role of short-term debt is not required with realistic entrepreneurs. Since these entrepreneurs hold realistic beliefs, they have the right incentives to make the necessary changes to the business.

"Long-term debt gives you more time to generate cash flow," says Landier. "You have to pay more if the project is a success, but if the project isn't a success right at the start, you don't lose everything."

Furthermore, optimistic entrepreneurs may not view their endeavor as a major risk, because they see success as inevitable.

"The investor, however, knows it's a risky project," continues Landier. "The short-term contract says, 'We disagree, but we're able to bridge this gap.' The investor is saying, 'If you are right, you pay me something small. But if you are wrong, I will get full ownership and control of the project.'"

Additional Ramifications

The authors find that the preference for short-term debt isn't the only thing that makes optimistic entrepreneurs different. These entrepreneurs also prefer using as much inside equity as possible to fund their ventures.

Optimistic entrepreneurs believe the financial markets underestimate the potential of their ideas. In their view, taking on debt and interest payments is an unnecessarily expensive way to finance their firms. Therefore, they prefer to use as much of their own and their family's wealth as possible.

In addition, the failed businesses which were run by optimistic entrepreneurs tend to be worth less just before their demise than other start-ups. As predicted, short-term debt mitigates this effect since it enables the financiers to fold the business when it is clear that it will fail.

"Short-term debt is clearly a controlling mechanism," says Landier. "It forces an entrepreneur to abandon his or her dream if the business is realistically doomed to failure. It's a way of committing the entrepreneur to a realistic viewpoint."

The authors also find entrepreneurial optimism tends to affect initial effort. Optimistic entrepreneurs tend to work harder in the initial stages.

"Overestimating the chances of success means you also overestimate the returns on the effort you put in the project," says Landier. "If you believe your start-up is going to be a success, you won't mind working nights and weekends on the project. If you know there is only a 30 percent chance of success, you may be more reluctant to work so hard."

As the authors point out, "For entrepreneurs, differences in beliefs do exist, have real effects, and therefore do matter in the design of financial contracts. A good contract is one that bridges the expectations gap."


Augustin Landier is assistant professor of finance at the University of Chicago Graduate School of Business.