Why Investors Shouldn't Overlook an Entrepreneur's Outlook
Research by Augustin Landier
Recent research suggests that investors should factor
in the optimism of an entrepreneur when designing financing
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
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
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 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,"
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
What are the other factors that encourage entrepreneurial
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
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
"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
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
"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.'"
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."