COGNITIVE BIAS
Why do investors keep funding failing companies?
Published date: 21 October 2024 | 5-Min Read
Before Apple’s iPhone revolutionized the smartphone industry, BlackBerry was a dominant force, seemingly invincible in both corporate and consumer markets. As competition intensified and touchscreens became the norm, BlackBerry’s leadership fell into the trap of believing their struggles were a temporary part of the natural ebb and flow of business.
This „It’ll-Get-Worse-Before-It-Gets-Better“ mentality led them to hold onto outdated strategies for too long, ultimately resulting in their downfall.
Investors face similar challenges when deciding whether to stick with a struggling startup or cut their losses.
The „It’ll-Get-Worse-Before-It-Gets-Better“ fallacy, a cognitive bias that clouds judgment, leads investors to believe that setbacks are temporary, and perseverance will ultimately lead to success. However, while some businesses do turn around after tough times, this belief can be especially dangerous in VC, where 90% of startups fail, and missteps can prove fatal (Failory).
This article explores how this bias plays out in venture capital, why it leads to poor investment decisions, and how investors can avoid falling into its trap.
It’ll-get-worse-before-it-gets-better
The „It’ll-Get-Worse-Before-It-Gets-Better“ fallacy refers to the mistaken belief that temporary downturns or struggles signal inevitable improvement—without evidence to support this claim. Investors fall into this trap when they convince themselves that poor performance is a precursor to future success, relying on anecdotal stories of turnarounds rather than solid data.
This bias is deeply rooted in optimism bias (the tendency to overestimate positive outcomes) and a misunderstanding of probability; answering the question „why do investors keep funding failing companies.“ In venture capital, where startups are already risky, the combined probability of success is startlingly low.
For instance, even when individual factors like sufficient capital, capable management, and market conditions are favorable, the combined probability of a startup’s success is just 17% (Harvard Business Review).
The Low Combined Probability of Success in Venture Capital
This reinforces the importance of data-driven decision-making and caution when a company is underperforming.
The belief that ‘things will get better’ can lead to significant losses if investors are not realistic about the compounding risks in the venture capital landscape.
How the bias plays out
1. Misinterpreting early signs of struggle
Founders and investors alike may rationalize early hurdles—such as missed revenue targets, product delays, or high customer churn—as natural growing pains. They believe these issues are temporary and will ultimately lead to success down the road. However, without objective data indicating improvement, this optimism may be misplaced.
According to research, only about 0.6% of startups make it to the scaling phase where they see exponential growth (Startup Genome’s). The overwhelming majority fail to overcome these early struggles, reinforcing the need for investors to remain vigilant and data-driven when evaluating performance.
2. Chasing sunk costs
Venture capitalists often make significant early investments in startups, and when things go wrong, they may double down—pouring more capital into struggling businesses. This behavior is a prime example of the sunk cost fallacy, where past investments influence future decisions. Investors convince themselves that recovery is just around the corner, even when performance metrics suggest otherwise.
Research shows that 60% of VC-backed startups return less than the initial capital invested, and a further 20% result in total loss (Kauffman Foundation). These statistics emphasize how dangerous it can be to continue investing in an underperforming company, particularly under the assumption that „it will get better.“
3. Survivorship Bias
One reason this fallacy persists is due to stories of successful companies that overcame early setbacks, like Amazon, Netflix, and Tesla, which have become market dominators.
While these stories are inspirational, they are also extremely rare. Only 4% of VC firms generate 60% of the industry’s total profits (Cambridge Associates), highlighting just how skewed returns are in venture capital.
Most companies that struggle early on never make it to the success stories we hear about.
4. Founder and Investor Persuasion
Passionate founders, who are deeply invested in their companies, often unintentionally encourage this fallacy. They persuade investors that the company’s current difficulties are temporary and part of a long-term strategy. Investors, in turn, may become emotionally attached to the founder’s vision, placing too much faith in potential without demanding solid evidence of progress.
Blackberry case study
A prime example of the „It’ll-Get-Worse-Before-It-Gets-Better“ fallacy is BlackBerry. Once a dominant force in the smartphone market, BlackBerry initially dismissed the rise of competitors like Apple’s iPhone and Android devices, assuming their strong position in the corporate world would sustain them.
In The Rise and Fall of BlackBerry, Stuart Heritage describes how BlackBerry was a symbol of productivity and status in the early 2000s, popular among celebrities, politicians, and business professionals. Yet, despite its early success, BlackBerry failed to recognize the significance of touchscreen technology and the consumer demand for sleek, intuitive devices.
Even as their market share eroded, BlackBerry’s leadership remained optimistic, believing their foothold in the enterprise sector would eventually lead to a resurgence. However, their optimism was misplaced. By 2016, BlackBerry’s market share had fallen to less than 0.1% from its 20% peak in 2009 (Statista). Despite attempts to modernize, BlackBerry couldn’t keep up with its competitors, and the company was forced out of the smartphone market.
BlackBerry’s failure to adapt to changing consumer preferences and reliance on the „It’ll-Get-Worse-Before-It-Gets-Better“ mindset caused significant losses for the company and its investors.
Key Statistics from BlackBerry’s Downfall:
- Market share decline: BlackBerry held 20% of the global smartphone market at its peak in 2009 but dropped to less than 0.1% by 2016, with iOS and Android dominating 99% of the market.
- Revenue drop: BlackBerry’s revenue peaked at $19.9 billion in 2011 but dropped to $2.16 billion by 2016.
- Device sales: From selling 52.3 million units in 2011, BlackBerry’s sales plummeted to just 400,000 units per quarter by 2016.
- Stock price collapse: BlackBerry’s stock price peaked at $147 in 2008 but fell below $10 by 2013, signaling a massive loss in investor confidence.
The Terminal Decline of Blackberry
Consequences for VCs
Prolonged Exposure to Risk
Sticking with failing companies diverts valuable capital and attention away from more promising investments. Since only about 1% of startups ever achieve a unicorn status, investors who spend too long chasing underperforming startups miss out on opportunities to back better-positioned companies.
Missed opportunity costs
Time and resources spent trying to revive a declining startup could be better used on newer, higher-potential ventures. With the average time to exit from the first VC investment being 8 to 10 years, holding on to a company for too long under false assumptions could waste valuable years.
Portfolio drag
A few underperforming companies can weigh down the overall performance of a VC firm’s portfolio, diminishing returns for limited partners (LPs). Since 75% of venture-backed startups fail to return capital, it’s critical that investors cut losses quickly and refocus resources on better opportunities.
The roadmap to a SaaS IPO
The roadmap to a SaaS IPO is long and fraught with financial challenges. As this graph shows, it can take nearly a decade for a startup to achieve unicorn status and reach an IPO, with significant losses and scaling investments along the way. Venture capitalists need to carefully consider when to continue supporting a company and when to exit. Holding onto a company through prolonged losses without clear revenue growth, as shown in years 5 to 7, can result in sunk costs and missed opportunities to reinvest elsewhere. Recognizing the point of inflection is key to avoiding the ‚It’ll-Get-Worse-Before-It-Gets-Better‘ fallacy.
Rising Momentum of VC-Backed Companies in Private Equity Buyout Exits
As this graph shows, private equity buyouts have steadily increased as a popular exit route for VC-backed companies. Between 2021 and mid-2023, buyouts accounted for a significant 24% of exits. The ‘It’ll-Get-Worse-Before-It-Gets-Better’ fallacy can prevent investors from capitalizing on such timely exits. By holding onto companies underperforming or stagnating, venture capitalists risk missing opportunities for profitable exits through buyouts or mergers. Staying vigilant and recognizing when to pursue these exits is key to maximizing returns and avoiding portfolio drag
How to avoid the bias
1.Focus on data-driven decisions:
Instead of relying on hope or anecdotal success stories, investors should focus on data. Key performance indicators (KPIs), such as revenue growth, user acquisition, and operational efficiency, should guide investment decisions. Clear metrics should drive whether further investment is warranted.
2. Reevaluate regularly
Continuous evaluation of a startup’s progress is crucial. Setting clear milestones and exit criteria can help investors avoid becoming emotionally attached to struggling companies. If a startup consistently misses key goals, it’s time to reconsider further investment.
3. Be wary of emotional attachment
Recognize when optimism or sunk costs are influencing decisions. Regular portfolio reviews, conducted by third-party advisors or objective board members, can help mitigate emotional bias and ensure a more disciplined investment approach.
4. Diversify investment strategy
A well-diversified portfolio allows investors to mitigate the impact of this fallacy. By not concentrating too heavily on a few struggling companies, investors can more easily cut losses without jeopardizing their overall returns.
Timing is critical
More than 80% of venture capital funding is directed at companies in their adolescent growth phase. During this time, the financial profiles of future winners and losers can appear quite similar.
Success in venture capital depends heavily on timing. The graph highlights how this growth stage can determine a company’s fate. While some believe short-term challenges lead to long-term success, this isn’t always true.
It’s crucial to distinguish between startups on a downward path and those entering healthy growth, avoiding the common mistake of thinking struggles will always lead to improvement.
The Critical Role of Timing in VC-Backed Companies Success or Failure
Sources:
- Rolf Dobelli, “The Art of Thinking Clearly” (2013)
About ACE Alternatives
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