Interesting new research from Gavin Cassar at Wharton, shows that entrepreneurs are overly optimistic when they launch their ventures. In a study that covered 5 years, entrepreneurs were followed to see if their business ideas became real companies, and whether or not their initial expectations were accurate. One interesting result of the research is that financial modeling and scenario planning actually increase over-optimism.
More generally, the findings also show how the use of information may lead the nascent entrepreneur to dysfunctional beliefs. In particular, the use of information in a manner consistent with an inside view, involving the use of plans, projections, or causal scenarios to successful outcomes, is associated with more optimistic expectations in nascent entrepreneurs.
In part, this is driven by Lake Wobegone syndrome – the idea that we all think we are above average at most things. It is also unknowingly driven by the banks, angels, and VCs, who require financial projections in order to analyze a request for capital.
Many financial intermediaries require ventures to submit financial projections in order to be eligible for financing. Such behavior is considered good business practice and not only provides potential financiers with information concerning the investment project, but also signals the competence and quality of the management team. The empirical findings show that the act of preparing financial statements is associated with more optimistically biased sales projections.
Why is this important? Because contrary to what you might read on Digg, starting a business is decision that should be taken seriously, and you have to factor in your optimistic bias.
The paper does point out one thing that lowers the optimism bias – real market data. That's why the startup process can't take place in a vacuum. Talk with potential customers, find out what your inputs really cost, and what price your outputs can fetch. See if anyone really likes what you have to offer. Confidence is a good thing for an entrepreneur, but blind optimism can be an expensive mistake.
You can download the full paper here.