Venture capitalists find it tough to escape the ‘sunk cost’ fallacy

Prosus also said that the “executive leadership at Byju’s regularly disregarded advice relating to strategic, operational, legal, and corporate governance matters." And this forced Prosus’s director to quit Byju’s board. The investor further said: “We continue to believe in the potential of Byju’s."

A recent report in Mint points out that Prosus is the largest non-promoter shareholder in Byju’s. It has invested more than $500 million in the company and owns close to a tenth of it. While I have no way of knowing what’s going on in the minds of those who run Prosus, this seems like a case of what psychologists refer to as the sunk-cost fallacy or the escalation of commitment.

Prosus has concerns about the “strategic, operational, legal, and corporate governance matters" of Byju’s, which means pretty much everything. It has also said that individuals running Byju’s don’t listen to what it has to say. Nonetheless, despite all this, Prosus says it continues to believe in the potential of Byju’s. This is a great example of escalation of commitment.

Indeed, escalation of commitment is all around us. We complete books and movies despite not enjoying them, because we have already bought the book or movie ticket.

Michael Lewis in The Undoing Project, a book that traces the work relationship of psychologists Amos Tversky and Daniel Kahneman, has an excellent example. As he writes: “Amos… decided in the first five minutes, whether the movie was worth seeing—and if it wasn’t he’d just come home," and watch something else. “They’ve already taken my money," he would explain. “Should I give them my time, too?"

But most of us don’t think this way. People spend years trying to make a bad marriage work because too much time and energy has already been invested in it. As Yuval Noah Harari writes in Homo Deus: A Brief History of Tomorrow: “Business corporations often sink millions into failed enterprises, while private individuals cling to dysfunctional marriages." All this suggests that something similar may be happening with Prosus’s investment and other venture capitalists (VCs) who have invested large sums in Indian startups which promised scale at the cost of cash-burn.

In a typical case of escalation of commitment, a corporation keeps throwing money at a floundering project. This may not be the case with VCs backing Indian startups. They may not invest more money in these firms. Nonetheless, they will have to publicly back them and the overall cause of startups, simply because so much money and time has already been invested.

In fact, while escalation of commitment might hurt firms, the same isn’t true for the individuals running them. As Kahneman writes in his classic Thinking, Fast and Slow: “Cancelling [a floundering] project will leave a permanent stain on the executive’s record, and his personal interests are perhaps best served by gambling further with the organisation’s resources in the hope of recouping the original investment—or at least in an attempt to postpone the day of reckoning."

How does this apply in the case of VCs invested in Indian startups? A VC invested in a startup might privately not be confident about its future—this is but natural, given that a bulk of VC-funded firms fail. Nonetheless, it will not admit this in public because it has a reputation to guard. At the same time, there is hope of selling the startup to another investor and “postpone the day of reckoning".

This is why you see so many VCs still sounding positive. They have a huge incentive in keeping the positive narrative around startups going. Further, what makes the Indian scenario peculiar is that so many startups with so little revenue have more than $100 million each of VC money invested in them.

So, where does that leave us? Interest rates in much of the Western world, where VCs get their money from, aren’t going to fall anytime soon, given that inflation remains high. Hence, money will remain expensive, making it difficult for VCs to keep investing money to keep cash-burning startups going.

Also, when interest rates are low, the present value of future cash flows is high, and so valuations are also high. But when interest rates rise, the present value of future cash flows falls. This should lead to the valuations of startups falling, something which has been happening over the past one year.

Prosus has slashed the valuation of Byju’s from $22 billion to $5.1 billion. VCs have cut the valuations of other big startups like Swiggy, Ola and Pharmeasy as well. An April report in Mint had pointed out: “There has been a 40-60% drop," in valuations. So, the revealed preference of VCs where they are marking down the value of their startup investments is a lot different from their public posturing. At the end of the day, we cannot expect VCs to call out a bubble they helped create in the first place.

Vivek kaul is the author of ‘Bad Money’.