Entrepreneurial overconfidence and its impact upon performance

Abstract

A hubris theory of entrepreneurship suggests that financial forecasts are often informed by the use of heuristic methods prone to overconfidence. While overconfidence can be advantageous during the start-up phase, it is also linked to overoptimistic forecasts, nonoptimal outcomes and firm failure. This article uses a data set from 203 micro and small firms operating in North West Italy where overconfidence is measured as the difference between budget estimates and actual results for earnings before interest, taxes, depreciation and amortization (EBITDA), owner equity and borrowing costs. These measures are employed to identify the extent of overconfidence by entrepreneurs in their financial forecasts and to analyse any relationship between overconfidence and the characteristics of the entrepreneur and the firm. A probit analysis is employed to investigate any association between overconfident financial forecasts and subsequent firm failure. The results are consistent with the hypotheses, suggesting that the majority of entrepreneurs are prone to overconfident budgetary forecasts that are directly associated with firm failure. Such overconfidence is mitigated by an entrepreneur's level of educational attainment and the use of budgetary controls. 2009). This article investigates the overoptimistic biases in the context of established firms. Considerable literature exists on the potential for entrepreneurs to be overconfident in their expectations of firm performance but the majority of this evidence is derived from self-reported attitudinal surveys. In addition, this literature has offered no empirical evidence that identifies an association between overconfidence and firm performance and only limited information on the attributes of the entrepreneur, or firm, that may lead to such behaviour (Ucbasuran et al. 2010). Using published data on the budget forecasts and actual results made available for 2012 by a unique sample of 203 Italian micro and small enterprises, this article addresses two research questions. Are entrepreneurial orfirm characteristics related to overconfident attitudes as exhibited in the financial estimations of small firms? Is overconfidence associated with a small firm failure? To address these questions, a novel measure for overconfidence is adopted, computed as the variance between actual and estimated values of three economic indicators:EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization), equity and borrowing costs, derived from comparisons between a firm's balance sheets and financial forecasts over time. We argue that systematic, inflated financial predictions of firm performance signal overconfidence and we operationalise the overconfidence construct as the difference between budgeted and actual performance (Cassar and Gibson 2007;Markovitch, Steckel, Michaut, Philip and Tracy, 2015).

The changing form of overconfidence and its effect on growth expectations at the early stages of startups

“…How entrepreneurial experience relates to the evolution of entrepreneurial overconfidence is not empirically evidenced (see for summary Zhang and Cueto 2017). Many studies confirm the existence of entrepreneurial overconfidence at later stages of the life cycle (Betzer et al 2017;Invernizzi et al 2016;Lowe and Ziedonis 2006;Shepherd 2009;Simon and Houghton 2003) and theoretical models usually suggest a gradual decrease in entrepreneurial overconfidence (Gervais and Odean 2001;Jovanovic 1982;Konon and Kritikos 2015).…”

“…In contrast to ESE, typically the negative impact of entrepreneurial overconfidence is accentuated in this respect. Entrepreneurial overconfidence was suggested or shown to lead to excessive risk-taking in entrepreneurial decisions (Grichnik 2008;Hayward et al 2006;Simon and Houghton 2003), to prolonging or failing to diagnose poor performance (Lowe and Ziedonis 2006;Shepherd 2009), to investing in failing projects (Betzer et al 2017), and, finally, to destroying the company's value-leading to failure (Invernizzi et al 2016;Hayward et al 2006;Wu and Knott 2006). At the same time, based on motivational theories, some scholars believe that entrepreneurial overconfidencejust like ESE-helps to overcome failures, increase resilience, and leads toward more ambitious goals (Everett and Fairchild 2015;Hayward et al 2010;Simon and Shrader 2012).…”

“…In line with motivation theories, Frese and Gielnik's framework theory (2014) suggests that higher perceived entrepreneurial skills are associated with higher growth expectations. In fact, entrepreneurship researchers often use the outcome expectations themselves as proxies for beliefs in entrepreneurial skills (e.g., Cooper et al 1988;Invernizzi et al 2016). However, perceived skills must be differentiated from outcome expectations.…”

“…At the same time, another line of research concentrates on entrepreneurial overconfidence. Even though the definition of entrepreneurial overconfidence varies (e.g., Åstebro et al 2014;Forbes 2005;Koellinger et al 2007;Zhang and Cueto 2017), entrepreneurial overconfidence is mostly described and assessed as someone's miscalibrated and inflated beliefs in his entrepreneurial abilities-i.e., the inflated form of ESE-and the overestimation of positive outcomes of his business decisions (Hogarth and Karelaia 2012;Invernizzi et al 2016;Malmendier and Tate 2015;Ucbasaran et al 2010). Indeed, cognitive researchers have suggested that entrepreneurs are especially predisposed to make biased decisions.…”

Human Capital Investments as Sources of Skills: An Analysis at Different Entrepreneurship Phases

“…Because entrepreneurs in the nascent phase have poor access to mentorship and coaching, they rely on self-taught skills which are acquired from reading about other entrepreneurs. Some of the nascent entrepreneurs may be overconfident and may not seek mentorship (Invernizzi et al 2016). As the businesses grow, entrepreneurs use skills obtained from mentors and coaches represented by bridging social capital (Putnam 2001;Stam, Arzlanian & Elfring 2014).…”