My Business Owes Me Money

The Fallacy of Sunk Costs in Business Valuations

Many entrepreneurs make the mistake of believing their business owes them money for the personal investments and sacrifices they made to get the company up and running. This type of thinking represents a cognitive bias known as the sunk cost fallacy. While understandable, clinging to sunk costs can cloud one’s judgement and lead to poor business decisions.

What Are Sunk Costs?

In economics and business decision-making, sunk costs refer to previous expenses that are irrecoverable. They are payments that have already been made and cannot be recouped. Common examples include:

• Research and development expenses for products that never made it to market
• Marketing costs for failed campaigns
• Equipment or supplies purchased that are now obsolete
• Permits or licensing fees for aborted projects
• Salaries paid to employees no longer with the business

Essentially, sunk costs are water under the bridge. Since these outlays are unrecoverable, they should be ignored when deciding how to move forward. The only costs relevant for future choices are incremental costs – new expenditures required going forward.

Why Founders Often View Sunk Costs as “Owed”

It’s understandable why many entrepreneurs feel their business owes them for sizable sunk investments made in the early days. Launching a new company often requires tapping personal finances – retirement accounts, home equity lines, credit cards – to fund operations before revenue kicks in.

Founders sacrifice financially in other ways too. Many work long hours for little or no pay in the fledgling days. Some leave lucrative careers or sell assets to pursue their venture full-time. When family and friends may doubt their idea, they forge ahead nonetheless.

With so much personal capital invested, it’s tempting to view these contributions as loans the business now owes the founder. But classifying sunk efforts and expenses as receivables is financially flawed thinking.

Why Sunk Costs Should be Ignored

From an economic perspective, sunk costs are irrelevant to rational decision making. Since they cannot be recovered, they should carry no weight moving forward. Considering sunk costs introduces cognitive bias into business judgements. It often leads to escalation of commitment to a failing course of action. Throwing good money after bad is irrational if it has low odds of succeeding.

Here are three reasons sunk costs should be ignored in business valuations and future decisions:

1. Obligation Doesn’t Change Value:
   Any personal funds the founder injected into the business in the past do not impact the company’s present-day worth or future profit potential. Valuations are based on expected future cash flows discounted to the present. How those cash flows were initially financed does not change the business’s intrinsic value.
2. Sets Bad Precedent:
   Treating sunk costs as owed sets a dangerous precedent. It could incentivize making reckless financial decisions under the assumption past expenditures will be repaid someday. A business needs sound financial practices, not excuses to throw good money after bad.
3. Clouds Judgement:
   Anchoring on sunk costs distorts rational decision making going forward. It biases owners to persist with failing projects rather than cutting losses. This emotional attachment to past efforts can lead companies to double down on doomed endeavors rather than adapt to changing market conditions.

In summary, sunk costs should never be considered obligations a business owes its founder. While the entrepreneur’s personal sacrifices may seem like loans, sunk investments are economically irrelevant to future decisions and valuations. Wise business owners ignore sunk costs, however painful, and focus only on incremental costs and benefits.

Further Reading

Investopedia
https://www.investopedia.com/terms/s/sunkcost.asp

Kevin Harrington

I’m a UK-based B2B marketing consultant, specialising in strategic advice for SME business owners. I bring extensive hands-on expertise to every client engagement. Senior leadership roles across technology, media, payments, and publishing have shaped my practical approach. Highlights include serving as Chief Marketing Officer at The Panoply plc (now TPXimpact), Chief Commercial Officer at Tungsten Network, and Global Marketing Director at BBC Worldwide. Over the years, I’ve guided numerous SMEs through transformation and value creation. Helping businesses evolve and thrive is a genuine passion. Practical marketing insights and succession planning strategies are at the heart of what I do, as I believe growing a business’s asset value should be a rewarding and positive journey for every entrepreneur.

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