In the popular version of how business works, Curt Schilling’s 38 Studios should have been a home run. The video game start-up had a bold vision and top-notch creative talent. In Schilling, it had a well-connected founder with a genuine love of the industry and a public image as a winner. What’s more, the former Red Sox ace had cast the ultimate vote of confidence in his company: He sank tens of millions of dollars of his personal fortune into it.
When the company went bankrupt this spring, many in New England reacted with shock: How could a company backed by a star like Schilling fail so dramatically?
But as it turns out, an entrepreneur’s big investment in his start-up is no guarantee of success—in fact, it can be the first sign of trouble. According to a new study by a pair of finance professors, start-ups that receive loans from their owner-managers—as 38 Studios did, to the tune of $4 million—performed worse than other firms and went out of business at a greater rate than start-ups that didn’t. It also found that the more of his or her own fortune an entrepreneur invested, the worse the start-up performed.
The study, by finance professors Tatyana Sokolyk of Ontario’s Brock University and William Bradford of the University of Washington, was designed to help settle the question of whether it’s a good sign or a bad one for owners to invest heavily in their own firms. One school of thought holds that owner investment predicts success—the more skin in the game, the more motivated the executive. This is what the researchers had expected to find. It is also, presumably, what the state of Rhode Island assumed when it loaned 38 Studios $75 million in 2010. The company defaulted on the loan this year.
“If the owner contributes equity and the owner also borrows from a personal account, then the owner actually has a huge stake,” which should create incentives for good performance and reduce the likelihood of irresponsible management, Sokolyk said in an interview.
Owner financing may bode ill for a start-up because it indicates that potential outside lenders and investors were unwilling to provide full financing.
But the data told a different story. Companies that received loans from their owner-managers, as opposed to banks or other outside lenders, performed worse overall and were 18 percent more likely to go out of business. And bigger loans meant lower net income for the firm.
The “skin in the game” theory did hold up to an extent. The study found that the higher proportion of a firm’s equity held by the owner-manager, the better the company performed, because a high ownership stake does encourage good management. But controlling for this effect, a higher percentage of an owner-manager’s personal wealth invested meant both lower net income and lower sales for a firm.
Broadly, as the researchers see it, these findings supported the competing view of what owner financing means: that in fact it bodes ill for a start-up, because it indicates that potential outside lenders and investors—who are more calculating and dispassionate, and often more experienced than the average owner-manager of a start-up—were unwilling to provide full financing.
The study, first publicized by Jared Konczal on the Kauffman Foundation’s Growthology blog, drew its data from two expansive business surveys: 3,000 companies from the Kauffman Firm Survey, which tracks start-ups founded in 2004, and about 1,500 young companies from the Federal Reserve’s Survey of Small Business Finances. (The data didn’t include Schilling’s company, which was founded later than those in the survey.)
Peter Russo, director of entrepreneurship programs at the Boston University School of Management’s Institute for Technology Entrepreneurship & Commercialization, didn’t find the study totally surprising—in fact, he said, many experienced entrepreneurs use the availability of outside financing as a kind of benchmark for their own ideas, reasoning, “If I can’t convince a professional investor to come along and fund my venture, then I probably shouldn’t be doing it.”
But Russo also pointed out that self-funding still drives much American business: 77 percent of the firms in the Inc. 500, which lists America’s fastest-growing start-ups, were founded at least in part with personal savings. More than 40 percent of the Inc. 500 funded their growth exclusively with internal cash flow.
Sokolyk’s findings may conflict with the cherished American image of the entrepreneur patiently saving up money to found his own business, but, as she pointed out, they do support one stereotype.
“Entrepreneurs...tend to be overly optimistic,” Sokolyk said.
Ben Schreckinger is an Atlantic Media fellow reporting for National Journal. He can be reached at