Equity Stakes and Exit: An Experimental Approach to Decomposing Exit Delay

Abstract

Despite evidence that delayed exit is a pervasive and consequential problem, relatively little is known about its causes. Moreover, the study of exit delay is confounded by the fact that behavioral theories arising in the literature on escalation of commitment and economic theories that incorporate option value both yield predictions that delay increases in sunk costs and uncertainty. We construct a laboratory experiment that enables us to compare the timing of participants’ exit decisions with optimal choices that incorporate option value in the absence of sunk costs. We show that receiving equity stakes – the actual cash flows of the enterprise and control rights over continuation – generates delay beyond the optimal exit point for participants allocated to unprofitable firms. While participants with equity stakes make decisions that are nearly optimal given their beliefs, their beliefs are significantly distorted relative to a control group that does not receive equity stakes. The pattern of distortion is consistent with confirmatory bias and motivated reasoning. More generally, we show that incentives affect decision making not only by affecting the payoffs of different outcomes but also by distorting information processing, which in turn affects how decision-makers see the relative likelihood of different outcomes. This suggests that models of behavior that assume incentives affect behavior alone may be incomplete.

Keywords: exit, real options, behavioral bias, behavioral strategy, escalation of commitment

JEL Classification: L20, D21, D81, C91, M13