Can a New Business Suffer from a Surplus of Resources?

by Fabrice Cavarretta , 06.03.14
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For decades, researchers have tried to find the magic formula to predict the success or failure of a new business. In this quest, many have focused their analysis on the company’s access to resources. Indeed, as might be expected, it was often assumed that the more resources a company has access to – both in terms of money and staff – the better the results. And although the question has also been raised about whether an abundance of resources can also have negative effects on a business, research has been ambivalent about how this could happen, and often contingent on many different factors.

With my co -author Nathan R. Furr from Brigham Young University, we have adopted a different approach to understand how these multiple factors may impact the performance of the company. We started with the observation that, with so many variables affecting the performance of a company, it is almost impossible to predict accurately. But then, if all variables are unknown or uncontrollable, does that mean that we cannot predict anything?

Organizational resources: too much of a good thing

Resources – including tangible assets and equipment or intangible assets like social capital or brand recognition, organizational processes, and new product development or acquisition capacity – are essential to organizations. And given the important role of resources in the operation of businesses in an economic world defined by the allocation of scarce resources, they are generally perceived as having a positive effect on the company.

Given the many benefits that resources can provide, and considerable trouble that companies have to obtain them, it might seem counterintuitive to say that too many resources might pose a problem. However, this is exactly what our most recent research shows.

In this study, we relied on a panel of 4928 new companies which we followed during their first four years in order to study the effects of two potentially conflicting canonical resources: financial capital and human capital. Our approach is to note that these resources may have little effect on the mid-level performance, but may have the effect of increasing the variability of performance. This variability in turn increases the occurrence of extremes, including bankruptcy on the negative end and super-performance on the positive. This nuance suggests that resource abundance may in fact be a mixed blessing, both potentially positive and negative.

The negative effects can partly explained by the fact that resources can lessen the impact of the surrounding realities. This may explain the failure of many new businesses / projects during the internet “boom”, a period which was characterized by the selling products at below cost and the waste of large amounts of capital on unproductive activities like customer acquisition for a value greater than the benefits they afforded.

But what is really interesting is that both extremes increased simultaneously: the more resources are added, the more extreme the success or failure. This goes against the usual theory whereas the effect of one factor is good or bad.

One question remains: why would it be interesting to predict this widening gap in a world where we are used to thinking in terms of averages?

The risk preferences: what investors really want to know

Researchers tend to believe that what investors want to do is predict the future and to look into a crystal ball. But rather than focus on the average likely future, we consider here that it’s also important to be able to predict variance.

Indeed, this study understands the fact that investors are more or less sensitive to risk. Some are looking for an exceptional result at all costs. Those investors who have a "positive preference for risk" attach importance above all the opportunity to invest in the future Google or Facebook, even though this also increases the risk of the company they invest in going bankrupt.

On the other hand, there are investors, and market regulators (AMF in France, the SEC in the USA) that have a "negative preference for risk", which means that they want above all to avoid disasters. These decision makers are more sensitive to risk and are interested in any strategy that can avoid a crash, regardless of the effect this may have on average. Indeed, if they want to increase the average performance (normal theory), more resources actually further disperses results, and so increases the size and number of crashes. This type of paradox is one of the main motivations behind of our approach.

So this concept of difference and the ability to predict extreme outcomes can significantly affect the choices and activities of many actors. Indeed, the abundance of resources actually tends to disperse the performance, and therefore, increase the likelihood of an extreme result. These two issues are closely related.

Beyond the question of resources, this study also suggests that we should rethink our approach to building organizational theories to better take into account the variability in order to better predict extreme results. Our results provide an illustration of how the theory of extreme effects may differ from theory on the average effects, and offers a clear path to revisit the way we develop theories in management.