Under-Investments in Innovative SMEs: The Effect of Entrepreneurial Cognitive Bias ¹

Abstract

The literature documents a shortage in the supply of external funding to small- and medium-sized enterprises (SMEs) in general and to innovative SMEs in particular. This study separates cognitive from financial constraints on innovative SMEs’ growth opportunities. Using data gathered through in-depth interviews with the CEOs of 115 SMEs, we reveal that over and above a problem with supply, there exists a twofold problem on the demand side. Specifically, we document that there is a tendency for these companies to avoid approaching external funding sources, especially ones that gear their investments toward innovation. Our results reveal a cognitive bias (over-pessimism) affecting the entrepreneurs’ (lack of) demand for external financing over and above other firm-specific factors. CEO tenure — our proxy for human and social capital — is significantly lower (higher) in firms that did (did not) pursue external funding. This finding may provide some support for our hypothesis regarding the cognitive bias and over-pessimism of the more veteran CEOs who have had negative experiences regarding recruiting external resources. The impact of this entrepreneurial cognition is shown to be economically detrimental to the enterprise. Nevertheless, the negative effects are not limited to the micro level, but have implications at the macro level as well, due to under-realization of the potential for employment, productivity, and growth of the firms comprising the vast majority of the economy.

Citation

Bar-El, R., Gavious, I., Kaufmann, D. and Schwartz, D. (2017), "Under-Investments in Innovative SMEs: The Effect of Entrepreneurial Cognitive Bias ¹ ", Russ, M. (Ed.) Human Capital and Assets in the Networked World, Emerald Publishing Limited, Leeds, pp. 385-422. https://doi.org/10.1108/978-1-78714-827-720171012