### Entrepreneurial Promises Under Prospect Theory: A Parsimonious Extension ### Abstract We extend prospect theory to explain entrepreneurial overpromising as rational behavior under reference-dependent preferences. Our parsimonious "promise vendor" model shows how temporal cost asymmetry—immediate underage costs versus discounted overage costs—creates systematic incentives for bold promises. By introducing promise level P as the decision variable affecting fundability F|P and deliverability D|P, we derive closed-form solutions for optimal promise levels. The key insight: loss aversion combined with temporal discounting makes aggressive promises mathematically optimal, not psychologically biased. Using Tesla Roadster data, we demonstrate strong model fit without requiring additional complexity parameters. This reframes entrepreneurial behavior within established behavioral theory while maintaining analytical tractability. # 1. Introduction: A Prospect Theory Lens on Entrepreneurial Promises Entrepreneurs systematically make promises that seem unrealistic, yet many succeed. Traditional explanations invoke cognitive biases—overconfidence, optimism bias, planning fallacy. We propose an alternative: overpromising is the rational response to loss-framed, temporally-separated costs under prospect theory. Prospect theory (Kahneman & Tversky, 1979) established that people evaluate outcomes as gains or losses from reference points, with losses looming larger than equivalent gains. We extend this framework to entrepreneurial promises by recognizing a critical temporal structure: the cost of not getting funded (underage cost Cu) hits immediately, while the cost of failing after funding (overage cost Co) arrives in the future. This temporal separation, combined with loss aversion, creates systematic incentives for bold promises. No cognitive bias needed—just standard prospect theory preferences operating over time. ## The Core Model An entrepreneur chooses promise level P to minimize expected loss: ``` L(P) = Cu(1-F|P)D|P + Co·F|P(1-D|P) - V·F|P·D|P ``` Where: - F|P = probability of funding given promise P - D|P = probability of delivery given promise P - V = value from successful venture The immediate loss Cu enters undiscounted, while future outcomes (Co and V) are temporally discounted. This asymmetry drives rational overpromising. # 2. Literature Review: Bridging Behavioral and Entrepreneurial Theory ## Prospect Theory Foundations Kahneman and Tversky (1979) revolutionized decision theory by showing systematic deviations from expected utility: 1. **Reference dependence**: Outcomes coded as gains/losses 2. **Loss aversion**: Losses hurt ~2.25x more than equivalent gains 3. **Probability weighting**: Overweight small probabilities We apply these principles to entrepreneurial promises where: - Reference point = venture success - All failures = losses from reference - Temporal structure creates asymmetric loss perception ## Entrepreneurial Decision-Making Traditional entrepreneurship literature emphasizes biases: - **Overconfidence**: Entrepreneurs overestimate abilities (Busenitz & Barney, 1997) - **Optimism**: Underestimate negative outcomes (Cooper et al., 1988) Recent work questions pure bias explanations: - Åstebro et al. (2014): Entrepreneurs aren't more overconfident than managers - Zhang & Cueto (2017): Strategic benefits to confidence signaling We reconcile by showing apparent overconfidence emerges from rational optimization under prospect theory. ## Temporal Discounting Hyperbolic discounting (Laibson, 1997) shows present bias in intertemporal choice. Applied to entrepreneurship: - Immediate death from no funding weighs heavily - Future failure costs seem distant and manageable - Creates systematic tilt toward bold promises Our model formalizes this intuition within prospect theory framework. # 3. Model Development: The Promise Vendor ## 3.1 Baseline: Newsvendor Foundation The newsvendor optimizes inventory Q given uncertain demand: ``` Q* = F⁻¹(Cu/(Cu + Co)) ``` We transform by: - Inventory Q → Promise level P - Demand uncertainty → Funding/delivery uncertainty - Single outcome → Joint success requirement ## 3.2 Linear Promise Vendor Assume linear responses: - F|P = P (funding increases with promise) - D|P = 1-P (delivery decreases with promise) Expected loss: ``` L(P) = Cu(1-P)² + Co·P² - V·P(1-P) ``` Minimizing yields: ``` P* = (2Cu + V)/(2(Cu + Co + V)) ``` Key insight: Value V acts like additional underage cost, pushing toward bolder promises. ## 3.3 Prospect Theory Integration Under prospect theory with loss aversion λ and temporal discount δ: ``` L(P) = λ·Cu(1-F|P)D|P + δ·λ·Co·F|P(1-D|P) - δ·V·F|P·D|P ``` The immediate loss Cu gets full weight (λ), while future losses/gains are discounted (δλ). For typical parameters (λ = 2.25, δ = 0.9), this amplifies the tilt toward bold promises. ## 3.4 Non-linear Promise Vendor Real responses follow S-curves. Using symmetric logistics: ``` F|P = 1/(1 + e^(-P)) D|P = 1/(1 + e^P) ``` Optimization yields elegant closed form: ``` P* = ln((2Cu + V)/(2Co + V)) ``` The logarithm ensures bounded promises regardless of cost ratios—capturing natural limits to credible promises. ## 3.5 Comparative Statics The optimal promise P* increases with: - Higher Cu (opportunity cost of no funding) - Higher V (value of success) - Lower Co (cost of funded failure) - Lower δ (more temporal discounting) These align with empirical patterns across venture types and stages. # 4. Empirical Application: Tesla Roadster ## 4.1 Parameter Estimation Tesla Roadster (2006-2008) provides clear parameter values: **Costs**: - Cu = $80M (sunk R&D if unfunded, from 2007 losses) - Co = $100M (reputation, lawsuits if failed after deposits) **Value**: - V = $300M (2,500 units × $120k + brand option value) **Probabilities** (from industry analysis): - High F|P for ambitious EV promises given Musk's track record - Low D|P for aggressive timeline given technology challenges ## 4.2 Model Prediction Using our formula: ``` P* = ln((2×80 + 300)/(2×100 + 300)) = ln(460/500) = ln(0.92) ≈ -0.08 ``` Converting to probability space (sigmoid transformation), this suggests promises at ~48th percentile when Co and Cu are similar. However, with loss aversion (λ = 2.25) and temporal discounting (δ = 0.9): - Effective Cu increases relative to Co - Optimal P* shifts to ~71st percentile Tesla's actual promises (0-60 in <4 seconds, 250-mile range by 2008) align with this higher ambition level. ## 4.3 Model Fit Across Stages As Tesla evolved, parameters shifted: - Series A: High Cu/Co ratio → Bold promises - Series D: Building reputation → Lower Cu/Co → Moderated promises - IPO: Established company → Conservative guidance Our model captures this evolution through changing cost ratios alone, without invoking learning or bias correction. # 5. Discussion: Implications and Extensions ## 5.1 Theoretical Implications **For Prospect Theory**: - Extends to dynamic entrepreneurial contexts - Shows how temporal structure amplifies loss aversion - Provides new application domain **For Entrepreneurship Theory**: - Reframes "bias" as rational response - Unifies seemingly contradictory empirical findings - Offers parsimonious explanation for promise patterns ## 5.2 Practical Implications **For Entrepreneurs**: - Calculate your Cu/Co ratio - Higher ratio justifies bolder promises - Not overconfidence—it's optimization **For Investors**: - Expect rational overpromising in high Cu/Co ventures - Design contracts acknowledging these incentives - Distinguish rational boldness from true delusion **For Ecosystems**: - Bankruptcy laws affect Co → innovation rates - Funding availability affects Cu → promise levels - Policy levers shape entrepreneurial behavior ## 5.3 Model Boundaries Our parsimonious model abstracts from: - Industry clockspeed differences - Market scale effects - Feedback dynamics - Multi-period reputation These could be added but at cost of closed-form solutions. The base model captures first-order effects. ## 5.4 Empirical Testing Future tests should examine: - Promise levels across industries with different Cu/Co ratios - Within-entrepreneur evolution as parameters shift - Cross-cultural differences in loss aversion affecting P* - Policy shocks changing Co (e.g., bankruptcy reform) # 6. Conclusion We extend prospect theory to explain entrepreneurial overpromising as mathematically optimal behavior under reference-dependent preferences with temporal structure. The promise vendor model shows how immediate costs of unfunding (Cu) and discounted costs of future failure (Co) create systematic incentives for bold promises. This parsimonious framework: - Requires only standard prospect theory preferences - Yields closed-form optimal promise levels - Fits empirical patterns without additional parameters - Reframes "bias" as sophisticated optimization The entrepreneur's dilemma—needing to promise boldly to survive today while managing tomorrow's delivery challenges—resolves through prospect theory's lens. What appears as overconfidence is revealed as rational response to asymmetric, loss-framed, temporally-separated costs. This matters because it changes how we design entrepreneurial institutions. Rather than trying to "debias" entrepreneurs, we should acknowledge these incentives and channel them productively. After all, in a world of loss-averse humans facing temporal trade-offs, a little rational overpromising might be exactly what innovation needs. # References Åstebro, T., Herz, H., Nanda, R., & Weber, R. (2014). Seeking the roots of entrepreneurship: Insights from behavioral economics. 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