When quitting is good, or, why leaders hang on so long to losing ventures
September 28th, 2012 by Briana Cummings
Although “quitting” a failing project or business is often seen as a sign of failure, it is really a perfectly normal part of the creation-destruction process, and a necessary step in responding effectively to new knowledge and changing circumstances.
Much has been written about the ossification of education – from K-12 up through graduate and professional schools – which in most major ways looks strikingly similar to the outdated education models that were created a century ago, if not earlier. As described in a 2008 McKinsey Quarterly article, resistance to change – and staying with a failing and/or outdated model – is a common problem in business too. A number of studies indicate that executives tend to stick with a losing project, business, or industry when clear signs indicate they should get out.
I’ve outlined some of these finding below because these lessons apply as much to building and running a law practice as anything else. Starting a practice requires fortitude and stick-to-itiveness, but it also requires adaptability and responsiveness to new information and events.
Among the business studies’ findings:
- The average total return to shareholders tends to decline as a business ages. Most of those who sell their shares would have received a higher price if they had sold earlier.
- Among a sample of companies from 1993 to 2004, the probability that a failing business would grow appreciably or become profitable within three years was less than 35 percent.
- Across industries, companies are more likely to exit at the troughs of business cycles – at the worst time to sell.
For example, General Motors’ small-car division failed to earn a profit after 21 years and billions of dollars (including a $3 billion investment in 2004 to try to rejuvenate it).
Interestingly, though they often exit or divest too late, companies rarely do so too early.
The psychological factors at play
One reason for this tendency is that change is difficult and often costly: worker layoffs and buyouts cost money, leaders who organize an exit strategy often thereby orchestrate the end of their own job, and abandoning a project may just plain look bad.
But another significant factor is the cognitive heuristics and biases that drive human decisionmaking – especially the confirmation bias, the sunk-cost fallacy, escalation of commitment, and anchoring and adjustment. “Such biases routinely cause companies to ignore danger signs, refrain from adjusting goals in the face of new information, and to throw good money after bad.”
The confirmation bias (or, the dangers of optimism)
The first step in deciding whether to exit a project is to evaluate whether it is meeting expectations. Has it met the goalposts originally set? What have been the historic costs and revenues and how to they compare to expectations? What is the expected profitability?
In answering these questions, a scientist would look for evidence that the project was not meeting goalposts, that its costs and revenues were not meeting expectations, and that it would not be profitable. As Karl Popper famously argued, the scientific method is, in essence, a quest to disprove a hypothesis.
Logically, no number of positive outcomes at the level of experimental testing can confirm a scientific theory, but a single counterexample is logically decisive: it shows the theory . . . to be false.
Scientists, then, gain confidence in their theories by trying really hard to disprove them. In contrast, research suggests that business executives tend to look for data that proves their theories. They seek market research that heralds a successful launch, predictions that a product will be reliable, and rosy forecasts of costs and start-up time that would make a turnaround successful. And they ignore disconfirming evidence.
For example, executives at U.S. beer maker Joseph Schlitz Brewing decided in the early 1970s to use a cheaper brewing process, citing market research suggesting that consumers couldn’t tell beers apart.
Although they received constant evidence, in the form of lower sales, that customers found the taste of the beer brewed with the new process noticeably worse, the executives stuck with their low-cost strategy too long. Schlitz, once the third-largest brewer in the United States, went into decline and was acquired by rival Stroh in 1982.
Similarly, when Unilever launched a new laundry detergent in the United Kingdom, in 1994, the company successfully tested the formula on new clothes. The company did not, however,
seek disconfirming evidence, such as whether it would damage older clothing or react negatively to common clothing dyes. Consumers discovered that it did, and Unilever eventually had to return to the old formula.
The sunk-cost fallacy and escalation of commitment
The second step in deciding whether to exit a project or business, after evaluating how well – or badly – the project or business is doing, is deciding whether to end it or try to improve it.
At this stage, two cognitive biases affect decisionmaking: the sunk-cost fallacy and escalation of commitment. The sunk-cost fallacy leads executives to focus on the unrecoverable money already spent or the project-specific capabilities already developed. This fallacy leads to an escalation of commitment: to justify their original costs, people invest more resources into a failing venture, no matter how bleak the outlook.
The Cincinnati subway is an example of decisionmakers not being swayed by these cognitive biases. The idea for the subway was conceived in 1884 and supported by Republicans and Democrats alike. Construction began in 1920. In 1927, after $6 million had been spent on the project and the tunnels for the project had been completed, the leaders of the city decided that it no longer needed a subway. Studies from independent experts indicated that World War I and shifting demographics had altered the need for one. Further construction was stopped. “Fortunately for Cincinnatians, during the past 80 years, referendums to raise funds for completion have all failed.”
Anchoring and adjustment
In deciding how much to sell a business for, another bias comes into play: anchoring and adjustment, which leads decisionmakers to not sufficiently adjust future estimates away from initial estimates. Three possible anchors come into play when valuing a business: (1) the sunk cost, (2) a previous valuation, perhaps made in better times, and (3) the price previously paid for other businesses in the same industry.
Some suggested strategies for counteracting cognitive biases
- Independent review: Ask someone who was not part of an initial proposal to assess it before signing off on it – and to conduct periodic reviews of the project.
- Contingent road maps: These lay out – before the project begins – signposts to guide decisionmakers through their options (e.g., whether to exit a project) at predetermined checkpoints over the life of the project or business. For example, a contingent road map might set up a timeline for targets that must be met and, if these targets are not met, strategies for exit (or, at least, for making a decision about whether to change course).