Cost of Escalation

The trouble is, those exit strategies may never be bought into play unless the organization takes positive steps to recognize and challenge the biases underlying executive decisions. The way psychological biases inhibit exit strategies was the subject of a recent McKinsey Quarterly article entitled "Learning to Let Go". Authors John T Horn, Dan P Lovallo and S Patrick Viguerie note staying too long with a losing venture is a common business problem.

"Faced with the prospect of exiting a project, a business or an industry, executives tend to hang on despite clear signs that it's time to bail out. Indeed, when companies do finally exit, the spur is often the arrival of a new senior executive or a crisis, such as a seriously downgraded credit rating."

The authors cite research that shows the costs that come with indulging this tendency to linger too long. For instance one study shows the average return to shareholders tends to decline as a business ages, and that sellers typically would have received a higher price by shedding the business earlier. Even more damningly, the authors claim researchers who studied the entry and exit patterns of businesses across industries found that companies are more likely to exit at the very worst time to sell - amidst the trough of a business cycle.

"Why is it so difficult to divest a business at the right time or to exit a failing project and redirect corporate resources?" they ask. "Many factors play a role, from the fact that managers who shepherd an exit often must eliminate their own jobs to the costs that companies incur for layoffs, worker buyouts and accelerated depreciation. Yet a primary reason is the psychological biases that affect human decision making and lead executives astray when they confront an unsuccessful enterprise or initiative. Such biases routinely cause companies to ignore danger signs, to refrain from adjusting goals in the face of new information and to throw good money after bad."

The authors note exit decisions stand apart from other important corporate decisions in the sense that bad timing in exit decisions tends to go in just one direction: companies rarely exit or divest too early. They urge executives to keep this fact in mind and to identify the biases at play, "determine where in the decision-making process they crop up, and then adopt mechanisms to minimize their impact. Techniques such as contingent road maps and tools borrowed from private equity firms can help companies to decide objectively whether they should halt a failing project or business and to navigate the complexities of the exit," they write.

Identifying Biases

Organizational researchers have identified numbers of psychological biases at play in organizational exit decisions. For a start there is the confirmation bias (people tend to seek information that supports their point of view and to discount information that does not) and the sunk-cost fallacy (which sees executives focus on the unrecoverable money already spent or on the project-specific know-how and capabilities already developed; a related bias is the escalation of commitment and the investment of yet more resources even when all indicators point to failure).

There is also the anchoring and adjustment bias, which affects judgements made under uncertainty. This is where executives "anchor", or overly rely, on specific information or a specific value and then adjust that value to account for other elements of the circumstance. Usually once the anchor is set, there is a bias towards that value, obviously flawed.

The McKinsey Quarterly article proposes several techniques to mitigate the effects of the biases. For instance, it says one way to overcome confirmation bias is to assign someone new from the management team to assess a project.

"At a multinational energy and raw-materials company, a manager who was not part of an initial proposal must sign off on the project. If the R&D department claims that a prototype production process can ramp up to full speed in three months, for example, the production manager has to approve it. If the target isn't met, the production manager, too, is held accountable. Making executives responsible for the estimates of other people is a powerful check: managers are unlikely to agree to a target they cannot reach or to overestimate the chances that a project will be profitable. The likely result is more honest opinions."

The article also recommends adoption of a contingent road map that lays out signposts to guide decision makers through their options at predetermined checkpoints over the life of a project or business. This allows the organization to make clear evaluations at the points when key uncertainties must be resolved. For a contingent road map to be effective, it notes, you must assign specific choices to each signpost before the project begins.