Business Law Articles
by John Melissinos
Los Angeles, California
One important attribute of any successful entrepreneur or business owner is knowing when to enter a new line of business or invest in equipment or employees to bolster an existing, growing service line. Another (perhaps even more important) attribute is knowing when to stopspending time, money and effort on a venture that will likely never work out or is not proceeding as planned. These two decision points—when to move forward and when to make a strategic retreat—are central to the success of any venture.
It is extremely hard to walk away from a project in which an executive is personally and financially invested. But the future viability of the organization always requires clear thinking, with all sentimentality, preconceptions, and vested interests cast aside. This inability or refusal to make a sensible, financial, and analytics-driven decision after a significant investment has been made in a project or an idea is known as the “sunk-cost fallacy.” As one textbook puts it:
“The sunk cost fallacy is the view that sunk costs should matter. Whenever issues involving sunk costs arise, it is always seems natural to think that it would be a pity to waste all the money that has been spent already. But that natural tendency does not lead to the best decisions. . . .”[i]
When the chips are down, a different perspective is often critically important. Business advisors, in general, and the restructuring community, in particular, are well aware of the sunk-cost fallacy. To combat its effects, management or a board of directors will bring in new experts to evaluate a transaction even if the existing participants have longer histories with the project and much better knowledge. But it is often very hard for management to let go of its plans for the future. Eventually, it is often a third party, be it a group of bondholders, the “special assets” group of a lender, or a financial advisor hired by the company that has to be the one to point the way forward and to identify the best way to cut ties with the past. Of course, by the time these players are involved in the business, it may be too late to accomplish anything without a painful restructuring of the company.
The human desire to “hang on” has a been a subject of much research. As a McKinsey Quarterly article put it, “. . . [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.”[ii] All restructuring professionals understand this human tendency, and we have all adopted strategies to address it, especially including fact gathering directly from the business units of the enterprise and independent financial testing and modeling.
However, the inability to let go of the past may be even more ingrained than is commonly thought. The Economist recently published a story about how entrenched the “sunk cost fallacy” can be. “Ball-game theory; The sunk-cost fallacy”.[iii] The Economist article discussed a recent study published on the topic by Dr. Christopher Y. Olivola in Psychological Science.[iv] Among other things, Dr. Olivola asked his research subjects to consider whether to use or enjoy, under adverse conditions, sporting event tickets and other items for which they had paid, or were given by a friend who in turn had paid for them. The reported results of the research was that even if the subjects had not paid for the tickets themselves, they still felt a need to attend the event.[v]
As The Economist put it: “As sunk-cost theory predicts, those told they had paid for the ticket themselves opted to attend the match, rather than watch it on TV, more often than those told they had obtained it for free. Intriguingly, though, this was also true of those told they had been given a ticket, if they were told as well that the ticket had cost money rather than being a freebie. . . .”[vi] And as Dr. Olivola summed it up, “These findings uncover a previously undocumented bias [and] reveal that the sunk-cost effect is a much broader phenomenon than previously thought. . . .”[vii]
Perhaps this might not be news to the restructuring professional. But, if the tendency to want to hang on to plan or a project in which much has been invested is even stronger than thought, then there is likely even more work to be done in convincing management to adopt a new course while they still can control their own destiny.
[i] Stanley Fischer and Rudiger Dornbusch, Economics, McGraw-Hill, 1983, Chapter 7, p. 180 (emphasis in original). As elaborated by Fischer and Dornbush in their textbook:
“. . . [S]unk costs are sunk. If certain costs have been incurred and cannot be affected by your decision, ignore them. They should have no role in your decision. . . . Suppose that we are halfway through building a bridge and we are told that completion will cost four times as much as originally budgeted. Should we proceed? The answer is quite independent of the amount that has already been spent to get half the bridge built. We need to compare the benefits of having the bridge with the marginal cost of completing it.”
[ii] John T. Horn, Dan P. Lovallo, and S. Patrick Viguerie, “Learning to let go: Making better exit decisions,” McKinsey Quarterly (May 2006).
[iii] “Ball-game theory; The sunk-cost fallacy,” The Economist, June 2, 2018, p.73.
[iv] Dr. Christopher Y. Olivola, “The Interpersonal Sunk Cost Effect,” Psychological Science, May 11, 2018.
[v] Id., pp. 2-5.
[vi] Id., The Economist.
[vii] Id., Olivola, pp. 1.