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November 1, 2006

Cutting Your Losses

Why is it so hard to act early when things go wrong?

New ventures almost never work exactly according to plan. From Coca-Cola's '80s launch of a new formula for its flagship brand that fell as flat as day-old soda to the botched introduction of the Chevy Nova in Latin America, where “no va” means “doesn't go,” failed ventures happen to the best of companies. Whether an acquisition, a product launch or a new market, the best-planned new projects land under the naked light of reality and become something different than the projections.

Yet, when new projects don't work, it's not always so easy to walk away. Executives often find themselves unable to act quickly to jettison a losing venture.

“When a venture goes awry, it's human nature to think you can make it better,” says John Horn, a consultant with McKinsey & Co.'s Washington, D.C., office and co-author of a recent McKinsey study, “Learning to let go: Making better exit decisions.”

“It's very hard to draw a line in the sand and then honor that,” he adds.

Earlier this year, the sage of Omaha, Warren Buffett, admitted to difficulty in eliminating a business unit. Buffet, the CEO of Berkshire Hathaway and second-ranked on the Forbes list of the world's wealthiest people, intended to shut down General Re Corp.'s derivatives business when he bought the re-insurer in 1998.

“Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation,” Buffett confessed in his letter to shareholders in March 2006. “Fault me for dithering. When a problem exists, whether in personnel or in business operations, the time to act is now.”

Yet psychological and cultural influences hinder a company's ability to make a timely course correction. That includes unrealistic expectations, excessive optimism and a tendency to block out bad news. Then there is what McKinsey & Co. calls the sunk-cost fallacy—a focus on the money already spent that cannot be recovered. There also is the weight of company culture, which comes down heavy on failure.

In new investments, it is essential to set a realistic hurdle rate—the minimum return on investment you are willing to accept and the amount of money you are willing to invest and lose, as well as the amount of time a company is willing to allocate resources to the venture.

“You really need to look at the long-term prospects for the project, and the length of time you are willing to invest in it,” Horn says.

CONFRONTING HUMAN NATURE

Unrealistic expectations and excessive optimism can impede timely action, says Rita McGrath, associate professor at Columbia University Graduate School of Business who specializes in innovation, strategy and corporate growth.

In the process of securing buy-in from various stakeholders, assumptions have a way of becoming accepted truth and lead to false expectations. In the course of selling the venture to stakeholders, educated guesses and assumptions take on the ring of fact after they've been repeated enough times.

Add to that a cognitive bias that can lead to information being filtered—the tendency to welcome information that confirms what we believe to be true and reject information that challenges what we believe to be true, McGrath says. Most of the time, it's not harmful, she says, but in uncertain situations, it can be fatal.

Horn, writing in the McKinsey Quarterly, cites the example of Joseph Schlitz Brewing, which in the early 1970s tried a cheaper brewing process. It relied on research suggesting that consumers couldn't tell the difference, but ignored evidence in the form of lower sales—that consumers found the taste to be worse. The brewer went into decline and was later sold.

The desire to avoid blame and finger-pointing also hampers reaction time—being associated with a failure often has real career consequences.

“Managers in particular are unwilling to admit a loss, so they often go to great lengths to avoid having one blemish their record,” says Edward Barrows, a lecturer in management and technology at Babson College in Babson Park, Massachusetts, and a business strategy expert.

Barrows says the “zero defects” mentality still pervades many organizations. “Especially at senior levels, where you see these deals being consummated, there's a lot of consensus building going on behind the scenes—rally the troops, make the business case, persuade people, cash in internal equity—because you believe so strongly in the deal,” he says. Recognizing that it's not working after the investment of corporate capital and personal credibility comes hard. Fear, he concludes, is “one of the greatest poisons in organizations.”

CUTTING THE CORD

Companies that encourage innovation have to be able to tolerate failure. It also helps to have a Plan B in place should that be needed. At Charlotte, North Carolina-based Nucor Corp., CEO Daniel DiMicco says it is important to give a venture every chance to succeed, but then pull the plug when failure is evident. Jimmie T.G. Coulson, the CEO of service center CD'A Metals in Spokane, Washington, says he's learned that when investments don't pay off, it's how quickly you react that really matters.

Nucor invested in an unproven technology to make a substitute for steel scrap. In 1994, the company built a plant in Trinidad, West Indies, to make iron carbide, but after four years and a $100 million-plus investment, the company concluded that it wasn't commercially viable and shuttered the plant. The plant failed to meet production volume targets, which made the product too expensive.

“It was very high-risk,” DiMicco says. “Going in, we knew we had the ability to absorb the cost of the risk under the worst-case scenario, and that's what we got. You have to give it a fair shot, but as soon as you recognize it's not working, you have the responsibility to shut it down and move on.”

McGrath says that's a good approach. “If you're an enlightened executive, get that bad news as early as possible, because that's when it's cheaper,” she says. The culture at Nucor makes that possible. Nucor's founder, the late F. Kenneth Iverson, liked to say that good managers make good decisions 60% of the time. So what about the other 40%?

“Ken's philosophy was that you hire good people, but they're not going to be perfect,” DiMicco says. “That's been part of the company culture from day one. It's OK to fail; just don't fail every time.”

FINDING PLAN B

Understanding when and how to pull the plug is often the result of lessons learned the hard way. That was the case at CD'A Metals where Coulson says he had time to learn because “every 10 or 20 years, we've had to reinvent at least a portion of the company.” That included a Chapter 11 reorganization in the 1960s. Now, he says, before going into a venture, “we know how we're going to get out if we need to.” That CD'A is closely held makes it easier to admit to mistakes.

For example, after closing a deal to acquire Rockwest Steel in Salt Lake City in 1980, CD'A discovered variances in inventory values that meant the acquisition would take several more years than expected to reach financial targets. The company was sold the following year.

After CD'A added metal convenience stores in Washington and Idaho during the past five years, initial market research indicated that Pasco, Washington, would make a good location for a fourth store, which the company opened in 2003 to disappointing financial results.

“We realized we could hang in for a couple more years and move up to profitability slowly, or we could move somewhere else,” Coulson says. CD'A cut its losses in Pasco in 2005 and moved the inventory and equipment to Missoula, Montana, where its fourth metal convenience store backed by the company's main Spokane plant is thriving.

ART AND SCIENCE 

While it is essential to set hurdle rates, knowing when to bail out is not always a hard science, but a combination of planning, experience and foresight. The failure of a venture is not always the result of a bad decision, cautions Jackson Nickerson, professor of organization and strategy, Olin School of Business at Washington University in St. Louis. Good decisions can lead to bad outcomes. Sometimes it's a matter of timing, as when the business cycle shifts.

“The firms that survive are the ones that innovate and then move back and forth between a focus on innovation and a focus on cost,” he says.

The McKinsey study, which examined business entry and exit patterns, found that companies are more likely to exit at the bottom of business cycles, which can turn out to be the worst time to sell. “Dumping a project because you're on the down side of the business cycle could be just as biased a decision as entering something just because the cycle is going up,” Horn says.

Horn says some techniques can mitigate the biases that stymie decision-making. For example, a manager from outside the development team can sign off on the project. “Making executives responsible for the estimates of other people is a powerful check,” he writes. He also advocates a road map that helps guide decision-makers through their options at certain checkpoints during the life of a project.

Horn cites the example of a petrochemical company that created a plan for an unprofitable unit that proposed a new catalyst technology in an attempt to turn itself around. The unit set precise targets that the technology had to achieve at a series of checkpoints over the years and set up exit rules if the business missed the targets.

Companies most actively involved in acquiring and divesting get better at it over time. “The more infrequently you make decisions like this, the more likely you are to make a mistake when you do,” Horn says. Having a process in place to think through the decision, rather than having to make it on a one-off or infrequent basis, makes all the difference.