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Strategy & Corporate Finance

Article
McKinsey Quarterly
May 2006

Learning to let go: Making

better exit decisions
By John T. Horn, Dan P. Lovallo, and S. Patrick Viguerie

Psychological biases can make it difficult to get out

of an ailing business.

W
hen General Motors launched Saturn, in 1985, the
small-car division was GM's response to surging
demand for Japanese brands. At first, consumers were very
receptive to what was billed as “a new kind of car company,” but
sales peaked in 1994 and then drifted steadily downward. GM
reorganized the division, taking away some of its autonomy in
order to leverage the parent company's economies of scale, and in
2004 GM agreed to invest a further $3 billion to rejuvenate the
brand. But 21 years and billions of dollars after its founding, it has
yet to earn a profit.[ 1 ] Similarly, Polaroid, the pioneer of instant
photography and the employer of more than 10,000 people in the
1980s, failed to find a niche in the digital market. A series of layoffs
and restructurings culminated in bankruptcy, in October 2001.

These stories illustrate a common business problem: staying too

long with a losing venture. 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.

Research bears out the tendency of companies to linger. One

study showed that as a business ages, the average total return to
shareholders tends to decline.[ 2 ] For most of the divestitures in
the sample, the seller would have received a higher price had it
sold earlier. According to our analysis of a broad cross-section of
US companies from 1993 to 2004, the probability that a failing
business will grow appreciably or become profitable within three
years was less than 35 percent. Finally, researchers who studied
the entry and exit patterns of businesses across industries found
that companies are more likely to exit at the troughs of business
cycles—usually the worst time to sell.[ 3 ]

Why is it so difficult to divest a business at the right time or to exit

a failing project and redirect corporate resources? 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.

In contrast to other important corporate decisions, such as

whether to make acquisitions or enter new markets, bad timing in
exit decisions tends to go in one direction, since companies rarely
exit or divest too early. An awareness of this fact should make it
easier to avoid errors—and does, if companies 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.

The psychological biases at play

The decision-making process for exiting a project, business, or
industry has three steps. First, a well-run company routinely
assesses whether its products, internal projects, and business
units are meeting expectations. If they aren't, the second step is
the difficult decision about whether to shut them down or divest if
they can't be improved. Finally, executives tackle the nitty-gritty
details of exiting.

Each step of this process is vulnerable to cognitive biases that can

undermine objective decision making. Four biases have
significant impact: the confirmation bias, the sunk-cost fallacy,
escalation of commitment, and anchoring and adjustment. We
explore the psychology behind each one, as well as its influence on
decisions (Exhibit 1).
Exhibit 1

Four cognitive biases significantly

affect exit decisions.

Analyzing the project

Let's start with a brief test of a person's ability to analyze
hypotheses. Imagine that someone deals four cards from a deck,
each with a number printed on one side and a letter on the
other.[ 4 ] Which pair would you choose given an opportunity to flip
over just two cards to test the assertion, “If a card has a vowel on
one side, then there must be an odd number on the other side”?
Most people correctly choose the U but then incorrectly select 7.
This pattern illustrates the confirmation bias: people tend to seek
information that supports their point of view and to discount
information that doesn't. An odd number opposite U confirms the
statement, while an even number refutes it. But the 7 doesn't
provide any new information—a vowel on the other side confirms
the assertion, but a consonant doesn't reveal anything, since
consonants can have even or odd numbers on their flip sides. The
correct choice is the 8 because it could reveal something: if there
is a vowel on the other side, the statement is false.

Now imagine a group of executives evaluating a project to see if it

meets performance hurdles and if its revenues and costs match
the initial estimates. Just as most people choose cards that
support a statement rather than those that could contradict it,
business evaluators rarely seek data to disprove the contention
that a troubled project or business will eventually come around.
Instead, they seek market research trumpeting a successful
launch, quality control estimates predicting that a product will be
reliable, or forecasts of production costs and start-up times that
would confirm the success of the turnaround effort. Indeed,
reports of weak demand, tepid customer satisfaction, or cost
overruns often give rise to additional reports that contradict the
negative ones.
Consider the fate of a US beer maker, Joseph Schlitz Brewing. In
the early 1970s, executives at the company decided 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. Like-wise, when Unilever launched a new Persil laundry
detergent in the United Kingdom, in 1994, the company tested the
formula on new clothes successfully but didn't 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.

Deciding which projects to exit

At this stage, the sunk-cost fallacy is the key bias affecting the
decision-making process. In deciding whether to exit, executives
often 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: yet more resources
are invested, even when all indicators point to failure. This
misstep, typical of failing endeavors, often goes hand in hand with
the sunk-cost fallacy, since large investments can induce the
people who make them to spend more in an effort to justify the
original costs, no matter how bleak the outlook. When anyone in a
meeting justifies future costs by pointing to past ones, red flags
should go up; what's required instead is a levelheaded assessment
of the future prospects of a project or business.

The Vancouver Expo 86 is a classic example.[ 5 ] The initial budget,

CAN $78 million in 1978, ballooned to CAN $1.5 billion by 1985,
with a deficit of more than CAN $300 million. During those seven
years, the expo received several cash infusions because of the
provincial government's commitment to the project. Outrageous
attendance estimates were used to justify the added expense (the
confirmation bias at play). Predictions of 12.5 million visitors,
which would have stressed Vancouver's infrastructure, grew at
one point to 28 million—roughly Canada's population at the time.
Moreover, Canadians had seen budget deficits for big events
before: the 1967 Montreal Exposition lost CAN $285 million—six
times early estimates—and the 1976 Montreal Olympics lost more
than CAN $1 billion, though no deficit had been expected.

Contrast that with the story of the Cincinnati subway.

Construction began in 1920. When the $6 million budget ran out,
in 1927, the leaders of the city decided that it no longer needed the
subway, a point suggested by studies from independent experts.
Further construction was stopped, though crews had finished
building the tunnels.[ 6 ] The idea for the subway had been
conceived in 1884, and the project was supported by Republicans
and Democrats alike, so this decision was not a whim; World War I
and shifting demographic needs had altered the equation.
Fortunately for Cincinnatians, during the past 80 years,
referendums to raise funds for completion have all failed.

Proceeding with the cancellation

The final bias is anchoring and adjustment: decision makers don't
sufficiently adjust future estimates away from an initial value.
Early estimates can influence decisions in many business
situations,[ 7 ] and this bias is particularly relevant in divestment
decisions. There are three possible anchors. One is tied to the
sunk cost, which the owner may hope to recover. Another is a
previous valuation, perhaps made in better times. The third—the
price paid previously for other businesses in the same industry
—often comes up during merger waves, as it did recently in the
consolidation of dot-com companies. If the first company sold for,
say, $1 billion, other owners may think that their companies are
worth that much too, even though buyers often target the best,
most valuable company first.

The sale of PointCast, which in the 1990s was one of the earliest
providers of personalized news and information over the
Internet, shows this bias at work. The company had 1.5 million
users and $5 million in annual advertising revenue when Rupert
Murdoch's News Corporation (NewsCorp) offered $450 million to
acquire it. The deal was never finalized, however, and shortly
thereafter problems arose. Customers complained of slow service
and began defecting to Yahoo! and other rivals. In the next two
years, a number of companies considered buying PointCast, but
the offer prices kept dropping. In the end, it was sold to Infogate
for $7 million. PointCast's executives may well have anchored
their expectations on the first figure, making them reluctant to
accept subsequent lower offers.[ 8 ]

Axing a project that flops is relatively straight-forward, but

exiting a business or an industry is more complex: companies can
more easily reallocate resources—especially human resources—
from terminated projects than from failed businesses. Higher
investments, which loom larger in decision making, are typically
tied up in an ongoing business rather than in an internal project.
The anguish executives often feel when they must fire colleagues
also partially explains why many closures don't occur until after a
change in the executive suite. Divestiture, however, is easier
because of the possibility of selling the business to another owner.
Selling a project to another company is much more difficult, if it is
possible at all.

When a company decides to exit an entire business, the

characteristics of the company and the industry can influence the
decision-making process. If a flagging division is the only
problematic unit in an otherwise healthy company, for instance,
all else being equal, managers can sell or close it more easily than
they could if it were the core business, where exit would likely
mean the company's death. (Managers might still sell in this case,
but we recognize that it will be hard to do so.) It sometimes
(though rarely) does make sense to hang on in a declining
industry—for instance, if rivals are likely to exit soon, leaving the
remaining company with a monopoly.

Becoming unbiased
Several techniques can mitigate the effects of the human biases
that confound exit decision making. One way of overcoming the
confirmation bias, for instance, 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.

Well-run private equity firms adopt these practices too. One

leading US firm assigns independent partners to conduct periodic
reviews of businesses in its portfolio. If Mr. Jones buys and
initially oversees a company, for example, Ms. Smith is later
charged with the task of reviewing the purchase and its ensuing
performance. She takes her role seriously because she is also
accountable for the unit's final performance. Although the
process can't eliminate the possibility that the partners' collective
judgment will be biased, the reviews not only make biases less
likely but also make it more likely that underperforming
companies will be sold before they drain the firm's equity.

Another tool that can help executives overcome biases and make
more objective decisions is 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.
Signposts mark the points when key uncertainties must be
resolved, as well as the ensuing decisions and possible outcomes.
For a contingent road map to be effective, specific choices must be
assigned to each signpost before the project begins (or at least well
before the project approaches the signpost). This system in effect
supplies a precommitment that helps mitigate biases when the
time to make the decision arrives.

One petrochemical company, for instance, created a road map for

an unprofitable business unit that proposed a new catalyst
technology in an attempt to turn itself around (Exhibit 2). The
road map established specific targets—a tight range of outcomes—
that the new technology had to achieve at a series of checkpoints
over several years. It also set up exit rules if the business missed
these targets.
Exhibit 2

A contingent road map establishes

targets.

Road maps can also help to isolate the specific biases that may
affect the corporate decision-making process. If a signpost
suggests, for example, that a project or business should be shut
down but executives decide that the company has invested too
much time and money to stop, the sunk-cost fallacy and
escalation-of-commitment bias are quite likely at work. Of
course, the initial road map might have to be adjusted as new
information arrives, but the changes, if any, should always be
made solely to future signposts, not to the current one.

Contingent road maps prevent executives from changing the

decision criteria in midstream unless there is a valid, objective
reason. They help decision makers to focus on future
expectations (rather than past performance) and to recognize
uncertainty in an explicit way through the use of multiple
potential paths. They limit the impact of the emotional sunk costs
of executives in projects and businesses. And they help decision
makers by removing the blame for unfavorable outcomes that
have been specified in advance: the explicit recognition of
problems gives an organization a chance to adapt, while a failure
to recognize problems beforehand requires a change in strategy
that is often psychologically and politically difficult to justify.
Before the invasion of Iraq in 2003, for example, it was uncertain
how US troops would be received there. If the Bush
administration had publicly announced a contingency plan
providing for the possibility of increased troop levels should an
insurgency erupt, the president would most likely have had the
political cover to adopt that strategy.

When companies are finally ready to sell a business, the decision

makers can overcome any lingering anchoring and adjustment
biases by using independent evaluators who have never seen the
initial projections of its value. Uninfluenced by these earlier
estimates, the reviews of such people will take into account
nothing but the project's actual experience, such as the evolution
of market share, competition, and costs. One leading private
equity firm overcomes anchoring and other biases in decision
making by routinely hiring independent evaluators, who bring a
new set of eyes to older businesses in its portfolio.

There are ways to ease the emotional pain of shutting down or

selling projects or businesses. If a company has several flagging
ones, for example, they can be bundled together and exited all at
once or at least in quick succession—the business equivalent of
ripping a bandage off quickly. Such moves ensure that the
psychological sense of failure that often accompanies an exit isn't
revisited several times. A onetime disappointment is also easier to
sell to stakeholders and capital markets, especially for a new CEO
with a restructuring agenda.

In addition, companies can focus on exiting businesses with

products and capabilities that are far from their core activities, as
P&G did in 2002, when it divested and spun off certain products in
order to focus on others with stronger growth prospects and a
more central position in its corporate portfolio.[ 9 ]

Although canceling a project or exiting a business may often be

regarded as a sign of failure, such moves are really a perfectly
normal part of the creative-destruction process. Companies need
to realize that in this way they can free up their resources and
improve their ability to embrace new market opportunities.

By neutralizing the cognitive biases that make it harder for

executives to evaluate struggling ventures objectively, companies
have a considerably better shot at making investments in
ventures with strong growth prospects. The unacceptable
alternative is to gamble away the company's resources on
endeavors that are likely to fail in the long run no matter how
much is invested in them.

1. Alex Taylor III, “GM's Saturn problem,” Fortune, December 13,

2004.
2. Richard Foster and Sarah Kaplan, Creative Destruction: Why
Companies That Are Built to Last Underperform the Market—and How
to Successfully Transform Them, New York: Currency, 2001.
3. Richard E. Caves, “Industrial organization and new findings on the
turnover and mobility of firms,” Journal of Economic Literature, 1998,
Volume 36, Number 4, pp. 1947–82.
4. This example comes from P. C. Wason, “Reasoning,” in B. M. Foss,
ed., New Horizons in Psychology I, Harmondsworth, United Kingdom:
Penguin, 1966, pp. 135–51.
5. Jerry Ross and Barry M. Staw, “Expo 86: An escalation prototype,”
Administrative Science Quarterly, Volume 31, Number 2, pp. 274–97.
6. Allen Singer, The Cincinnati Subway: History of Rapid Transit,
Chicago: Arcadia Publishing, 2003.
7. John T. Horn, Dan P. Lovallo, and S. Patrick Viguerie, “Beating the
odds in market entry,” McKinsey Quarterly, 2005 Number 4, pp. 34–45.
8. Linda Himelstein, “Dusting cobwebs off a Web staple,” Business
Week, July 14, 2003.
9. Procter & Gamble annual report, 2002.

About the author(s)

John Horn is a consultant in McKinsey's Washington, DC, office;

Dan Lovallo is a professor at the Australian Graduate School of
Management (of the University of New South Wales) as well as an
adviser to the firm; Patrick Viguerie is a director in the Atlanta
office.