Overcoming the Psychological Biases That Destroy Exit Decisions

A business is an asset. Like any asset, there is an optimal point at which it can (and likely should) be sold. That optimal point is driven by internal factors (earnings, risk, and growth) and external factors (market conditions, consumer trends, etc.). And, owners miss that optimal point all the time. Why?

Psychological Biases Delays Exit Decisions

As it turns out, there are a number of psychological reasons why executives routinely enter the market at the wrong time. They ignore danger signs, they refrain from adjusting goals based on new information and data, and even increase their investments in the business at times when they probably shouldn’t.

Psychological biases impact both sides of M&A deals as some companies do not exit on time and others do not invest when the time is right. The biases that tend to have the biggest impact on exit decisions are:

  1. Confirmation Bias,
  2. Sunk-Cost Fallacy and Ongoing Commitment Bias
  3. Anchoring and Adjustment Bias

#1 – Confirmation Bias

Confirmation bias influences how we gather information as well as the way we interpret and recall information. It is a tendency to search for and favor such information that supports our prior beliefs. It makes us unconsciously select information that supports our values while ignoring the non-supportive information.

Now, let’s try to understand the confirmation bias from the business perspective. Consider when a project needs to be evaluated for its performance on parameters such as the hurdles, costs, revenues, etc.

Reviewing executives may unconsciously seek market research that approves of the project, quality control estimates that predict that their product will be reliable, and forecasts for start-up times and production costs that confirm the success of the turnaround effort of their troubled project. Rarely do they seek information that is likely to disprove the belief that their project will be successful.

So, whenever they receive reports of poor customer satisfaction, low demand, or increased costs, they gather such reports that contradict them. In this way, confirmation biases hinder the routine assessment of the company’s processes and products, making them weak and unreliable.

For instance, in 1994, Unilever launched a new Persil laundry detergent in the UK after testing it successfully on new clothes. However, the company did not test the new detergent on older clothes and how it would react with common clothing dyes. Had they done so, they would have discovered disconfirming evidence for the product. When consumers complained of the detergent damaging their older clothes, the company had to eventually take the new product off the market.

#2 – Sunk-Cost Fallacy and Ongoing Commitment Bias

Sunk-Cost refers to the cost that you have already incurred in a project that is not likely to be recovered. People commit the sunk-cost fallacy when they continue a behavior or endeavor as a result of previously invested resources such as time, money, and effort. This fallacy is usually connected with ongoing commitment bias. Simply put, ongoing commitment bias results from our desire for consistency and our aversion to loss.

Let’s assume you need to attend an important meeting. Instead, you go to see a movie because you have already bought the ticket and your money spent on it could go waste. It’s an example of a sunk-cost fallacy because you decided to watch the movie to prove that your investment was worth it and missed out on something else that may actually have been important.

The sunk-cost fallacy plays a crucial role in impacting the second step of the exit decision-making process which is deciding on which projects to exit. It occurs when management falls prey to the sunk-cost fallacy bias and focuses on the investment that they have already made. They focus instead on the hours already spent, the capabilities already developed, and the project-specific know-how already gathered.

At the same time, the related bias of ongoing commitment comes into play when management decides to invest more into the troubled project that is not showing signs of a turnaround. Individuals who have already invested in the failing project try to justify the investment through further commitment, and in doing so, they put in more money.

When someone justifies future costs by pointing at past costs, it is an indication of the sunk-cost fallacy and ongoing commitment bias in action. Such a situation demands an objective, bias-free assessment of future prospects of the project.

#3 – Anchoring and Adjustment Bias

Anchoring is a cognitive bias where people base all future negotiations, arguments, and estimates in a decision-making process on an initial idea or some pre-existing information. Once the value of the anchor is set, they adjust their beliefs based on this starting point. However, if the value of the anchor is inaccurate, all future adjustments will also be inaccurate, leading individuals away from the true value.

Often in exit decision-making, owners tend to over-weight initial impressions of value (no matter how flawed that initial estimate was). A friend tells them they sold their business for 5x earnings, and they get in their head that their business has a similar value.

Because of anchoring bias, decision-makers fail to adjust actual value sufficiently away from the initial perception of value. This bias is particularly relevant in divestment decisions.

M&A deals often experience three possible anchors – the sunk cost that the management hopes to recover, a valuation made much earlier in better times, and the price other businesses in the same industry have received. For example, the first company in a particular industry sells for $10 million. Other business owners tend to think that their companies are worth that much while ignoring the fact that buyers usually target the best company in the lot first.

How to Overcome Biases for Better Exit Decision-Making

Business owners can mitigate the effects of psychological biases that hinder exit decision-making in several ways.

#1 – Overcoming Confirmation Bias

To overcome confirmation bias, companies can assign a task to assess the project or business to new management members. If one set of individuals are a part of the initial proposal, then a new group should sign off on the project.

For instance, if the R&D department claims it can finish a prototype production process in six months, the production manager should approve the feasibility of the plan. By doing so, the production department becomes accountable for the completion of the target and is not likely to overestimate.

By making executives responsible for the estimates of other people, companies can get honest opinions on their processes, products, and projects. This method may not eliminate biases, but it reduces them and ensures that the company goes to market before it gets completely drained.

#2 – Overcoming Sunk-Cost Fallacy and Ongoing Commitment Biases

A contingent road map helps executives overcome biases and make more objective decisions. It lays out signposts at predetermined checkpoints over the life of a project and guides in decision making. Signposts highlight the stages when decision-makers must resolve uncertainties as well as provide possible outcomes of ensuing decisions.

Establishing signposts provides specific choices for the decision-makers before the start of the project and ensures improved effectiveness of the contingent roadmap.

For example, a petrochemical company created a contingent road map for a failing business unit that proposed new technology for a turn around. It provided specific targets with stringent outcomes that the new technology needed to achieve at different checkpoints over a predefined number of years. It even defined exit rules in case the business unit missed those targets.

Here, the contingent road map helped decision-makers isolate the specific biases that affected them earlier. Instead of only considering the significant initial outlay of time and money in the new technology, executives had clear, objective criteria at each signpost to confirm the need to continue or to exit.

The general rule is that the companies using the contingent road map are allowed to make changes to the future signposts based on new information but never on the current signpost. Adhering to this rule prevents executives from changing their decision criteria midway through the journey unless they have a valid and objective reason to do so.

Contingent roadmaps help executives to focus on future expectations rather than past performance and explicitly recognize uncertainty using multiple potential paths. They can limit emotional sunk costs and remove the blame for unfavorable outcomes by unambiguously recognizing problems.

#3 – Overcoming Anchoring and Adjustment Bias

Using independent evaluators who have never seen the initial projections of the company’s value helps overcome the anchoring and adjustment bias when the business is finally ready to sell.

Independent evaluators bring a new set of eyes to the business. They also are not influenced by earlier estimates. As a result, reviews are strictly based on actual business performance, market share, costs, competition, the marketplace, etc.

Closing Thoughts

Decision-making biases are hard-coded into us as humans. When we ignore them, we can make ineffective decisions. When planning for and facilitating an exit the stakes are high. Take the time to build workarounds into your value creation plans to help mitigate the risk.

Author Summary

Dan Doran

Dan Doran

Is the Founder of Value Scout, Quantive and the 2019 Exit Planner of the Year. He is a recognized expert and speaks frequently about M&A, valuations, and developing more deliberate value creation strategies.
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