CEOs Throwing Good Money after Bad

I started my consulting practice in 2001. I exited a corporate environment with some of the brightest financial and legal minds I have ever worked with to this day. Sometimes, we made some poor investments, but those decisions were rare. The people I worked with fully understood the concept of due diligence before approaching an investment or divestiture decision.

With my background and preconceived ideas on how owners should approach their wealth-building process, I was in for a rude awakening after I took on my first client. They spent $375,000 without my input, which yielded nothing in return. I was shocked. No, I was mortified. Or maybe I was bewildered at how any owner could make such a decision. Even their general counsel at the time agreed with me.

This foolish outlay was not a one-time occurrence. I saw dollar after dollar being thrown into bad investments by other owners. After several years of observing this pattern, my ongoing question was, “How in the world do successful business owners who have reached the top in their niche squander so much money in other endeavors outside their expertise?”

I just gave you part of the answer at the tail end of the question. However, a few more years would go by before I started to grasp the cause of this behavior. I’m not an industrial psychologist or a CEO sociologist. But I have some theories on why CEOs throw good money after bad.

The Over-Confidence Game

Confidence is one of the most powerful forces in the mind of any decisive CEO who knows where she is going. But confidence can also betray intelligent CEOs who have the best of intentions.

In their 2011 research, The Evolution of Overconfidence, Johnson, and Fowler state in their abstract that “Confidence is an essential ingredient of success in a wide range of domains ranging from job performance and mental health to sports, business, and combat.”

They also add:

However, overconfidence also leads to faulty assessments, unrealistic expectations and hazardous decisions, so it remains a puzzle how such a false belief could evolve or remain stable in a population of competing strategies that include accurate, unbiased beliefs.

The curse of overconfidence is real in small businesses all over America. Overconfidence is one of the leading causes of CEOs throwing good money after bad. This behavior is not because of a lack of intelligence. Instead, it’s a bias that’s hard to shake, but how?

I have one suggestion. Most thinking exercises in strategy rooms include business models that validate the reasons to go forward with an investment. How about reversing that thinking by finding ways that an investment will fail?

I don’t call this negative thinking. A Prussian general in the 1800s innovated red-team and blue-team thinking. One team takes the offensive; the other takes the defensive. If you ever took debate in college, you probably served on one of these teams when sparring on certain topics.

Taking a negative position on an investment idea doesn’t mean you’ll walk away from a potentially bad deal. Instead, the thinking process may deepen the conviction to move forward. If so, that’s a good thing. But keep using this process after the investment is made, or beware of becoming a slave to sunk costs, which I will address later.

The Rule of 25™ in Investments

After some time has elapsed after a business owner has made a poor investment decision, I spring the ‘Why?’ question. The majority of responses are, “I just acted on instinct.” Little thought was put into any due diligence. I have a solution to the disease of acting on instincts or emotions alone.

When I’m asked to negotiate the purchase of a business that my client wants to buy, I start the conversation with the seller by asking, “If I gave you a million dollars, what return would you want if you were to invest it?”

I’ve been asking this question for years. The responses are fascinating. The lowest return is 18%. Many say 20%. The highest is never 30%, 35%, or more. It’s 25%. And that’s where The Rule of 25™ in Investments comes from.

Ping me on LinkedIn if you want to know why I play this game with sellers. I’ll tell you if it works in my negotiation process.

The Rule of 25™ in Investments goes like this: can you generate a 25% return on your investment in seven years? I’m not looking for an exact yield. I’d be okay with 18% or slightly higher. The exercise is not about prediction. It’s about exercising a lethargic brain muscle to think about return instead of relying on a gut feeling or emotions alone.

In the video, there are three numbers:

• the initial investment
• the yearly cash flows
• the exit

Those last two bullet points show the CEO’s mind slowing down by asking if these numbers are achievable. That’s the magic of this mental construct. At this juncture, I don’t care if the CEO goes forward with the investment. This framework has done its job.

Honesty, Humility, Hunger

When I’m coaching and mentoring controllers and accounting managers, we address the 3Hmindset™ in the early going. I look for the following traits, values, and behaviors in every professional I work with:

For high-dopamine CEOs that I serve, honesty and hunger are non-issues. I’d like to see more humility in the early stages of making a significant investment.

Regarding side investments, instincts kick in for about 30 percent of the CEOs I have served over the past 20+ years. This 30 percent is decisive with a right-now attitude. That’s the hunger kicking in as they make these investments.

While I typically don’t subscribe to, “That’s a poor decision,” but rather, “That’s a decision with multiple outcomes, most of which could probably end badly.” I wish the CEO would slow down briefly and ask for input in these cases. That takes humility.

If you are the CEO who has made some poor investment decisions in the past, I’m curious if the outcome would have been different had you sought a sounding board at the outset.

To summarize this section, the H3mindset™ can be a powerful mental construct that can thwart throwing good money after bad, but only if we let it.

Help Me Out of This Pit

The Money Pit is a fun, feel-good comedy from the 1980s. A young couple buys a mansion on the cheap only to find it disastrously falling apart after continuous renovations.

Unfortunately, that story hits too close to home. I have observed far too many CEOs throw good money after bad, even after the bad money keeps withering away.

I like what Shlomo Maital has to say on this topic in Executive Economics:

One reason bad projects die a hard death is because of the pervasive influence of sunk costs. Sunk costs measure money that has already been spent, but rather than treating it as water under the bridge, executives often pretend that they can and will recover revenues from them. They refuse to let go, becoming captives of spent money which is only a part of history and of no relevance in the present and future. Sunk costs are utterly without relevance for forward-looking decisions that ask, as they should.

Maital, Shlomo. Executive Economics: Ten Tools for Business Decision Makers (p. 37)

I wish there were a required class for every CEO entrepreneur that included a topic on sunk costs. Their past success takes over the mind by saying, “You can pull out of this mess; just feed me with some more money.” And CEOs go on to listen to this little voice in their head.

They don’t realize that new opportunities with better odds of success are suffocated because precious and limited resources are being thrown into an investment money pit.

I can’t just say, “Put a stop to this.” If only this advice were so easy to accept for a CEO. Walking away from sunk costs is hard. And I don’t think anyone is immune from this devastating mind trap.

But I can give two pieces of advice for the CEO who hasn’t experienced a money pit yet:

1. Write down on paper why you are investing. Be clear. Be specific. Writing is another one of those magical wands that slows the mind down. Thinking is fast. Writing is slow. The written word forces us to reexamine our thoughts. Move forward if the written word is compelling and validates your original thinking process.
2. In your narrative, include how much you are willing to invest and your exit plan should failure lie ahead. Put a stop loss on the investment. By putting these ideas on paper now, you could avoid a money pit should an investment go south.

Sometimes, Say No

I have not spoken to David Shepherd for years. His dad was a small-town radio mastermind who pioneered many innovations in this industry. David grew the business to 16 stations before selling the radio portfolio for $30 million in 2007.

David once said, “Mark, I don’t like accountants because they don’t know how to spend money. They are more about saving money.” I took that message to heart about two years before I acquired my accounting degree.

I never want to be that CFO who says, “No, don’t do that.” CEO-founders are special. They have a knack for spending money. They write me big monthly checks because they take risks that most of us would never take.

That’s why I’ve learned to be careful in my haste toward judgment on a questionable investment. However, I understand the concepts of over-confidence, The Rule of 25™, sunk costs, and humility’s role in investment decisions.

Occasionally, we must tap the brake and ask, “What am I doing?” Remember, I’m writing about the CEO who has already experienced success in another endeavor. Third, fourth, and fifth businesses are tricky, and there are no guarantees the pot of gold will be found at the other end of the rainbow.

I will never tell a CEO, “No, don’t make that investment.” My goal will always be for the CEO to make that decision for herself, and I think these suggestions can help.