Good Failures and Sunk Cost Fallacy

Jan 8th, 2021

What is failure in business?  Canadian government statistics seem to count a business as a “failure” if it exists one day and then does not exist the next, so long as that non-existence is not being the result of it having been sold to another business.  In other words, a business which closes and goes away is said to have “failed.”  Conversely, a business which is operating but accumulating debt registers as a “success.”  Failure is commonplace, too.  Industry Canada notes that in a typical year Canada sees approximately 95,000 new employing businesses appear, and 85,000 existing businesses disappear.  The ten-year survival rate for Canadian businesses was, in 2019 across all sectors, 42.9%.

But despite the wealth of discussions about businesses failing, it’s difficult to find productive business writing about failure.  This is because entrepreneurship is about hope.  People start businesses because they dream big and they desire success and status.  Entrepreneurs want to read stories about people who started like them and made it big, so that they can aspire, imitate, and follow.

Cultural values also unfairly separate people into “winners” and “losers.”  Nobody starts a business imagining that the cash flow will dry up and the business will cease operations.  Nobody wants to be remembered as that person who used to have a business.  Nobody wants to become “A Failure.”  But this division also means that it’s difficult to get entrepreneurs to tell stories about their failures, except of course those who made fortunes on later attempts and now have the privilege and security to reflect on the past without being stigmatized.

The problem is that literally all businesses end.  Long-lived business exist, but they’re essentially lottery winners.  Nobody who starts a business should expect to be founding a Zildjian (founded 1623) or Fiskars (founded 1649).  Companies have a life cycle which includes a beginning and an end.  It’s simply that the businesses we see as successes are the ones that haven’t ended yet.

This leads to a significant problem of survivorship bias in business writing.  Survivorship bias has long been one of my favourite informal fallacies, and it’s gaining meme-grade internet traction in recent months.  It’s a flawed logic which studies successes or survivors and disregards failures.  The most famous illustration is as follows: the US military wanted to know how to armour bombers most efficiently.  The obvious answer is to place armour where returning bombers most frequently have damage.  The true answer is to armour where returning bombers never had bullet holes, because bombers hit there never return to add to the data set.

Survivorship bias is everywhere and it takes conscious effort to recognize it.  A friend of mine lamented how new buildings don’t last as long as old ones, as he gestured to the hundred-year-old old barn across the way; he can’t gesture at the crappy barns that fell down already.  A tired meme juxtaposes a pristine ancient Roman road against a potholed Canadian street; but that picture doesn’t show the other 400,000 km of Roman roads which are lost to time.

This means that if we only tell the stories of the businesses which are still here, and if we only tell negative stories about the businesses that are gone, then we learn incomplete knowledge of business life cycles.  We perpetuate survivorship bias and continue to stigmatize the ending of a business as a stain on the reputation of the entrepreneur, who is now “A Failure.”  Much business writing in this vein neglects to analyse or to educate, and instead offers empty aspirational pablum.

A good day way to die

Here I want to argue that because failure is inevitable, 1) that there is such a thing as a good failure of a good business, and 2) that the person at the helm of that good failure should be regarded as a good businessperson.  This analysis explicitly excludes the monstrous financial shell games played by private equity firms which create investor wealth by intentionally sinking companies and exploiting employees.  When I write “good business,” here or elsewhere, I mean in the dual sense of efficacy and as the opposite of evil.  A good business is good in terms of mutual benefit, social development, and defensible ethics.

So a business hoping for a good failure (or perhaps a more positive metaphor would be “a business aiming to stick the landing”) needs to mind two categories: stakeholders and resources.  The more that these two categories avoid harm, the more cause the operator has to hold their head high.

“Stakeholders” includes any person who depends on the business in any way.  The main stakeholders who can be hurt by a dissolution are customers, employees, and creditors.  Damage here consists of “disappointment” and “harm.”

Customers experience harm from a business’s closure in the failure to deliver on a commitment, whether paid or unpaid.  A common example of this kind of harm is when construction companies collect payment from customers but close without delivering complete service, leaving the customer’s space in an unfinished, unsatisfactory, or unsafe condition.  Even if a customer has not yet paid or contracted, a sudden closure can leave someone without a needed service.  Other forms of harm can include the termination of ongoing user supports, or the invalidation of warranties.

Employees experience harm through the loss of wages, benefits and in the opportunity cost of employment and career advancement.  The most insidious examples are those aforementioned private equity firms, such as Sun Capital which purchased American chain Marsh’s Supermarkets, which have a track record of seizing employee pension funds from acquired companies to pay investors.  Similar harms happened to Sears employees.  Less monstrous is the disruption to an employee’s long-term planning that closure can cause.

Creditors experience harm through the non-payment of debt.  This requires little discussion or example, as the procedures and terms of bankruptcy and debt collection are well known.

When these stakeholders are visible, the methods for shielding them from harm seem obvious: deliver your services and refund those you can’t; pay your employees and advise them of the business’s health; pay your bills.

Meanwhile “Resources” includes the cash and capital that fuels a business.  The obvious aim here is not to burn money for a lost cause.  To continue to put time, effort, and resources into a doomed venture is an exercise in the sunk cost fallacy – the erroneous belief that to make additional investments is justified by the earlier investment.  A person falling into a sunk cost hole will be trying to protect the earlier, lost money, or to earn it back.  Sometimes we call this “throwing good money after bad.”  This is also the impulse of the degenerate gambler.  Somebody like Kenny Rogers probably wrote an extremely famous country western song about this kind of thing. 

Business failures which are disasters for the operators are often made worse by sunk cost errors.  The target for the operator here is to avoid accumulating mass debt or squandering fungible resources in the business’s death throes.  The best way to do this is to look at future reinvestments into a venture separate from the past ones: to evaluate the business in terms of its current value (assets, equity, and liabilities), not in terms of its past value.

The trick in the affair is for the operator to monitor those resources so that the resolution of the business can occur before stakeholders suffer.  In the case of a business resolving such that a) all customers are satisfied as contracted, b) all employees are compensated as promised, c) all bills are paid as owed, and d) minimal resources squandered so no damage is done.  The worst effect is that stakeholders might be disappointed that the business will no longer exist.  If true, that is the one success, because it means that the business generated positive experiences and prosperity for its stakeholders.

Here at least we return to the owner.  My framing thus far may seem to suggest that the business owner must be a stoic martyr shielding others from the harms of the business’s collapse.  But the owner gets the greatest benefit from a clean shutdown and takes the most harm from a bad one.  If the shutdown is clean, the owner will a) protect their reputation for fair dealing with workers, customers, and lenders, b) have gained valuable market knowledge, and c) preserve resources that can be later used for reopening on an improved model.

The common aphorism about business and success alleges that many successful entrepreneurs fail six times before they succeed, but that will only be true of those who know when to fail so that they can try again to succeed later.  A good closure can be the right decision, and failure then is both an ending and an opportunity for a new beginning.  It gives an owner the opportunity to reset, reassess, build on what they’ve learned, and to try again, better equipped for success.  When a business isn’t working, it may be the wrong answer to try to force it to work.