Darryl Laws

 Escalation of commitment / a.k.a. sunk cost fallacy. Escalation of commitment refers to the psychological condition whereby people continue to support or believe in something that is repetitively failing. In managerial decision-making escalation of commitment can refer to either continuing with a high-priced M&A bid. It may also refer to overestimating one’s own managerial capacity or ability. This is an extension of problem solving where the CEO does not accept they do not have a solution or they have to let go. With escalation of commitment there is a compulsion to not let go. Escalation of commitment was first described by Barry M. Staw (1976) in his article, Knee deep in the big muddy: A study of escalating commitment to a chosen course of action. More recently the term sunk cost fallacy has been used to describe the phenomenon where CEO justify increased investment in a merger / acquisition based on the cumulative prior investment, despite new evidence suggesting that the cost of continuing the decision outweighs the expected benefit.

Irrational escalation of commitment reflects the choices of decision-makers who are unwilling to admit that they were mistaken to have gone too far in the merger / acquisition process with a target company in the first place. Decision-makers too often persist in bidding even after the price exceeds the target company’s value, simply to justify the actions and cost that they have already spent (Staw, 1976). Often this arises in situations in which the bidding process is too costly, but there still appears to be a possibility of achieving better outcomes by continuing to bid. Entering a bidding contest is costly. Bidders have to pay fees to their investment bankers and M&A lawyers, whose reputations will often be as much on the line as those of the acquiring company and its executives. Further, group dynamics plays a role. Executive teams and even boards of directors become invested in the bidding process, creating rationales to show why walking away would cost more in terms of reputation, momentum, loss of key skills, or even share price pressure (Haleblian, Finkelstein, 1993). Previous expenditures such as financial and legal due diligence, consultancy, financing, or even on a previous high premium platform acquisition are sometimes be used as arguments by themselves to continue bidding. They should be ignored, unless their nature and any associated learning provide real insights into whether it makes sense to continue.

Darryl Laws