Short Take

How to Spur Capital Spending: Plan for Failure

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Companies might invest more in new ventures if they could see in advance how to redeploy the assets if things don’t pan out

After years of booming corporate earnings, American companies are facing political and social heat to invest in new products, jobs and facilities in the U.S. That’s a key element of President Donald Trump’s “Make America Great Again” program.

But how best to deploy shareholders’ capital in what are inherently risky new ventures? Research by UCLA Anderson’s Marvin B. Lieberman, Gwendolyn K. Lee of the University of Florida and Timothy B. Folta of the University of Connecticut proposes a blueprint, of sorts, for making the wisest possible corporate investment decisions.

For inspiration, the authors draw in part on the growth philosophy of Amazon Inc. founder Jeff Bezos. In his oft-quoted 2015 letter to shareholders, Bezos described two tiers of decision making. “Type 1” decisions are “consequential and irreversible or nearly irreversible — one-way doors — and these decisions must be made methodically, carefully, slowly,” Bezos wrote. But most business decisions are “Type 2” decisions, he said: they are changeable, reversible — two-way doors. “If you’ve made a suboptimal Type 2 decision, you don’t have to live with the consequences for that long. You can reopen the door and go back through,” Bezos said.

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That two-way door concept favors investing in new projects that are related to a company’s established business lines, Lieberman, Lee and Folta write in the Strategic Management Journal. On the face of it, that advice might appear to merely endorse the old-fashioned idea of seeking “synergy” among a company’s businesses. But the authors say traditional notions of synergy don’t capture all the benefits of what they term “relatedness” venture investing by corporations.

Specifically, the authors stress the need to have an advance, or backup, plan for redirecting company resources: If a new-product idea turns out to be a flop, the pain can be lessened if many of the resources used to develop the idea — brainpower, machinery, raw materials — can be quickly redeployed elsewhere in the business.

“The ability to redeploy resources inside the firm reduces the cost of entry ’mistakes,’” the study says. “If a new business turns out to have poor profitability, the ability to redeploy more of its resources back into the firm’s other businesses allows recycling of investment and can speed up the retreat. This reduces not only the cost of exit, but also the cost of entry.”

That, in turn, should foster greater corporate efficiency as well as a more dynamic approach to new-business development. “By decreasing the cost of failure, the potential for redeployment justifies the undertaking of riskier entries and greater experimentation” by management, the authors write.

The study cites two major investment decisions by household products giant Procter & Gamble in the late 1990s. One was the development of Olay Cosmetics, an extension of the firm’s successful Olay skincare line. P&G pulled the plug on the Olay cosmetics franchise within two years of launch. Although the new venture failed, P&G “could easily redeploy its people, production lines, and other resources” to its established Cover Girl and Max Factor brands, the authors write. “Because of this ability to internally redeploy, the sunk costs of the Olay Cosmetics entry were largely limited to the $40 million expenses on advertising and promotion tied to product launch.”

By contrast, P&G spent $500 million over 25 years to develop Olestra, a “fake fat” for food. The U.S. Food and Drug Administration approved Olestra in 1996, and P&G had high hopes that the product would be widely used as a way to reduce fat in processed foods. But Olestra was soon dogged by allegations that it caused cramping. P&G finally gave up on the product in 2002, selling off a factory built specifically to produce it. Lieberman, Lee and Folta write that P&G’s “slow exit” from Olestra, despite the market’s rejection of the product, illustrates one of the major risks involved in funding expensive new ventures largely unrelated to a company’s core businesses. A company may be more inclined — often wrongly — to stick with a failed idea if the only alternative for the resources involved is a painful asset fire sale.

To back up their theories about optimal corporate investment strategies, the authors studied 1,575 new-product introductions by 163 firms in the telecom and internet sectors from 1989 to 2001. The study tracked how many of those products were terminated (and how quickly) because they didn’t meet expectations. The authors found that the speed of exit increased with the number of related businesses a company operated. In other words, “The higher the potential for redeployment [of assets], the faster the exit,” the study says.

A major theme of their corporate investment blueprint, the authors say, is that companies should think like venture capitalists. A plan to enter a new business also should include consideration of how the business would be exited. “Venture capitalists carefully evaluate modes of exit when they fund a business; we argue that the same should apply for managers considering new ventures within established firms,” the study says.

Lieberman, M.B., Lee, G.K., & Folta, T.B. (2017). Entry, exit, and the potential for resource redeployment. Strategic Management Journal, 38. 526–544. doi: 10.1002/smj.2501

Marvin Lieberman

Harry and Elsa Kunin Chair in Business and Society
Professor of Strategy

Marvin Lieberman joined UCLA Anderson in 1990 from the Stanford Graduate School of Business. His teaching and research interests are in the areas of competitive strategy, industrial economics and operations management. He was early in his life fascinated by the economics of competition, including in the realm of entrepreneurship and business startups. His research now focuses on issues related to market entry and productivity, broadly defined.

 

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