Michael B.

Porter

Please Note of Nearest Extit:

Exit Barriers ancj Planijiing

With the recent economic downturn following on an extended period of merger activity and diversification, the topic of divestment or exit from a business is receiving attention. While exit was once a rare and desperate management decision, several authors have urged that it become an expected and regular strategic decision made in response to unfavorable market circumstances.; The observable increase in the number of publicly acknowledged divestments probably means tihat in reality the number of such decisions is much higher still. ^ Recent works have given scjime attention to why divestment may make sdnse,^ the optimal strategy for divestment once the divestment decision has been made^ and the intricate process by which divestment is actually carried out."* While tfliose who write about divestment may acknowledge that the decision to exit from a businesii is a difficult one, little attention has explicitly been paid to why this is so. In this article, I will argue that such attention is critical preparaftion for making sound divestment decisions, afnd for strategic planning in general. I will not be concerned here with cases where divestment rjiay be appropriate because a profitable businesis does not "fit," but rather with those cases wjhere divestment involves a business earning a cjhronically insufficient return (although WINTER I 1916 I VOL. XIX / NO. 2

many of my arguments wijl apply to botk cases). My central point in this aifticle is that thbre are a series of barriers to exit forking again^ divestment decisions, in such ^ way that co|n|ipanies are inclined to hang on to unprofital|le businesses, i I Exit barriers arise from the industry Environment, strategy and decisi<in-making probess of a company, and can be divided into thrte broad classes: j Structural (or economic) exit barriersj: characteristics of the technolo y and the fiked and working capital of a busir^ess which impede exit. Corporate strategy exit barriers: rela ionships between a business and ^ther business;? in the company as a result of 4 company's cjorporate strategy which deter exit. j Managerial exit barriers: aspects 01 a company's decision-mal<:ing process itself v^ljiich inhibit exit from unprofitable businessesJj In this article I will identify and andlyze the major sources of these barriers to exiii. Using data on a large sample pf businesses ^n major North American coirporaijions, it will be possible to statistically test for th^ presence of t|^ese exit barriers by examining t i e structural, Strategic and managerial chai'acterjstics of busin|sses that have been unprofitable over a long lieriod of 21

time but not divested. Armed with the support of the importance of barriers to exit that these tests provide, I will then look at some of the implications exit barriers carry for corporate strategy formulation and organizational planning.
Sources of Stractural Exit Barriers

Structural exit barriers are characteristic of businesses which make it in the companies' best interest to stay in them even though they are earning an unacceptably low rate of return or a rate that is below the cost of capital. The major source of structural exit barriers is characteristic of the assets employed in a business: Durable and specific assets. The more durable the assets are, the more specific they are to the particular industry, the particular company or the particular location, the less likely it will pay to sell off or shut down an unprofitable business, and the larger the immediate loss the firm will face if it does shut down the business. The significance of durable and specific assets as an exit barrier stems from their effect on the calculation determining the desirability of exit. It pays to exit from a business if its contribution to the entire company divided by its resale or liquidation value is less than the company's opportunity cost of capital. While a business may be earning a very low return on its book investment from a strictly economic point of view, it only makes sense to get out of the business if the assets freed by so doing will earn more elsewhere. But the value that can be recovered by scrapping or selling off a business may be quite a bit lower than the value of these assets on the books. When the investment in a business is written down accordingly, the contribution the company is earning on the assets by operating them may exceed its next best use for the capital, in which case the business should not be divested. If the company does decide to exit
Michael E. Porter is Assistant Professor of Business Administration at the Harvard Graduate School of Business Administration. He has contributed to various economics and business publications, and his books include Interbrand Choice, Strategy and Bilateral Market Power.

from the business, the book losses it faces are substantial. The specificity of assets to the particular business, company or geographic location lowers their market or resale value relative to their book value. Specificity of assets to the business means that their use outside of the particular business is limited or absent. Thus their liquidation value is low, and possibilities for reselling them are limited to other firms wanting to put the assets to the same or nearly the same use; that is, in the same business. If the assets are even more specific, that is, specific to the company (custom designed to the company's unique specifications) or to the particular location at which they are in use, the market for selling them becomes even thinner and their resale value correspondingly lower. The more specific the assets are, then, the lower the recovery value the firm can expect to receive. If the assets are also durable, the beating the company takes if the assets are sold is worsened. Durability means that it may be a long time before the book value of the assets falls to the point where it pays to sell them off and until the book losses accompanying their sales become small. Furthermore, the thin market for specific assets is quite likely to deteriorate badly just when a. company wants to sell them. Two broad types of disturbances generally lead to unsatisfactorily low rates of return in a business: innovations in production, distribution, or selling which render assets in that business obsolete; or a competitive weakness which cannot be overcome but which is unrelated to the company's assets per se. A business earning an unsatisfactorily low return has two alternatives for exiting: liquidating the assets or selling the business as a going concern. Specificity of the assets of the business to a particular use means that the only likely buyers are those who plan to use the assets in the same or similar business. If innovation has made the assets obsolete, it is most unlikely that buyers will be found for them, which further depresses their value by forcing the liquidation alternative. Examples of durable and specific assets are: Specialized plant and equipment: the more

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specialized the plant and equipment to the particular business, and even more important, to the particular company and location, the higher the barriers to exit. Specialized inventory investment: the more difficult it is to liquidate inventory investments on favorable teims, the higher the barriers to exit. Working capital investments are very durable because they do not depreciate on the books. Specialized distribution, receiving, and transportation arrangements: captive distribution, inhouse loading and storage facilities and other assets, if they are specific to the business or location, raise barriers to exit. Intangible assets: specialized production expertise, goodwill, brand names and product formulations may be highly firm-specific and have much lower value to other firms, thereby raising the barriers to exit. (These assets are often written off quickly, which may minimize their effect.) Labor and management protected by severance agreenients: the more the fixed costs of terminating employees, the higher barriers to exit. While structural exit barriers are to some extent inherent in the nature of a business, it is clear that strategic decisions made by the firm can raise or lower them. Sources of Cprporate Strategy Exit Barriers Just like structural barriers to exit, certain kinds of overall corporate strategy choices can place companies in situations where it pays for them to stay in a business even when the business is earning a chronically unsatisfactory rate of return on investment. The major source of corporate strategy exit barriers is the relationships that may bei present between the business and others in the company. Interrelatedmess. The more complementary or linked the bitisiness is to other businesses in the company, thip less likely will it be economically justified to s-ell or shut down the business even if it is chronically unprofitable, and the larger the immediate losses the firm will face if it does so. Even if a business is being charged its fair share (and no moire) of overhead expenses, divesting it WINTER / 1976 / VOL. XIX / NO. 2

will affect the sales or costs of those other businesses if it is linked or complementary to o|ther business in the company. The case of con|plementarity in sales or distribution is the rjiost clear. Suppose sales in business A help impi-ove the company's image, reputation, and sal^s in business B. Then when mailing a decision toiexit from A, this contribution to business B's prpfits must be included in the cE^Iculation. Similar reasoning holds if exit froni A affects the cjompany's relations with its customers, distribuj^ion channels, or suppliers in any of its other Businesses, or affects its relations with its sl|areholders through the price of its sitock. Foj example, if business A shares facilities with o|ther businesses, the contribution to overhead mu|t be weighted as a benefit to the ex|tent that the (fompany does not have alternative uses for the f|icilities or they cannot be rerited on the (|)pen market. If business A is related to other |)usinesses through vertical integration, savin in transportation or inventory 4osts which be eliminated if the company purchased or jsold outside must be weighted as a\ benefit when jconsidering exit. Business A's prdsence may alsb allow the company as a v/hole to get better ppces from suppliers when purchasi^ig is consolidated. Thus a company can have businesses which] correctly show unsatisfactory returns on |heir financial statements, but divesting them will lead to larger overall losses due to interrelatedjiess. Since interrelatedness is clearly somellhing management can to some degiiee control through strategic choices, this form of exit barrier ip.ust figure prominently in my discussion of th4 implication of exit barriers for linanagement. ( Sources of Managerial Exit Barriers j

Managerial exit barriers are characteristics <^f the company's decision-malcirig firocess which peter its management from makink decisions to! exit from a particular business ev^n though thev are justified on economic grouncjs. These are d ifferent from the structural or Corporate strategic barriers discussed above, sinc^ they produCi decisions not in the best interests of the company. We can usefully divide man^gerisd exit banners into two major categories: information-related barriers and confiicting goals. Information-related barriers. A company m^y be earning an unsatisfactory return in one elf its 23

businesses but not know it. Even if management knows about a poor performance instinctively, financial data in the appropriate form are often not available on an ongoing basis. Often financial and control information is compiled for groups of businesses rather than for the appropriate individual business units. Profit centers for accounting purposes are often not economically relevant businesses; or if they once were, changing conditions have at times made them obsolete. Accounting systems have their own inertia and often lag behind market conditions. In such cases where the accounting unit is not the economically relevant business, profits from healthy businesses may obscure the unprofitability of others. Usually management will be aware of problems in a particular business even if the numbers are not collected for that business separately. But being aware of a problem is a far cry from seeing the cold, hard financial results of the business year after year. This discussion suggests a number of dangerous situations where information-related exit barriers may be substantial. Information barriers may be high in a business that is one of a group of vertically related businesses in a company. Information barriers may be high in businesses that are closely related to other businesses in the company through shared distribution channels or shared production facilities. In both these cases, there is a high probability that data for the particular business are not rendered separately. It is easy to see why this would be true. It is often quite difficult, and at least arbitrary, to separate the financial performances of related businesses. Difficult problems of transfer pricing and charges for joint facilities are involved. Where the businesses are not separate profit centers, costly and time-consuming special calculations must be made. But while these may be valid difficulties in compiling the required information, they are a major sources of policies obscuring unsatisfactory financial results and blocking exit from losing businesses that can place enormous drains on management. This article has discussed the absence of appropriate financial or accounting information, but the absence of critical nonfinancial information may be just as much of a problem. The reported financial results of a business do not tell manage24

ment whether or not it is viable. To make such assessments, managers need strategic as well as operating data. These strategic data take the form of information about the market and competitive conditions in a business, and other often nonquantifiable information so crucial to the judgment about the future of a business. Rarely do companies have systems which provide this sort of strategic data to top management. They are frequently forced to rely on second-hand opinions and current financial statements are prone to attribute problems to bad operating management rather than to the fundamentals of the business. Closely related to the lack of ongoing and appropriate financial and nonfinancial data as an impediment to exit is the difficulty of gathering the information relevant to making the exit calculation itself. Accounting data, which are dessigned to measure the health of a business as a going concern, are inappropriate for making the exit decision. The exit decision requires information that is often uncertain and difficult to estimate, regarding the sale or liquidation value of a business. In addition, the problems of dealing with complementarity among businesses, joint costs, overhead allocation and the like increase the information demands the exit decision makes. These costs and subtleties of the exit calculation provide a deterrent to exit. The significance of this deterrent is increased by the fact that, unlike capital budgeting and other major corporate decisions, few companies have experience in making exit decisions or procedures for doing so. Another information-related barrier to exit is the cost of planning and executing the exit process once the decision is made. In today's world of labor protection and concern for impact on the local comrhunity, exiting from a business involves an enormously complex and costly process involving retraining, resettlement and severance payments.^ The fixed cost in financial resources and top management time consumed in the process of actually divesting a business may pose a substantial deterrent to doing so. Conflicting goals. Decisions to exit from a business have been called the single most unpalatable decision managers have to make.^ But despite California Management Review

this conimon observation, little systematic attention has been paid to which characteristics of the exit decision lead the company to stay in a business when the economics suggest they should exit. To do this we must clearly identify the factors which lead to situations where a manager's goals diverge from the overall economic goals of the firm. Not only will these factors be important in and of themselves, but they can help us identify company situations where the forces working against sound exit decisions are especially strong. There are many reasons why managers may avoid exiting from a business even when the economics clearly suggest they should. We can divide these into two major categories depending on whether we are considering a single business company or division, or whether our focus is on the mariagement of a multibusiness company. Since managers of multibusiness companies must often rely on managers of divisions or subsidiaries for information about whether a particular company can be saved or should be abandoned, they must contend with the former category as well as the latter. Source of Conflicting Goals in Single Biisiness Companies or Divisions There are a number of interpersonal and organizational factors which raise confiicting goals in making the exit decision in single business companies or divisions. They are discussed below. Exit is a blow to a manager's pride in his professional competence. Managers, particularly good ones, develop pride and commitment to their businesses. Commitment and intense involvement with the business are, in fact, some of the important characteristics of a successful leader and effective manager. In the face of the commitment, however, it is difficult to "give up" by making the divestment decision. Divestment is a blow to a manager's professional pride because ft reflects his inability to make the business successful. In fact, managers may view divestment as an indication that their commitment to the business was insufficient and that they die. not try hard enough. The more committed Ihe manager to a business, the harder the exit decision tends to be. Ironically, then, it may be harder for good managers to make WINTER / 1976 / VOL. XIX / NO. 2

economically justified exit decisions than for less successful managers to do so. Exit severs identification with a busines^. Managers identify personally with businesseis 4nd with the people in them, just as they find th|sir identity in their home, their state, their religious affiliation, or their nationality. The psycliological aversion to cutting themselves off from |he business can be great. h Exit is often taken externally as a sign o^failure, which reduces mobility elsewhere. While managers may not have been responsible for t|:le problems that caused the cj^mpany to ritionally choose exit from the business, potei^tial employers may treat the fac^ that an exit idecision was made as indicative of' fault and m|y be reluctant to give the managers comparably responsibility elsewhere. The prospective ejmployer may ask, "Who wamts a loser?" | Exit threatens specialized managers' cdfeers. A manager's talents n\.&y b(; specialized tjo a particular business, or to a specialized piche or function within that business that he is|unlikely to find in demand elsewhjre. Thus the exit decision may mean great uncertainty about his future. Exit often conflicts with facial goals. Exit often puts loyal employees out of work, causes economic hardship in a comijnuniity in whi|;li managers have worked for lojjig periods, an|i upsets numerous relationships ^hich manage|^ value. Managers' or compimies' social goals oron confiict with the decision to exit, and the jijroblem of exit may be one of the raost impcfiftant to consider when setting social goals. \ Incentive systems often M^ork against e:^it. If the managers are part of a larier company, liicentive and reward systems often place no prei|iiium on exit decisions and may actually discoura^fe them. Sound exit decisions maj^ reduce managers' incentive compensation if |io adjustmentj Is made in compensation systems designed for i|s^ in ongoing businesses, i These forces working against exit deci|i^ns can be very strong in companies that ijiyolve a single business, even mojre than in di\^lsions of multibusiness companies. In "the absentee of external pressure from stocl^holders or financial institutions, such companie^ maiy remain \k opera25

tion for long periods of time, earning low returns and depleting the company's assets. The danger of this tends to be especially strong where the company is old and has a long tradition, or where managers have been promoted from within the company or come from backgrounds inside the industry.
Sources of Conflicting Goals in Multibusiness G)mpanies

In a multibusiness company, there are some^offsetting forces present which can override the tendency of the managers of individual divisions or subsidiaries to avoid economically justified exit decisions. There is a layer of top management superimposed over the component companies which can take a more detached view of the individual business, and act as an internal capital market in allocating the resources of the parent away from unprofitable business. In addition, the multibusiness company has the potential to transfer managers and employees to its other units. This minimizes some of the identification problems noted above by detaching the career and future of a manager from the future of a particular business both psychologically and actually. Despite these offsetting forces, however, managerial barriers to exit are still present in multibusiness companies. While they may be more subtle, they can prove to be just as important. This observation is reinforced by the fact that the diversified company often has the financial resources to carry a loser indefinitely. Exit may be viewed externally as evidence of poor corporate management. Even though top management does not directly run the business, they are indirectly responsible for it. Rightly or wrongly, outsiders may take divestment as a sign of poor corporate management. Exit is still a blow to top management's pride and taken as a sign of failure, even in multibusiness companies. The same pride and commitment to individual businesses described earlier for good division management applies to good corporate management. Corporate management can view divestment as evidence that their leadership and support of division management is inadequate, even though this may be far from the case. The danger that pride and com26

mitment will impede sound exit decisions is particularly great in the following situations: when current top management made the decisions leading to the company's presence in the business; when current top management has been in control of the company for some time while the business's performance has been unsatisfactory; and when the business is close to, or related to, the company's main or dominant activities. If it is unrelated, exiting from it reflects less unfavorably on the competence of management. An interesting study by Gilmour of three divestment case histories found that in all three cases a change in top management was required before the companies could exit from chronically unprofitable businesses.' Others have made similar observations in a variety of other companies. While the requirement of a management change may not be necessary in all situations, these cases do illustrate the difficulties faced by an incumbent t:op management in deciding to exit from a business for which it feels some responsibility. Top managers of multibusiness companies still identify with particular businesses. Top management can identify with and develop particular commitment toward individual businesses which are components of the overall company, impeding sound exit decisions. The danger of excessive identification may be especially important where the business has been part of the company for a long time; and the business has been one of the historical foundations of the company's current growth and success. This also applies when the business is perceived as the company's "base business" or "home industry." General Mills' decision to divest itself of its basic flour milling business is an example of a case where identification was particularly strong. In that case, a previous experience with divesting a less "sensitive" business and a new chief executive officer were important conditions allowing the divestment decision to be made. Another trying situation is when the business is related to other businesses in the company. Where it is unrelated and separate, it is much easier t:o decide to exit from it. A chief executive of a large industrial products firm commented, for example, that it was easy to gain California Management Review

agreement to divesting a recently acquired consumer products company, while a more needed divestment in a closely related business was "politically impossible." It may be more difficult to divest a business that was developed internally than one added through acquisition or merger. It may take much longer to develop real commitment toward an acquisition, while a business developed from scratch after painstaking planning and the complexities of start-up must have strong internal commitment even to get off the ground. Exit decisions may be seen as placing blame or demonstrating lack of confidence in subordinates. Especially when effective and committed subordirtates are involved, a divestment decision can be taken as a vote of no confidence in a subordinate manager, and may affect that manager's reputation and status in the organization. In some cases, talented subordinates may even threaten to resign if their business areas are divested. Rather than finding ways of communicating confidence in a subordinate, and of insuring that kis reputation and status are preserved, top management sometimes avoids divestment decisions that are in the best interests of the company. Top managements of multibusiness companies tend to overvalue the synergistic benefits of related businesses. Where a business is related to others in the company through shared facilities or throuiijh vertical integration, the adverse impact of divesting can be overvalued, impeding sound exit decisions. This evaluation may be in part a rationalization used to justify, either publicly or to management itself, failures to exit for the conflicting goals discussed earlier. Examples of this barrier are an overvaluation of the adverse imjpact of losing a captive supplier by exiting from part of a vertically integrated chain, or the disruptive effects of exiting on customers, suppliers, and distribution channels shared with other businesses in the company. The loss of image with stockholders may be similarly overestimated. As was discussed earlier, true jointness or synergy can erect a real economic barrier to exit. Here I am arguing that risk aversion and the emotional difficulty of the exit decision can be reflected in unwillingness to exit from a business WINTER / 1976 / VOL. XIX / NO. 2

which is rationalized by synergies whijch disappear uiider closer scrutiny. When exitimg from a vertically related business, for example, the risks of becoming dependent on supplier^ or the risks of strikes in suppliers' plants may tie minimal if there are several capable supplier^ in the market. In fact, competition among sikppliers often can lead to a better product than tjiiat produced within the comparjy by a unit ivith an assured market. Despite this, the exit parriers due to true synergy amo^g related businesses can be reinforced by barijiers due to irpagined synergy. ; Pressure for sales growth (pr steady finakcial results leads management to ^void exit decisions in the long-run best interesi\ of the stock^iolders. Except for a very small business area, tjae decision to exit will usually le^d to a dip in ijhe sales or earnings per share of th^ company, or a divergence from its historical trend line. Despite the fact that an economically [justified exit decision is in best interests of tjie company'^ stockholders in the long iTinJ the concern of top management for the company's short-terlm stock price or public image may lead to avojding it. Either the business is sl0wly liquidat|}d at a higher cost than necessary, managemerit hopes the problems will go awaV, or futile atte|inpts at rescue are initiated. i The danger of heavily weighting the shojrt run is greatest when the company has had| a long record of steady financial results or wjhen the company is a recent participant in t h | public capital markets. i Exiting From a Business Versus Attempting a "Resjcue" j <

The first inclination is to make a bad: Situation better, and one often oqserves repeated futile efforts to rescue an unprbfitable business with new management and continued infusicjn of resources. In some cases th^ number of |uch attempts and the resource^ invested se^ms surprising to the outsider. Attempts at tur|iaround are extremely expensive to compani4s; they often involve the best management talent the company can muster, to siy nothing of Ithe financial resources expended. They consui[kie large amounts of top management time and mjay leave those involvedmanagerrjent themseWes and 27

outsidersquestioning their own and everyone else's managerial abilities. While many turnarounds obviously are successful, and the decision about whether a series of unprofitable years is temporary or permanent is a subtle one, managerial exit barriers seem to me to explain a large portion of the substantial resources spent each year in futile turnaround attempts. Turnaround efforts recognize the unsatisfactory performance of a business, but avoid the exit decision. So exit barriers not only trigger chronically unsatisfactory returns on investment, but they trigger throwing good money and managerial resources after bad as well. Exit decisions actually made are often made late, and ironically, are often made without adequate study and analysis. Gilmour found that in none of the three divestments he studied was any quantitative data even analyzed until the decisions to exit had effectively been made. These observations about the nature of observed exit decisions support the existence of substantial managerial barriers to exit.
Empirical Examination of Failure to Exit in Practice

Do the barriers to exit outlined above serve to deter exit even in large diversified companies? To answer this intriguing question, I performed statistical tests utilizing a unique data base assembled by the PIMS Program of the Strategic Planning Institute.^ The PIMS data base contains data on return on investment and measures of numerous other dimensions of strategy and market characteristics for over 500 individual businesses. The statistical tests sought to explain the characteristics of businesses that had earned persistently low rates of return on investment averaged over the four-year period 1970-73 and yet which were still in operation; that is, businesses that had not been divested even though their fi-' nancial results would suggest this. In order to avoid grouping in this category those businesses whose low current rates of return were probably temporary, I excluded from the sample all businesses that were started within the five years prior to the period under study, or that were perceived by their managers to be in the introductory or growth phases of their product life
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cycle. This screening yielded a sample of 310 businesses, of which 94 had average pre-tax ROI's of less than 8 percent over the four-year period, 69 had less than 5 percent, and 31 had less than 0 percent. The continued operation of the business despite chronically subnormal returns was taken to signify the presence of barriers to exit. The objective of the statistical analysis was to determine what the characteristics of those businesses and their markets were.^ A number of measures of both structural, corporate strategy, and managerial barriers to exit refiecting the arguments presented earlier were constructed using PIMS data, and multiple regression analysis was performed to see if those measures of exit barriers indeed increased the probability that a business was still operating despite chronically low return on investment. Table 1 lists the company and market variables tested, their definitions and the results of the statistical analysis. The results provide some confirmation of the importance of exit barriers. Measures of the durability and specificity of assets, measures of linkages between the business and others in the company as well as the proxies for managerial exit barriers were all important in predicting whether a business was continuing to operate despite low returns. Almost all variables were statistically significant, and they almost always affected exit in the expected way. While Table 1 is largely self-explanatory, several of the results deserve further comment. First, the more diversified the company in which the business is situated, the more likely the company is to continue to operate it even if it is chronically unprofitable. Thus even though a more diversified company can be less emotionally tied to any of its businesses, the net effect in my sample is that the unwillingness of division managers to exit and managerial barriers at the top management level outweigh any greater objectivity of diversified company top managements toward exit. This is not surprising if we suppose that even the objective top management in a more diversified company often has less knowledge with which to counteract the antidivestment arguments of unit managers than they do in a less diversified company. Another interesting result in Table 1 is that the California Management Review

presence of facilities shared with other businesses is much more important than the presence of shared marketing or distribution channels in deterring exit from an unprofitable business. Since shared facilities lead to an especially visible form of shared overhead, this might be anticipated. A final result that may appear unusual is the asymmetry between backward and forward integration as exit barriers. If a business is a customer for the output of other divisions in the company, my results show that this deters exit from it even when it is chronically unprofitable. If the business sells to other divisions in the company, however, on average the company is more likely to exit from it. But this is not surprising. While the desire to have a captive customer may lead to reluctance to exit from a business which is a heavy internal purchase, this would not be so for a business which sells heavily internally. If such a business is earning a chronically low return it is likely to be suffering from production inefficiencies or an inferior quality product relative to its competitors. The divisions of the company forced to purchase the inferior or high-cost product, at a disadvantage to their strategic positions, may provide a major internal stimulus for top management to exit from such low-return businesses. They will bring the inefficiencies of the lowreturn business to the attention of top management, will lobby for permission to purchase outside the company and will provide a force overcoming managerial exit barriers. This force is altogether lacking in the case where the low-return business purchases substantial amounts internally. Exit Barriers and Strategic and Organizational Planning What can managers do about barriers to exit? The overriding answer is that barriers to exit should be explicitly recognized in the strategic planning process. A first step, and an important one, is the explicit recognition of the major categories of exit barriers when considering strategic action on an unprofitable business. Considering barriers to exit out in the open should allow managers to better avoid reasons for not divesting which they would tend to overvalue unconsciously. Second, managers must recognize and factor exit barriers into their decisions to WINTER / 1976 / VOL. XIX / NO. 2

enter businesses, make investments in them and chang ? their strategies. Planning for ijhe contingency of exit is rarely done. But baiiders to exit increase downside risks, and preparing for the possibility of exit v/hefi mgjor strate||;ic decisions are made and on an ongoing basis ckn have large payoffs which justify the discomfort involved. I I can also sketch some mdre specific illij|strative consequences of exit barriers for the final's own optimal strategy, the appiropdate des[g]|i of its organizational systems and for the strat|3gies of its competitors. I Exit barriers and company strategy. Sincb a business locked in by structural or corporate strategy exit barriers is one |where the ec4nomics dictate keeping it despite unsatisfactory j-eturns, the best medicine is pr^ventative. Ejfit barriers are something managers can and j should think about before jurnpihg into a busi|rtess or investing more resources iiji it. One genem relationship is that the same factors that brovide barriers to entry often lead! to barriers to exit, so the two are often associatjed in a business. Following this, strategjic changes which increase entry barriers usually increase exit baiiiers as well. Some specific implications of exit [barriers for strategy formulation follow. I Minimize asset specializa^on consisted with maintaining a sound competitive positio^. Often a number of alternatives ^re available ik major corporate investment decisions. It is imjbortant not to increase the specialization and I inflexibility of the business's asset:s needlessly. Jljie prevailing trend toward reaping scale econoniiles and taking advantage of learning cuirve effects| has led to little attention being pajid to the dsks jof asset specialization. Often alternatives can b^ found which achieve the desired strategic res|ult but avoid locking the business into situation! which breed difficulty in shifting assets if une.|pected technological change or competitive weajknesses emerge. Companies are probably too pl-One to make use of custom-desigiied and unsal\|ageable equipment. I It may not pay to keep up reinvestment ^ja maintain saleability in a business with high structural or economic exit barriers. Companiesj i sometimes continue to invest in an unprofitable 29

Table 1. Business Characteristics that Either Erect Barriers to Exit from Chronically Unprofitable Business or Help Overcome Them
Measure of Exit Barriers for the Business 1. Investment intensity Predicted Effect on Likelihood That Unprofitable Business Will Be Exited Deters exit from the business Statistical Significance

Definition Average investment of fixed and working capital divided by sales at full capacity.

Hypothesis A structural exit barrier. The higher investment intensity, the more durable and specific the assets tend to be and the less likely the firm to exit from an unprofitable business. A structural barrier. The higher advertising and sales promotion, the greater the degree of intangible specific assets and the less likely the exit will be. A structural barrier. We expect a business in difficulty to go through a period of low capacity utilization. But in the absence of exit barriers, capacity would be reduced to match the lower demand levels in the medium to long run. Thus where chronically low capacity utilization is associated with chronically low profits, we have evidence of exit barriers due to durable and specific assets.
A chronic adverse price/

Actual Effect

deterred yes exit

2. Product Differentiation Intensity

The sum of advertising, sales-promotion expense plus product R&D expense, divided by sales.

Deters exit from the business

deterred yes exit

3. Capacity utilization

Percentage of standard capacity used during the year arranged over the test period.

Indicates deterred exit from the business

deterred yes exit

4. Relative Price/ Relative Cost

Ratio of management's estimates of its selling price relative to its competitors, and management's estimate of its relative costs.

cost relation in persistently low-return businesses (negative sign) would also be associated with exit barriers. Because the price/ cost ratio records management's own perceptions of its competitive deficiencies, a management in a persistently low-return business must be deterred from exit either by durable and specific assets or rnanagerial barriers.

Indicates deterred exit from the business

deterred yes exit

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California Management Review

Measure of Exit Barriers for the Business 5. Importance of Shared Facilities

Definition A yes/no measure depending on whether the business shared 10% or more of its plant, equipment and personnel with other components of the company. Yes/no measure depending on whether a business shared more than 10% of of its marketing expenditures with other components of the company. Yes/no measure depending on whether a business made 25% or more of its sales to customers also served by other components of the company. Percentage of total purchases of materials, supplies, etc., obtained from other components of the same company. Percentage of sales by this business made to other components of the company. Number of different SIC activities the company is in weighted by their sales and how diverse they are.

Hypothesis Measure of structural and management barriers. The greater the sharing, the higher the exit barriers.

Predicted Effect on Likelihood That Unprofitable Business WiJil Be Exited Deters exit jfrom the business

Statis5 tical Actual^ Significance2 deterrel exit

yes

6. Importance of shared marketing expenditures

Measure of structural and managerial barriers. The greater the sharing, the higher the exit barriers. Measure of structural and managerial barriers. The greater the sharing, the higher the exit barriers. Measure of managerial barriers.

Deters exitlfrom the business.

deteirrejd no
exit, l i

7. Importance of shared distribution channels

Deters exit from the businesp.

tated exit.

8. Degree tp which the business purchases internally

Deters exit jfrom the businesL

deterrejd yes exit. I

9. Degree to which the busitiess sells internally

Measure of managerial barriers. The more sold internally, the more pressure from internal buyers. Measure of managerial barriers.

Facilitates pxit from the business.

facilitated exit.

yes

10. Overall company diversity

Could facilitate or deter exit.

deterrdd yes exit.

1. The actual effect is the direction of the relationship in the data based on a multiple regression analysis.
mftasi^rfiH in this tfst ic rnnrinm ^

\
\

2. Statistical significance indicated by "yes" means that there is no more than 1 chance in 20 tfiat the association

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business so that they will be able to recover the maximum investment in selling it. For the reasons previously discussed, buyers at favorable prices are rarely found for such businesses which have high exit barriers. "Milking" or "harvesting" businesses with high exit barriers that have developed strategic difficulties may often be the preferred strategy. Avoid sharing for sharing's sake. Establishing joint or shared facilities, personnel and distribution channels should only be done where real and substantial efficiencies are available. In their absence, keeping businesses separate will not only allow better control and evaluation, but will facilitate exit if it becomes required. Exit barriers and competitors' strategies. Competitors have barders to exit, too. Especially where these are structural exit barriers, competitors will not give up easily in response to price cutting or other actions which reduce their market shares or cut into their profits. Such considerations should be raised when planning strategic moves. Part of the diagnosis of competitor strengths and weaknesses should be a diagnosis of his barriers to exit. Exit barriers and organizational planning. Managerial barriers to exit imply that companies should provide mechanisms for collecting the information relevant to exit decisions and, even more importantly, for resolving the confiicting goals which may surround them. In view of managerial exit barders, divestment decisions must be forced because they will not happen otherwise. This will require careful attention both to top management's own feelings and attitudes, and to the design of checks and balances to overcome the forces previously discussed. Some more specific suggestions are as follows: Build a top management team that includes someone whose odentation will force the issue of the divestment decision. The chief executive's team can usefully include a manager who is the sort that will take a hard look at the financial results of the company's businesses, has the orientation to force examination and reexamination of the divestment 32

option, and commands the respect necessary to have his arguments heard. A balance of skills is one hallmark of a good top management team, and a team consisting of individuals with different skills and orientations is especially cdtical in dealing with divestment.

Explicit mechanisms need to be present which encourage managers of individual businesses to recommend exit where appropriate. While it is important that individual managers develop commitment to their businesses and do not give up at the first signs of trouble in their businesses, many forces in companies seem to be stacked against deciding to exit, representing an equally unsatisfactory situation. Ongoing review procedures, to be discussed below, are one important stimulus to sound exit decisions. Others include a periodic analysis of the organizational structure and the strategic planning process to encourage new individuals to examine businesses in new ways. It is also desirable to design compensation and incentive systems so that they do not discourage sound exit decisions. Some ways of doing this are to establish service charges for use of corporate capital, to reduce the velocity of promotions out of businesses, and to allow no arbitrary penalties in bonus compensations if exit occurs. Handle early decisions to exit carefully because they will be a signal to the whole company about management's intentions. The way early divestment decisions are handled can either reinforce or allay middle management's fears about job secudty and career progression. Care taken by top management in placing competent managers from exited businesses into new and responsible positions in the company will have payoffs in encouraging sound exit decisions in the future.

Design management information and control systems to provide ongoing financial information at the level of the smallest meaningful business entity. This will avoid obscudng the results of poor performers. Planning and control systems should ideally be California Management Review

structured so that decision makers receive firsthand strategic data on the market and competition position of a business as well as its financial results. To serve this function is another important argument in favor of formal strategic planning in companies. Ongoing and pre-agreed-upon review procedures need to be present to regularly screen out poorly performirig businesses for review with respect to divestment. Forcing itself to decide regularly and explicitly to remain in a poorly performing business should aid management in facing the eventuality of exit if it comes. Information gathered in such reviews should accumulate to offset some of the informational difficulties of making exit decisions I have discussed. Information relevant to the exit decision itself should ideally be collected as part of the strategic planning and capital budgeting processes. One diversified company in technologically oriented businesses includes an estimate of liquidation value in the yearly planning requirement for each business. This not only invites exit versus no-exit calculations, but also can serve to attune managers to how their strategic decisions will affect liqiLjidation value. Such attention is particularly important in this company, since its technological orientation puts a strong premium on rapid divestment when technological gambles do not pay off. Managerial exit barriers provide a motivation for periodic turnover in leadership. In many large companies today, the tenure of the chief executive is five to eight years. From the point of \iew of making economically sound divestment decisions, this periodic change in leadership can be beneficial. New chief executives can lack the commitments built up over time by incumbents, and new chief executives also have the tendency to want to take write-offs and clean house immediately.

Summary Managers tend to think positively: what new businesses can be entered? What is the optimal strategy for success? This l^uman tendency is far from unique to managers. However, thinking negatively about the unpldasant contingency of strategic failure can be ^s useful in today's multibusiness company tovironment. |It can avoid needless losses wheii businesses afe sold, can prevent futile attempts at tumaroujjnd and can provide insights into ifow competit<|rs may react to strategic moves. Planning for advfitsity is well worth the effort. i

REFERENCES

1. See Leonard Vignola, Strategic Divesffn^t (New York: American Management A-Ssociation, 197|t), chapter 1. : j! 2. Vignola, op. cit., chapter % 3. R. H. Hayes, "New Emphasis on Divestment Opportunities," harvard ^wsmew ReTtiiew (July-Augu'st 1972), pp. 55-64. 4. F. A. Lovejoy, Divestment for Profit (Financial Executives Research Foundation, 1971). 5. See Lovejoy, op. cit. |
i

6. P. Hilton, "Divestiture: T^ie Strategic Moie on the Corporate Chessboard," Management Reviey^ (March 1972), pp. 16-19. 7. S. C. Gilmour, The Divestr^ent Decision Process, unpublished DBA dissertation, I^arvard Universiijy, 1973. 8. Gilmour, op. cit., chapter 9. This point is allso made by P. Hilton, Planning Corporate Growth and Diversification (New York: McGraw-Hill, 1970). 9. A description of the PIMS data is found in Buzzell, Gale and Sultan, "Market Sh^re-A Key to Profitability," Harvard Business ReUew (January-February 1975). 10. Some related useful suggestions are proposed in Gilmour, op. cit., and Lcivejoy, lop. cit. |

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