Seven Ways to Fail Big

In the 1960s, IBM CEO Thomas Watson, Jr., called an executive into his office after his venture lost $10 million. The man assumed he was being fired. Watson responded, "Fired? Hell, I spent $10 million educating you. I just want to be sure you learned the right lessons."

Years ago, Paul Carroll and I observed there were thousands of books about successful companies but virtually none about the lessons to be learned from those that failed. So, we, assisted by a very smart team of researchers, embarked on an extensive research effort to examine the most significant business failures of the prior quarter century, and provide proven methods for boards, managers, and investors to avoid making the same mistakes.

In those prior 25 years (between 1981 and 2006), 423 publicly traded companies with combined assets totaling $1.5 trillion filed for bankruptcy. 258 major companies combined for more than $380 billion in write-offs. 67 companies had combined losses from discontinued operations that totaled almost $30 billion. (Amounts are not inflated adjusted, so the losses would higher in today's dollars.)

Businesses rack up losses for lots of reasons—reasons not always under their control. But in our study of 750 of the most significant failures over that period, we found that nearly half could have been avoided. In most instances, the avoidable fiascoes resulted from flawed strategies—not inept execution, which is where most business literature plants the blame. Moreover, had the executives in charge taken a clear-eyed look at the evidence available to them, they could have saved themselves and their investors a great deal of trouble.

Many of the failures were so ill-advised that we deemed them "inexcusable," and chronicled them in detail in our book, "Billion Dollar Lessons: What you can learn from the most inexcusable business failures of the last 25 years."

Again and again in our study, seven types of strategies accounted for failure, and ample evidence of their inadvisability was there for the asking. These business moves aren’t always bad ideas; they’ve generated a tremendous amount of wealth for some companies. But they are alluring in ways that can tempt executives to disregard danger signals.

In the time since we published "Billion Dollar Lessons," there have been thousands more books about replicating successful companies and little more than a handful looking at failures. And, unfortunately, the failure patterns we observed have withstood the test of time, i.e., they've kept on happening — over and over again.

That has prompted me to revisit our research and learnings. In this article, I'll review the seven risky strategies and our advice on how to resist their charms.

1. The Synergy Mirage

Often a company seeks growth by joining forces with another firm that has complementary strengths. The whole isn’t always greater than the sum of its parts, however. Look at the 1999 merger of disability insurers Unum and Provident, which operated in the group and individual markets, respectively. Executives thought that each company’s salespeople would be able to sell the other’s products, but the two businesses served entirely different customers through different models. Unum’s sales reps called on corporations to sell group policies; Provident’s crafted sales pitches for individuals. They had different skills and no particular desire to collaborate on cross-selling. Joining the two companies proved costly and complicated. The merger just ended up producing higher prices for everyone and an aggressive posture toward denying claims, which provoked a series of lawsuits that imperiled UnumProvident’s reputation and finances. Unum eventually undid the merger, dropping the Provident name and exiting the individual market in 2007. Its stock price plummeted and is still less than half what it was in 1999, and the company continued to cope with class action suits from claimants for a long stretch afterwards.?

Even when synergies do exist, excitement over them can lead a company astray. Quaker Oats overpaid horribly for Snapple in 1994, which it acquired to freshen up a dowdy brand and gain access to Snapple’s direct-store-delivery system and network of independent distributors. At the time, analysts warned that the $1.7 billion price might be as much as $1 billion too high. Quaker never dug deep enough to understand Snapple’s distributors, who fought efforts to push Gatorade and other Quaker products. Just three years after the acquisition, Quaker sold Snapple for $300 million. Synergies can prove problematic in more subtle ways, too, as when executives focus so much management time and energy on capturing them that they lose out on other, more fruitful opportunities. And clashes of culture, skills, or systems can make it impossible to achieve even synergies that seem easy and obvious.

2. Pseudo-Adjacencies

Adjacent-market strategies attempt to build on core organizational strengths to expand into a related business—by, say, selling new products to existing customers, or existing products to new customers or through new channels. Such strategies are often sensible; they fueled much of General Electric’s growth under Jack Welch. But in our research we found many cases where ill-conceived adjacencies brought down even storied firms. Oglebay Norton, a regional steel provider, is just one example. After 143 years the Cleveland-based company was looking to diversify because steel was in decline. Limestone seemed like a logical choice because Oglebay’s shipping business was already hauling it for its steel mills. Limestone is used in steel production to separate impurities, which are removed before molten iron is turned into steel. It has many other industrial uses, especially in production.

Oglebay began buying up limestone quarries, but it lacked a fundamental understanding of the limestone business. For one thing, iron ore was shipped on the Great Lakes, mostly on 1,000-footers, but limestone often needed to be transported on rivers to get closer to customers. That required much smaller vessels, which Oglebay didn’t have in its fleet. The company filed for bankruptcy on February 23, 2004, with $440 million of debt, most of which was incurred as part of the push into limestone. It would emerge from bankruptcy but never recover its footing. After selling off its fleet piecemeal to retire its debt, it was acquired by Carmeuse North America.

Four patterns emerged among the failed adjacency moves in our research. The first was that a change in the company’s core business, rather than some great opportunity in the adjacent market, drove the move—witness Oglebay Norton’s desperation to reduce its reliance on steel. A second was that the company lacked expertise in the adjacent markets, leading it to misjudge acquisitions and mismanage competitive challenges. Avon made this mistake with a move into health care in the early 1980s, including the acquisition of medical-equipment-rental businesses and substance-abuse centers—a strategy justified by its “culture of caring.” But these acquisitions did nothing to build on Avon’s core asset, its door-to-door sales force, and overlooked the regulatory realities, in which it had no expertise. Avon took a bath. After significant losses, it took a total charge of $545 million for dismantling its health care business in 1988.

The third recipe for disaster was overestimating the strength or importance of the capabilities in a core business. Successful companies are particularly prone to this; their ability to achieve in their own market makes them overly optimistic about their prospects in others. Laidlaw, the school-bus operator, fell victim to this type of thinking when it figured it could leverage its considerable expertise in logistics in the ambulance services business and went on a buying spree. The company suffered big losses in the ambulance business, taking a $1.8 billion write-down on it in 2000.

Finally, adjacency strategies tended to flop when a company overestimated its hold on customers. Just because people buy one service from you doesn’t mean they’ll buy others. Several utilities seeking to expand in the mid-1980s fell prey to this kind of thinking. When regulators began threatening to cut rates, utilities looked for opportunities in other industries. Some made a classic mistake: They jumped into high-growth markets without having any idea about whether they were qualified to operate in them. They thought they could simply leverage their customer bases and sell them products like life insurance, but they found few buyers.

3. Faulty Financial Engineering

Aggressive financial practices don’t necessarily lead to fraud, but they can be dicey. The stakes are high—brands and reputations and even entire businesses can crumble as a consequence, and corporate officers may be exposed to massive fines and even prison.

If subprime mortgage lenders and the banks that supported them had paid attention to the story of Green Tree Financial, they might have realized how dangerous lending to unqualified buyers was. A darling of both Main Street and Wall Street in the 1990s, Green Tree made its fortunes by offering 30-year mortgages on trailer homes—which depreciate rapidly and can have a life span as short as 10 years. Three years after a $50,000 purchase, a homeowner might be stuck with an asset worth $25,000 while owing more than $49,000 in principal. At that point, defaulting starts to look pretty attractive. All the while, Green Tree followed aggressive “gain on sale” accounting methods to record profits, basing its calculations on unrealistic assumptions about defaults and prepayments. With profits based on loan origination, there was also little incentive to qualify buyers.

Attracted by Green Tree’s rapid growth, Conseco, an Indiana-based life and health insurer, bought the firm for $6.5 billion in 1998 in the hope of creating a broader financial services company, only to find itself stuck with a house of cards. Conseco ultimately took almost $3 billion in write-offs and special charges related to Green Tree, essentially erasing all profits earned by the unit between 1994 and 2001. CEO Steve Hilbert resigned in April 2000, and Conseco filed for Chapter 11 bankruptcy protection in 2002—reportedly the third-largest bankruptcy in U.S. history at the time.?

The rise and fall of Green Tree and its ensnarling of Conseco illuminate two problems with financial engineering strategies: First, they can produce flawed products, such as easy-credit mortgages, that attract customers in the short term but expose both buyer and seller to excessive risk over time. Second, they encourage further hopelessly optimistic borrowing to finance more investment. Green Tree’s model was elegant in that the firm could borrow short-term funds at low rates and lend at much higher rates—but at the same time preposterous, because the machine seized up as soon as the flaws in the underlying mortgage product became apparent.?

Overly clever financial reporting is also risky, especially when it involves cutting corners to increase profits and deliver better bonuses. Such techniques tend to veer toward fraud, even when outside auditors have blessed them. Like other aggressive practices, they’re powerfully addictive: Investors reward increased profits, which leads the company to scramble for even greater creativity.

4. Stubbornly Staying the Misguided Course

Redoubling your investment in your current strategy in response to market signals is a strategy in itself, and it can lead to disaster. Executives too often kid themselves into thinking that a problem isn’t so severe or delay any reaction until it is too late. Eastman Kodak stuck to its core in the face of a blatant danger: digital photography. Company executives had made a detailed analysis of the threats posed by digital technology as far back as 1981 (when Sony introduced the first commercial electronic camera, the Mavica) but couldn’t shake their attachment to film, prints, and traditional processing. The margins were hard to pass up as well—60% on film, chemicals, and processing, versus 15% on digital products. Digital technology also eliminated the huge recurring revenue stream that came from film and reprints (though some companies—HP and Epson—long profited from recurring revenues from ink cartridges for printers).

This is a common reason companies don’t change course: The economics of the new model don’t measure up to the economics of the old. Companies also falter because they don’t consider all the options. Kodak’s executives couldn’t fathom a world in which images were evanescent and never printed. The company fought only a rear-guard action against digital cameras and didn’t make a big move into the space until the early 2000s. Its hesitation was costly: it went into a decades-long slide before declaring bankruptcy in 2012.?

Pager company Mobile Media had even less of an excuse to stand by its strategy, because pagers were essentially a fad that lasted only several years. They were a status symbol in the mid-1990s, when cell phones were still bulky and calls expensive. But even as cellular technology followed Moore’s law, Mobile Media acquired other pager companies and focused on designing new-generation technologies that nobody wanted. Following a purge of senior executives, Mobile Media filed for bankruptcy in January 1997. But the brunt of the decline in paging was borne by Arch Communications, which bought Mobile Media in 1999.

It isn’t just fast-moving technology companies that fatally ignore new threats. Pillowtex was an old-line company that manufactured pillows, comforters, and towels. It grew steadily for decades—largely through acquisition—and by 1995 reached annual sales of almost half a billion dollars. In 1994, however, the United States began to phase out quotas on imports. Other companies immediately began outsourcing production to developing countries so they could compete with low-priced imports, but Pillowtex redoubled its acquisition efforts, hoping that efficiencies from scale would give it an edge. The company’s SEC filings from the late 1990s barely mention outsourcing or off-shoring as an option, instead highlighting the $240 million that Pillowtex spent on new, efficient machinery for its U.S. plants in 1998 alone. Two bankruptcies later, the company shut down in 2003 and was liquidated. Although part of the company’s rationale for keeping manufacturing in the United States was to protect American workers, 6,450 lost their jobs. The layoff was the largest in the history of the U.S. textile industry.

5. Riding the Wrong Technology

The huge rewards for breakthrough products and services understandably inspire many companies to search relentlessly for the next Google or iPhone. Still, in our research we discovered that many technology-dependent strategies were ill-conceived from the get-go. No amount of luck or sophisticated execution could have saved them. To keep pursuing the strategies that produced these failures—some quite spectacular—companies had to go to great lengths to deceive themselves.?

Motorola’s Iridium satellite-telephone unit—a $5 billion venture that filed for Chapter 11 less than a year after the phone system went live—is widely cited as a failure of execution or marketing. In fact, the failure stemmed from a misguided captivation with technology. The project began in the 1980s to solve a legitimate problem: Cell phones were expensive and lacked global connectivity, and existing satellite alternatives were cumbersome and unreliable. But as Motorola pursued its development plans, it ignored its own engineers’ warnings that the ultimate product would share the limitations of early 1980s cellular technology even as cell phones got better and cheaper with every passing year. Motorola was so enamored with its technology that its market research amounted to little more than marketing. For instance, when it asked if customers would like a global portable phone for a “reasonable price,” it didn’t define “reasonable” as an initial outlay of about $3,000, plus monthly charges and pricey minutes; and its description of a phone that would “fit in your pocket” assumed that your pocket would hold a brick.

Federal Express made a similar mistake in the mid-1980s with Zapmail, a service whereby couriers would pick up paper documents and deliver them to a nearby processing center, where they would be faxed to another processing center, close to the destination, and delivered by courier to the recipient, all within two hours. The price was $35 for up to five pages, with a discount and faster delivery if the customer brought the documents into a FedEx office. At the time, few companies owned fax machines, because they were expensive and transmission quality was often poor. As prices fell and the technology improved rapidly, fax machines proliferated; soon it seemed silly to use FedEx as an intermediary. In 1986, FedEx shut Zapmail down, taking a $340 million pretax write-off after losing $317 million during its two years of service.

6. Ill-Conceived Consolidation

As industries mature, the number of companies in them diminishes. Holdouts have an incentive to combine and reduce capacity and overhead and gain purchasing and pricing power. Our research shows that it is sometimes better to sit back and let others fumble through consolidation. Though there’s more glory in being the buyer, it may be wiser to sell and pocket the cash before industry conditions deteriorate.

Take the demise of Ames Department Stores. The company pioneered the concept of discount retailing in rural areas four years before Sam Walton got into the game. But it got reckless in its attempts to build a national presence. In its zeal to compete with Wal-Mart, Ames made a series of acquisitions, without adequately considering what it would take to win that battle. The moves didn’t build on its core strength—merchandising—and exacerbated its greatest weaknesses: back-office systems like accounting. For instance, after Ames acquired discount chain G.C. Murphy in 1985, it suffered an enormous amount of shrinkage (industry speak for theft) because it had no system for checking inventory. Disgruntled Murphy’s employees were reportedly stealing goods off delivery trucks and then logging complete shipments into stores. In 1987, Ames lost $20 million worth of merchandise and couldn’t tell why. Even as the company struggled to integrate G.C. Murphy, Ames’s managers went for another, bigger, takeover—Zayre, for which it paid $800 million, a glaring overpayment. The company filed for bankruptcy in 1990 but recovered, only to make the same mistake again. After struggling with the disastrous acquisition of Hills Department Stores, Ames again filed for bankruptcy in 2000 and was liquidated in 2002.

Consolidation plays are subject to several kinds of errors. For one thing, you may be buying problems along with assets. Ames repeatedly overlooked the fact that many of the stores it bought were damaged goods. For another, increased complexity may lead to diseconomies of scale. Systems that work well for a business of a certain size may break as a company grows. USAir bought Pacific Southwest Air for $385 million in 1987 to expand into the West and then bought archrival Piedmont for $1.6 billion. The company almost tripled in size in a bit more than a year, and its information systems couldn’t handle the load. Service suffered, computers repeatedly broke down on payday, and crews were taxed to the limit by their new schedules. Before the merger, USAir and Piedmont had operating profits six to seven percentage points higher than the industry average; after the merger operating profits were 2.6 points below the industry average.

Furthermore, companies may not be able to hold on to customers of a company they buy, especially if they change the value proposition. And last, other options may be preferable to being the industry’s consolidator. Ames didn’t have to go toe-to-toe with Wal-Mart. It was doing nicely as a regional retailer with a far more limited product line. As far as we can tell, Ames never considered holding on to its position and potentially selling out to Wal-Mart down the line.

7. Roll-Ups of Almost Any Kind

The notion behind roll-ups is to take dozens, hundreds, or even thousands of small businesses and combine them into a large one with increased purchasing power, greater brand recognition, lower capital costs, and more effective advertising. But research shows that more than two-thirds of roll-ups have failed to create any value for investors.

We were interested to find that many roll-ups were afflicted by fraud—among them, MCI WorldCom, Philip Services, Westar Energy, and Tyco—but I won’t focus on those in this article because for the most part the lesson is simply, “Don’t do it.” Instead, let’s look at the fortunes of Loewen Group. Based in Canada, it grew quickly by buying up funeral homes in the U.S. and Canada in the 1970s and 1980s. By 1989, Loewen owned 131 funeral homes; it acquired 135 more the next year. Earnings mounted, and analysts were enthusiastic about the company’s prospects given the coming “golden era of death”—the demise of baby boomers.?

Yet there wasn’t much to be gained from achieving scale. Loewen could realize some efficiencies in areas like embalming, hearses, and receptionists, but only within fairly small geographic proximities. The heavy regulation of the funeral industry also limited economies of scale: Knowing how to comply with the rules in Biloxi doesn’t help much in Butte. A national brand has little value, because bereaved customers make choices based on referrals or previous experience, and being perceived as a local neighborhood business is actually an advantage. In fact, Loewen often hid its ownership. And it damaged whatever reputation it did have with its methods of shaming the bereaved into buying more expensive products and services (such as naming its low-end casket the “Welfare Casket”).

Nor did increased size improve the company’s cost of capital. Funeral homes are steady, low-risk businesses, so they already borrow at low rates. The cost of acquiring and integrating the homes far outweighed the slight scale gains. What’s more, the increase in the death rate that Loewen had banked on when buying up companies never happened. Fast-forward several years and the company filed for bankruptcy, after rejecting an attractive bid. (Relaunched under the name Alderwoods, Loewen was sold to the same suitor for about a quarter of the previous offer.)

Often roll-ups cannot sustain their fast rate of acquisition. In the beginning, all that matters is growth—buying a company or two or four a month, with all the cultural and operational issues that accompany a takeover. Investors know that profitability is hard to decipher at this point, so they focus on revenue, and executives know that they don’t have to worry about consistent profitability until the roll-up reaches a relatively steady state. Operating costs frequently balloon as a result. Worse, knowing that the company is in buying mode, sellers demand steeper prices. Loewen overpaid for many of its properties.

Finally, roll-up strategies often fail to account for tough times, which are inevitable. A roll-up is a financial high-wire act. If companies are purchased with stock, the share price must stay up to keep the acquisitions going. If they’re purchased with cash, debt piles up. All it took to finish off Loewen was a small decline in the death rate. When you go into a roll-up, you need to know exactly how big a hit you can withstand. If you’re financing with debt, what will happen if you have a 10%—or 20% or 50%—decline in cash flow for two years? If you’re buying with stock, what if the stock price drops by 50%?

The vast majority of business research focuses on successful companies, in an effort to generalize from their traits, tactics, or strategies. Executives scrutinize healthy businesses for best practices they might be able to imitate.

Our research looked at the data that others tend to ignore: companies that tried to do the same thing as the winners and failed. We know that companies are capable of learning from failure, given the right incentives. Airlines have a better-than-average record on preventing disaster because their own personnel go down with customers. Perhaps that’s an overly dramatic example, but I do believe that enormous value lies in learning from companies that have lost millions, if not billions, in pursuit of fundamentally flawed strategies.

Besides, how can you hope to invent the Future Perfect if you repeat the mistakes of the past?

This article is drawn from "Billions-Dollar Lessons" and its companion HBR article, "Seven Ways to Fail Big," both by Paul B. Carroll and Chunka Mui.

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