Tip 2: Avoid Sunk Costs

A sunk cost is an investment in time or money that has already been made and can’t be recovered. For example, if you spend 50 hours negotiating with a buyer and $50,000 in legal fees negotiating the LOI, this is a sunk cost because you can’t recover the expense.

Why are sunk costs dangerous? Enter the sunk cost fallacy.

The sunk cost fallacy describes a human’s tendency to follow through on commitments the more time, effort, or money they’ve invested, even when faced with evidence to the contrary. Many people continue to invest in a commitment regardless of whether following through is rational. The sunk cost fallacy is rooted in the human aversion to loss and the bias toward ongoing commitments. 

A prime example of a sunk cost is when you spend time or money evaluating a potential purchase, be it a home, a car, or an investment. The more time and money you invest in evaluating that decision, the more likely you are to decide to make the commitment, even if the terms or conditions are less than ideal. After all, walking away from this potential purchase would mean that you must walk away from the sunk costs of time, money, and energy you spent evaluating it. That “waste” is viewed by many people as a loss – and humans have a strong aversion to loss. In fact, studies have shown that humans have a much stronger aversion to loss than they have a desire for gain. 

So what does the sunk cost fallacy have to do with negotiating the sale of your business? Everything.

The more time and money you spend negotiating with one buyer, the more emotionally invested you’ll become in that one buyer and the more difficult it will be for you to walk away from the transaction. 

In my two decades of experience selling companies, I’ve seen grown men and women melt like butter once they’re under the spell of the sunk cost fallacy. Unfortunately, many savvy buyers know this and use it to their advantage. Fortunately, there’s an antidote – reduce your sunk costs. Lessen the amount of time, money, and emotion you invest in negotiating with any one buyer. 

How do you do this? Here’s how: 

• Conduct pre-sale due diligence. Doing this speeds up the due diligence process and reduces the amount of time and money you invest with a buyer. This also reduces the possibility that the buyer discovers problems during due diligence, which the buyer can use to drag out the process and chip away at the price and terms.
• Include milestones in the LOI that the buyer must meet to maintain exclusivity.
• Reduce the length of the exclusivity period.
• Hire an M&A advisor or investment banker to conduct a private auction process to create as much demand for your company as possible.