The three principles that entrepreneurs use to control their risk

How do entrepreneurs manage risk? A persistent and widely shared belief is that entrepreneurs are risk seekers; that they like taking risk. Ask anyone in the street or in a classroom, and they will tell you, “An entrepreneur is someone who is courageous, who likes to take risks.” But nothing could be further from the truth. Entrepreneurs don’t like risk; no study has ever shown that. What studies show is that while entrepreneurs are willing to take risks, because they recognize that it is necessary, they try to control them. To do that, they use three principles that are at the core of the entrepreneurial theory called effectuation, proposed twenty years ago by Darden professor Saras Sarasvathy.

Entrepreneurs don’t like risk, they control it

The first principle entrepreneurs use to control risk is to define their objectives based on their available means. If they have to invite friends for a meal, instead of preparing a complicated meal in advance, they will open the fridge two hours before and imagine what they can do with it. If I know I’m a bad cook, and I have pasta in my cupboard and tomato sauce in my fridge, then I’ll make pasta with tomato sauce. It may not be the gourmet meal of the century, but I will have fed my friends and it might be a very nice evening. Starting only from what I have and what I know, I reduce the possibility of failure to almost nothing. I’m almost certain to succeed.

Saras Sarasvathy: Make failure inexpensive!

Affordable loss: always limit your possible losses

The second way entrepreneurs control failure is to think in terms of affordable loss. We are trained to make our decisions in terms of expected return: I invest X in a project because I think I can get revenue Y from it. In investment choices, we compare the initial investment to the expected return, and we validate the project if the latter is (significantly) higher than the former. However, entrepreneurs are well aware that, in uncertain situations, the expected return is largely hypothetical. No one can predict it with certainty, especially in innovative situations where the future is totally unpredictable. Since entrepreneurs do not like risk, they want to control it and therefore base their decision on the only thing they control, i.e. the initial investment X. They tell themselves: “what am I willing to lose to try?” For example, somebody losing her job might decide to spend six months and €5,000 to advance an entrepreneurial idea. At the end of this period, she will take stock and decide to continue or stop. These six months + €5,000 represent her affordable loss, i.e. if the result is disappointing, she can recover from the loss as she is confident that she would be able to find a job easily.

Entrepreneur therefore reduce the ambition of each action to the point where it represents an acceptable risk for them, i.e. if the result is disappointing, it is not too much of a big deal. I cook pasta because, at least, I know how to do that. Of course I dream of knowing how to make a fancy Brazilian meal, but if I do that, my risk is too high. This is a very counter-intuitive but very powerful principle. Naturally, people always raise an objection when presented with this principle: “But you lack ambition!” On the one hand it is true: ambition is precisely reduced to avoid failure. But the other hand this is not true: the absence of failure, or the low cost of failure if it occurs, means that we can keep going. Ultimately, the ability to keep going, because failures are small and inexpensive, allows ambition.

Co-creation

The third way entrepreneurs control risk is by working with others. An entrepreneur who has an idea for a green chair goes to a potential customer and suggests his idea. Say the customer replies: “I like your chair but I would prefer it in blue.” In essence, the entrepreneur thinks the future is green, while the customer thinks the future is blue. Who is right? No one, because the future is not written yet; that is uncertainty. The entrepreneur has the choice to persist in his idea that the future is green, and therefore to go see another potential customer, but may not find any. Alternatively, he can negotiate with the customer and say: “Would you be willing to commit to a pre-order of X units if we make you the chair in blue?” No one knows if the future is blue or green, but if the client agrees to commit to the blue, then the future turns (a little) blue (uncertainty is reduced). The entrepreneur controls his risk because there is at least one customer in the world who has agreed to pay for a blue chair, allowing to move one step forward. The risk has not completely disappeared, as the client may default when the entrepreneur delivers his blue chairs, but it has disappeared with regard to the demand. Perhaps only one customer, but at least (paying) one. Co-creation, illustrated by this very simple example, is a powerful way to control entrepreneurial risk. In essence, in the face of uncertainty (blue? green?), act, but if you fail, do it at an acceptable cost and above all, do not fail alone.

The principles of risk control by entrepreneurs can therefore be summarized as follows: entrepreneurs only do things that they know how to do with what they have on hand; they reduce the ambition of each action to the point where the cost of failure is affordable; and they co-create their next action to move forward despite uncertainty (each party risks only an affordable loss; if the action is a failure, we can start over).

Enabling action by limiting the cost of failure

Taken together, these three principles reduce both the risk of failure and its cost if it occurs. They allow you to stop seeing success or failure as a binary variable. An entrepreneurial project becomes a succession of actions; some fail, but because the cost of their failure has been kept small so that it is affordable, it does not prevent the continuation of the process, while others succeed and allow progress.

The application of these three principles shows that the belief that entrepreneurs like risk is actually a myth. Entrepreneurs do not like risk; they accept it but seek to control it through these three principles. The word control is therefore central in the process. The classic theories of innovation and entrepreneurship, and indeed of management in general, are based on a predictive logic: you have to anticipate your market in order to be able to determine a favorable position; on the contrary, effectuation is based on a logic of control. If I control my environment, I no longer have to predict it. Risk control is therefore one of the essential dimensions by which entrepreneurs are able to transform their environment. It will not have escaped the reader’s attention that these principles go beyond the entrepreneurial domain alone; they also apply at the personal and organizational level. They are what can unlock action in an uncertain environment: enough risk to allow for action, but small enough for failure to be affordable.

To read more about effectuation, read my previous article: Effectuation: How Entrepreneurs (Really) Think and Act.

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