Whenever the ratio of what is known to what needs to be known approaches zero, we tend to invent ‘knowledge’ and assume we understand more than we actually do. We seem unable to acknowledge that we simply don’t know.
—David L. Rosenhan,“On Being Sane in Insane Places”1
Are you worried about risk? You should be. A new idea is not much more than a bundle of risks. Almost nothing is proven; virtually everything can go wrong. If you decide to start an enterprise from your idea, you may be exchanging a secure situation and a steady income for a leap into the unknown. Perhaps you do not have a secure alternative and figure your idea is your best opportunity. There are almost always alternatives to starting a company. Very few people have nothing at risk. Risk is everywhere. How should you think about risk?
What is risk? Webster’s Collegiate Dictionary provides the classical definition: “hazard; peril; exposure to loss or injury.” Other definitions focus less on peril, injury, or damage and more on risk as hazard. Still others define risk as a more value-neutral term that is essentially synonymous with uncertainty—the existence of more than one possibility when a certain outcome is not known.
Sometimes people talk about risk in quantitative terms, treating it as a noun, a measure of uncertainty, a set of probabilities assigned to different possible outcomes. The science of estimating probabilities and expected values can be very valuable, but failure to understand the full dimensions of risk and hazard can have dire consequences. Economists generally refer to uncertainty when they discuss future outcomes that are not known with confidence and risk when they discuss uncertainties in which some of the possible outcomes are undesirable. Although you can measure and express both risk and uncertainty as probabilities, your assessment will be accurate only if you have enough information. Unfortunately, this is seldom the case. Some people look at risks not only as present problems to be addressed but also as future issues to be avoided, mitigated, or even exploited to one’s advantage. Seeing into the future is an exercise in risk analysis and risk management, but who can see clearly into the future?
Risk is also a verb meaning to expose to a chance of loss, hazard, or danger. The difference between noun and verb is an important one, a distinction between risks we face and risks as we take them. Some risks just are and can’t be avoided, but others we choose to take, expecting rewards if we win. When you decide to embark on something entrepreneurial, you essentially choose a context infused with risk. Most choices in the entrepreneurial environment involve a calculus between taking a chance to attain something good and the counterbalancing chance that some things will happen that are not so good. The idea, of course, is to take the risks when the risk-reward ratio looks favorable and avoid them when it does not.
It sounds easy. All you need to know are the probabilities and the rewards. It’s one thing to predict the outcome of a coin toss or a roll of dice. Although you don’t know the outcome of any particular trial, you do know the odds, and, given enough independent trials, reality approximates the odds. Of course, most real-life situations are not so obvious or simple. When you face a decision involving complex risks, many times you can’t know the odds. Sometimes you’ll know some of the factors that can affect the odds and be able to use them to help you reach a marginally informed decision. At other times the best you can do is guess at the good outcomes and ask: What’s the worst that can happen? If the worst isn’t too bad and the upsides are good, you may go for it. “Entrepreneurs will most likely take the risk of failure if the losses are constrained on the downside and the potential rewards are high on the upside.”2 Still, wouldn’t it be nice if there were a better way?
There is no perfect way, but you’ll be better off if you appreciate the important difference between perceived risk and actual risk. Thinking about risk is seldom just a cold calculus; it triggers all kinds of emotions, and this makes it hard to untangle the reality of risks from our perceptions. We need to remind ourselves constantly that emotional perceptions are not reality, even though they can create reality. If your emotional reaction to risk is out of proportion to the reality in either direction—too anxious or too cavalier—you cannot make good decisions. The core of risk management and mitigation is understanding the future realistically, making the most grounded and realistic assessment of possible future outcomes, and making the best guesses about the probabilities of those outcomes. This is a matter of investigating, reflecting on, and in the end deciding what you really know versus what you are only imagining or guessing—again, epistemology. Or as Frank Knight, an important twentieth-century economist and risk theorist, said:
It is our imperfect knowledge of the future, a consequence of change, not change as such, which is crucial for our understanding of the problem. … It is difficult to think of a business “hazard” with regard to which it is in any degree possible to calculate in advance the proportion of the distribution among the different possible outcomes.3
Said perhaps a little more simply, you can’t calculate the risks, but you have to proceed anyway. Taking risk is not an all-or-nothing decision in life and business, but it is ubiquitous and universal. We all constantly face and take risks, often without realizing it. Little in life is guaranteed, and so dealing with future uncertainty is one of the core functions inherent in creating and running any enterprise.
As you embark on building a business, you must consider all kinds of risks, even though you won’t be able to assess many of them realistically. Nevertheless, it pays to keep them in mind. In their book Technology Ventures, Richard Dorf and Thomas Beyers provide a comprehensive table with five families of risk factors that start-ups face.4 Although this list certainly isn’t complete, it makes a good point. You’ll have no shortage of risks:
Customer
Market size and growth
Channels
Competitors
Capabilities
Financial strength
Talent
Learning skills
Strategies
Cost
Technology
Materials
Suppliers
Design
Government regulation
Federal and state laws and local ordinances
Standards and industry rules
Cost and availability of capital
Expected return on investment
It has been said that managers accept risks in part because they don’t expect that they will have to bear their consequences. The same thing can’t be said for entrepreneurs; risk goes with the territory. The entrepreneur takes risks every day and faces the very real possibility that the desired outcomes won’t arrive. Unfortunately, the only preparation for dealing effectively with risk many entrepreneurs ever get—if they get any at all—comes from working as a manager or under one, and managers don’t face risks the way entrepreneurs do. Risk implies winners and losers; it has personal and professional consequences. However, people don’t often think through those consequences, ignoring or underappreciating them until it’s too late. As an entrepreneur, it is imperative that you work diligently to recognize, manage, and eliminate risks as early and often as possible. Think clearly and constructively about risk—how to recognize, analyze, and live with it—and how to make it work for you. This is the single most effective way to add value to your idea and your start-up company.
People generally react to risk in one of two ways: They are cavalier—Alfred E. Neuman’s “What, me worry?”—or they are terrified—a deer in the headlights. Both are wrong. In a way, risk is your friend. Many people make good money quantifying risks. Just ask any insurance actuary or casino operator. Entrepreneurs make money quantifying risks too. Almost by definition, each risk you eliminate or reduce increases your venture’s inherent value. You are the person starting an enterprise with little or nothing but an idea. The main value you bring to the effort is that your work will eliminate risks one by one, and that’s what creates value in a company. The only appropriate reaction to risk—the entrepreneurial reaction—is to work systematically to eliminate the risks you can and quantify the ones you can’t.
This means that when it comes to risk, there is no substitute for knowledge. Only by gaining knowledge can you reduce uncertainty. Knowledge allows you to know which risks are worth taking and which are not, how to take them, and how to position yourself to benefit from uncertain outcomes. Thus, the first step in dealing effectively with risk is to learn to gain that knowledge. The more you learn, the more you will know the right steps to take and what you can do to give your idea more substance and resilience, which after all are the things that will make it more valuable. But you need to learn not only knowledge that’s already out there—information you need to find—but also knowledge that doesn’t yet exist, such as customer preferences; that is information you must discover or create. This is one of the most important things you as the founder-entrepreneur must obsess about every day: What do I need to discover? What do I need to learn, and how do I learn it?
Learning is not a mystery, an autonomic process, or a lucky accident. You can be systematic about learning what you need to know, and this means essentially learning how to learn. Once you know that, you can figure out what’s important much more efficiently and effectively and then work on achieving those things. How do you learn? A kindergarten poster put it succinctly: “Learning is 5 percent hearing, 10 percent seeing, and 85 percent doing.”
A full 5 percent of what you learn on any topic you learn by hearing, listening to someone talk about it, or reading about it. All kinds of heard information comes from books, lectures, classes, and advisors; these are all great resources. The only trouble is that there is so much good information out there that you can’t possibly access it all, much less internalize it; this is especially troubling because this information is only 5 percent of your learning. The main challenge becomes defining what’s relevant. Sifting information effectively comes with experience, and you aren’t going to get that by reading a book. Even if you could read and remember all the information out there, in terms of building your business and reducing risk, it’s still just 5 percent of what you need.
A full 10 percent of what you learn, you learn by seeing. If you watch someone else do something, you internalize that action on many levels. In his book Blink, Malcolm Gladwell writes, “We learn by example and by direct experience because there are real limits to the adequacy of verbal interaction.”5 Psychologists call this imitative or social learning, noting that it is “a group of learning mechanisms in which observation of other individuals facilitates or enables the acquisition of a novel behavior”6 and “the learning of an act by seeing it done.”7 It is almost automatic—hardwired learning. Numerous psychological studies of both humans and primates document the instinctive acquisition of innovative behavior by simply seeing others acting out those behaviors.8,9,10,11 This effect is so pronounced that it spontaneously occurs even between species; chimpanzees, for example, imitate novel behavior they observe in humans.12,13 If one of the best ways to reduce risk in your venture is to become a more effective entrepreneur and leader, you will learn the most about that through imitative learning. Observe people who do this effectively and successfully, who do it really well. The more you are around them, observing them closely over long periods, the more you’ll find you can’t help absorbing their behaviors and ways of thinking. If you can, recruit team members who have behaviors or skills you want to learn or even go to work for someone you admire and want to be like. Spend as much time with those people as you can. You’ll be amazed at how much you absorb without sensing that it’s happening. This is the 10 percent.
Then there’s learning by doing—the 85 percent. Aristotle said, “What we have to learn to do, we learn by doing.” Most of what successful entrepreneurs learn about their ideas and almost all of what they learn about executing, they learn by doing. This is the ready-fire-aim strategy again. Saras D. Sarasvathy, at the University of Virginia’s Darden School of Business, studies learning by doing, a process she calls effectual reasoning. She explains the process as executing first and continuously, learning what works, and then building a plan and a strategy:
Unlike causal reasoning, which comes to life through careful planning and subsequent execution, effectual reasoning lives and breathes execution. Plans are made and unmade, cast and recast through action and interaction with others on a daily basis. Yet at any given moment there is always a meaningful picture that keeps the team together, a compelling story that brings in more stakeholders and a continuing journey that maps out uncharted territories. Through their actions, the effectual entrepreneurs’ set of means, and consequently, the set of possible effects changes and gets reconfigured.14
In this way, an entrepreneur learns about the potential opportunity. This is the market validation discussed in Chapter 4. It’s the competitive research involved in a prior art search that was examined in Chapter 5. It’s the effective positioning against the competition that will be covered in Chapter 11. It’s building prototypes, creating proofs of concept, refining design—it’s trial and error. For the first-time entrepreneur, this effectual reasoning, this ready-fire-aim strategy is the way to learn how to be an effective entrepreneur. Good information is 5 percent; watching others work is 10 percent. However, 85 percent is getting started, doing what you can, and correcting as you go along. Things like this book, others’ advice, and what you see successful people doing may help you get started, but that’s all they can do. Most entrepreneurs have this testimony. You just can’t teach people how to swim while they stand by the side of the pool and practice with you. They have to get in the pool. G. Christian Jernstedt, the Dartmouth professor who studies learning, put it this way: “The one who’s doing the work is the one who is doing the learning.”
One of the biggest reasons this is true is that mistakes are a terrific teacher. Peter Brabeck, Nestle’s CEO, said, “The biggest problem with a successful company is that you don’t learn from success. Learning from failure is so much easier.” Indeed, in 2001 an Accenture study reported that
[Seventy-one percent] of executives say that aversion to risk and failure is stopping people in their organizations from acting entrepreneurially. GE doesn’t promote senior executives unless they have a significant failure to their name, in the belief that if a person has never failed, he or she has not been sufficiently innovative or aggressive.15
While Gregg was at Samson, managing geologists drilling for oil and gas, there were years when the dry hole percentage was so low that he had to tell them they were not drilling enough dry holes. Of course, he didn’t intend for the geologists to drill where they knew they would miss. The point was that they were not taking enough risk. Without taking risk, you’ll never reap the great rewards. Risky investments almost always command higher rates of return. A smart entrepreneur removes risks and reaps the rewards for having taken on a risky opportunity. George Bernard Shaw said, “A life spent making mistakes is not only more honorable, but more useful than a life spent doing nothing.”
First-time entrepreneurs—and many others besides—often make the mistake of treating their ideas like babies. Babies are endearing. Babies are helpless. They are utterly dependent. Someday they will grow up to be clever, strong, and resilient, but when they are babies, they need to be loved and nurtured, protected from all the bad and nasty things that can hurt them. This is the way many entrepreneurs think about their ideas. They protect their ideas when they are just born. They feed and nurture them and protect them from harm until they are ready. They try to build as much substance into their ideas as possible and wait as long as they can to take on the hard risks, things such as, Will customers really pay for their products or services? Will the prototypes really work the way they need to?
The fact is, ideas are not babies. It makes no sense to coddle an idea. From the first day your number one objective is to find out as quickly and cheaply as possible if your idea has a fatal flaw. Basically, it’s like saying you should not coddle your baby; you should take it by the ankles and knock its head on the desk. No one does that to babies to prove what won’t kill them. But with ideas the goal is to eliminate the risks that will kill an idea. Remember the point in Chapter 3: The value in early-stage companies is almost entirely a product of the future upside potential discounted by the chance that it will fail—the risk.
Continuously ask yourself, What might I find out about this enterprise that would make me want to stop? There is no glory in sinking money into an idea that eventually is going to die because of a failing you could have found earlier. Smart entrepreneurs spend a lot of time thinking about their ideas’ risks. Then they figure out how to test those risks, starting with the ones that are cheapest and most likely to be fatal, because if those cheap, highly probable risks are going to kill the deal, they want to know it early. This is the so-called fail-fast or derisking strategy: Do everything you can to take on the hard risks and put your idea through its paces. In terms of risking both capital and time, it’s by far the most efficient approach to entrepreneurship. Every time you eliminate a risk that could kill your idea, your enterprise becomes a little more valuable; there’s that much less of a chance it will fail. Remember: Effective execution to eliminate risks early creates the value in a start-up. Your ideas are not your babies; make them prove themselves early and cheaply, before you raise a lot of money from others and find the fatal problems with their money or, even worse, a lot of your own.
What does risk mean to you?
How well do you handle uncertainty? Can you make decisions under uncertainty? How do you do that? Do you do it in a timely way? How do you define timely?
Do you feel you have to know how things will work out before you make decisions?
1. Rosenhan, D. L. (January 19, 1973). “On Being Sane in Insane Places.” Science 179 (4070): 257..
2. Dorf, Richard C., and Thomas H. Byers, Technology Ventures (Boston: McGraw-Hill, 2005): 125.
3. Knight, F., 1921: III.VII.1, III.VII.25.
4. Dorf and Beyers, 2005: 128.
5. Gladwell, Malcolm, Blink (New York: Little, Brown, 2005): 71.
6. Call, J., “Levels of Imitation and Cognitive Mechanisms in Orangutans,” in Parker, S. T., R. W. Mitchell, and H. N. Miles, editors, The Mentalities of Gorillas and Orangutans: Comparative Perspectives (Cambridge, UK: Cambridge University Press, 1999): 317.
7. Voelkl, B., and L. Huber, “Imitation as Faithful Copying of a Novel Technique in Marmoset Monkeys,” PLoS One 7, e611 (July 2007): 1–5.
8. Stoinsky, T. S., J. L. Wrate, N. Ure, and A. Whiten, “Imitative Learning by Captive Western Lowland Gorillas in a Simulated Food-Processing Task,” Journal of Comparative Psychology, 115, no. 3 (2001): 272–281.
9. Voelkl, B., and L. Huber, “True Imitation in Marmosets,” Animal Behaviour 60 (2000): 95–202.
10. Whiten, A., V. Horner, C. A. Litchfield, and S. Marshall-Pescini, “How Do Apes Ape?” Learning and Behavior 32, (2004): 36–52.
11. Zentall, T. R., “Imitation: Definitions, Evidence, and Mechanisms,” Animal Cognition 9 (2006): 335–353.
12. Hayes, K. J., and C. Hayes, “Imitation in a Home-Raised Chimpanzee,” Journal of Comparative and Physiological Psychology 45 (1952): 450–459.
13. Whiten, A., D. M. Custance, J. C. Gomez, P. Teixidor, and K. A. Bard, “Imitative Learning of Artificial Fruit Processing in Children (Homo sapiens) and Chimpanzees (Pan troglodytes),” Journal of Comparative Psychology 110 (1996): 3–14.
14. Sarasvathy, Saras D., “What Makes Entrepreneurs Entrepreneurial?” Darden Case Collection ENT–0065 (2004): 3.
15. Accenture Consulting, “Liberating the Entrepreneurial Spirit,” 2001.