Disciplined Entrepreneurship

For many people, entrepreneurship is about “living the dream.” Recently minted MBAs and middle managers in Dilbert-sized cubicles fantasize about striking out on their own, translating a vision into reality and reaping the rewards of their efforts. In recent years, senior executives at established corporations have caught the entrepreneurial bug, too. After cutting costs to the bone, many big companies now hope to drive top-line growth by seizing fleeting opportunities before upstarts and established rivals beat them to the punch.1 While the pursuit of opportunity promises outsized rewards to entrepreneurs and established enterprises, it also entails great uncertainty. Uncertainty lurks in every corner and comes in many flavors: known unknowns (what you know you don’t know); unknown unknowns (what you don’t know you don’t know); new information that is imperfect or incomplete; and conflicting signals.2 It’s not all bad news, though; uncertainty can have an upside as well: Technologies sometimes work better than anticipated or solve an even bigger problem than the targeted one, the market may be larger or grow faster than expected, or well-endowed rivals might be asleep at the wheel. The critical task of entrepreneurship lies in effectively managing the uncertainty inherent in trying something new.3 Investors have many tools to manage their risk, but individual entrepreneurs and managers cannot wield these same mechanisms. Venture capitalists investing in risky startups, for example, routinely syndicate the uncertainty by taking only a piece of a financing round and sharing the remainder with other investors. Entrepreneurs, of course, cannot easily band together to invest in one another’s ventures. Insurance, as a practical matter, is no more promising than syndication. Entrepreneurs can rarely afford the premiums to cover identifiable risks and certainly cannot buy a blanket policy indemnifying them against business failure. Diversification — one of the most powerful tools for investors — is hazardous to the health of most new ventures, because managers and entrepreneurs lack the time, attention and money to hedge their bets. If they cannot rely on syndication, insurance or diversification, how can entrepreneurs and managers cope with the uncertainty that is part and parcel of pursuing an opportunity? A few of the most common approaches are among the least effective. At one extreme, entrepreneurs can ignore uncertainty — simply jump into the fray and make it up as they go along.

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References

1. A growing consensus has emerged that entrepreneurship is defined by the pursuit of opportunity rather than the size of a business or its stage in the life cycle. See H.H. Stevenson and J.C. Jarillo, “A Paradigm of Entrepreneurship: Entrepreneurial Management,” Strategic Management Journal 11 (summer 1990): 17–27; and S. Shane and S. Venkataraman, “The Promise of Entrepreneurship as a Field of Research,” Academy of Management Review 25, no. 1 (January 2000): 217–226. For a comparison of how an opportunity-based strategic logic contrasts with the resource-based and positional logics of strategy, see K.M. Eisenhardt and D.N. Sull, “Strategy as Simple Rules,” Harvard Business Review 79 (January 2001): 107–116.

2. Theorists have delineated multiple ways in which our knowledge of the future is incomplete, which I group under the broad term “uncertainty.” These categories include: Risk, or a variable known to be relevant to an agent’s decision (for example, financial return to investors) with a known probability distribution. See F. Knight, “Risk, Uncertainty and Profit” (Boston: Houghton Mifflin, 1921); Complexity, or “the minimum number of distinct variables a formula or model must possess in order to reproduce the characteristic patterns of a structure.” Complexity multiplies both the number of relevant variables that must be included in a model and their potential interactions, thereby increasing the difficulty of predicting outcomes. See F. Hayek, “Studies in Philosophy, Politics and Economics” (Chicago: University of Chicago Press, 1967), 25; Ignorance, or “unknown unknowns,” which results when a variable’s existence or importance is unknown to an agent at a point in time. Israel Kirzner placed this at the center of his theory of entrepreneurial discovery. See I.M. Kirzner, “Perception, Opportunity and Profit: Studies in the Theory of Entrepreneurship” (Chicago: University of Chicago Press, 1979); Indeterminism that results because an agent’s actions — particularly in response to unforeseen events —influence ultimate outcomes. Because the agent can respond creatively to unforeseen events, outcomes are not determined by initial conditions. See K.R. Popper, “The Open Universe: An Argument for Indeterminism” (London: Routledge, 1982).

3. Economic theory linking entrepreneurship with the management of uncertainty has a long and distinguished pedigree. The first definition of an entrepreneur, made by Richard de Cantillon in the 1750s, defined the entrepreneur’s role in terms of bearing the uncertainty inherent in a new undertaking. See R. de Cantillon, “Essay on the Nature of Commerce in General” (New Brunswick, New Jersey: Transaction Publishers, 2001). More recently, the economists collectively known as “The Austrian School” studied the role of entrepreneurship and focused on entrepreneurs as economic agents who deploy resources in new uses and therefore face challenges of incomplete knowledge about the returns from the resources in their new deployment. See J.A. Schumpeter, “The Theory of Economic Development” (Cambridge, Massachusetts: Harvard University Press, 1934), 64–83; and L. von Mises, “Human Action: A Treatise on Economics“ (San Francisco: Fox & Wilkes, 1996), 252–256.

4. A large body of academic research assumes that managers generally avoid risk through a variety of mechanisms including “uncertainty avoidance strategies.” See R.M. Cyert and J.G. March, “A Behavioral Theory of the Firm“ (Englewood Cliffs, New Jersey: Prentice-Hall, 1963): 167. On “routinization,” see R.R. Nelson and S.G. Winter, “An Evolutionary Theory of Economic Change” (Cambridge, Massachusetts: Harvard University Press, 1982). On “buffering” a firm’s technical core against uncertainty, see J.D. Thompson, “Organizations in Action” (New York: McGraw-Hill, 1967). On accumulating slack resources as a hedge, see J. Pfeffer and G.R. Salancik, “The External Control of Organizations: Resource Dependence Perspective” (New York: Harper & Row, 1978). On imitation of organizations perceived as successful, see P.J. DiMaggio and W.W. Powell, “The Iron Cage Revisited: Institutional Isomorphism and Collective Rationality in Organizational Fields,” American Sociological Review 48 (1983): 147–160.

5. The philosopher Karl Popper conceptualized science as an iterative process of identifying an anomaly between existing theory and empirical data, forming a tentative hypothesis to explain the anomaly and then eliminating errors in the hypothesis by submitting it to logical scrutiny and empirical testing. This process creates new knowledge that the scientist uses to refine his understanding of the anomaly, which in turn stimulates further logical analysis and experimentation. For an in-depth description of Popper’s thought, see K.R. Popper, “Conjectures and Refutations: The Growth of Scientific Knowledge” (London: Routledge and Kegan Paul, 1963). For an accessible summary see, K.R. Popper, “Unended Quest: An Intellectual Autobiography,” vol. 1 in “The Philosophy of Karl Popper,” ed. P.A. Schilpp (La Salle, Illinois: Open Court Publishing, 1974); and B. Magee, “Philosophy and the Real World: An Introduction to Karl Popper” (London: Fontana, 1973). While Popper’s model provides insight into the entrepreneurial process, it requires adaptation to fit business. The stimulus for the process is not an anomaly between theory and empirical data, but rather a gap in the market that could potentially be filled at a profit by a novel combination of resources. It is also necessary to add a step in which the entrepreneur assembles resources to test a hypothesis.

6. For a general and accessible overview of managers’ mental models, see C.C. Markides, “All the Right Moves: A Guide To Crafting Breakthrough Strategy” (Boston: Harvard Business School Press, 1999), 27–48.

7. For an accessible and useful process to surface and test assumptions, see R.G. McGrath and I.C. MacMillan, “Discovery-Driven Planning,” Harvard Business Review 73 (July 1995): 44–54.

8. For an in-depth and practical discussion of financial issues facing entrepreneurs, see W.A. Sahlman, “The Financial Perspective: What Should Entrepreneurs Know?” in “Entrepreneurial Venture,” eds. W.A. Sahlman, H.H. Stevenson, M.J. Roberts and A.V. Bhide (Boston: Harvard Business School Press, 1999), 238–261.

9. Knight argued that the selection of managers is the single most important means of managing uncertainty because individuals vary in their propensity to bear and ability to manage them. See Knight, “Risk, Uncertainty and Profit,” 291–298. Recent research has focused on the team, rather than the individual entrepreneur, as a mechanism for managing uncertainty. See, for example, K.M. Eisenhardt and C.B. Schoonhoven, “Organizational Growth: Linking Founding Team, Strategy, Environment and Growth Among U.S. Semiconductor Ventures, 1978–1988,” Administrative Science Quarterly 35, no. 3 (September 1990): 504–529.