The Three Principles that Entrepreneurs Use to Control their Risk

How do entrepreneurs deal with risk? A persistent and widely held belief is that entrepreneurs are risk-takers; that they like to take risks. Ask anyone on the street or in a classroom and they will tell you: “An entrepreneur is someone who is bold, 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 do show is that while entrepreneurs are willing to take risks because they recognize that they are necessary, they try to control them. To do this, 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 goals based on their available resources. If they need to entertain friends, instead of preparing a complicated meal in advance, they will open the refrigerator two hours before and imagine what they can do with it. If I know I’m a bad cook and I have pasta in the cupboard and tomato sauce in the fridge, 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 could be a very nice evening. By working only with what I have and what I know, I reduce the possibility of failure to almost nothing. I’m almost certain to succeed.  

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 decisions in terms of expected return: I invest X in a project because I think it will generate Y in revenue. When making investment decisions, we compare the initial investment with the expected return, and we validate the project if the latter is (significantly) higher than the former. However, entrepreneurs understand 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 completely unpredictable. Since entrepreneurs do not like risk, they want to control it and therefore base their decision on the only thing they can control, i.e., the initial investment X. They ask: “What am I willing to lose to try?” For example, someone considering quitting their job might decide to spend six months and 5,000 euros developing an entrepreneurial idea. At the end of this period, she will take stock and decide whether to continue or stop. These six months + $5,000 represent her affordable loss: if the result is disappointing, she can recover from the loss because she is confident that she would be able to find a job easily. Entrepreneurs 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. Of course, I dream of knowing how to make a fancy Brazilian meal, but if I do, my risk is too high. This is a counterintuitive but very powerful principle. Of course, people always raise an objection when presented with this principle: “But you lack ambition!” On the one hand, it is true: ambition is reduced precisely to avoid failure. But on the other hand, it is not true: the absence of failure, or the low cost of failure when it occurs, means that we can keep going. In the end, the ability to keep going because failures are small and inexpensive is what makes ambition possible.  

Saras Sarasvathy: make failure affordable!

Co-creation

The third way entrepreneurs manage risk is by collaborating with others. An entrepreneur who has an idea for a green chair goes to a potential customer and pitches his idea. Suppose the customer responds: “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? Nobody, because the future has not yet been written; that is uncertainty. The entrepreneur has the choice of sticking with his idea that the future is green, and therefore going to another potential customer. Or 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 customer agrees to commit to blue, then the future becomes (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 him to take a step forward. The risk has not disappeared completely, because the customer may not pay when the entrepreneur delivers his blue chairs, but it has disappeared in terms of demand. Maybe only one customer, but at least one (paying) customer. Co-creation, illustrated by this very simple example, is a powerful way to manage entrepreneurial risk. In essence, act in the face of uncertainty (blue? green?), but if you fail, do so at an acceptable cost and, above all, do not fail alone.

The principles of entrepreneurial risk control can therefore be summarized as follows: entrepreneurs do only what they can do with what they have; 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 fails, we can start over).  

Enabling Action by Limiting the Cost of Failure

Taken together, these three principles reduce both the risk of failure and the cost of failure. They allow you to stop seeing success or failure as a binary variable. An entrepreneurial project becomes a sequence of actions; some fail, but because the cost of their failure has been kept small enough to be affordable, it does not prevent the process from continuing, while others succeed and allow progress to continue.  

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 they try to control it through these three principles. The word control is therefore central to the process. The prevailing 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 determine a favorable position; on the contrary, effectuation is based on a logic of control. If I control my environment, I no longer need to predict it. Risk control is therefore one of the essential dimensions by which entrepreneurs can 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 levels. They are what can unlock action in an uncertain environment: enough risk to allow action, but small enough to make failure affordable.

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

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