A few years ago, Saras Sarasvathy, now a Professor at Darden College, set out on the audacious task of getting inside the minds of the world’s greatest entrepreneurs. Using a research technique developed by her supervisor, Nobel Prize winner Herbert Simon, she had 27 of America’s best entrepreneurs think out loud while they wrestled with some of the toughest business problems that most entrepreneurs face.
The most important finding of her research is that great entrepreneurs make decisions differently to corporate managers, novice entrepreneurs and investors. One of the key ways that great entrepreneurs think differently is how they evaluate business opportunities. Great entrepreneurs don’t think in terms of returns, but rather, evaluate business opportunities in terms of what they can lose if the business fails.
Corporate managers tend to put a lot of effort in predicting the sales and profits of new products and new divisions. MBA programmes teach tools for students to predict which new products will be successful and which products won’t. Great entrepreneurs don’t do this, they rather decide how much they are willing to lose up front and spend time thinking about how they could lower the downside if it all goes pear -shaped.
Saras Sarasarvathy describes this principle as the affordable loss principle: “committing in advance what one is willing to lose rather than investing in calculations about expected returns to the project.” In the messy, unpredictable and often hazardous world of entrepreneurship and innovation this approach makes sense. It is hard enough to predict whether a business will succeed or fail, let alone predict how well a business will do.
Yet predicting sales is how many entrepreneurs spend their time. Even though research shows that most entrepreneurs’ projections are kilometres off actual sales figures. A recent study undertaken by the Start up Genome project conducted on 650 internet start ups showed that unfunded start ups on average over-estimate their market size by about 100 times.
So when planning out your next big business idea it might be worthwhile to skip the feel good exercise of projecting sales figures and rather consider what would happen if it all went horribly wrong.
Putting affordable loss to use
Decide up front how much time, effort and money you are willing to put in the business. Less is often better. Great entrepreneurs in extreme cases are able to set up business with almost no personal investment, getting customers, investors or partners to fund the business.