Here’s news that won’t stop the presses: doing anything in the unknown entails risk. Given that, you need to decide how much you can afford to lose before you get underway. There is a way to keep those losses to a minimum and guarantee that if you fail, you fail quickly and cheaply while learning a lot. (And, after all, that is the second best outcome.) Here we show you how to minimize your potential losses.
There’s a reason that seasoned entrepreneurs don’t think of themselves as risk takers, even though everyone else does. They have developed terriï¬c ways to limit potential losses as they start a new venture.
That fact surprises many people because if you read the popular press, you might well think that successful entrepreneurs love risk. Faced with the edge of a cliff, according to media accounts, they would prefer jumping off with a homemade parachute made of bed-sheets to ï¬nding another way safely down.
That’s simply not true. They like ropes and harnesses. More specifically, they prefer measured steps as they head off into the unknown and try to start their new venture. They don’t like risk. They accept it as part of the game and then work extremely hard to reduce it to a minimum.
People who have started one or more ventures will tell you that you need to know how much you are willing to lose before you even begin to think about starting something new. And you need to do everything possible to make sure you don’t exceed that ï¬gure.
Successful serial entrepreneurs adhere to the basic principles of risk management. If you’re going to play in a game with uncertain outcomes: (1) don’t pay or bet more than what you can expect as a return, and (2) don’t pay or bet more than you can afford to lose. Both of those ideas can be summed up with the phrase “acceptable loss,” a concept in which you consider the potential downside of whatever risk you are about to take—such as starting a new company or some other venture that is going to consume a lot of your time, capital, or other assets—and put on the line no more than you ï¬nd acceptable to lose should it not turn out the way you want.
This is, of course, not how risk is treated in the Prediction universe. In a predictable world, you spend a lot of time estimating the size of the prize—the ï¬nancial rewards of pursuing a particular opportunity and optimizing the plan to achieve what those in the ï¬nance community call “the expected return.” The logic is straightforward and looks something like this:
1. Analyze the prospective market and choose segments with the highest potential return.
2. Develop and optimize the plan for your product or service to achieve the expected potential.
3. Calculate the costs in money, time, and resources of achieving that potential.
4. Then discount whatever you came up with to account for the fact that nothing is certain.
This logic results in one number that tells you whether you should pursue the opportunity. If you work at a big company, this should sound very familiar. It’s a logical result of years of conditioning to “maximize shareholder wealth.”
While it makes enormous sense in a predictable setting, this logic makes no sense at all in the face of the unknown. If you use this logic there, all you are doing is making projections on assumptions that are contingent on guesses, which you buttress with extensive studies and calculations. Finally, you pretend that you are creating certainty by multiplying the whole thing by something less than 100 percent to compensate for uncertainty in order to end up making seemingly rational decisions.
But the more uncertain the situation, the more this math is foolish. After all, there is little value in ï¬ne-tuning estimates of the unknown. And that explains why entrepreneurs and other creators use an opposite logic, that of acceptable loss. They don’t spend much time forecasting or evaluating the comparative risks of the various opportunities they face. Instead of asking, “How big is it going be?” they ask, “Is it big enough to interest me?”
And instead of focusing on expected return, or how much they could possibly make, their attention is on acceptable loss, or how much they might lose, should things not turn out the way they hope.
As you can see, employing the concept of acceptable loss does two things: On the one hand, it keeps any failures small. By deï¬nition, you never lose more than you are willing to. On the other hand, it gives you a different way to evaluate an opportunity, a way that does not depend entirely on proï¬ts.
You entered into a new venture for some reason. It could be to make a lot of money, but it could be because of other reasons: “I can’t stand my boss and I’m going off on my own.” You might do it because of a noble aim: “I really want to help women back home,” or it could just be that “if I don’t start my own company now, I never will.” Using acceptable loss frees you to use other motivations than generating the highest return on assets (although, as we said, “I want to make a lot of money” is a ï¬ne reason for starting a business).
But although the reason for starting a business can be open-ended, the amount of money at risk is clearly deï¬ned; it is limited by how much you ï¬nd acceptable to lose.
How pivotal is the idea of acceptable loss? Of all the serial entrpreneurs Saras Sarasvathy studied, not one, before starting, “tried to garner speciï¬c information about potential returns or predict an ideal level of investment for their projects. Instead they wanted to spend only what they could afford to lose.”
How acceptable loss works
As you prepare to take action, you need to ask two questions to make sure you stay within the bounds of your acceptable loss.
• What can I afford to pay to take the next step?
• What am I willing to pay to take the next step?
The costs we are talking about go beyond the ï¬nancial. In fact, there are at least ï¬ve classes of assets at your disposal and at risk.
1. Money. This is the most obvious, of course. Getting a new venture up and running can be costly, and you don’t want it to be, if there is any way to help it.
2. Time. You want to guard your time just as much as you guard your money. And just as you have a dollar ï¬gure that you think would be “acceptable” to lose, you want to have a time limit as well. (“I am willing to give this idea up to six months to see if it will work.”)
3. Professional reputation. We all have one, although when you are ï¬rst starting out, it may be extremely slight. There is nothing wrong with failing if the idea you tried was worthy and you were sufï¬ciently committed to it. You gave it your best shot. It didn’t work, so move on to the next. But if you are seen as someone who doesn’t anticipate obvious problems, or who can’t conserve resources and use them properly, that failure can seriously hurt you in whatever you do next. You may ï¬nd it far harder to raise money or even to get another opportunity. Damage to your professional reputation can be a huge loss.
4. Personal reputation. People may hate the question, “What do you do for a living?” arguing (correctly) that they are more than their job. Still, how people see you is partly shaped by how you earn your income. You don’t want your new venture to be an embarrassment, which could affect your self-esteem or fail to represent who you truly are. This kind of loss is similar to a loss of professional reputation, but it hits literally much closer to home. Losing your standing with those near and dear to you, within your church, civic group, or whatever can be devastating. Unintelligent or frequent failures are embarrassing and carry psychosocial consequences.
Moreover, one of the primary sources of resources for your venture comes from your family and friends, and you certainly don’t want to waste their money (and your good graces), especially if it comes from your in-laws. And all the time you will be spending on the new venture will keep you away from kith and kin, so you want to choose whatever you plan to do extremely carefully to make that loss of spending time with them worthwhile.
5. Missed opportunities. If you are working to start venture X, you cannot be working on venture Y at exactly the same moment, and Y could potentially be a far better idea. In business, this is known as an “opportunity cost”—the cost of not pursuing other opportunities. You want to be mindful of what you are choosing not to do and you also want to recognize other forms of opportunity cost: The price to be paid for not acting right away—someone else might conceive and implement your idea. And the price to be paid for inaction—you might spend the rest of your life in a job you hate or miss a great opportunity to make a once-in-a-lifetime contribution.
We doubt there is any reliable formula that can provide security when venturing into the unknown and make it more likely for a particular effort to succeed. But there is absolutely no doubt that Creaction will reduce the cost of failure, should there be one. If you fail, you fail cheaply.
This point is worth emphasizing, since it runs contrary to the image of entrepreneurs as people who constantly “swing for the fences,” betting everything they own on new ventures. While that is sometimes true, most of the time, it’s not. In general, they either prefer the cheapest alternative or come up with creative ways of doing things at little cost to themselves.
Furthermore, they explicitly see themselves as ï¬nancially conservative. For example, one serial entrepreneur said, “When I start something, I am always aware of what I am spending. I always go the cheap route. I cover my costs so I don’t have to take any huge risks if I can help it.”
Not only are entrepreneurs ï¬scally prudent, they like the limitations that acceptable loss imposes. As Joshua Herzig-Marx, a founder of Incentive Targeting wrote on our blog, Action Trumps Everything, having a ï¬rm handle on your acceptable loss “is like walking into a casino with $50 in cash and no credit cards. Knowing how much you can lose, and trusting yourself not to exceed that amount, frees you to have more fun.”
Acceptable loss is extremely personal
Acceptable loss does not depend on the venture, but the individual. It varies from person to person, and across the course of someone’s life- time. (For example, you may be willing to risk more when you are young, knowing you will have decades to recover should things go wrong, less when your kids are approaching college age and you need to save every dollar you can for those upcoming tuition bills, and then more later once those bills are behind you.)
Let’s see how acceptable loss plays out in practice. Consider the case of a man in his mid-forties who is thinking about quitting his high-paying job to start his own company. If our potential entrepreneur were to follow Prediction, he would do in-depth research to estimate not only the size of the market, but all the risks and challenges he might face (competitors, changing market conditions, and so on). The more potential risks or challenges he believed he was up against, the more money he would raise, in part to offset the uncertainty in his situation.
The potential entrepreneur might say, “I’d better do a business plan.” (Months, maybe years pass while he does research and prepares the document.) At the end of that time, he says:
It looks like I need $1 million to start my idea of creating a service that matches recent MBAs who have a scientiï¬c background with high-tech employers. Creating and maintaining the database is going to be a huge expense. Still my projections show this is the biggest potential market that matches my skill set. And they also show I’ll break even in two years. I can put in $100,000, which is all the money I have saved and can get from family and friends. So, I need to raise another $900,000 before I can start. That’s assuming that I’m okay giving up all the money I would have made at my day job for the next two years. Let me think about that over the weekend. [Some 72 hours later] Okay, I’m in. Let me start raising that $900,000.
In contrast, someone using Creaction would start by examining the means at hand, and what he can afford to lose. That leads to a very different interior monologue:
I am forty-six. I’ve always wanted to be my own boss. By drawing on my own resources and borrowing from family and friends, I have $100,000 I can commit to ï¬nally going off on my own. I need $50,000 for expenses and $50,000 to live on for the next six months until I get some revenue. In the worst case, the company I start goes under and I lose every dime. If that happens, I’m out the $100,000 and go back to my old job, or get a different job within the industry and ï¬gure out a way to pay back everyone I borrowed from. I am willing to risk that. If I end up losing the money, so be it. It won’t be the end of the world.
But, if I don’t take this risk now, when am I going to do it? I don’t want to wake up twenty years from now and be one of those people who talk about “what might have been.” It’s a sad thing to have regrets about something you wanted to do but never did. My family is onboard with me taking the risk, and while I know every new venture is a crapshoot, I feel pretty good about this. I am going to do it and adjust on the ï¬‚y if I have to. My basic premise must be right. There is an unaddressed opportunity to serve the MBA market. I think the job-matching idea has a lot of promise, but if it turns out a Web site is better, or a newsletter or whatever, that’s what I’ll do, once I am underway.
Note, the person who is using Creaction is not thinking, “Where will I get the biggest bang for the buck?” or “What will lead to the most proï¬t?” Instead, he is acting out of desire. This is something that he wants to do. He expects to be successful, but has identiï¬ed his acceptable loss.
As you can see, acceptable loss frees you to focus on immediate options that generate more options for the future. This will only work, of course, if you are willing to adjust the shape of your venture (“I’ll do something to serve the recently minted MBA market” as opposed to “I’m only interested in a job-matching service for recently minted
MBAs with a technology background”.) In other words, if you adapt to your means, rather than remaining ï¬xated on one speciï¬c goal, you end up having more options to pursue.
Starting with few resources
While managers are taught to analyze the market and choose target segments with the highest potential return, people starting a business using Creaction tend to ï¬nd ways to reach the market with a minimum expenditure of resources such as time, effort, and money. In the extreme case, it means starting a company with virtually no resources. That isn’t hyperbole. Just think about all the technology companies—Hewlett-Packard and Apple among them—that began, at least metaphorically, in someone’s garage.
And not only do they often start on the proverbial shoestring, serial entrepreneurs commonly do not do much traditional research before getting underway. Instead they often take a prototype to the nearest potential customer and, in an attempt to receive an order, describe in elaborate detail the ultimate features and beneï¬ts.
Why? You learn a lot by how those potential buyers react. You ï¬nd out where the obstacles are, what questions customers and potential customers have, and what you could charge. You might even get some cash. So the market research is actual selling. And the fact is that until someone buys your widget, the idea for creating a new company is imaginary. Not until the ï¬rst sale is it real.
Winning by losing
The concept of acceptable loss can provide more opportunities to start new businesses for the simple reason that you are likely to get more times at bat in the same elapsed time. Why? First, there are lower costs to get underway, so you can start sooner. As opposed to Prediction, where you line up all your resources ahead of time, people who employ Creaction take small steps toward their goal. Often this means you get the market’s “reality check” sooner. Second, because of lower costs, you can stay in the game longer and can rapidly adjust as you proceed. At any point in the journey, if you decide it isn’t going to work, you quit. That also limits your loss. Both those elements mean that if you fail, you fail fast and cheaply. That frees up resources—both time and money—for you to try something else.
Even if you start a new venture and get to the end point—deï¬ned as reaching the limits of what you were prepared to lose—the decision to quit (either because you no longer have the desire to continue or the market isn’t interested in what you have) isn’t fatal, since you didn’t risk more than you could afford. It is simply time to regroup and think about what you want to do next.
Contrast that to what happens if you employ Prediction. You seemingly plan forever. You assemble a team, which takes more time. If you go the traditional funding route and look for venture capital money, it can take as long as two years (really) to get the money you need, if venture capitalists decide to fund you, and they probably won’t. They fund about 1,200 of the 600,000 new businesses started every year. Of those 600,000, the U.S. Small Business Administration says 66 percent survive two years, and other research shows 44 percent survive eight years.
If you do the math, you’ll ï¬nd that in the same two years, you might start and fail in two ventures and begin a third. The odds favor one of them working, and you would have a good chance of owning 100 percent of a successful ï¬rm, as contrasted with a 0.2 percent chance of owning a venture capitalist–funded ï¬rm.
And remember, while you are spending all this time ï¬nding someone to give you the money, the marketplace is changing, and by the time you get funding, your window of opportunity may have closed.
Getting started quickly
In chapter 3, we said that entrepreneurs like to get started quickly with the means at hand. Now we can return to how they can start quickly. It’s really pretty simple: when you want something and your next step is within your means and within your acceptable loss, the most natural thing in the world is to act. Under these circumstances, it is really unnatural not to act.
This is the secret of seasoned entrepreneurs and why they seem so impulsive. They drive the cost of their next step down to the point where it makes no sense not to act, given that they imagine accomplishing something they want. They construct and play a game in which no one decision is likely to be fatal and where moving quickly and correcting mistakes as you go along are more intelligent than overthinking.
The recipe for acting quickly is really pretty simple: make sure that this is something that you want and get creative to devise an acceptably inexpensive next step with the means immediately available to you. If you do these things, the next thing you will ï¬nd is that you are taking action.