Musings on Entrepreneurship and Innovation
Sunday, January 15, 2006The Irrationality of Entrepreneurship
"Irrational passion may just be the ticket to overcome the paralyzing effect of irrational fear."
More than one observer has emphasized the importance of an entrepreneur's passion. There is new scientific evidence that suggests that the assertion may be true, at least initially. It strikes me that there are important implications for how a promising start-up gains access to the capabilities it needs to execute its business model over time.
The Claim for the Primacy of Passion
Curt Rosengren, for example, claims:
Passion is the essence of the entrepreneurial spirit. It is an entrepreneur’s fuel, providing the drive and inspiration to create something out of nothing while enduring all the risks, uncertainty, and bumps in the road that that entails.
Personal experience has demonstrated to my satisfaction that passion is a key element of entrepreneurial success. Nevertheless, extraordinary claims such as Rosengren's bring out the skeptic in me. After all, experience has also shown me that sweeping attributions are often self-serving smokescreens and masks for a lack of rigor. Even so, I'm swayed by scientific evidence.
The Ambiguity of Promising Start-ups
There is more than one kind of start-up. Because of their disproportionately large economic impact, we tend to focus on two types: promising start-ups (e.g., Microsoft) and venture-backed start-ups (e.g., Compaq). Although both types entail risk, the sources of risk are different. Promising start-ups are risky due to the existence of ambiguity; venture-backed start-ups are risky due to the relatively large investment required.
By ambiguity, I mean what Hugh Courtney calls residual uncertainty, "the uncertainty left after the best possible analysis to separate the unknown from the unknowable." While some kinds of uncertainty can be resolved analytically, ambiguity must be resolved through experimentation. In other words, the ambiguity that characterizes promising start-ups must be resolved through entrepreneurial action.
The Biology of Ambiguity
Rationality manifests itself in the scientific method. So, I was struck this morning by the element of irony in a blurb in the February 2006 issue of Scientific American that reported on research at Caltech regarding the way in which the human brain responds to known risk and ambiguous risk:
This more ambiguous game activated the amygdala and orbito-frontal cortex, brain areas associated with emotion processing, whereas the game of known risk did not.
In other words, there may be hard-wired, physical reasons that our tendency toward loss aversion is triggered in the face of ambiguity. As our ability to resolve uncertainty analytically diminishes, our fear grows.
Fighting Emotional Fire withi Fire
It appears that founders of promising start-ups overcome the fear of loss that is apparently triggered by ambiguity in a couple of ways:
- The potential for loss is limited. As Amar Bhidé observed in The Origin and Evolution of New Businesses, promising start-ups tend to be launched with very modest amounts of money by people having low opportunity cost. In other words, the founders of promising start-ups tend not to have much to lose. (The lack of financial capital also forces bootstrapping. Consequently, promising start-ups have no choice but to resolve ambiguity through iterative, experiential experiments.)
- The emotion of fear is mitigated by the emotions of passion, commitment, and conviction. If loss aversion in the face of ambiguity is irrational, the evidence from the Caltech researchers suggests that such fear may be the consequence of very real biological processes. Irrational passion may just be the ticket to overcome the paralyzing effect of irrational fear.
Implications for Fund-raising
Like all entrepreneurs, a key task of the founders of promising start-ups is to gain access to the capabilities of others. Over time, the fungibility of cash makes it a valued commodity. But, the ambiguous nature of promising start-ups has some important implications for fund-raising:
- Friends and family, relatively speaking, tend to respond to the emotional appeal of a new venture. Because of their relationship with the founders, there is a possibility of intrinsic reward for a friend or family member. On the other hand, because founders of promising start-ups tend to have low opportunity cost (i.e., they aren't rich, experienced, nor well known and highly regarded), they tend not to have rich friends and family.
- It is reckoned that "angels" provide the vast majority of external equity financing to promising start-ups. In my experience, relative to professional investors, angel investors are more likely to respond to the emotional appeal of a prospective investment and are less likely to engage in analytical due diligence. On the other hand, angels hedge their bets. Regardless of their net worth, an angel will typically limit his or her downside by investing no more than $50,000 to $100,000 in a promising start-up.
- Professional investors (e.g., the general partners of venture capital and private equity funds) tend to be highly analytical and motivated by extrinsic rewards. Furthermore, their opportunity cost is high. It should come as no surprise, therefore, that they don't, as a rule, invest in promising start-ups. VCs will underwrite a lot of analyzable uncertainty, but not ambiguity.
Selling the Promising Start-up
Doug Hall has noted that market success is, to a significant degree, a function of one's ability to clearly articulate an overt benefit to the right customer, at the right time, in the right context:
Customer benefits can satisfy the logical mind by having rational dimensions. They can also satisfy the heart through emotional components...Both rational and emotional benefits have equal chances of success...However, when the message is diffused, with combinations of emotional and rational, probability of success declines.
If Hall's analysis applies in the context of fund-raising, and I believe it does, the founder of a promising start-up faces an interesting set of challenges:
- Notwithstanding the emphasis placed upon business plans and other instruments of rational salesmanship by business schools, SBDCs, and the popular business press, a clearly articulated emotional appeal may be the best approach in the early days of a promising start-up. (I saw this ten years ago at a company called Off the Beaten Path. One investor told me that she was going to invest despite my workmanlike business plan because she believed in the good the company was doing for the greater Yellowstone Park region.)
- As the result of entrepreneurial action, the ambiguity that defines a promising start-up will be resolved, and analyzable uncertainty and the increased need for investment will begin to supplant ambiguity as the primary sources of risk. Increasingly, a rational appeal will begin to be more compelling to a prospective investor.
There may be an unavoidable conundrum during the transition from the former to the latter stage of development. As the founders of a promising start-up reach farther afield to attract requisite resources, the passion and emotional appeal that were so critical early on must necessarily be supplanted by cold-hearted, verifiable market data. Getting caught betwixt-and-between is dangerous, because mixing emotional and rational messages diminishes impact.
