Thursday, February 16, 2012

A New Proposal for Entrepreneurs

Thinking, Slow and Fast is a remarkable book and I have written its review on a separate page on this blog. One of the very important implications of human biases the book refers to is the tendency of human beings to be overconfident as also to have conformity bias. The first one is easy to understand (even easier to prove - ask a group about how many of them think they are better than average drivers and you will typically get affirmative reply from far more than 50% of the population - a logical fallacy as in only half can be actually better than average!). The second one, stripped of its technicality, simply means that we like to seek and believe news, ideas, theories which conform with our views and ideas - if I think Dhoni has lost his form, I would pick up examples selectively which point to that; but using similarly biased selection of facts from the exactly same time period and matches played, someone else can prove her own bias that Dhoni has regained his form recently. Views matter even when - and probably most when - we watch and interpret news!

What's the connection with entrepreneurs? We will get to that soon enough! But before that, another very common aspect of overconfidence and conformity bias is the unwarrantedly high post-facto attribution of a firm's success to a man/woman's vision, charisma, grit or whatever else great leaders are touted to have. Fooled by Randomness (i just don't seem to be tired of quoting this book!) covers many instances of how random luck then gets covered by foresight some leader possessed and how people flock to interview him/her to understand the mantras of success. In reality luck does play a far larger role in any given individual's and company's "success" than most people - including leaders themselves - care to admit. However we are biased to favor a person-driven account of the greatness of the company and the randomness of the fate of individuals and companies is deeply unsettling for most of us to digest. Hence visionary halo to a successful leader is merely an act of completing what most of us would like to see anyway.

Coming back to entrepreneurs finally! It does not matter whether the big company CEO appreciates the role of luck in his/her success. Ultimately s/he goes home with a decent salary and perks even if the company does just ok. If it does very well, s/he goes home with much more and subsequently writes a book of generalities ("its about people!", "what's your moat?", "its about cashflows!", "its not about cashflows!" and such). For an entrepreneur, life is not as forgiving (I am speaking from personal experience). If you get it wrong, you wrap things up and go home. If you get it right, you are a hero. Numerous entrepreneurs understand and appreciate this - very well infact. They dont mind the odds and the experience is anyway rather enriching. However, the fate of the unsuccessful entrepreneur need not be becoming part of what Daniel Kahneman calls "The Engine of Capitalism" - i.e. successful or failed, an enterprise pushes forward the growth of the economy in its own way.

Entrepreneurs are by design (and self-selection) overconfident (again, been there!!) How can a rational and cool-thinking (and yet overconfident) entrepreneur account for this in her plans? I would propose the following (finally!)
Build to maintain a steady positive cash flow through a long period of time. Which means keep costs modest and revenue steady even if low. A priori one does not know which of the various small opportunities is the big break. Hence the prudent thing would be to maximize the number of such opportunities while not betting on any one with everyone one has got. Even something looks very very promising (which can't be all of the opportunities!) it is best to find a partner who can share risks and rewards of that specific opportunities. Then in exchange for the downside protection one gives up share (even if large) of the upside. This ensures that the enterprise has multiple shots at the big break. Post facto such a strategy would look stupid if things work out on that one nondescript idea. But then a priori one did not know which that one idea would be. One can even use the proceeds of the modest gains one would have made from this (owing to having given up much of the upside) to create even more breathing space to take on larger piece of the next few promising opportunities.
What's the trade-off? Well, like a VC firm one would like to try out a small number of highly promising but nascent ideas. But keeping that number at one, a la the conventional entrepreneurs, is to really try to take statistics head on!
What's the downside? For something like a potential google or facebook, in terms of the financial upside lost, its not much (in relative terms, not absolute). For a moderately successful enterprise, one is likely to feel some heartburn for not having taken that leap of faith, but it is still a high quality problem. For failed ventures, it is much better to have not risked the firm's existence on them - even post facto!!


Anonymous Fella said...

Daniel is underestimating when he refers to entrepreneurs as "Engines"..Guards would be a more apt descriptions because without entrepreneurs, there would be no Capitalism -- No entrepreneurs means no Corporate sector and obviously the Govt is the sole employer. Lo and behold, we have pure Socialism/Communism where State is the only employer !!

And didn't get the reference to conformity and entrepreneurs though I believe you would agree that entrepreneurs are inherently non conformists. And Irrational (Perfect rationality means keep your job!!)

Swapnil Pawar said...

I agree with you on the irrationality of entrepreneurs. In the same vein, I referred to conformity in the context of how entrepreneurs see the world - their overconfidence is typically shaped by selective percpetion of views that comform to their outlook.
I am not suggesting that entrepreneurs conform themselves. They do not. But they to keep their attention reserved for ideas, news, opinions that favor their own outlook. (In this sense, they rarely objectively criticize their own plans.. If all entrepreneurs did so, the economy would stop growing! That was the underlying thought in calling them engines of capitalism)