Chapter 6 - The Fallacy of Risk in Entrepreneurship
To read:
THE Classic: Now three decades old, The Innovator’s Dilemma by Clay Christiansen is reviewed as the “classic” book on disruptive technology.
Risk-averse Ted Turner: Malcolm Gladwell’s essay in The New Yorker explores the risk-averse nature of successful entrepreneurs and it is essential reading.
Netflix, Blockbuster, and ‘bad profit’: In this Lucky7 blog series, Brett Hurt explores the difference between ‘good’ and ‘bad’ profits.
Building a culture of thrift: You can build a better business culture with bigger ripple effects if you are capital efficient, argues Brett Hurt in this Lucky7 blog post.
A father’s counsel: My father’s words: "Son, one day you may realize the value of keeping life simple…,” he said… “or you may not."
The new capital: Unlike angel investors, venture capital is a different ballgame, argues Bonobos Co-founder and CEO Andy Dunn. These folks are fiduciaries who probably own at least 10 percent of your business, and frequently more.
Chapter 6
The Fallacy of Risk in Entrepreneurship
“Take calculated risks. This is quite different than being rash.”
— Gen. George Patton
To understand the dynamics and reality of the entrepreneur’s risk, a good place to start is the ultimate study of success and failure. This is Charles Darwin’s theory of evolution first published in 1859. You’ve certainly heard some version of this a million times: the virtue of competition is that it weeds out the laggards. The “survival of the fittest” is what business is all about; the iron laws of nature reward the strong over the weak.
Sound familiar? From boardrooms to locker rooms, we’ve all heard some version of this classic argument analogizing Darwin’s insight to the dynamics of software markets, political campaigns, or the upcoming final game of the World Series. There’s just one problem. This pervasive understanding of Darwin is wrong. Much like our understanding of the entrepreneur as a risk-taker, jumping off cliffs and building wings on the way down to fly.
So, let me try and explain this perhaps odd connection between the fallacies in the popular understanding of what Darwin learned from his trip that produced his treatise, The Voyage of The Beagle, and the deeply rooted myths about risk and entrepreneurship.
In recent years, many scientists have lamented the pervasiveness of “bad Darwinism.” But the best argument I’ve heard of why this is wrong came from Stewart Brand, the famous counter-culture thinker who founded the Whole Earth Catalog in the late 1960s, the Global Business Network scenario planning group in the 1980s, and most recently published his sixth book: Whole Earth Discipline: An Ecopragmatist Manifesto.
Brand, who I had the chance to meet once at a TED conference, has eloquently argued that we’ve radically misunderstood and misconstrued Darwin. It’s not the best competitor who wins out in the evolutionary sweepstakes. Rather, it’s the species most adept at avoiding competition, the one who masters specialization, who finds a niche with the fewest rivals within a given ecosystem. Sure, when all else fails, competition in nature is inevitable. Just as it is in business. But a better way to think about evolution is that it is about the survival of the best specialist. After all, the world’s some 5,000 species of lizard didn’t evolve from the earliest reptiles by seeking out snakes and hawks to challenge, but by adapting to habitats not easily accessible to their predators. And drop in on a conversation with Brand and economist and cultural critic Tyler Cowen that you’ll find on the Digital Companion.
Given the more entrepreneurs that we back as angel investors, and the more I practice entrepreneurship myself, the more Brand’s re-reading of Darwin appeals to me. It’s a pretty good way to think about risk in the business ecosystem as well. For the myth of the intrepid, risk-taking entrepreneur placing all his or her bets on a spin of the wheel is an idea that just needs to be excised from the world. Yes, of course, entrepreneurs are brave as I wrote about in Chapter 1, The Soul of the Entrepreneur. But that doesn’t mean they don’t work really hard to mitigate risk, including before they even start their new business.
In other words, successful entrepreneurship is not about risk-taking but risk mitigation. Or, to paraphrase a famous general, about risk calculation. Risks are what you take after you have examined the hazards and uncertainties through the eyes of potential customers, studied them with industry experts, explored them with potential partners, and validated your startup idea with your own judgment and analysis of market timing.
A related bit of heresy comes from entrepreneur Peter Thiel, the founder of both PayPal and Palantir and an initial investor in Facebook, who frames the argument as, “Competition is for losers.” Culturally, socially, and even psychologically, he argues in his book Zero to One, many if not most new entrepreneurs see competition as validation — if others are doing it, it must be right. And fierce competition, he readily concedes, will make you better in a narrow slice of endeavor. But it certainly will not make you financially successful. Instead, he counsels in a great lecture included on the Digital Companion, “You always want to aim for monopoly and you always want to avoid competition.”
And equally important, as business scholar Clayton M. Christensen so magnificently describes in his seminal book The Innovator’s Dilemma, is an understanding of the distinctions between “sustaining innovation,” practiced by established companies, vs. the “disruptive innovation” of new startups. The varying stages of innovation involve different elements of risk and mastery of the nuance is critical, as I explain below. A detailed review is linked on the Digital Companion, which yields a full understanding of innovation as the essential value that entrepreneurs create. Christensen makes the case that it is by innovation that entrepreneurs change the world and carry humanity forward. So let’s truly understand just what innovation is and how risk-taking is just one of many elements.
Lastly, I encourage attention to the book I’ve mentioned earlier, The Power Law — Venture Capital and the Making of the New Future, by Sebastian Mallaby. You’ll find a review on the Digital Companion but he describes a key metric of risk — the so-called “Perkins Law,” named for Tom Perkins co-founder of the VC firm, Kleiner-Perkins: “Market risk is inversely proportional to technical risk.“ In other words, if you solve a truly difficult technical problem you will face minimal competition.
So against that backdrop, I want to get to how I’ve applied some of these principles to my businesses (and frankly sometimes failed to apply them). But first, I need to summarize these foundational concepts because in my view Christensen — without specifically saying so — really builds on Brand’s framework of understanding with his book. I encourage you to pick it up next after you’ve finished this one. In fact, Steve Jobs famously described The Innovator’s Dilemma as the only business book worth reading.
For if Brand focuses on our misunderstanding of how species operate within a specific ecosystem, Christensen’s refinement of this is how entrepreneurs misunderstand what he calls the “value network,” the system of inputs, suppliers, production cycles, and, of course, customers. In my analogy here, innovation in the “value network” is the equivalent of evolution in the ecosystem. And value networks differ in the three stages of entrepreneurship we discussed in Chapter 3, Advice For The Middle Age Entrepreneur. This pernicious myth of the swashbuckling risk-taker feeds in part on the lack of understanding that there are two very different kinds of broad innovation.
“Sustaining innovation” is that which enables an existing, successful, well-run company to iterate improvements that keep its margins high and investors happy. This would be like a “Stage 3” business in my typology. Think Gillette and the last razor you bought among the 4,000 iterations since the company’s founding in 1901. “Disruptive innovations,” however, are those that break the cycle of incrementalism and introduce something brand new, displacing incumbents and bringing new value and creativity. This is the innovation in my “Stage 2” description of businesses, or even in some cases, “Stage 1.” My favorite example in this latter category is Netflix, which at Stage 2 upended the $6 billion, 8,000 store Blockbuster Video that was well into Stage 3. Now in mid-2022, Netflix is itself a Stage 3 company, and the new headwinds the company faces reflect the entry of newer and more nimble streaming rivals. I include some much more detailed analysis on this dimension of risk from Vox’s Recode podcast and my blog on the Digital Companion.
The “innovator’s dilemma” is the insight that an organization may — and in fact, must — excel at sustaining innovation as it matures. But maturity, the demands of customers, the challenge of continued revenue growth, and the resulting imperatives and corporate culture in the now-mature firm, lock the organization into one value network. This success, in turn, all but eliminates its ability to break into the new value network demanding the products created by disruptive innovation. It would have been easy in theory for Blockbuster to break into streaming with the advent of the Internet, but its value network, and all the corporate systems contoured around it, made this impossible. And, as we know, Netflix founders Reed Hastings and Marc Randolph ate the lunch of Blockbuster CEO John Antioco. But as noted above, Christensen’s cycle continues.
I realize I’m belaboring risk in the abstract here. But I need to emphasize Brand’s and Christensen’s insights because they frame the concrete elements of risks and threats that I’m coming to, and they help explain my own bias on the subject. I’m a very risk-averse entrepreneur. This comes as a result of bootstrapping my first three businesses and almost failing on my fourth, Coremetrics.
Abstractly, my brush with disaster at Coremetrics was in part because I had not really internalized these distinctions about the intricacies of risk and innovation. But more concretely, almost failing at Coremetrics was due to market timing; I was too early, I had failed to foresee the dot-com bust, and I was frankly overcapitalized. We were just trying to do too much, too fast. There is a natural digestion period and capability zone for any company at any point in time. Your job as an entrepreneur is to push the limits of that, but I simply pushed way too far. I pushed to the point where I jeopardized the core of Coremetrics. Our foundational offering was a Web analytics product called “eLuminate” that gave online businesses deep insights into their customers’ behavior while shopping within their digital storefronts. But eLuminate was melting down and therefore making our customers very unhappy. Which meant we were perilously close to failing before Coremetrics had a chance to take off, with a strong, customer-loved core product.
In addition to this experience, my risk aversion I alluded to above also comes from the fact I’m a product of bootstrapped entrepreneurs — my parents, who took minimal risk. As I wrote about my father in my tribute to him, which is online on this book’s Digital Companion, he turned down Walmart when I was 10 years old and the retail giant wanted to sell his product in all of its stores nationwide. He was already happy with his life and he didn’t want to take on the complexity and risk. But even though my parents took little risk, I witnessed them go through the inevitable ups and downs in business. And their support was critical when I was going through my own humbling experience of earning my living through entrepreneurship.
Living this harsh lesson at Coremetrics, with six projects going at once in our first year of business, was overly ambitious, to say the least. This drove nearly everyone in the company crazy and, as mentioned, our foundational product — the retail-focused Web analytics that we eventually became well known for — was failing. I realized that nothing would matter if we didn’t get Coremetrics fixed. And fixed fast. I had co-located Coremetrics in San Francisco and Austin, where we had the 60-member R&D team based. I was working out of our San Francisco office but dropped everything to fly to Austin to spend the month with our team there, where I launched the “Stand & Deliver” project. We would stand and deliver for our customers, investors, families, and ourselves. We immediately killed all extraneous projects, which in retrospect were essentially the kind of “sustaining innovations” that Christensen describes. They might have been fine at a later stage, but I had allowed them to overshadow the “disruptive innovation” of eLuminate.
Ultimately, we did deliver for our customers, investors, families, and ourselves by shoring up the core of Coremetrics. Most of the extraneous projects never again saw the light of day, which in hindsight I’ve regretted when we reached the later stages of our business. For example, I wish that we had gone back into building a personalization engine to deliver individually targeted merchandising discounts based on the data Coremetrics was collecting. Indeed, personalization became a big opportunity for the industry overall. But I digress - the point is I’m convinced that, at that early stage of our business, if I hadn’t decided to “Stand & Deliver” and focus, Coremetrics would have failed in 2001 and almost no one reading this chapter would have ever heard of the company.
Andy Dunn, the Co-founder, and CEO of Bonobos wrote a great Medium post (featured on the Digital Companion) that describes the nature of the overcapitalization that can erode the focus of a business, which is what happened to us. He writes in part:
“Prior to a lobotomy I just underwent which removed shiny new object syndrome (SNOS) from my brain, I was both an asset and a threat to my own company. The company is trying to do one thing, and I would come up with another. I can’t tell you how dangerous this is. If the founder doesn’t know what the company is doing, the company won’t either.
In some cases the shiny new object you come up with saves the company. In other cases, it sinks it. If it’s the former, they will call it a pivot and hail you as brilliant. If it ends up being a distraction or taking the company off-course, they will call you delusional and un-focussed.”
Needless to say, by the time I got to my fifth business, Bazaarvoice, I had learned a great deal from this do-or-die moment. The organization has gone on to become a global success story as a mostly customer-funded and very capital-efficient business, especially leading up to our IPO.
Another deep thinker on these topics who I recommend is the author Malcolm Gladwell. He is one of my favorite writers, and his famous book, The Tipping Point, was a source of early inspiration for us at Bazaarvoice. His book, Outliers, is a critical study of the ingredients of success, and his essay in the New Yorker, entitled The Sure Thing, further illuminates this fallacy of risk. Again, there’s a link to it on the Digital Companion and I highly recommend it.
Gladwell notes a long list of the reasons entrepreneurs fail: from trying to sell to customers already well served by competitors, to misunderstanding financial controls, to underemphasis on marketing. Summarizing the work of other experts, he makes the point that taking over an existing business is often a better bet than starting from scratch. This is an important consideration, though I started both Bazaarvoice and Coremetrics from scratch, and Debra and I have also angel-backed companies over the past ten years that have started from scratch. In my view, the key is knowing the market. In the world with which I’m most familiar, SaaS (Software as a Service) businesses, if you know the market — and you make sure that clients will pay for your solution (ideally selling it before actually building it) — you are not taking much risk. SaaS businesses are like an annuity that you earn through both great products and services. In SaaS, you should be able to both pre-sell and collect a good portion of cash up-front from your clients.
“The failures violate all kinds of established principles of new-business formation,” Gladwell writes…. “But a good many of these risks reflect a lack of preparation or foresight.”
Or as Christensen puts it: “Managers who don’t bet the farm on their first idea, who leave room to try, fail, learn quickly, and try again, can succeed at developing the understanding of customers, markets, and technology needed to commercialize disruptive innovations.”
Which is the essence of risk mitigation. No one has articulated this better than Alex Honnold, who is not an entrepreneur but a rock climber. Honnold is best known for his free solo ascents of big walls, in particular his free-soloing of El Capitan, in Yosemite National Park in 2017. On the Digital Companion, you’ll find a brief talk he gave at TED in which he describes his years of getting ready, a practice run on less challenging Half Dome, his study of the 3,000-foot face of El Capitan, rehearsal climbs with ropes to map the terrain and his rigorous mental preparation before execution.
He describes the point just beyond the riskiest stage of the climb:
“I knew that I had done it. With 600 feet to go, I felt like the mountain was offering me a victory lap,” he said. “I climbed with smooth precision and enjoyed the sounds of the birds swooping around the cliff… I reached the summit after three hours and 56 minutes of glorious climbing. It was the climb that I wanted, and it felt like mastery.”
As you scale the face of your own El Capitan, here are some questions to ask yourself every day as you journey toward your mastery:
First, do customers truly love what you do?
If you don't know, ask them — directly. And if you don’t have customers yet, ask those who you hope will be. There is no substitute for face-to-face market research. If customers love you, and the market is big enough, you'll be just fine as long as you always remember to serve them well. Just keep in mind that it’s not a laundry list. Working from their priorities and trying to build everything they ask for is a fool's errand. Practice the Pareto principle, sometimes called the 80/20 rule. Build the 20 percent that you and your team believe will solve 80 percent of your customers' problems, or at least deliver 80 percent of the real value.
Second, are you positioned well competitively?
Do you have some technological insight that your competitors don't? Is there something truly novel that will be loved by your industry? As Netflix has proven, it often takes less than you would think — look at how long it took Blockbuster to get religion about the threat that Netflix became with incredible speed and excellence.
Third, how many people have you talked to who are experts/veterans of the industry you are seeking to serve?
Make the list long and keep it growing. I suggest being as transparent as possible about your plans. It is so hard to start a business in the first place, as I discussed at the outset in Chapter 1, The Soul of the Entrepreneur. Given this, there is almost no risk in being this transparent. I'm not suggesting that you go to Google and ask someone there to assess your plans for building a better search engine. I am suggesting that you go to people who pay Google and tell them, very transparently, about your plans for a better search engine. See if they would be interested or if it is already game-over due to Google's size. One caution here, though. As with your queries about what to build for customers, don't make the mistake of listening to these experts blindly. Many of them will never take the risk of starting a business of their own. So be careful as they may tell you things that are inaccurate to dissuade you from starting something new. But you'll form a pattern after speaking with enough of them, especially if they are the "cool kids" of their industry. In Chapter 16, Selling to the “Cool Kids” we’ll discuss how to understand who the cool kids are and how to reach them.
Fourth and lastly, what are you doing right?
Ask yourself this question every day. This is related to what we discussed in Chapter 2, The Paralyzing Fear of Getting Started. Fear happens when you don't have confidence in your actions. A great way to build confidence is to assess that you are doing it right.
Fast forward to today, now six years into my sixth business, and it’s fair to ask: Have we gotten it all right at data.world? Of course not. We’ve made many mistakes along the way, and the heartbeat of what we are doing — with a mission to “build the world’s most abundant, collaborative, and meaningful data asset” — is very difficult and uber ambitious. But we are having a blast and doing our best to mitigate our risk and maximize our opportunity. And, most importantly, customers love our enterprise data catalog product and the COVID-19 pandemic only accelerated their adoption of it.
Let me leave you with one more bit of insight from one of my favorite entrepreneurs:
“If you’re prepared and you know what it takes, it’s not a risk. You just have to figure out how to get there. There is always a way to get there.”
— Mark Cuban, Entrepreneur