It’s not the size of payoff but the size of worst case that drives some entrepreneurs

In the past I wrote about the difference between the mind of an analyst and that of an entrepreneur,

It is impossible for someone who rationally estimates net present value of all options, stress tests their assumptions, meticulously conduct sensitivity analysis, determines market sizes and customer demands to start a new venture. (Dan Ariely calls this Optimism Bias, Gavin Cassar attributes this to selection bias)

Corollary: To start a venture one needs to be risk seeking and at the very least be willing to suspend their  rational mind to make the leap.

A research conducted by Saras Sarasvathy, Assoc Prof at University of Virginia points to evidence on how entrepreneurs evaluate outcomes, that it turns out it is indeed different from the methods of a rational decision maker,

Sarasvathy interviewed 45 successful entrepreneurs, all of whom had taken at least one business public (see caveat at the end of this post).  It was not the planned outcome, carefully constructed from comprehensive business plan and understanding of customer needs that drove these founders. They started with resources they had and imagined the possibilities.  Instead of estimating the size of rewards from a venture from successful outcomes or the likelihood of such outcomes, they asked, “what is the worst that can happen if they failed”.

If the failure was not all that bad they went right ahead.

In fact the failure is indeed not bad. Another research conducted by Pfeffer of Standard GSB, found that

Few of the participants in entrepreneurial activity suffer significant consequences from unsuccessful decisions, and therefore many players have less incentive than one might expect to improve their decision-making  – VCs get guaranteed principal and Entrepreneurs often, although not always, are working with other people’s money, so their financial downside, except in terms of the opportunity costs of their time, are also limited

Since entrepreneurship is already viewed and accepted by all as a high risk activity, failure is not only accepted but glorified as example of risk taking.

It’s not the size of payoff that drives them but imagining what is the worst that can happen. And it appears the worst case is not worst at all.

Caveat: Sarasvathy interviewed 45 successful entrepreneurs whose venture went public and more importantly agreed to talk to her for her study. Clearly there is survivor, selection and availability biases here. The results are also based on the conversations with those entrepreneurs which is prone to hindsight and narrative biases.

Take this for what it is worth.

Optimism Bias

Every time you see a commercial  for casinos, they show seemingly happy people each stating how much they won at the casino. I have all reasons to believe these are true endorsements. Of course what they are not telling us is what  their net earnings are after all the money they  spent since they started gambling. It is not surprising that the casinos do not want to highlight this, after all they want to only talk about the winnings. But you might find this surprising to hear that in real life, outside of the commercials, neither do the protagonists in those commercials talk about the total amount they lost to gain these winnings. It is human behavior to ignore or downplay the negatives and focus on the positives. This is the same reason that led them to gambling in the first place.

Prof. Dan Ariely writes in his blog about this irrational optimism

The basic idea is that when people judge their chances of experiencing a good outcome–getting a great job or having a successful marriage, healthy kids, or financial security–they estimate their odds to be higher than average. But when they contemplate the probability that something bad will befall them (a heart attack, a divorce, a parking ticket), they estimate their odds to be lower than those of other people.

This is the same irrational optimism that leads many entrepreneurs to start their venture, despite the market conditions, lack of strategy, lack of competitive advantage and their own lack of wherewithal to execute. Just like the gambler commercials that focus on the winnings, most entrepreneurs tend to focus on the success stories. The two common traits in both are –  first, they ignore the opportunity cost of the capital and time they are investing, be it gambling or the new venture and second they strengthen their own resolve to jump in by overestimating gains and underestimating risks.

The result is the big gambling losses and the increasingly high number of start-up failures. All from Predictably Irrational Exuberance.

Biased Expectations

Before you make the big decision to quit your job to start your own venture or to move to a different city to start fresh, be aware of the highly biased opinion we have about our abilities. The very trait that defines an entrepreneur, unbridled optimism, works against them by preventing them from interpreting the data in an unbiased manner.
Wharton professor Gavin Cassar says,

“It’s been shown in many studies that people are overly optimistic. Individuals form an inside view forecast by focusing on the specifics of the case, the details of the plan that exists and obstacles to its completion, and by constructing scenarios of future progress.”

Even when the entrepreneurs use metrics and accounting systems to budget and forecast, their self bias make them overestimate the opportunities and diminish the risks. As Cassar says, “it is important to recognize that financial projections of success are merely projections based on beliefs, which are sometimes based on overconfident or optimistic assumptions”.

The other aspect that leads one to quit the current job and enter self-employment is due to incorrect estimation of costs, more specifically ignoring the opportunity cost of doing so. Focused on the earning possibilities and the project cost of making those earnings, individuals ignore the income they were leaving behind and whether the new income compares well against what they were letting go. The opportunity cost is not just your pay check, it includes the health insurance,4 01K matching, holidays and vacation pay and other fringe benefits.

The question is, when the startup bug bites you would you recognize the need to do the costing and earnings estimates right?