Risk/Return Bets in Entrepreneurship

As a person trained in finance and investing, I’m always interested when I see these principles apply to other parts of life. But perhaps there is no better place where the lessons of investing could come into play than in entrepreneurship.

(You may also be interested in reading Relationships, Careers, and Investments, which more talks about the opportunity in finding these bets)

Investing and entrepreneurship have always been explicitly tied together, so this blog post is by no means a groundbreaking revelation. There is not too much difference between the job of a venture capitalist and the job of a startup founder. But there is no real great place where these similarities are described in depth, nor their callbacks to the singular concept of risk management.

Let’s start with the obvious: a VC and a founder are both scouting for market opportunities. A founder has an idea they’d like to build, whereas the VC would like someone to build it for them. But each is looking for the same thing: a return on investment. 

The basic law of risk management states that, as risk increases, the potential return also increases. This is not strictly accurate – some bets have high risk and low return (particularly bad) whereas others have low risk and high return (particularly good). The former bets are thrown out of the market as silly opportunities, whereas the latter events are quickly eaten up. That leaves those opportunities which fit our basic law. 

Another important thing to note is that, in this specific market, the plays are always bets, and not really investments. I.e. Those who are in the startup game are inherently speculators, and have to have a good sense of risk management over just plain skill or mathematical knowledge. Low risk low return games are for income generators, who tend to be bootstrapped and do not develop the attention of VCs. 

So, these two points bring us to the title of this article: there are risk/return bets in entrepreneurship. But how do you value these bets?

Well, the traditional method is to use the tools of expected value. With entrepreneurial activity, an expected value looks something like (size of addressed market) * (percentage of market share), which is the value, and then some sort of probability measure which grants you the expected value. There are a whole lot of ways of going about this, though it is easier to do for startups who have already proven that the market does exist (this is why most non-seed VCs look for that exponential growth in revenue). 

But something else is quite interesting here. Risk, in this universe, is malleable. It is not like in the investing world where you have someone else do it for you, and thus have less control over the overall process. You can change the demand, and thus affect the overall nature of the risk/return bet!

For example, good marketing is all about changing demand. Your product can either be a silly little toy or a life-changing device depending on how well it’s marketed. You can even just say “Fuck it”, and fake the demand – this is what a ponzi scheme is! (I said these were examples, not things you should do). The lesson here being that, when your bet is intrinsically tied to the demand of a product, there’s a lot of ways to influence this, ethically or not. 

If you’re a little queasy about changing demand yourself, there’s some other methods to use. A pretty popular one is crawling, also often referred to as sprinting or “making a Minimal Viable Product (MVP)”. The method behind this is actually quite clever. You start with an idea you have that you think people might like. Then, you make up a solution that happens to look like a fully resolved version of this idea. In reality, you haven’t made anything! But that’s alright – that step comes later.

Next, you use some sort of cue to “gauge interest”. For example, the most popular version of this is an email sign up form. You put up some sort of sign that says “Coming Soon!” and then ask people to put in their email to keep up to date. The more emails you get, the more likely it is there is a real market for this product, in which case you can build without worrying too much about whether you’ll waste your time making a tool for no one. Of course, this tool isn’t perfect – many people will freely show interest in something, only to scatter at the first sign of a price point. Still, at some level you have the law of large numbers at your side. 

Anyway, that’s a summary of bets in the startup/entrepreneurship sphere. Hope you found some interesting ways of thinking about this problem!

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