Stuart Read | Expert entrepreneurs make it okay for themselves to fail

Stuart Read | Expert entrepreneurs make it okay for themselves to fail

Bangalore: Stuart Read is a professor of marketing, innovation and entrepreneurship at the International Institute for Management and Development (IMD), a business school in Lausanne, Switzerland. Before that, he was part of the creation of six technology start-up firms, four of which were acquired by industry leaders including Sun Microsystems Inc. and Lotus Development Corp.

Read’s major work is in the area of effectuation, a set of heuristics that describes how people make decisions and take action in situations of uncertainty. In his recently released book, Effectual Entrepreneurship, he talks about how successful entrepreneurs do things differently from what they are taught in business schools.

During a recent visit to teach a course on entrepreneurship at the Indian Institute of Management, Bangalore, he talked about how successful start-ups need not wait for venture capital (VC) funding, but should focus on finding a customer first. Edited excerpts:

What does your research tell you about successful entrepreneurs’ decision mechanisms?

Entrepreneurship research has been heavily criticized in the academic community because it hasn’t yielded much of theoretical interest or stuff that can be taught. All it has done is find traits of successful entrepreneur—sometimes physical. They have frankly found nothing conclusive on that front either, and you cannot teach such a thing anyway.

So what do you teach people in a business school? It is usually older areas like management, market research, finance, or how to make a business plan. But most entrepreneurs don’t write a business plan. Even if they do, they end up throwing it away. The business they build often has nothing to do with the business plan.

The same thing is true with funding—what we teach in finance is how to take money to make money. A whole industry of venture capitalists has sprung up around entrepreneurs. But when you look at the statistics, 98% of new ventures never even talk to venture capital (firms). Also, less than 27% of companies that go for IPOs (initial public offerings) ever seek venture capital. So it’s not like those who don’t seek VC, don’t grow big.

Nor do entrepreneurs use the famous 4Ps (a management concept that breaks up marketing into four elements—product, price, place, promotion) theory to analyse a market. What they do is go out and sell one thing to one person, unlike large companies.

There are five things we have learnt about what expert entrepreneurs do, which is completely upside down from what textbooks teach.

The first thing they do differently is they start with the stuff they have available. This is called starting with the means rather than the goal. An entrepreneur will, for example, set out saying he knows software and partner with someone who knows graphic design and get into making graphic skins for the iPad. But in talking to the customers, he may discover that a security service is what people really want and he will end up making this.

My favourite example is a company is Switzerland called Freitag. A couple of brothers, without a grand plan really —use waste material to sew up bags which people like. It was something people wanted and they could make it easily.

The other thing they do differently is how they approach competition. In management, we teach how to look at competition using Porter’s five forces. Do you think the Freitag brothers bothered about competition? They cared more about working with partners, their bicycle messengers who would help them create a market. Looking at partnerships in the early stage is more useful than looking at competition.

Take one of the richest women in the world—Cheung (Yan) in China who runs a company called Nine Dragons (Paper Holdings). Her business is entirely based on exporting waste paper out of US into China to use in packaging. She started off in a Dodge minivan, driving around the US with $3,000 (Rs1.36 lakh), buying waste paper and filling containers. Today, waste paper is the largest export of the US. As she grows, of course she worries about huge paper companies like UPM (The Biofore Company). But do you think she cared about it when she started?

Thirdly, people love talking about the risk-taking entrepreneur. The truth is expert entrepreneurs take on very little risk. What we teach in finance is measuring risk according to the size of the opportunity. You value the market you will target, then you risk adjust it and decide how much you can afford to invest for that. For an iPad graphic-skin, you will assume five million customers, and think you can afford to invest $10 million, because in the worst case you will make $25 million, assuming a 75% risk. That looks good. So you set out to raise $10 million.

But what happens if you realize the customer wants a security application? Or Apple stops making iPads?

Our research shows that expert entrepreneurs look at the worst case, instead—if he’s spending six months and $20,000, he will ask himself if he will be broke and on the streets when it doesn’t work. If the answer is no, he will do it. All of a sudden, the huge uncertainty about whether five million people will buy the iPad application goes away.

Expert entrepreneurs make it okay for themselves to fail. They always make investments they can recover.

The next effectual entrepreneurship trait is how they deal with surprise. If you make a plan, what do you do when a surprise comes? The expert entrepreneur uses it to create a new opportunity. The best example is the Post-it, an engineer at 3M trying to make an engineering adhesive.

You talk about doing business the ethical way in your research. What is your view on the microfinance model in India?

I think what happened with microfinance is the same thing that happened with venture capital in Silicon Valley. It started off very functional. Suddenly, the world thought they figured out the key to funding entrepreneurship in developing countries. They started pouring money with abandon from IMF (International Monetary Fund), big institutions. All of a sudden, this institution that was built on the idea of scarce resources had way too much. So it had to figure out new ways to invest, which were inconsistent with the original model.

You say that successful angel investors often rely on non-predictive information after the due-diligence stage. What do you mean by this?

In Silicon Valley, angel investors today invest as much as VCs, but have a higher 20-year rate of return. A study talks about how VCs invested $24.4 billion over a three-year period between 2004 and 2007, while angels invested a nearly equivalent $24.3 billion. And the return rates of the latter were much higher. Angel investors are very effectual. They believe in non-predictive strategies more and these have a lower rate of failure, (involve) smaller investment and better returns, compared to peers who make bigger bets based on predictions. By non-predictive information, I mean, they do not rely unduly on predictions.

The VC story doesn’t really represent what’s going on out there. They are a good model, but they are just the tip of the iceberg.

If you ask someone what percent of new companies fail, the prevalent logic is 90%. But what defines failure? If failure is not going in for an IPO, that is a large number for firms. But if it is not going bankrupt, closing doors on outstanding debt —the number is only 10%.

A lot of Indian technology start-ups on academic campuses such as the Indian Institute of Science (IISc) aren’t doing so well because they are not able to raise money.

While I haven’t closely watched the Indian start-up space, it is similar in Europe. Academic start-ups aren’t doing well, and they think it is because they are not making money. They are also overly subsidized by the government. Let me piece this apart using the effectual model.

The starting assumption that they need money to do well is wrong. They needn’t spend millions of dollars in being technologically perfect. I have done a number of start-ups, but I have raised money only twice. Better money is the customer.

You see a new model more and more in Silicon Valley now —extreme programming—the idea that you build just a month at a time, and at the end you have to sell what you build. You cannot go on unless you sell it.

When you have a technology, the clever ones will start looking at who they can sell to right now, not when it is finished and perfect. What is remarkable is you can actually sell what you have right now, but maybe to a different customer, or someone who wants to be a development partner, or to an advanced customer who wants to pay you to build a prototype.

When you go to someone who is already in the same business, they are much more willing to take raw technology, test it on the production line and tell if you if it is 100% perfect or if they can push it off to the second line.

But don’t some research and development firms need VCs who need a special kind of domain expertise and a longer view?

Clearly, in some industries like drug development, things take a little longer. But the entrepreneur could still find ways to spread out risk, find financing. Go to a large pharma company and ask for a 20% option for them to take it to the market. The large company has a larger affordable loss. You might not exploit the full value of it, but you can turn it into more than zero! If you are trying to take the whole thing to market, you are being much too rigid.

Also, we argue that a firm need not live forever. The shareholder may be better served by looking at firms as exploiters of opportunity. When you distribute the wealth to shareholders, you create so much more novelty and ideas with those dollars, the shareholders would be better off.

Let me give you a very concrete example. Microsoft (Corp.) has $60 billion. I would have a hard time convincing you that Microsoft would take that money and turn it into something which will make the next Microsoft. The chances are really against them. The truth is they have taken an entrepreneurship opportunity like Windows and exploited it to the hilt. Companies should be allowed to die.