Posted on May 2, 2016 @ 09:18:00 AM by Paul Meagher
Dennis Patrick Leyden is a Professor of Economics at the University of North Carolina who studies entrepreneurship and innovation. He published an interesting article called Entrepreneurial Risk and Uncertainty in
the Concise Guild to Entrepreneurship, Technology and Innovation (2015).
The concepts of risk and uncertainty are central to the current definition of a startup and what it means to be an entrepreneur. Risk and uncertainty, however, are not the same. If you have no basis in prior experience or logic to measure the degree of uncertainty involved in a situation, then you can't assign a level of risk to it. Insurance companies and banks deal with uncertainty in the form of risk whereas startups and entrepreneurs often deal with unquantifiable uncertainty. The distinction between risk and uncertainty gives us a way to think about how entrepreneurial companies might evolve over time from uncertainty-based ventures to risk-based ventures and possibly back to uncertainty-based ventures if they decide to reinvent themselves. Here is a passage from Professor Leyden's article that discusses the relevance of the distinction:
Although the entrepreneurship literature has increasingly come to accept Knight's view that entrepreneurial action takes place under conditions of uncertainty, that view is far from universal. For those who take the view that the entrepreneur lives in a world of (quantifiable) risk, it may be reasonable to think of entrepreneurial opportunities as objective phenomenon waiting to be discovered, albeit with risk. But under an uncertainty-based view, entrepreneurs do not so much discover profit opportunities as create them. As Alvarez and Barney note, such creativity is the result of the entrepreneurs' own organizing efforts in the face of uncertainty. However, because the condition of uncertainty may change over time, the bases for organizing entrepreneurial firms are also likely to change. As a result, entrepreneurial (that is, uncertainty-based) firms over time may be transformed into non-entrepreneurial (that is, risk-based) firms once the probability distribution of outcomes associated with uncertain exchanges is learned through experience. Based on this reasoning, Schumpeter's notion of creative destruction can be thought of as including not just the replacement of older firms by newer firms, but also the transformation of entrepreneurial firms into non-entrepreneurial firms over time. Such transformations, which Schumpeter saw as common, imply a continual need for new (or reinvented) firms that, through their decision to be entrepreneurial, enter willingly into a world of uncertainty and creativity. ~ p 72
The valuation of a startup may also be based upon whether its prospects are completely uncertain or whether it has received enough feedback that it can start to quantify some of its operational uncertainty. For example, when a startup first starts to market its products there may be no clear relationship between its marketing efforts and the number of new customers that effort produces. After awhile, however, it might start to see that certain types of marketing produces better results than other types of marketing. Once it can start to quantify some marketing relationships (even if the relationship still has alot of variability) it can leverage that risk information with investors to potentially achieve a higher valuation. Investors are generally more comfortable dealing with risk than uncertainty and may be inclined to agree with higher valuations when there is less uncertainty involved.