The Constitutive Role of Risk in Entrepreneurship

In an earlier, somewhat inaccessible essay, we began to explore some of the rough outlines of what constitutes entrepreneurship. In particular we suggested that a novel, instrumental idea, along with the desire and action to see it realized, might be minimum or necessary conditions, though they may not be sufficient. Here we will explore the potential constitutive role of another factor that is often associated with entrepreneurship: risk.

In this piece, our examples will all involve commercial business situations, but that is for the sake of simplicity and clarity, not to limit the discussion or conclusions to entrepreneurship of a commercial nature. Further, for those concerned with rigor, I will point out that in any definitional enterprise there are two value-laden considerations. The first is due to the fact that we have purposes driving the need for a distinct term, and the second that if we are to trouble ourselves with a distinct term, then its meaning should be unique in some way so as to perform some cognitive work. While the latter point is generic, I should clarify for the sake of the former that my purpose is in studying the nature of entrepreneurship, as I believe it has been and will be a major contributor to human civilization.

The popular archetype of an entrepreneur includes “risk-taker” as an attribute, and risk is normally present in entrepreneurship. However, this could be a consequence of another factor, or even just a coincidence resulting from the way entrepreneurship is historically conducted. We would like to determine whether it is among the necessary or sufficient conditions constituting entrepreneurship. We would also like to understand more about the role it plays, given its apparent ubiquity.

To do that, we will need to look more closely at what the term “risk” means in this context. It has several definitions, such as “variability of economic returns” (finance) and “uncertainty of outcome in making a decision” (psychology). In relation to entrepreneurship, we might instead emphasize the possibility of loss of something one currently possesses. What sorts of things might an entrepreneur lose?

Most obvious is the potential for financial loss. Entrepreneurs are usually their own first investors, not only supporting direct outlays but also expending effort and time that could have been directed toward earning money. Bootstrap entrepreneurs sometimes use credit cards, second mortgages, and savings to get the business off the ground. And entrepreneurs - even those with outside financing - rarely draw a full market salary.

Also apparent is the possibility of harming one’s reputation. If the venture fails, one might be viewed as less competent or capable by colleagues, as an embarrassment to one’s family, as an object of pity to one’s friends. Recently, there has been some emphasis on the positive aspects of business failure (for example, learning and experience), and in Silicon Valley some entrepreneurs even tout such failures as a selling point. Nevertheless, loss of reputation remains a real risk.

Less widely understood is the potential for a toll on one’s health, both physical and mental. Entrepreneurship typically involves long working hours, grueling travel, and rushed or indulgent meals. It involves substantial emotional stress, difficult and awkward interactions with a wide variety of people, and extraordinary volatility in the prospects for success. Depression is common and the daily instability may exacerbate any propensity to bipolar disorders.

A few other potential losses, possibly not as consistently present, come to mind. Often an enterprise is founded with trusted and respected colleagues: those relationships could be damaged. The entrepreneur’s adventurous spirit or enthusiasm could be lost. Sometimes the very vision that guides the effort is a longtime dream and an integral part of the entrepreneur’s persona, and failure would do violence to it.

Thus when we speak of risk in entrepreneurship we are typically talking about important values such as these, values that the individual currently possesses and that the venture might directly or indirectly cause to be lost. Further, if the notion of risk is to help us demarcate entrepreneurship from other endeavors, it seems necessary that such risk exceeds that of commonplace activities - whether due to putting larger quantities of the aforementioned values at stake, or from a higher probability of loss.

With that framing of risk in place, let us now consider whether it is a necessary or sufficient condition for entrepreneurship.

We do not normally consider gamblers and thrill-seekers to be entrepreneurs despite their bearing considerable risk. The reason seems to have something to do with the absence of creation: even if the gambler wins, or the thrill-seeker survives and garners an adrenaline boost, nothing new has been produced. This becomes even more clear if we add a creative element to each activity. A “gambler” who develops a team method of counting cards, or a thrill-seeker who devises a new way to plunge toward the earth and decelerate before impact, these activities seem to come closer to our sense of what an entrepreneur does.

Based on these examples it seems that risk alone is not a sufficient condition to constitute entrepreneurship. More difficult to ascertain is whether it is necessary. Put another way, is it possible for an activity to be entrepreneurship if there is no incremental risk?

Let us assume for a moment that our previously suggested conditions are necessary but perhaps not sufficient. A putative entrepreneur has a novel, instrumental idea along with a desire to see it realized, and takes action on that account. Do we need to add risk to the broth?

Suppose we stipulate further that our subject is financially very sound, physically and emotionally healthy, and has had several large successes as well as some failures, putting her reputation beyond reproach and rendering her ego stable. The amount of time and money she intends to put at risk are proportionately small. The envisioned widget is clearly needed in the market and for whatever reason there are no competitors. Is this activity entrepreneurship?

If we were to claim that it is not, we would be in a somewhat uncomfortable position. An activity that, earlier in our subject’s career, might have been clearly entrepreneurship, is not so designated because the person has managed to be successful and healthy and the project is relatively small. By requiring risk per se, we make the question of whether an activity is entrepreneurship dependent on the financial, health, or reputational status of the subject pursuing the activity. This would be a startling result. We do not ask about a scientist’s prior success to determine whether his latest experiment is science, nor an artist’s mental condition to decide whether her attempts at sculpture constitute art.

Perhaps, though, the necessary conditions we assumed are too strong, and occlude an underlying need for risk in constituting entrepreneurship. Two elements that seem promising in this regard are the novelty of the idea and the need for action. We can consider each in turn.

Imagine an individual investing his entire net worth to purchase a local chain of dry cleaning outlets from the retiring owner. The chain is successful, and no significant changes are planned, so there is no novelty in this endeavor aside from the fact that our subject will be managing the business. Nevertheless, there is considerable risk due to the scale of the investment and the ever-present, uncontrollable macroeconomic factors that affect all businesses. Is this entrepreneurship?

It is a case where opinions might vary. Peter Drucker, in Innovation and Entrepreneurship, excludes situations such as this despite the risk, because there is no innovation involved. Others might hold that in this case the risk substitutes for novelty in constituting entrepreneurship. Still others might claim that the existence of the risk implies at least some hidden novelty - for example, every moment in time has different characteristics - though this sort of claim tends to blur any distinction between entrepreneurship and other activities.

We can more likely agree if we perturb the scenario, so that the subject does not actually operate the business but merely makes the investment. In that case we see the individual as an investor, or perhaps a gambler, but not an entrepreneur. It seems that at a minimum, for risk to act as a substitute for novelty, we also need to see ongoing involvement beyond an initial transaction.

We can take this further, and address the requirement for action, through the following, admittedly recherché, scenario. Here imagine an individual who is a non-operational major shareholder in a company, who has a novel idea and a desire to see it realized. She describes this idea to an operating executive but takes no further action. There is novelty, and there is also risk, but there is no direct action on the part of the shareholder.

Though agreement may not be universal here, most would not call this entrepreneurship. The reason is subtle: the risk does not appreciably arise from the idea or even the fact that it was shared. The risk antedates the sharing of the idea, and exists whether or not the idea is ultimately implemented. WIthout her stake in the company, our subject is merely someone who has an idea and shares it, which is quite outside the realm of entrepreneurship.

From these scenarios we conclude that in constituting entrepreneurship, risk cannot substitute for action, and to the extent that we think that risk can substitute for novelty, it needs to be combined with ongoing action. Consequently, risk is neither a sufficient nor necessary component of entrepreneurship, unless it is substituting for novelty.

We now return to a more realistic scenario to fill out the picture. Suppose an individual seeks a role within a large organization, having distinct novel ideas about how the role could contribute to the firm’s success, and subsequently joins the firm and executes on those ideas. This seems to be entrepreneurial without being entrepreneurship. That is to say, it is similar to entrepreneurship, or has some but not all of the qualities of entrepreneurship. A comprehensive elaboration of this distinction is outside the scope of the present discussion.

But what if we now substitute risk for novelty, as we did before? For example, the subject leaves a stable job and moves her family to a new city to join a company in a particular role, but has no particular novel ideas about that role. Here the similarity seems to fail. The subject is merely making a risky job move; not only is it not entrepreneurship per se, it does not even seem particularly entrepreneurial. This outcome suggests that, even if we do consider risk to be a potential substitute for novelty, its constitutive role is considerably weaker.

If risk is only a necessary condition for entrepreneurship in limited circumstances, and even there its constitutive role is weak, why does it seem to be present virtually all of the time? There are two straightforward reasons.

First, action in the face of novelty always carries incremental risk, above and beyond that of prosaic activities, even if such risk seems immaterial to a particular subject. Not only is there some probability of failure; that probability can be quite difficult to estimate, because there are no genuine comparables to rely on.

Second, the relatively strong requirement of action means that there is an opportunity cost risk for the entrepreneur. Typically, an entrepreneur makes a deep commitment to a single venture rather than engaging in a portfolio as an investor would; thus there is significant unique risk (as the term is used in portfolio theory) relating to the time, money, and effort expended. Even in cases where the entrepreneur is involved in multiple activities simultaneously, each one limits the time available for the others. This commitment implies a concomitant risk, again even if it is not material for the individual.

Given these straightforward causal relationships, it is no wonder that we often conflate risk with entrepreneurship. More accurately, we might consider certain forms of risk to be entrepreneurial, even if the activity as a whole is not genuinely entrepreneurship. As a similarity relation, the term entrepreneurial admits of degrees. For example, in a scenario where an individual takes a job with a startup at half-pay in exchange for a significant equity stake: that is surely entrepreneurial in some degree, simply because bearing risk of this particular kind is common among entrepreneurs.

Finally, risk is often present in entrepreneurship because investors and other parties see it as a motivational tool. The upside is a carrot; the risk is a stick. An entrepreneur who takes little risk is seen as lacking commitment. When difficult situations arise, so this view goes, the entrepreneur with “skin in the game” will be more likely to persevere in the effort and do whatever is needed to succeed. Whatever the merits of this view, risk incurred for this reason is clearly not constitutive of the activity of entrepreneurship, but simply represents a common business practice.

As the practice of entrepreneurship continues to become more professionalized and systematized, it is important to recognize that the presence of risk is a common but not inevitable artifact of other, essential characteristics, or of particular business methods.