SOPHISTICATED FINANCE

Entrepreneurship and Complexity

About ten years ago I began teaching entrepreneurship at a university, which lead to the realization that I needed to study more about entrepreneurship. The study of entrepreneurship still continues, but I have expanded my study to include learning and complexity. These three themes are actually part of an integrated whole, if one considers Henry Mintzberg’s concept of emergent strategy, but today I just want to discuss entrepreneurship and complexity.

To set the stage, let me define entrepreneurship and complexity. I think Harold Gardner at HBS defined entrepreneurship well as “entrepreneurship is the pursuit of opportunity without regard to resources currently controlled”. The focus on opportunity and the challenge of mustering resources in order to execute frames the issue well. I might have added the concept of “scaling” in the definition of entrepreneurship, but most traditional economists do not. “Complexity” is a dynamic system where variables are inter-related but uncertainty from lack of information prevents deterministic analysis. Uncertainty here is Frank Knight’s definition, which to paraphrase is “a situation where you lack sufficient information to determine probabilities”. (For Knight “risk” was a situation where you had sufficient information to determine probabilities.) Deterministic analysis is the type of mathematical analysis that one finds in operations research, financial modeling and most planning disciplines. So to summarize, complexity is an uncertain situation not subject to deterministic analysis for lack of sufficient information about the inter-related variables.

What lead me to ponder the relationship between entrepreneurship and complexity was the fact that entrepreneurship is a classic example of the inter-related variables inherent in complexity. However, much of the analysis in entrepreneurship is deterministic. So how does one reconcile the uncertainty of complexity with the deterministic, mathematical analysis so common in entrepreneurship and business? Fortunately economic theory provides most of the answer. It just took me awhile to put it together.

If we think about entrepreneurship, we can break it down into two concepts—opportunity and execution. Opportunity or market opportunity sets the theoretical size of the company and execution dictates whether the company scales, fails or suffers along at below its potential. Execution can be further simplified to two basic  concepts—product development and sales. Effectively, the company needs to develop repeatable processes to source, manufacture and distribute the product. Repeatable processes also explain the approach to product/market fit initially and at scale, which allows the company to successfully satisfy the needs of the customer. These repeatable processes, what we can consider as optimization problems, are where the mathematical analysis applies. One could probably argue that if the process is not repeatable, the mathematical analysis would not be reliable. To put it another way, repeatable processes provide sufficient information to determine the accurate probabilities required for mathematical analysis. It all looks so deterministic, so where does the complexity come into entrepreneurship?

If we return to the product development-sales framework, product development governs the relationship with suppliers. As the entrepreneur adjusts the product for any of a myriad of self-interested reasons, the suppliers of goods or services are “shocked” in economic speak and forced to act in their self-interest. However, we lack information sufficient to determine how the suppliers may react and therein we find the complexity. In the sales framework, imagine the entrepreneur raises prices. We lack sufficient information to determine how the customers, the competition, the press and perhaps even the government will react. Again, the “shock” of the price increase allows complexity to manifest itself.  "Economic phenomena like prices are the unpredictable result of the complex mutual adjustment of millions of individuals" [1] acting in their self-interest.

The shocks described here are the normal shocks of supply-demand--the allocation of market resources--and the related information travels over a peer-to-peer network of linked individuals including suppliers and customers. This peer-to-peer network extends the shocks and the complexity and leads to what Brian Arthur at Santa Fe Institute calls the perpetual invention of the economy … and the entrepreneur. This perpetual invention would be called evolution if we were studying biology.

The next subject for me to explore is the role of networking in economic shocks. May have to go back and re-read Sandy Pentland's "Social Physics", an excellent book on how networks really work.

Further reading that influenced this article and my thinking on entrepreneurship and complexity:

1. Complexity Economics: A Different Framework for Economic Thought; W. Brian Arthur
2. The Capitalist and the Entrepreneur (Chapter 5, 6); Ludwig von Mises Institute (Available in PFD version)
3. Economies of Scale, Economies of Scope; Ribbon Farm; Venkatash Rao
4. Classical Liberalism: A Primer; Institute of Economic Affairs [1]

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We Need better Moderators

I have stopped doing panel discussions, but I am happy to be a moderator if the panelists are interesting. In the last two weeks I have watched several panels on very interesting subjects with great panelists that completely flopped. They all flopped because of the moderators. If you are moderating a panel my advice would include:

1. Research the subject of the panel well and invest equal time to understand the careers and thinking of the panelists
2. Refrain from introducing your own opinions. Nobody comes for the moderator
3. Do not under any circumstances argue with the panelists
4. If you do not have an insightful followup question, move on to the next planned question

Someone needs to provide a free training program for moderators.

My New Book on Social Entrepreneurship

I have been teaching social entrepreneurship for five years at FIU in the Honors College and at MIT Sloan, which was made possible in part by my 3+ years as CFO of One Laptop per Child (OLPC). OLPC was started by Nicholas Negroponte and faculty at the MIT Media Labs to provide every child in the developing world with a connected laptop. OLPC started as a donative non-profit but converted to a social entrepreneurship model in 2009. I joined to carry out this change in business model at OLPC.

Steven Weinberg, Nobel laureate physicist, says he teaches a new course to learn a subject. I do the same thing, but courses are better for organizing conceptual thinking and writing books I think is a better method to organize practical thinking. So when I think I understand the practical side of a subject, I write a book to confirm it to myself.

The first half of my new book, Scaling Social Entrepreneurship: Lessons Learned from One Laptop per Child, deals with defining social entrepreneurship. I do this in part by contrasting it with government, non-profits and NGOs. Two themes are developed in the first half of the book:

1. Social entrepreneurship is a better model to solve social problems than the traditional ways and increasing in popularity
2. Properly taught and modeled, over time entrepreneurship should not need the modifier "social" and the debate about the morality of capitalism can be put to rest

Organizing a social project is not particularly challenging, but organizing something that can scale to multi-country or Google scale is very challenging. In attempting such an effort one has to plan for worldwide coverage from the beginning. In traditional entrepreneurship, one gradually reaches the point of scaling after product/market fit and commercialization. In social entrepreneurship, early on one needs to find the model because lower operating returns and less startup capital do not give you the flexibility to iterate. This fact is even more true if you operate  as a non-profit.

The second half of the book is devoted to the business model to scale a social venture. I strongly recommend in favor of for-profit companies in order to have better access to capital markets. I believe evaluation needs to be baked in from the beginning because access to social impact funds is becoming increasingly competitive. I advocate that one try to establish a movement to support the social objective, something akin to Gandhi, Mandela and King. That may look like a difficult undertaking, but OLPC achieved that objective--worldwide 1:1 computing for children. Lastly, I cannot say enough about the importance of partners to a social entrepreneurship venture and I recommend private sector partners.

The book is available in both paperback and Kindle versions on Amazon. I would be happy to sign a copy of the book that you give as a gift. I also think it makes a fine introduction to social entrepreneurship for a corporation looking to transform its corporate responsibility program into something more substantive. 

 

Companies Need to Keep Learning

This video on Big Think describes corporate learning at IBM. Corporate learning is the company-wide method to provide lifelong learning to IBM employees. The program covers mostly current topics in IT but, of course, that is IBM's domain. Format appears to be a MOOC.

Most interesting part of the story is that the CEO established the program and teaches a course once a month. Leadership from the top makes the commitment and objective obvious.

I think that more formalized, high value corporate training will become a big business opportunity. The business environment is becoming more complicated as AI and Big Data are more integrated into day-to-day business. Companies are increasingly narrowing the range of their business expertise partly by relying on third party providers, which will require companies to be extremely vigilant in their area of expertise. Lastly, knowledge is doubling every 13 months, which means there is 8 times more knowledge every three years. Such a scale of growth in knowledge puts pressure on companies to help their employees to stay current.  

Simple Way to Determine New Business Concept Feasibility

SSIR has an interesting article, "Why Criticism is Good for Innovation". The article advocates the use of a rubric to evaluate new projects or products. A rubric is a scoring tool to evaluate criteria relevant to an analysis. The real value is that referring to the rubric reduces the risk that a comment is taken as a criticism, thereby potentially demotivating the creative type. The article does not suggest the outline of such a rubric, but I will.

For a new product or project, a rubric should evaluate the feasibility of commercialization. The factors that should be considered would include:

1. Market--size (based on bottom up methods) and growth rate
2. Customer--target customer, estimated customer acquisition cost and lifetime value
3. Competition--Company, products, pricing, features
4. Unit Economics--marginal product revenue and  cost (assumes production has been thought through)
5. Sales and Distribution--sales and marketing cost 
6. Investment to Cash Flow Breakeven 
7. Scaleability--can the execution strategy scale

Perhaps assign ratings of high, medium and low to reflect attractiveness or risk. Smarter yet, work on each factor until it has a high positive rating.

These factors should give one sufficient opportunity for feedback on objective issues such that one would never make the "criticism" personal. 

 

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Dormant Abilities Awakened for Creativity

I had lunch with a friend yesterday. He is about sixty and works as a corporate executive. He is a perfectionist in everything he does, which has included a wide range of interests from physics and violin to now painting. While showing me his paintings which are a combination of Escher and Monet and quite good, he mentioned that he was now seeing the world differently. He said he has found a new appreciation for color, perspective and shapes. After we talked about his new level of appreciation for things artistic, we tried to find an explanation for this appreciation. My friend said that "it must have been dormant" and now has awoken. I said that creativity is frequently a result of child like behavior and that he had returned to the natural state of a child. Even if schools or parents or environment have turned off the natural talents and interests of childhood, it appears some of us can turn the talent back on. My friend is very intelligent, intense about what he does and sets the highest standards for himself. I have not read anything about the conditions required to reawaken childlike abilities, but it would be interesting to hear similar stories. My hypothesis at this point is that perfection or precision is the trigger to reawaken the natural ability.

Understanding the Key Assumptions in a New Business

Peter Drucker, the leading management thinker of the 20th century, had a little noted idea referred to in HBR simply as "Theory of the Business". Basically Drucker believed that every company has two or three key assumptions that determine success or utter failure. These assumptions represent the biggest risks in the business, which I talked about in this previous post, Business Model Assumptions.

Drucker's way of thinking about critical assumptions is demonstrated well by this figure from the European Innovation Institute.

To launch the iPod Apple had three key assumptions, one of which was untested and two where other companies provided evidence to reduce the risk. I think we could apply Bayes Theorem to get a better understanding of the risk. 

At any point in the life of a startup, one could ask what are the 2-3 assumptions that have to be tested in the next 6-12 months. Powerful tool to bring focus to management. Also clearly highlights the skills and resources required to succeed.

 

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