Effectuation: Elements of entrepreneurial expertise
Saras Sarasvathy
This book explores how entrepreneurs† think about business problems and how this style of thinking might differ from conventional business thinking. The book is written by an academic for academics, so includes many details about how data was collected and interpreted. The book is very clear that this comparison can’t be framed in terms of better and worst; causal (conventional) and effectual thinking are approaches suited for two different situations. And, the distinction is probably more one of situational preference. Some entrepreneurs may prefer to think in ways that differ from the ways that people in conventional business think.
The central differences between the two approaches relate to beliefs about prediction and control, and the consequences of those beliefs. Conventional business believes that the future is generally predictable and that understanding risks allows for mitigation plans. Entrepreneurs believe that the future is uncertain, but susceptible to influence; the ability to change course allows uncertainty to be neutralized. Conventional businessmen seek data to justify investment decisions; entrepreneurs doubt the validity and usefulness of data to understand the future. Entrepreneurs tend to focus on products and markets that do not really exist yet, while conventional business serves existing markets with products familiar to customers††.
Causal problems are problems of decision: effectual problems are problems of design. Causal logics help us choose; effectual logics help us construct. Causal strategies are useful when the future is predictable, goals are clear and the environment is independent of our actions; effectual strategies are useful when the future is unpredictable, goals are unclear and the environment is driven by human action. The causal actor begins with an effect he wants to create and asks, ‘what should I do to achieve this particular effect?’ The effectuator begins with her means and asks, ‘What can I do with these means?’ And then again, ‘What else can I do with them?’*
Entrepreneurs appear to use 5 principles or mindsets that are different from conventional business thinking.
The bird-in-hand principle
Decisions are based on the means at hand rather than the goals. This means that there is not much attention on long-term goals as a motivator for decisions. Instead decisions are motivated by the type and amount of resources that are already available.
To illustrate the effect, an entrepreneur who is going to fix dinner looks in the kitchen to see what is available and creates a menu from ingredients in hand. A causal thinker decides what the menu should be and then buys anything not already available. Both approaches are effective, but they usually create different outcomes.
Entrepreneurs seem to have three types of means: identity, knowledge and social networks. Many entrepreneurs start from who they are; how they see their interests, values and role. Entrepreneurs prefer to develop concepts that mesh with their own knowledge, which is unsurprising. One of the major discoveries in this research was the important roles that an entrepreneur’s social network plays in both choosing which concepts to develop and how the concepts were developed.
The affordable loss principle
Investment decisions are made based on the ability to lose the investment rather than based on the expected returns. A prediction is required to estimate returns, but there is no prediction required to estimate what you already have. If causal mindset is based partly on the best possible case, effectual thinking is based on the worst case – a total loss.
It is commonly thought that entrepreneurs are risk seeking, but this seems to be untrue. They can be very conservative and frugal. On the one hand, they are willing to lose “everything” that they can afford to. On the other hand, they know that they need to husband their resources to cope with uncertainty. This leads many to seek out others who can invest something in the venture to forestall spending. These investments are usually in the form of an underutilized or cost-free resource. Examples of this kind of investment might be shelf space in a store, introductions to potential customers, unutilized production capacity or unnecessary materials.
The crazy quilt principle
Activities that take advantage of stakeholders willing to make actual investments are more important that competitive analysis or opportunity costs. Entrepreneurs often start by seeking a variety of partners who can commit useful resources to the venture. They tend to pay almost no attention to market research or competitive analysis. As mentioned above in affordable loss, entrepreneurs seek commitments from potential stakeholders in order the increase their resources. A key feature of this principle is that stakeholders are taken in a kind of first-come-first served basis. Somebody willing to commit now is more important than somebody who may commit later. This aspect links to the bird-in-hand principle.
Part of what makes this a crazy quilt is that the entrepreneurs appear to spend little effort on competitive analysis and so do not appear to worry much about which stakeholders would be most advantageous. This is part of an assumption that their venture does not have any specific competitors because the venture is new. Thus an outsider would look at the web of connections and struggle to see the logic of who was included or excluded. It would not be obvious how some stakeholder conferred competitive advantage, which would correctly reflect the fact that competitive advantage was not a criteria for inclusion/exclusion.
The lemonade principle
When given lemons, make lemonade. Startups always have surprises, and entrepreneurs spend little effort trying to avoid them and more effort finding some advantage in the surprise. In this sense, failures and surprises are resources that allow you to learn more about reality. Never underestimate seridipity….in these types of situations, the traditionalists…the M.B.A. from…Harvard would confine themselves to certain paradigms that existed before. The entrepreneur would break the paradigm.
Thomas Stemburg ran out of the printer ink on the weekend that he needed to print his new business plan for a grocery store. He could not find on open store that carried the right ink and he realized that small business people could not get office supplies easily. He went on to found Staples. Tom Fatjo’s neighborhood association was having trouble getting their garbage picked up. He borrowed some money to buy a garbage truck and collected garbage before work. He eventually quit his regular job to found Browning-Ferris Industries.
The pilot-in-the-plane principle
This principle reflects the fact that entrepreneurs believe in the importance of people. The term comes from an explanation about machine intelligence. Airplanes have an autopilot. If you ask passengers what they think about using the autopilot, they will say that they like that there is an autopilot, but just as important to them is the fact that there is a pilot too. If the autopilot is good at handling the routine and methodical, the pilot can respond creatively to the unexpected.
An example of the importance of the pilot-in-the-plane is found in new product design and development. Human creativity and adaptability is required to navigate the suicide quadrant and this is the prime domain of entrepreneurs. A number of entrepreneurs interviewed in the research indicated a preference for this quadrant. In their opinion, a predictable quadrant would give bigger or smarter companies an advantage, but those same companies would shy away from the uncertainty that a small company would be willing to try.
Together, this set of principles can be thought to be the foundation of effectuation. The author created this word as a contrast to causation. In the causation world view, the focus is on discovery and control of causes in the belief that this will have the best chance of reaching a goal. Effectuators do not believe that the future is that predictable; rather than predict the future, reaction to the unexpected is most important. Effectuators see the world as open and emergent; actions by people can change the future. Markets are created - not found. Causal thinkers believe that ‘To the extent that we can predict the future, we can control it’. Effectual thinkers believe that ‘To the extent that we can control the future, we do not need to predict it.’*
The semantics of risk and uncertainty play an important role in the thinking of entrepreneurs. The distinction between these two terms can be understood by thinking about cutting cards. If you cut a standard deck of cards, you can calculate the probability that another cut of the deck with result in a higher card. The outcome is strictly controlled by the mathematical probability (assuming no cheating) – this is risk. When you play against the house in Las Vegas, you experience risk. Two ways to think about uncertainty can be illustrated. First, imagine that the deck is non-standard; perhaps it has more or less than 52 cards and that the distribution of cards is not the normal one (there are 93 cards that include 10 9s) but you do not know this. You can’t calculate probabilities so you are uncertain about the chance to draw a higher card. Another case of uncertainty arises when you are playing against a person. Suppose you are playing poker and have 3 kings. You can calculate the odds that another player has a better hand, but as betting proceeds you do not know whether the other players is betting because he has a good hand, is ignorant about their chances, or betting as a form of bluff. The possibility of bluffing makes the outcome uncertain. There are many situations where there is no valid basis for classifying instances. Some other examples of uncertainty are: predicting earthquakes, future stock prices, outbreak of war and new product acceptance.
In a business setting, Coca-Cola provides another comparison. Coke has offered many price reductions in the past. If they were to offer 10% of the standard price, they can calculate reasonably well how much sales with increase. It is not a perfect prediction and the variation from time to time represents the risk. In contrast, when Coke introduced New Coke, consumers reacted very badly. Coke had done substantial consumer testing and thought that they faced some risk of consumer rejection. In fact, the intense consumer reaction was not predictable and the product was withdrawn. That is an example of uncertainty. Entrepreneurs believe that most new ventures are uncertain. No amount of data collection can decrease the uncertainty, so seeking that information wastes resources and probably misdirects the effort.
The subsequent question must be whether a potential new market exists (and thus is governed by risk) or is emerging (and thus is governed by uncertainty). This is not always obvious. When Starbucks was beginning did a market exist for coffee shops? By one definition, the answer was yes. You could go into many places and buy coffee. By another definition, the market was empty. There were practically no coffee shops where you could choose a variety of coffee drinks and comfortably sit and have a conversation. Was the data from coffee shops relevant to the Starbucks concept? In fact, the market data related to coffee at the beginning of Starbucks was quite negative with coffee consumption in a long term decline. Starbucks rescued the entire coffee industry by redefining the coffee experience. One doing a risk assessment would never have invested, but one doing an uncertainty assessment would have seen the opportunity to escape the existing market with a new offering. This illustrates a problem with prediction in uncertain environments – you can’t know which information is relevant until after the fact. In high predictability environments, the right information can be chosen based on history. This is not true in uncertain environments.
Nothing makes a market more uncertain than the possibility of changing as a result of human action. An example of this phenomena is the commercial evolution of the internet. Originally, a data communication network for researchers, there were many possible ways that the internet could evolve. Might it have been different if Microsoft had introduced a browser before Mosaic/Netscape? What would have happened if consumers had rejected buying books online? We can never know the answer to this sort of question. But if entrepreneurs can’t trust market data and prediction methods, how can they cope with the uncertainty of the real world. An important part of the answer is based on their means – specifically their social networks.
Sarasvathy proposes the following cycle of market exploration.
- Determine the means (who I am, what I know, whom I know)
- Set a preliminary goal for the venture – given the means
- Connect with people who might help reach the goal
- Gain commitments from stakeholders
- Gain new means (return to step 1) OR set new goals (return to set 2)
At some point, there will be sufficient means to achieve the goal and a new market will come into being. This cycle represents a kind of learning-by-doing rather than learning-by-analysis. Earlier in this summary, it was indicated that entrepreneurs did not start from goals, but means. This does not mean that goals have no place in the cycle – just that they are not the primary driver of action. The key action in this cycle is the stage of gaining commitment from stakeholders; people who are not making commitments have no role. For example, a non-customer or non-supplier has no input, influence or role in the venture. In other words, the venture exists for actual customers much more than for possible customers. Early stakeholders have enormous impact on the direction of the venture, often changing it completely. As the venture progresses through cycles of development, it solidifies and the scope for leverage by new stakeholders decreases. Negotiation, when a concept is being exploited, is quite different from when it is being developed. Interestingly, entrepreneurs often defer discussions related to dividing up the gains from a venture until the exploitation stage is reached. Rather than being focused on the returns, entrepreneurs remain focused on means until the venture is no longer means-limited.
Starting from means instead of goals, then modifying the approach has some interesting further implications. One implication is that a means-oriented person actually gets more chances to develop a viable concept because they are not wed to the goal. If the first idea looks weak, the firm can move to another idea. In contrast, a goal-oriented person will struggle to abandon the goal when evidence suggests that the concept was flawed. Thus a fixed amount of means may allow two or three attempts to discover/create a market. Being means-oriented results in a stronger urge to husband and develop means, which results in longer survival times.
The author teaches a class in entrepreneurship where an assignment is to develop and launch a business. One student started to develop a business to help obese people lose weight. He did some market research that showed that there are a large number of obese people, but that fewer than 20% of people who lose weight can keep it off. He interviewed a number of business that sought to serve this population but had gone out of business. During a mid-term report, this student had decided to give up on the idea. When the idea was presented to the class early in the course, most students thought it was a poor idea. You would think that the confirmation that this was a tough business would confirm the early assessment (it was a lemon). Instead, three students immediately asked if they could take over this idea (make lemonade). Asked why, students offered observations like:
- If 20% succeed, raising that success rate to 30% is a huge competitive advantage (50% better) and that does not seem that hard
- Obviously there is an unmet need if all these companies are trying but maybe they are offering the wrong services
In other words, the barriers to the concept increased these students perception that the venture could succeed. One of the entrepreneurs in the research made the point that success was a process. “We fail all the time. The key is to know that success is a process and not an outcome. And failures are essential input into that process”.
There are a number of concepts about what “creates” entrepreneurs. One concept is that entrepreneurs are entrepreneurs due to a set of personality traits. It is their intrinsic personality that leads them in this direction. Many books attempt to compile lists of traits and behaviors common to entrepreneurs with the idea that we can adopt these traits and become entrepreneurs. The problem with this approach is that failed entrepreneurs often have the same traits. A further problem is that there are many successful entrepreneurs who display different traits. One alternative, is that the most important driver is market opportunities. Once the opportunity is recognized, a bit of creative thinking, logical action and luck leads to success. In this view, the environment is most important. It is this perspective that leads governments to create policies, programs and incentives to improve the environment. There is little indication that these incentives have any useful effect. A final concept is that entrepreneurial action is a matter of skills that can be learned in a straightforward way. This seems to be the author’s bias, but with a twist. She suggests that anybody can be an entrepreneur, but different people will become different kinds of entrepreneurs. A useful question in this regard might be ‘Given who I am…what kind of entrepreneur can I become? Given the circumstances…what kinds of entrepreneurial activities can I engage in? ‘
There is an idea that entrepreneurs are better at recognizing opportunities than others. Academics have attempted to determine how opportunities are found and exploited, but there is scant evidence that entrepreneurs have superior insights compared to other business people. An alternate concept is that the entrepreneur does not find the opportunities - they create them. Perhaps they “repair” something done by an earlier entrepreneur. In this sense, effectuation is a bit like the scientific method. It is a logical system that has a generally productive effect in solving certain kinds of problems. It is not for everything, but it is good for creating opportunity. This is closely linked to the idea of an emergent world (a world in the making) rather than a fixed world. But the world in the making is not idealized in any way. In fact, entrepreneurs and effectuation are pragmatic approaches to uncertainty.
The pragmatism is exemplified by one story about Ebay. Pierre Omidyar has been given credit for developing a very robust computer system to run auctions that seems to be self-sustaining. He is credited with a kind of genius foresight. Omidyar describes it differently. When he was developing the system, he had a regular job and wanted his weekends free for other things. He made the system so he would not need to spend much time minding it. A purely practical personal consideration led to a self-sustaining system.
The pragmatic approach is forward looking. Two phrases capture the effect of backward and forward looking approaches. When we analyze the past, we treat our assumptions “as if” they were testable and lead to predictable outcomes. In contrast, the phrase “even if” suggests that other outcomes are possible. Everybody acts as if product launches are difficult. Even if most product launches don’t work like we’d prefer, there are people who want the product and may sustain the business. It is hard to look backwards to find possibilities. Looking forward, it is possible to imagine designing an offering that will be valued by some even if it does not appeal to everyone. Pragmatically, it makes no sense to go into this uncertain situation too highly committed, but it makes perfect sense to test the opportunity through prototypes and partners.
Sarasvathy’s student often conclude that effectual thinking means not doing any research or planning. This is incorrect. Some other misunderstandings include:
- Effectuation allows an anything goes approach similar to the anything goes creativity concept. Instead, effectuation is another process – not “no” process.
- Effectuation means you don’t need to think about the numbers. Instead, effectuation does not invalidate useful data or logic. Effectual thinking is most useful when uncertainty is predominant. Affordable cost decisions very much require attention to the numbers
- Effectuation is an irrational/intuitive approach. Instead, effectual thinking involves different assumptions and logic, but it is a logic. Effectuation is a guide to decision making under the condition of uncertainty.
- Charisma and effectual thinking go together; you need some charisma to be effective. Instead, entrepreneurs may tell their stories in ways that emphasize their personality’s effect, but their decisions indicate a consistent pattern of framing and acting.
- Effectual thinking requires passion or is another term for passion. Instead, effectuation is a process and the entrepreneur may be passionate about their process. Many stories can be found of entrepreneurs who were more passionate about starting a business, any business, than about making a particular business concept successful. They are pragmatic, not idealists.
- Effectual thinkers are unafraid to embrace risk. Instead, the process of effectual concept creation is actually rather risk averse in the context of uncertainty. Risk is minimized by capping the loss and transferring risk to partners as quickly as possible.
- Effectuation is just a set of entrepreneurial traits. It is easy to imagine that some people are effectual and others are not. Instead, the author has compared beginning and experienced entrepreneurs and found that effectuation is more prevalent as experience increases. This suggests that it is learned.
- Effectuation insures success. Instead, nobody wants to fail so everybody does the best they can. There are numerous examples of experienced entrepreneurs that “failed” in a venture after their initial success in the sense that the venture did not make money. Most of these entrepreneurs had the resources to try again and again thanks to their ability to husband resources, use partners and limit their exposure. Most ventures fail, whether well-conceived or not. Effectuation is a way to make decisions that give a concept its best chance.
As an illustration of some elements of effectual thinking, here is an example based on an examination of the development of Starbucks by Howard Schulz. Coffee drinking had been declining for 20 years; consumption was down more than 30%. There was little sense of a premium coffee experience. The original Starbucks was founded by 3 guys in 1971; it sold premium roasted bean, tea and so forth – but not actual hot coffee. The founders really started this business because they wanted good coffee and they could not find it; the business was based on their own needs and not market analysis (which would have told them that demand was falling). Schulz worked at a housewares supplier. On a trip to Italy, he discovered a different coffee experience and thought that Americans would like it to. He was aware of Starbucks and went to them with his idea for Il Giornale – an Italian coffee shop where servers wore bow ties, served expresso in a space where opera music played constantly. Schulz approached 242 potential investors, of which 25 were willing to invest. In particular, the Starbucks owners would not convert their business into an Italian coffee house, but did provide some funds and advice. Il Giornale launched and Schulz soon discovered than bowties were a nuisance, Americans had a limited appetite for opera, wanted some flavored coffees, and expected to have comfortable chairs if they were going to stay around for long. The store changed in response to this feedback by eliminating the ties, adding chairs and more musical variety, BUT did not add flavored coffees. The flavored coffee seemed inconsistent with a focus on good coffee. By 1987, Schulz had changed from the original Italian coffee concept to something better suited to American tastes, merged Il Giornale with Starbucks and began the process of expansion. Schulz was not a retail expert but wanted to run his own business (start with who you are). He entered a market that said demand was falling (don’t give too much credit to predicting the future), and started a failed concept with a small number of stakeholders some of whom would provide advice and resources (crazy quilt and affordable loss). His original concept received both positive and negative feedback that incorporated into a different concept (lemonade). One of the interesting choices that Schulz made was to own the shops – not to sell franchises. Part of the entire concept was the barista who personally prepared the coffee for the patron. This person was not just a part-time worker; they were professionals who upheld the standards of the company and symbolized the commitment to quality and service. The commitment to this role is an example of the pilot-in-the-plane; the barista controls the customers experience and thus maintains the value proposition. After the fact, it is hard to reconstruct what Schulz was thinking all along the way, but the outcomes and story seem consistent with some effectual thinking during the process.
† The book describes effectuation almost entirely in the context of entrepreneurship, but Sarasvathy thinks that other professions may include people who use this approach. Prototyping, as done by designers and product developers might be one example. Some investors may also use this mindset.
†† Throughout, the book (and this summary) treats the causal and effectual worlds as complete contrasts; entrepreneurs actually use both styles of thinking – depending on the circumstances. Non-entrepreneurs do not use these effectual principles to the same degree. Entrepreneurs often shift between effectual and conventional mindsets depending on the situation. Effectual thinking is more prevalent early in a venture and causal thinking more prevalent near maturity.
Comments and interpretation:
- I have been thinking about the expression of risk and uncertainty for a while because I have been aware that most future predictions were just guesses with convincing stories. Having participated in a number of prediction exercises, I realized that they were based on weak data. Lots of people have commented on the induction fallacy (Silver, Taleb, and Kahneman). Managers want more risk analysis and mitigation plans and this is not unreasonable. The problem is that it is rarely the risks that we identify that cause us trouble. Our problems arise from uncertainties and we can’t practically identify and resolve. Sometimes the only way to know is to do. This has led me to think in terms of reducible and unreducible uncertainty. Some exploration of what could go wrong is very useful, but there will be a limit to how much uncertainty can be identified or mitigated. To use another expression, we need to know that there are “unknown unknowns” out there, but we can only, maybe prepare for the “known unknowns”. The majority of truly innovative work lies in the domain of uncertainty. Incremental change is the domain of risk and risk management. Methods for risk management will do little to deal with uncertainty.
- Bob Thomas and I began to study project management with an eye of the question “when was project management useful and when it was not useful?” We decided that project management was most useful when both the goals and approaches to achieving something was clear. It was less useful, and maybe counterproductive when either the goal or the approach was up in the air, but the general direction was clear. Back then, we decided to call it program management and we identified a few principles. One was that a program manager was always very interested in their current situation. What did they know right with respect to moving in the right direction? Second, a program manager’s job was to get the most that they can from a fixed set of resources – they started with the resources and acted based on that. This is similar to the bird-in-hand and affordable loss concepts described here. We did not come close to the other principles in our thinking, but this book has made me realize that we were touching on how to lead transformational projects. By almost any definition, a transformational project in entrepreneurial in nature and loaded with both uncertainty and risk. Thinking and decision making in projects and programs would be very different.
- The book contains a number of comments that are hard to fit into the narrative of the summary. One such comment relates that a lot of energy has gone into the concept of a “sustainable competitive advantage” and the associated strategy. No such silver bullet has been found. The author notes that the logical consequence of a sustainable competitive advantage would be a monopoly, and ultimately an economy of monopolies. It is not clear whether the failure to find sustainable advantages arises from the uncertainty of the world (unpredictability) or the impossibility of sustained strategy. Either way, companies dominating a market may encounter times when they must use a more effectual/adaptive approach to cope with unexpected circumstances.
- Discovery and big-R research both seem to fit with effectual thinking. One of 2014’s Nobel Prize winners in Chemistry had a very effectual experience in developing a new method and device for microscopic examination of biochemical phenomena. See: http://www.npr.org/2014/10/08/354639749/chemistry-nobel-given-to-scientists-for-work-on-optical-microscope .
*text in italics is quoted directly from the book
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