Economics and Finance

Risk Recognition and

Investor Readiness
Business Mortality Risk
Most new business ventures fail
It is estimated that 90% fail within five years
Even for large firms, many new products and
services turn out to be failures
E.g. The New Coke fiasco
E.g. Nikes MP3 player
E.g. Segway Personal Transporter?
What can we do to mitigate this risk?
Business Risk
Business risk
The variability of profit outcomes over time
Drives stock prices up and down, depending on
variance from investors expectations
The risk of financial failure (bankruptcy)
i.e. the non-survival of the new venture
The liability of newness
New firms need to learn how to become an efficient
and effective business entity
Risk Attitudes
Risk Preference
You would seek the riskiest alternative*
Risk Neutrality
Risk does not bother you*
Risk Aversion
You would choose the less risky alternative*
Risk aversion comes in different degrees
Low risk aversion = High risk tolerance
High risk aversion = Low risk tolerance
* Other things (particularly rewards) being equal
Are Entrepreneurs Risk Tolerant?
Strong presumption that entrepreneurs must be less risk
averse since they bear high risk
But consider the risk-return trade-off
And did they foresee the risk before they jumped?
Risk perceptions may have been inaccurate
Studies show conflicting results
Some show risk aversion as significant, while
Others find risk attitude an insignificant determinant of
entrepreneurial behaviour.

Brockhaus, R.H. (1980). Risk taking propensity of entrepreneurs, Academy of Management

Journal, 23(3): 509-520.
Busenitz, L.W. (1999). Entrepreneurial risk and strategic decision making, Journal of Applied
Behavioral Science, 35(2): 325-340.
Risk Perceptions
Clear-lens effect
More knowledge of market & technology
Which causes greater Self-efficacy
Due to greater relevant education and experience
Rose-lens effect
Over-confidence
They see the risk but expect to be able to handle it
Blue-lens effect
Use simple decision rules (heuristics)
That do not consider all information
And thereby they do not see some of the risk
Risk Perceptions
Yellow-lens effect
Urgency for first-mover advantages
Aversion of risk is outweighed by preference for the income associated
with first-mover advantages
Purple-lens effect
Involvement in the process intrinsic benefits
Disutility due to risk is outweighed by utility gained from being involved in
the entrepreneurial process
being recognised as the first mover
feeling a great sense of achievement
Framing Effects
Framing influences decision making
70% chance of success
Entrepreneur perceives it as less risky, but if you say
30% chance of failure
Entrepreneur perceives it as more risky
Prior experience affects risk-seeking
If things are going well, decision-maker exhibits risk averse
behaviour (to protect prior gains)
If things are going badly, decision-maker acts more aggressively
(to try and capture some gains)
Tversky, A. & Kahneman, D. Judgement under uncertainty: Heuristics and biases. Science, vol.
185; pp.1124-1131.
How do we reconcile this?
Entrepreneurs exhibit a range of risk attitudes
From highly risk averse to highly risk tolerant
Entrepreneurs typically underestimate risk
Due to a combination of cognitive biases and the use of heuristics
After the fact, they discover how risky it is
Then they choose to soldier on and bear the risk
Even if they hate risk, they would hate failing more
Those who are highly risk averse AND who perceive risk well,
may not become entrepreneurs
Conversely, the risk tolerant and non-perceptive might!
Sources of Business Risk
Industry-based risks (Porters Five Forces)
Buyers, Sellers, Barriers, Substitutes, Rivalry
These can appropriate your surplus
Resource-based risks
No VRHN resources initially
Unable to keep them VRHN
Unable to build VRHN resources
Ignorance-based risks
Lack of knowledge/information
Ignorance about the customer, production processes,
and management processes
External Sources of Risk
Porters unattractive industry analysis
Buyer power
A single buyer (or cartel) can exploit you
Supplier power
Single supply source (or cartel) can exploit you
Barriers to entry
Lack of, allows newcomers toe easily compete
Substitute technologies
If offering value (V = Q/P) can replace you
Rivalry
Rivals compete on price or quality, repressing margins
Strategies to reduce external risk
To reduce buyer power?

To reduce supplier power?

To raise barriers to entry?

To stay ahead of substitutes?

To minimize rivalry?
Resource-Based Risk
Lack of resources that are initially VRHN
Me-too offerings face quality risk
And switching costs (obstacles to adoption)
Inability to maintain VRHN of resources
Rivals appear, having imitated your (previously) rare
resources
Substitutes appear, rendering your (still) rare
resources unnecessary & irrelevancy
Inability to build VRHN resources
Reputation, Organization, Culture, Networks
Strategies to build VRHN Resources
Strategies to avoid Imitation
Make your initiatives hard to copy
Service culture (speed, problem solving, flexibility)
Productivity (depends on skills, attitudes, motivation)
Networking and relationship building
Complex human interactions
Strategies to avoid Irrelevancy
Keep substitutes at a distance
Identify, Evaluate, Monitor, Act
Sustaining technological improvements
Maintain your value propositions superiority
Ignorance causes risks
Ignorance = Lack of knowledge
Knowledge may be out there, or yet to be
discovered
Novelty of new ventures means much information is yet to be
discovered
Some might be predictable from experience but other information
may be unknowable in advance
Ignorance means outcomes cannot be predicted
with accuracy
Foreseen (probabilistic) outcomes vs. unforeseen
Risk vs. Uncertainty
The dimensions of ignorance
Consumer Ignorance
Lack of knowledge about the new product, its availability, price,
quality, how to use it, what benefits it offers, etc.
Producer Ignorance
Lack of knowledge about the production process for the new
product, leading to cost blow-outs, quality variability, materials
wastage, etc.
Manager Ignorance
Lack of knowledge about management skills needed for this
product in this market at this time
Investor Ignorance
Strategic Risk Reduction

MORTALITY RISK

Pure Mortality Risk Curve

Strategic Mortality Risk Curve
30%
20%
10% Best practice

TIME
Consumer Ignorance Reduction
Advertising and promotion
Personal selling
Free samples, miniature packages
Direct marketing
Free lessons to learn how to use new product
Gaining publicity, press reports
Comparative tests (e.g. in magazines)
Celebrity endorsements
Licensing (sell under known brand name)
Joint Venture (associate with known brand)
Producer Ignorance Reduction
Hire educated, skilled, experienced people.
Training sessions for new employees.
Poach employees from other firms.
License rather than manufacture.
Subcontract manufacturing (initially?)
Enter by acquisition (rather than start-up from
scratch) to acquire expertise.
Active listening (to glean information).
Management Ignorance Reduction
Hire well-educated experienced managers
Executive development training sessions
License or sub-contract weak areas
R&D, marketing, manufacturing, distribution, etc
Enter strategic alliances, joint ventures
Take insurance
Cash conservation practices
Overcapitalization. Get lines of credit