People are not rational economic actors -- and entrepreneurs are among the most irrational. Consider the ridiculously long odds of creating a successful startup. Someone has a 1 in 5 million chance of starting a company and boosting its value above $1 billion. Given these long odds, an entrepreneur should really invest only $200 in his or her startup.
Of course, determined entrepreneurs invest millions in their ideas -- and most who do lose all the money they invested.
Why are entrepreneurs so irrational? What can entrepreneurs do to boost their odds of success? Of course, entrepreneurs, who are passionate about their ideas, think they can beat the odds. And indeed they can boost those odds by making three hard choices.
All these ideas came to me after my session last week of my "Foundations of Entrepreneurial Management" class at Babson College. The 30 undergraduates, split among five teams, were tasked with developing business ideas aimed at relieving human pain. Each student had to spend two hours observing that pain in the wild.
Before I tell you the three odds-boosting choices the students faced, consider a bit more about why a rational person should not invest more than $200 in his or her startup.
First off, there's the idea of expected value, a way for someone to make decisions like whether to invest when the outcomes are uncertain. Expected value is calculated by multiplying the probability of an outcome by its payoff. Simply put, expected value helps someone calculate how much to pay for the ticket that provides entry into a particular game.
What's the expected value of the typical startup? Drawing on my interviews with venture capitalists Peter Bell and Mike Maples for my book Hungry Start-up Strategy, I came up with this estimate:
A venture capitalist might speak with 1,000 entrepreneurs a year and invests in perhaps only two of their companies, according to Bell. Moreover, the odds that a funded startup will be worth at least $1 billion are 1 in 10,000, according to Maples Jr. Multiply $1 billion by the probability of gaining venture capital and achieving a $1 billion valuation (1 in 5 million). Thus a startup that's not funded has an expected value of $200.
To be sure, these numbers have not been derived from exhaustive statistical research of all startups but rather based on the opinions of people who know what they are doing. And even if these figures are off by a factor of 10, the very low odds of success suggest that entrepreneurs are basing their calculations on something other than pure economic logic.
One of the biggest reasons that people start companies stems from their deep passion for the problem that their startup is aimed at solving. The founders of one startup I knew closed up shop after working on a problem for 14 years and pouring millions into trying to make the company a success.
Another startup raised $5 million from family and friends based on the CEO’s conviction that once he built his business, its mere existence would lure customers. But after the company's creation, not many buyers materialized because the venture was not aimed at solving a problem of great customer importance.
And so for my recent class, I asked students on each team to develop business ideas they were passionate about. Then I asked them to observe people who might become customers of their company. This was done so that these aspiring entrepreneurs could repeatedly see how their business ideas might solve real problems.
Some students went to Boston's Logan Airport to observe passengers awaiting departure. The students noticed that many passengers pulled around their wheeled luggage while seeking a place to sit -- often to no avail. So the students developed a clever solution: wheeled luggage with fold-down seats on the side.
Yet these students like many an entrepreneur had to successfully maneuver three difficult choices:
1. Be passionate about the problem to be solved.
Displaying passion is important but not enough. Passion is the only thing that can compel a person to work 80 hours a week for years at low pay to make a venture successful.
Yet as the above examples suggest, passion can keep someone on the wrong road a long time. The would-be entrepreneur is not deterred by market signals suggesting he's wrong. From relying on passion alone, he or she will run out of money and be in a bad position to raise more.
Entrepreneurs must be passionate about the problem they are trying to solve but open to market signals that might cause them to change their ideas.
2. Find others who share the pain that prompted the company's start.
Plenty of entrepreneurs fear diluting the purity of their great ideas that they're convinced will better the world. So while developing their ideas, they don’t like to speak to potential customers or observe them in their natural habitat.
Many entrepreneurs find it hard to subject an idea to the bracing reality of the marketplace because they'd be in danger of learning it might not be as good as they thought. But running a startup is not for the thin-skinned.
As an investor, I'd rather bet on a CEO who tries to ensure there's a match between his product or service and a widely shared unmet need. The entrepreneur who sets out to prove a match exists by talking to customers has a greater chance of success.
3. Be sure the opportunity area is one the founder is qualified to tap.
Even if the entrepreneur is passionate about solving a problem and other people seek its resolution, this hardly means she's the best person to solve it. The founder might have to hire someone better suited at turning the idea into a product.
If you lack any key skills to tap the opportunity -- for example, my students had the idea for an international SIM card for smartphones but lacked the technical ability to build a prototype -- then skip the opportunity. Find an opportunity for which you have the key skill required to capitalize on it and build a team of people who complement you so that your enterprise has all the skills needed to succeed.
But if someone is unwilling to make these three tough choices, he or she would be irrational to invest more than $200 in the startup.