The Affordable Loss Principle

Abstract

Ideal for a study of entrepreneurship as a phenomenon, this note explores the difference between causal models and effectuation. Whereas causal models focus on maximizing returns by selecting optimal strategies, effectuation begins with a determination of how much one is willing to lose and leveraging limited means in creative ways to generate new ends as well as new means. The effectuator then uses the very process of building the venture to bring other stakeholders on board and creatively leverages slack resources available in the world. At each stage of the process he or she chooses options that create more options in the future.

Excerpt

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THE AFFORDABLE LOSS PRINCIPLE

Causal models focus on maximizing returns by selecting optimal strategies. Effectuation begins with a determination of how much one is willing to lose and leveraging limited means in creative ways to generate new ends as well as new means. The causal entrepreneur calculates up front how much money he or she needs to start the venture and invests time, effort, and energy in raising that money. The effectuator, in contrast, tries to estimate the downside and examines what he or she is willing to lose in order to start the venture. He or she then uses the very process of building the venture to bring other stakeholders on board and creatively leverages slack resources available in the world. At each stage of the process he or she chooses options that create more options in the future.

Estimating what is affordable does not depend on the venture but varies from entrepreneur to entrepreneur and even across his or her life stages and circumstances. By allowing estimates of affordable loss to drive their decisions about which venture to start, effectuators do not need to depend on any predictions. To calculate expected returns, we have to estimate future sales and possible risks that constitute our cost of capital, and then raise enough money to make the venture happen. To calculate affordable loss, all we need to know is our current financial condition and a psychological estimate of our commitment in terms of the worst-case scenario. This is not only a nonpredictive mode of estimation, it also is a way to nullify the role of uncertainty in early-stage funding decisions.

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Keywords: entrepreneurial decision making, risk management, expected return, new venture investment, opportunity costs, the plunge decision