Entrepreneurial risk
Timothy B. Folta
Entrepreneurship has long been linked with the concept of risk. Scholars have viewed risk as fundamental to the entrepreneurial function, and the entrepreneur’s ability to tolerate risk as central to the formation of new ventures. How ever, these views are not held by all, and there remains considerable debate about the relation ship between risk and entrepreneurship. On a fundamental level, a precise definition of entre preneurial risk has been elusive. This confusion may hamper discussions around the role of risk in entrepreneurship. In this essay, we set out to entrepreneurial risk 111 illuminate the discussion around entrepreneurial risk, beginning with some ideas about its defin ition.
A Starting Point for Understanding Entrepreneurial Risk
Economists conceptualize risk as unanticipated and unpredictable movements in a variable of importance, typically income or revenue. The more volatile and unpredictable sources of income are, the riskier income is generally con sidered to be. From a statistical point of view, economic risk is generally measured as the vari ance of the probability distribution, or more appropriately, by the variance as conditioned on prior trends in the data. This latter correction adjusts for the situation where variance is pre dictable based on prior trends. (This advance ment is the basis for the 2003 Nobel Prize in Economics won by Robert Engle.)
The concept of risk is central in early defin itions of entrepreneurship. For example, Rich ard Cantillon (1680–1734) described the entrepreneur as someone who reduces risk for others by taking it on him or herself in the form of a fixed price contract over time. The entre preneur bears the risk caused by price fluctu ations in consumer markets, while ensuring workers or suppliers by buying their products or labor services for resale before consumers have indicated how much they are willing to pay for them. If they guess right, they enjoy a surplus or profit; if not, they suffer a loss. H. K. Mangoldt (1824–68) brought the element of time into the equation of risk bearing, suggesting that the longer the productive process, the risk ier would be the entrepreneurial function.
Frank Knight (1921) distinguished between risk and uncertainty as part of his analysis of profit and its origins. Knight adopted the reasoning that profit arises because people do not have perfect knowledge about the future. Whenever anything happens to make outcomes not match expectations, then the revenues from the goods will not equal costs, and profit may occur. The profits accrue to those parties willing to take on chance. In Knight’s formulation, the economic implications of risk, which is measur able, and uncertainty, which is not, are decidedly different. Since risk can be quantified, entrepren eurs can make arrangements to ‘‘insure’’ them selves against it, but doing so will eliminate any profit potential.
We submit that it is worth considering under what conditions the distinction between risk and uncertainty is meaningful. This distinction be tween risk and uncertainty is somewhat artificial, since uncertainty represents a problem of ‘‘knowledge’’ of the relevant probabilities, not of their ‘‘existence.’’ Moreover, one might argue that there are actually no probabilities to be ‘‘known’’ because probabilities of future events are really only ‘‘beliefs.’’ Moreover, Knight’s claim that risk should be inconsequential faces challenges on several fronts. Years after Knight’s original treatise, it was pointed out that unsys tematic or idiosyncratic risk is the type of risk that can be diversified away (Markowitz, 1952), so systematic risk is what should be pertinent to owners of assets. However, relative to the owners of corporations, entrepreneurs may find it diffi cult to diversify away risk that is unique to their venture, perhaps because of information prob lems or limited access to financial markets. Thus, it seems that entrepreneurs should be concerned about both (unsystematic and, in most cases, systematic) risk and uncertainty, as defined by Knight.
What do Entrepreneurs Risk?
The implication of the previous discussion is that the entrepreneur risks something in the event profits turn out worse than expected. This claim is not universally held. For example, Joseph Schumpeter did not view the entrepren eur as a risk bearer. In Schumpeter’s view, the financial intermediary who lends the funds to the entrepreneur is the risk bearer. Some defin itions of entrepreneurship are careful to point out that an entrepreneur need not own the re sources of the firm, and hence, is not at risk of losing them (e.g., Stevenson et al., 1999, define entrepreneurship as the pursuit of opportunity without regard to resources currently con trolled). At one time, one might have argued that an entrepreneur’s reputation is ‘‘at risk,’’ but many now view failure as a ‘‘badge of cour age.’’ Thus, one must be careful in identifying to what extent resources are ‘‘at risk.’’
In every case the entrepreneur risks the op portunity costs associated with starting the ven ture. These costs may be represented by the 112 entrepreneurial risk income the entrepreneur could have generated had he or she started another venture or chosen a wage earning position. These opportunity costs are represented by the individual’s own discount rate and are the basis for the risk–return relation ship in finance theory. The higher the discount rate (which is a function of systematic risk) underlying the venture opportunity, the higher are the expected returns the individual should demand. Since it is widely agreed that entrepren eurship is generally more risky than wage earning positions, one explanation for why indi viduals start ventures, and accept higher oppor tunity costs on average, is that they have higher expected returns than other income alternatives. Others have looked at the higher proportion of ‘‘failure’’ among smaller firms as evidence that these firms face more risk. However, we caution against this interpretation because failure seems to be a choice determined in part by each entre preneur’s unique threshold, or tolerance, for poor performance (Gimeno et al., 1997).
More recently, a stream of literature called real options theory has elaborated upon a differ ent type of opportunity cost that is pertinent to the decision to start a venture. If starting a ven ture involves making sunk costs, then there are opportunity costs of committing to the venture. The entrepreneur cannot fully recoup the in vestment if things turn out poorly. In this theory, total risk defines opportunity costs, not merely systematic risk. The greater total risk, the greater the opportunity costs associated with starting a venture, which should lower the pro pensity for entrepreneurs to rush to start new ventures. Consistent with these expectations, O’Brien, Folta, and Johnson (2003) found that total risk lowered the likelihood of entrepreneur ial entry. This perspective suggests that factors that raise the irreversibility of new venture cre ation should raise the riskiness of committing immediately to entrepreneurship.
Other Explanations for How Risk is Linked with Entrepreneurship
The high rates of entrepreneurial failure have led many researchers to question why we see such high rates of entry. Some have suggested that entrepreneurs are not only risk bearers, but also risk seekers (Begley and Boyd, 1987; McGrath, MacMillan, and Scheinberg, 1992). This stands in contrast to managers of large organizations, who have been described as risk averse. Risk aversion is central to the positive relationship expected between risk and returns. In fact, few studies have shown statistically sig nificant differences between entrepreneurs and managers in large organizations in their risk taking propensity (Brockhaus, 1980; Low and MacMillan, 1988). Prospect theorists claim that risk taking propensity may differ depending upon whether an individual is above or below some reference point (Kahneman and Tversky, 1984). Risky alternatives may be more acceptable when the decision maker’s economic situation is below the reference point. When this theory is applied to an entrepreneurial context it suggests that prospective entrepreneurs performing below aspiration levels may be more willing to initiate a venture than those above aspiration levels (Simon, Houghton, and Savelli, 2003, have found results consistent with the view that prospect theory explains entrepreneurial deci sion making). This seems a promising area of research.
Rather than focusing on risk propensity, sev eral scholars suggest that risk perception might explain why individuals start new ventures (Sit kin and Pablo, 1992; Palich and Bagby, 1995; Busenitz and Barney, 1997). It may be that entrepreneurs are more susceptible to biases and heuristics and are likely to perceive less risk in a given decision situation than are man agers in large organizations. By being more willing to generalize from limited experience and by feeling overconfident that they will be able to master the major obstacles, entrepreneurs may conclude that a situation is simply less risky than would managers in large organizations. Cooper, Dunkelberg, and Woo (1998) found that 95 percent of entrepreneurs believe their venture will most probably succeed even though over half of all new ventures fail. Simon, Houghton, and Aquino (1999) found evidence that individuals start ventures because they do not perceive the risks involved and not because they knowingly accept high levels of risk.
Conclusion
We have considered that entrepreneurial risk is represented by an entrepreneur’s inability to eliminate the stochastic nature of the entrepreneurial risk 113 environment. The existence of risk presents the
opportunity for abnormal returns, but also the potential for losses. Let us be clear that increased risk propensity or decreased risk perceptions are neither necessary nor sufficient conditions for entrepreneurs to start ventures, but will certainly impact new venture formation.
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