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Choosing Ventures that Might not Die: Effectuation

 

Being in an MBA program and encountering the concept of “effectual entrepreneurship” for the first time can be jarring. Effectuation is everything corporate finance is not. We are used to the “causal” thinking of large and established businesses, where deep pockets require extensive planning and oversight, and obviate the need for a more flexible approach. In large, established businesses, causal thinking exists to protect managers from making poor decisions. However, in a startup, this type of corporate thinking all too often distracts from the core issue facing an entrepreneur – survival. In order to be successful, a venture must first achieve the more mundane and pragmatic goals of finding customers, bringing in more money than the venture spends and delivering a valuable product or service. Effectuation encourages those more pragmatic goals, so we look for ventures that use effectual logic. To see where the differences lie between effectuation and corporate/causal thinking, let us walk a hypothetical bakery through the five core concepts of effectuation.

Bird in the Hand

Effectuation tells us to look at what we have to determine where we can go. Causal thinking tells us to look at where we want to go to determine what we need to obtain to get there. An effectual baker will see they have flour, milk, sugar, eggs, and chocolate — and decide to make chocolate cake. A causal baker will decide they want to make carrot cake — and will go find the missing ingredients. The effectual baker produces a cake less expensively and more quickly than the causal baker. While the causal baker is out looking for carrots, the effectual baker is already working on customers for the chocolate cake, and because of lower investment has less to lose if potential customers do not like the chocolate cake.

Affordable Loss

Affordable loss is all about minimizing downside, rather than focusing on the potential for profits. A causal baker will project they can sell so many cakes per oven per hour, and buy as many ovens and ingredients as they can afford to scale as rapidly as they can. An effectual baker will begin with a rented oven and minimal ingredients while they test demand. If the causal baker fails, they lose a significant amount of capital. If the effectual baker fails, it is easier to learn from the less expensive failure and pivot to try again.

Crazy Quilt

“Crazy quilt” describes the patchwork of stakeholders around which an effectual startup forms. Effectual entrepreneurs build their business around stakeholder pre-commitments to minimize risk and ensure demand exists. An effectual baker will pre-sell cakes to raise money for supplies and determine which type of cake to bake. A causal baker will rely on market research and analytical models to determine what and how much to make. Not only does the effectual baker reduce risk by ensuring revenue before spending money, the effectual baker also improves the likelihood of market acceptance by involving stakeholder customers earlier in the venture development process.

Making Lemonade

Effectual entrepreneurs treat surprises as new opportunities — when faced with lemons, they make lemonade. If both bakeries order cake tins but receive muffin pans, an effectual baker will make cupcakes. A causal baker will return the muffin pans and wait for cake tins to arrive, because their model tells them to bake cakes. While the causal baker is sitting idle, the effectual entrepreneur is busy selling cupcakes and possibly discovering a new market.

Pilot in the Plane

Entrepreneurship is all about control. Effectuation emphasizes controlling the present, rather than trying to predict the future. A causal baker will predict carrot cakes will sell well next week, and order carrot cake ingredients. An effectual baker will avoid making a prediction by relying on the other four principles — they will look at what they already have and pre-sell cakes to ensure demand actually exists.

These five concepts together embody effectual entrepreneurship. In the Willamette Angel Fund, we search for ventures that use effectuation (whether they know it or not) because we believe the approach improves their chance of survival. And once a venture survivies, then it has the potential to be hit by lightning (please see my next post).

 


Nathan Foos

Nathan Foos is an MBA/JD candidate at Willamette University, and is an alumnus of the WU College of Liberal Arts where he studied history, mathematics, and economics. With a strong interest in the provision of capital to growing firms, Nathan has actively engaged in the experiential course offerings at AGSM, including the O’Neill Student Investment Fund and the Willamette Angel Fund. In particular, Nathan enjoys angel investing because he can engage on a personal level with investee companies, obtain real-world insight into a plethora of industries, and learn from the mistakes and successes of hundreds of startups.

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