A look at the intersection of calculated risk, the minds of entrepreneurs, and why the best business owners make long shot bets.
I’ll Have Another had a chance to become the 12th horse in history to become a Triple Crown winner, a feat that has not been accomplished since 1978. But a last-minute injury forced the horse out of the race.
Still, horse racing is a bettor’s delight. Had he had run, I’ll Have Another would have been the race favorite. And at roughly 1-to-1, a bet of $100 would have returned just $100–or just a bit more. But, statistically, betting the favorite to win, in the long run, is a sucker bet: The race favorite will only win one-third of the time. Not every race favorite will pay out even money, but since winning a 1-to-1 bet will only double your money, you’ll likely lose your bankroll pretty fast. In other words, taking risks is the only way to make real money in horse racing.
Betting the ponies and running the business are, of course, completely different. But it’s curious to see how, individually, entrepreneurs approach the question of risk through the lens of odds, percentages, and potential reward–and more importantly, how that risk-taking mentality applies to running a successful business.
Chris Golec, CEO and founder of Demandbase, a real-time personalization and targeting platform, explains why he goes for the long shot–while mitigating potential downsides.
“If you are VC-funded entrepreneur, like me, you likely sold the promise of a 10X return,” he says. “As you build the company you need to constantly mitigate risk and blockers from accelerating growth to get those type of return levels. Blockers might be products that don’t take off, people, or, even realizing the market does not exist. If you are a different entrepreneur (restaurant owner or franchisee, for example) there is much less risk and you likely are not expecting a 10X return. You are essentially a different horse in the race and are just happy to be participating.”
Just like investors use the “efficient frontier”–a portfolio theory that determines levels of upside at particular levels of risk–Golec makes bets on decisions that have high-upside potential. In other words, sometimes it pays to bet the long shot.
“For Demandbase, we–meaning management and investors–know we operate in a high-risk and high-return space,” Golec says. “Everything we do is about mitigating risk, with the exception of going after what we believe to be large markets with innovative, high-value solutions. But when you learn a particular product or service does not offer that high growth, for whatever reason, it is actually riskier to stay with it. It slows down the horse and the race is all about winning, not second place.”
Brian Zuercher, a serial entrepreneur who is the CEO of VenueSeen, a social-media-management tool, agrees. Good entrepreneurs, he says, make calculated bets on potentially known assets. But if they’re looking for a big exit down the road–a sale or an IPO–they’ll need to roll the dice.
“The more long shot bets an entrepreneur makes on any of these questions, the more likely they are going to fail,” he says. “Conversely, if all of the hypotheses have favorite bets, then it may not be a tremendously valuable outcome.”
“Ultimately, in my opinion, the equation most people come up with looks like this: Technology Adoption (long shot) + Team (favorite) = Big Payday (most likely).”
–Brian Zuercher, CEO of VenueSeen
He even drew out a basic equation for maximum return while mitigating risk: “Ultimately, in my opinion, the equation most people come up with looks like this: Technology Adoption (long shot) + Team (favorite) = Big Payday (most likely).”
This somewhat rudimentary equation is actually a pretty good way to view how entrepreneurs approach risk-related questions. On one side, they must take big leaps of faith, but mitigate the gamble with known factors.
Jeff Kear, founder and CEO of Planning Pods, a four-person software start-up in Denver, says he would make two bets at a horse rase. First, he’d bet on a horse with good odds, say 3-to-1. Then, he’d make another bet on a horse that’s a long shot, something like 40-1. He does the same in his business, too.
“First, I would want to diversify my “investment” by spreading it across multiple bets; as an entrepreneur I do this by creating multiple products in different channels and industries,” Kear says. “Second, I would pick a horse with good odds because it’s more “proven” to pay out (compare this to creating a product in a smaller, niche market that may not be as lucrative but has better chances for success) as well as a long shot for the potential of a big payday (launch into a bigger market to improve chances of bigger revenues, but with risk of more competition). I wouldn’t bet on
the favorite because, like a copycat product, many others have already made that “bet” and the payout wouldn’t be as appealing.”
The subject of risk and reward is a particular area of focus for management academics. In 2007, researchers at the UCLA Anderson School of Management decided to study how entrepreneurs make inventory decisions by looking at the newsvendor problem, a classic economic conundrum faced by newspaper boys starting in the 1800s. In a nutshell, the newsvendor model is this: Buy too many newspapers, and be stuck with excess inventory. Buy too few, and lose out on potential profits. In a paper titled “Entrepreneurs and newsvendors: do small businesses follow the newsvendor logic when making inventory decisions?” the researchers set out to find if entrepreneurs make the rational inventory decisons based on economic principles, or if they gamble.
The result was pretty fascinating: When purchasing inventory, entrepreneurs “treat investments in inventory as potential profits, not as potential losses; that is consistent with their documented tendency to be overconfident, in this case about their ability to sell whatever inventory they have.” In other words, entrepreneurs are more willing to risk for the sake of profits—not for the sake of mitigating losses.
This is not a bad thing. In fact, a healthy level of risk is necessary for long-term success.
Researchers at IZA, the institute that studies entrepreneurship and labor in Germany, came to a similar conclusion. In a June 2008 study titled “The Impact of Risk Attitudes on Entrepreneurial Survival,” researchers studied the risk-taking tendencies of entrepreneurs versus their long-term success. They concluded:
“Specifically, the failure rates of medium-level risk takers drop by about 40% compared with those not willing to take any risk, whereas those of high risk takers almost double.”
–2008 Study by IZA
“Persons with particularly low or particularly high risk attitudes fail as entrepreneurs more often than do persons with a medium-level risk attitude. This result notably holds for all kinds of risk measures. Our analysis further reveals that the economic impact of this variable is fairly strong. Specifically, the failure rates of medium-level risk takers drop by about 40% compared with those not willing to take any risk, whereas those of high risk takers almost double.”
But back to Belmont. Curious to know how entrepreneurs approach this type of risk, I asked them how they’d bet the race. All things being equal (i.e. assuming the entrepreneur has no Rain Man-esque handicapping abilities):
Ilya Pozin, a serial entrepreneur and founder of Los Angeles based web design firm Ciplex, is risk-averse to decisions he can’t control. “I’ve been to horse races before, and the only time I’ve ever bet, is if I went with a friend that knew the race really well and knew the horses. I bet on my friend and not the horse,” he says.
Others welcome the opportunity to gamble. Zalmi Duchman, CEO of FreshDiet, says he’d bet the trifecta box, taking three horses, including the favorite, and bet them to come in win, place, and show. “One of them would be a long shot so the pay out would be decent,” he says.
Russell Perry, founder of creative agency NSB/Keane in Phoenix, is even riskier, saying he would bet the Superfecta.
“Low cash outlay, high reward,” he says.
Roman Scharf, co-founder & CEO of Talenthouse, a social media marketing company and influential online community headquartered in Palo Alto, California, says that risk is good for the entrepreneurial ecosystem. Scharf previously co-founded telecommunications firm JAJAH Inc, which sold to O2/Telefónica in December 2009 for $207 million.
“If the stakes aren’t high your potential gains aren’t either,” he says. “So in the example of a horse race, I would never bet or gamble in the traditional sense, but if I did, I would probably bet on the underdog who has a potentially much higher return on investment. Running a company successfully means taking risks, small and large, all the time. As an entrepreneur, you have to trust your gut feelings and experience and ‘bet’ on things that aren’t yet, the future. Those decisions often entail so many variables and what-ifs that there is no quantitative way to calculate or determine the outcome beforehand; you have to trust in your vision and ideas. It is not pure gambling. You weigh the risks of the decisions you make. The goals of what many entrepreneurs are building in Silicon Valley are often set sky-high for a reason.”
Or, more succinctly, in the words of Kelly Meyer Douglas, co-CEO of children’s products maker Itzy Ritzy: “Go big, or go home.”