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Beyond War Stories and Anecdotes: Theory, Practice and Entrepreneurship



Though entrepreneurship as an academic discipline continues to lack generally accepted cumulative or unified theory of its own (as the definitions of entrepreneurship and the entrepreneur remain subject to vigorous debate, perhaps this should not be too surprising) and has historically focused more on describing (as opposed to predicting) entrepreneurial phenomena, the entrepreneurship literature does pull from the theoretical wells of other well-established disciplines including economics, sociology, psychology, business management, strategy, industrial organization, accounting, and finance.  Theory, regardless of its reputation for being dry, prescribes behavior—in an entrepreneurial context, it tells us what entrepreneurs should do.  But, why not just study what entrepreneurs do?  The overwhelming majority of them fail.  There is certainly room in the classroom, the boardroom, and the garage or living room for anecdotes, rules of thumb, and war stories, but theory can take us much further.

The Standard Assault on Theory – Groundless, But Pervasive

For reasons that I do not fully comprehend, theory seems to be anathema to many students and practitioners of entrepreneurship (not to mention other fields).  Spending as much time in the classroom as I have over the past decade, I have heard the litany of complaints that generally masquerade in the form of (paraphrased) questions like these:

  • How is (fill-in-the-blank) theory relevant to real life entrepreneurial decision-making?
  • What is the value of taking classes from professors who have never worked in the real world or built their own businesses?

In fairness, these are important and legitimate student inquiries—especially given the material cost of both undergraduate and graduate-level educations.  Further, as such doubts regarding both theory and the theoretically-inclined are also held by many practitioners (successful or otherwise), it is incumbent on the targets to establish their own legitimacy.  To do so, however, generally requires little more than a cursory overview of the empirical record.  Entrepreneurs, on average, do nothing more than burn money.  Accordingly, a better set of questions would be:

  • Why do entrepreneurs overwhelmingly fail?
  • What can theory do to help us from becoming just another statistic?

Though the entrepreneurial world is often obsessed with failure (to the point of holding conferences in celebration of it), theory yields an alternative rooted in logicality and testability that just might make the difference for entrepreneurs of all kinds—if only they open their minds to it.

The Application of Theory in an Entrepreneurial Environment

To help make my case for theory, I have selected four that I think are particularly deserving of exploration: real options, signaling theory, game theory, and behavioral finance.

Real Options

The real options framework is one of the more strategically interesting contributions of corporate finance to daily decision-making in a business setting (entrepreneurial or otherwise).  Digging into its roots, you’ll quickly find yourself in rich intellectual and theoretical territory.  A fundamental assumption of options pricing theory is that asset prices are driven by Brownian processes—something originally developed to explain the random movement of particulate matter and eventually utilized by Einstein more than a century ago to support the hypothesized existence of atoms and molecules.  As the field of finance became more mathematical in the 1950s and onwards, it drew heavily from physics—and options pricing theory, which dates back to the early 1970s, is the most notable achievement of the movement.  The Nobel prize was awarded to Robert Merton and Myron Scholes for the contribution (and, except for his untimely death, Fischer Black would have also shared in the award).

Fast-forward a few years to 1977 and Stewart Myers of MIT found a major corporate application for options theory: the real options framework.  A real option is defined as the right but not the obligation to undertake a particular business decision: to wait, expand, contract, or even abandon a project.  Under conditions of uncertainty, real options like these have actual value which can be estimated at time zero using options pricing models and which should be considered in the capital budgeting decision-making process.

As an example, consider an investment opportunity which requires $100,000,000 to build a commercial real estate complex that is expected to be sold a year later for $110,000,000—a 10% profit.  For the sake of simplicity, assume that the project will be funded 100% by debt at the current yield of 10.3%.  Back of the envelope, the Net Present Value (NPV) for this project is roughly negative $300,000.  According to the decision rule for NPV, the project should be rejected.

With the above in mind, what if someone approached the firm and offered to buy the opportunity for $100,000.  Should the firm accept the offer?  Well, according to standard NPV logic, the answer is yes—the firm should sell the opportunity since someone is willing to pay a premium for it.  But, what if the yield dropped in the near future from 10.3% to 9.8%?  In such a case, the NPV of the project would be roughly $200,000.  According to the decision rule, should the project be considered under such circumstances?  Seemingly, yes; however, if the project has already been sold, this is no longer possible.

I have borrowed this particular example from Stephen Ross who sums up the implications quite nicely:

every project competes with itself delayed in time [emphasis my own].  This is the essence of the problem with applying the NPV rule.  In a capital budgeting context with a budget constraint, undertaking a project means taking on that feasible combination of projects that maximizes the NPV. Clearly with interest rate uncertainty, we trade off the value of taking on the project today against the lost opportunity cost of foregoing the option to undertake the project at some later date when interest rates are more favorable. This same reasoning can also resolve the problem of rejecting the project when it should be accepted, i.e., of selling the rights to the project too low. Selling the project to the dealmaker is not only selling today’s project, it is also the sale of all the potential future projects.”

Instead of viewing the world through the all-or-nothing, now-or-never lens of NPV, the real options approach helps us to identify (or manufacture through contracts, negotiation, and/or strategic planning) and value embedded optionality in our project portfolios—so that we can make better-informed capital budgeting decisions.  For further reading, Aswath Damodaran’s website is an incredibly valuable resource for learning more about real options (as well as anything and everything regarding project- and firm-level valuation), this article from the Harvard Business Review does a nice job of coupling strategy and real options, and Real Options: A Practitioner’s Guide by Copeland and Antikarov and Strategic Investment by Smit and Trigeorgis are excellent textbooks on the subject.

Signaling Theory

Many of the things that we most want to know about the disparate parties with whom we have or expect to have interaction are not directly observable: Is a competitor weak or resilient?  Is a customer’s financial condition tenuous?  Does a potential hire have what it takes to succeed?  Do entrepreneurs have confidence in what they are doing?  These are tough questions because the answers are oftentimes obscured via informational asymmetries and conflicts of interest.  This leads us to signaling theory, a Nobel-prize winning branch of contract theory developed in the early 1970s by Michael Spence, and the search for and interpretation of signals which expose otherwise obscured information.

Consider, for instance, the matter of entrepreneurial confidence.  If an entrepreneur is trying to raise money, but is unwilling to invest his or her own savings, such timidity should be taken as a negative signal regarding his or her actual level of confidence in the endeavor (irrespective of what the entrepreneur has actually expressed).  Similarly, an unwillingness to take on the obligations of debt should be viewed much the same way if the preferred financing alternative is dilutive—though the matter of personal guarantees makes debt admittedly far riskier in an entrepreneurial environment than in the public space.  That said, an exception exists for equity (or convertible securities) issued as part of a venture capital round as such institutional interest signals that the entrepreneurial effort has substantial upside potential.

Beyond interpreting the signals of others, we must also be concerned with managing the signals that are communicated by our own actions.  Consider a classic hold-up scenario where a critically important employee in an entrepreneurial venture decides to try and exploit his or her relevance to extract unreasonable concessions from the owner(s).   In a situation like this, the desire to try and cut a deal with the employee is understandable; however, such a deal will be interpreted as a signal of weakness.  If a deal is made, it should come as no surprise when the same employee attempts another coup down the line or when others who observed or otherwise become aware of the original interaction play copycat.  A superior strategy might entail firing the employee on the spot (or accepting their notice), taking the hits, and rebuilding.  Regardless of the short-term pain, the signal of strength of fortitude will be impossible for other would-be holdup artists to miss.  For further reading, this review article is a good place to start.

Game Theory

Game theory offers a fascinating theoretical framework for rational decision-making under conditions of uncertainty.  Game theory has antecedents which reach back into the eighteenth century; however, the polymath John von Neumann and economist Oskar Morgenstern effectively established the field through their early writings in the 1940s.  Since that time, game theory has found permanent homes in the academic disciplines of economics (eleven game theorists have been awarded the Nobel Prize), business management, political science, international relations, and psychology, among others, and has been widely utilized in practice to bring about better business and geopolitical outcomes.

Entrepreneurial applications of game theory are endless.  Fundamentally, business consists of little more than a never-ending stream of interactions between diverse and sometimes (or even frequently) evolving parties: customers, vendors, and competitors.  As these separate parties often have unique and divergent interests, incentives, and options available to them, a core function of management, therefore, must be the optimization of strategic decision making in a competitive environment.  Game-theoretical modeling is particularly useful for firms engaged in competitive bids; negotiations with labor, vendors, customers, and lenders; advertising, marketing, and reputation-building; and market entry and exit situations.

Admittedly, the formal mathematics needed to calculate payoff expectations is overkill (and a non-starter) for many practical applications of rigorous game theoretical modeling in a business setting; however, the process of engaging in game-theoretical reasoning with even the most rudimentary estimates of utility or preference is still richly rewarding in terms of intuition gained.  For one, it forces us to think about and take into consideration our counterparties, their interests, and their likely actions in addition to our own.  This may seem obvious, but due to either ignorance, error, or a combination of both, it is an oft-omitted step in the decision-making process with the end result being money lost (or left on the table).  Additionally, it helps to identify areas where we might want to make changes, exert pressure, or employ misdirection in an attempt to constrain (or control) the actions of counterparties to either gain a strategic advantage or mitigate or eliminate a strategic disadvantage.  For further reading, MIT OpenCourseWare is a great place to start: Lectures and Other Resources – Game Theory.  There are countless books on the subject, but The Art of Strategy by Dixit and Nalebuff is quite readable.

Behavioral Finance

Behavioral economics has been an exciting field since Daniel Kahneman and Amos Tversky established it through their efforts to bridge the gap between economics and psychology in the late 1970s (Kahneman was awarded the Nobel prize for the contribution—an award which Tversky would have shared had he still been living).  Concerned with the effects that psychological, social, cognitive, and emotional factors have on economic decision-making, behavioral economics stands in sharp contrast to mainstream neoclassical economics and its assumption that participants are rational, utility-maximizing agents.  Driven by the work of Richard Thaler (who himself was awarded the Nobel Prize in 2017), behavioral concerns entered the finance discipline in the early 1980s and have blossomed into the rich subfield of behavioral finance.

Behavioral finance is largely focused on explaining perceived market inefficiencies by highlighting the alleged irrational tendencies of market participants.  These tendencies are seemingly driven by biases such as excessive optimism, overconfidence, confirmation, and the illusion of control; heuristics including representativeness, availability, anchoring and adjustment, and affect; and framing issues such as attitudes toward risk and loss, aversion to a sure loss, and narrow framing bias.  Though much of the literature is focused on asset pricing, behavioral finance has much to offer in both corporate and entrepreneurial settings as well.

Consider, for example, sunk costs and the issue of sure loss aversion.  Having previously and irrevocably been incurred, sunk costs are supposed to have no bearing whatsoever on future decision-making.  And, yet, even in the face of data that suggests that we should not move forwards with a project, the presence of material sunk costs seems to have an uncanny tendency to probe decision-makers into further escalation of financial commitment (which is likely to only succeed in magnifying losses).  Why might this happen?  Well, visibility probably plays a role.  Consider, for instance, an entrepreneur whose identity is fully wrapped up in his or her business.  If the business should start to fail, the owner is likely to commit every resource available to try and save it, even if there is little to no hope of actually doing so, because the perception of personal (coupled with professional) failure is too much to accept.  The likely end result: an even more devastating failure.

Acquisitions are also interesting to explore from a behavioral angle—especially given the poor returns often associated with them.  In order to acquire another firm, a premium needs to be paid.  Depending on either how many suitors exist or how badly a potential buyer craves a deal, these premiums can run the gamut from modest (less than 10%) to substantial (multiples of the current value).  Naturally, if a buyer ends up paying too much, returns are going to suffer.  So, why might we be inclined to pay too much?  Consider an old, but instructive case: RJR Nabsico.  In 1988, RJR Nabisco was “put into play” when Shearson Lehman Hutton and the RJR Nabisco management team made an offer to buy out the other shareholders and take the firm private.  In short order, a rapid bidding war took place that involved several strongly-motivated participants—each badly wanting to win the deal for reasons mostly relating to perception—and culminated in the largest takeover of the decade when the offer made by Kohlberg Kravis Roberts & Co. (KKR) was accepted at a valuation nearly three times that of the pre-bid stock price.  Needless to say, this did not end up being one of KKR’s better deals.

Behavioral finance has methodological issues that are beyond the scope of this post; however, as a conceptual framework which highlights and underscores the threats and opportunities presented by irrationality, it is extremely valuable for entrepreneurs.  For additional reading, I would suggest Hersh Shefrin’s Beyond Greed and Fear and Behavioral Corporate Finance.

Coming Full Circle – In Justification of Theory

At the beginning of this post, I mentioned that students often ask questions like these:

  • How is (fill-in-the-blank) theory relevant to real life entrepreneurial decision-making?
  • What is the value of taking classes from professors who have never worked in the real world or built their own businesses?

Regarding the first question, I would argue that the four theories outlined above—not to mention countless others ranging from big picture to small—make a strong case for relevance.  In their own way, they help us to view the world differently: seeing value where it otherwise might be ignored (real options); inferring private information from the actions of others (signaling theory); considering the interests and likely responses of counterparties in competitive situations (game theory); and exploring the impact which psychological and related quirks can have on both our decisions as well as the decisions of others (behavioral finance).  Though the mathematics underlying these theories (especially the first three) may seem overly obtuse for entrepreneurial application, even if it is fully stripped away, the core logic and reasoning at the foundation of these approaches is more than enough to change our decision-making for the better.  As for the second question, it should go without saying: theorists (as well as empiricists) possess, debate, and create knowledge that can help us to find order and predictability in a world that otherwise might seem chaotic and random.  War stories and anecdotes are great, but they are severely context-restricted and prone to misapplication.  Theory, on the other hand, is transcendent.  Not to mention liberating.