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Within this brief paper about douglas, evan (2006) new venture risk taking perceptions and preferences.
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This is the author-version of article published as:
Douglas, Evan (2006) New Venture Risk Taking – Perceptions and
Preferences?. In Proceedings Babson College Entrepreneurial
Research Conference, USA, Indiana.
Accessed fromhttp://eprints.qut.edu.au
Copyright 2006 the author
Babson2006DouglasPerceptionsPreferenceV2.doc
NEW VENTURE RISK TAKING: PERCEPTIONS AND PREFERENCES?
Evan J . Douglas
Brisbane Graduate School of Business
Queensland University of Technology
Abstract
This paper clarifies and expands the ‘perceptions’ view of entrepreneurial risk taking and provides two
additional concepts to explain why entrepreneurs undertake risky new ventures. The utility-maximizing
model of entrepreneurship is extended to include these additional concepts. We argue that entrepreneurs will
truncate risk-reducing information-search, firstly because the delay involved in search activity may cause the
loss of additional income associated with first-mover advantages, and secondly because the entrepreneur’s
psychic involvement in the process of becoming an entrepreneur and/or pioneer might be so important that
he/she trades off risk reduction to become an entrepreneur sooner.
Introduction
It is commonly presumed that entrepreneurs must have relatively high tolerance for risk, as compared to
managers of other firms, since it is entrepreneurs rather than corporates who typically start new high-risk
business ventures (Stinchcombe, 1965; Reynolds, 1986; Phillips & Kirchoff, 1988). But empirical studies of
entrepreneurial risk propensities have shown mixed results, with some being quite averse to risk, others are
less averse to risk, and no significant difference found between entrepreneurs and managers of other firms
(Brockhaus, 1980; Brockhaus & Horwitz, 1986; Low & MacMillan, 1988; Palich & Bagby, 1995; Busenitz,
1999). Gifford (2003) demonstrates that what might seem to be risk aversion or preference might instead be
the result of different personal investments in knowledge acquisition. In any case, the lack of a simple
empirical relationship between attitudes to risk and the risk taking behaviour of entrepreneurs is not
surprising, the entrepreneur’s attitude to risk is neither a necessary or sufficient condition for the decision to
behave entrepreneurially (Douglas & Shepherd, 2000).
A more recent view focuses on the risk perceptions of entrepreneurs. Cooper, Woo & Dunkelberg
(1988) found that entrepreneurs exhibit higher self-efficacy than other managers, and consequently think that
they are better equipped to deal with risks than are non-entrepreneurs. Palich & Bagby (1995) found that
entrepreneurs exhibit the cognitive bias of ‘overconfidence’. Busenitz & Barney (1997) and Simon, Houghton
& Aquino (2000) found that while all managers exhibit overconfidence, entrepreneurs exhibit greater
overconfidence than do employed managers. Accordingly, entrepreneurs might undertake risky ventures not
because they are unworried about the risk but because they do not perceive the amount of risk that others do
in that new venture.
The ‘perceptions’ view of entrepreneurial risk-taking may not tell the full story, however. Risk taking
can be defined as undertaking an action without complete information, and the source of new venture risk can
be largely traced to the incomplete information (or ignorance) in the minds of consumers, producers, and
managers (Shepherd, Douglas & Shanley, 2000). Lack of knowledge will mean that at least some risks will be
unperceived, of course. Accordingly, these risks do not even exist for the entrepreneur, and consequently they
undertake new ventures that others, with better knowledge, would not. If entrepreneurs ‘do not know what
they do not know’ then they will, particularly if afflicted by overconfidence, leap in and take risks. We need
to know why entrepreneurs appear to be satisfied with their current quantum of knowledge and why they
typically eschew, or at least truncate, information search activity.
In this paper we provide further answers to the question ‘why does the entrepreneur forsake further
information search activity?’ While Cooper, Woo and Dunkelberg (1988) and others have asked the same
question, the question has been answered in terms of cognitive biases. We examine the issue in terms of the
economics of entrepreneurship and show that there are a series of issues that may reduce the utility expected
from the entrepreneurial process if additional information search activity were to be undertaken. We bring
together psychological and economics thinking to argue that entrepreneurs may perceive lesser risk for both
perceptual and preference reasons.
In the next section we overview the literature on the perceptions view, the ignorance view, and the
utility-maximizing view of entrepreneurial risk taking behavior. In the third section we examine two
additional reasons for truncating information search activity – these relate to the ‘urgency’ and the
‘involvement’ with which the entrepreneur considers the entrepreneurial process. The third section discusses
the implications of the foregoing and suggests a series of propositions that might be tested empirically.
Finally we conclude with a statement of the contributions made by this study.
Literature review
The Perceptions View of Risk Taking
Krueger & Dickson (1994) looked at the relationship between self-efficacy and its relationship with
increased risk taking. When self efficacy is inflated to exceed one’s capability to deliver, it becomes
overconfidence. Palich & Bagby (1995) argued that the operative issue is perceived risk, rather than attitude
to risk, and that entrepreneurs tend to downplay the risk they perceive, expecting to triumph over any adverse
situations that arise. They found that entrepreneurs typically possess overconfidence exemplified by their
consistently looking at new venture opportunities more positively than others (see also Chen, Greene & Crick,
1998; Forbes, 2005). Cooper, Folta & Woo (1995) argued that higher levels of self-confidence were related to
lower levels of information search activity, and therefore greater risk bearing due to the entrepreneur’s
ignorance of the risks being borne. They argued that “the entrepreneur is ‘blinded’ to the need for more
information due to his/her overconfidence.” (1995:110). Saraswarthy, Simon & Lave (1998) and Hillier
(1998) found that entrepreneurs are biased in their perceptions of risk and opportunities. Palich & Bagby
(1995:443) used the term ‘rose-coloured glasses’ to characterize the rosy-hued view taken by entrepreneurs
who underestimate risk due to overconfidence.
Busenitz & Barney (1997) and Busenitz (1999) found that entrepreneurs use cognitive biases and
decision heuristics more than do self-employed managers and accordingly take greater risks without
necessarily knowing that they are doing so. Faced with high levels of uncertainty and pressure to make
decisions before the perceived window of opportunity closes, entrepreneurs adopt simplified decision rules
that allow quick decisions (Tversky & Kahneman, 1974). But simple decision rules might be suboptimal and
thus adversely affect the new venture’s survival prospects. In contrast to the ‘rose-colored’ glasses, we might
say that the entrepreneur dons ‘dark glasses’ to block out the overload of light (i.e. information) that is
potentially available but the processing of which would hinder speedy decision making.
Many studies have attempted to relate individual ‘human capital’ (Becker, 1964) to nascent
entrepreneurship, entrepreneurial intentions, entrepreneurial behaviour and entrepreneurial performance (see
Shane, 2003, pp. 61-95 for an overview). Gifford (1998) posits a model of ‘limited attention’ that explains
why those with greater entrepreneurial ability are more likely to engage in entrepreneurial activity. Shane &
Venkataraman (2000) argue that entrepreneurs who possess proprietary knowledge about new venture
opportunities appear (to those who lack the information) to be willing to accept greater risk. Baron (2000)
argues that entrepreneurs’ lower perceptions of risk relates to their lesser ability to engage in counterfactual
thinking. The human capital literature on entrepreneurship (e.g. Davidsson and Honig, 2003; Kim, Aldrich
and Keister, 2003) argues that individuals have differing capabilities due to their differing ‘general’ human
capital (such as age, gender, years of education and work experience) and ‘specific’ human capital (such as
relevant education and industry experience, relatives who are self-employed, social networks, and so on).
Most recently, J anney & Dess (2006) argue that the entrepreneur may possess specialized knowledge and
idiosyncratic resources that mean that risks perceived by others do not apply to the entrepreneur, who
effectively has superior human capital resources.
Thus, a person with substantial prior education, knowledge and experience in the relevant technology
and market realms may see little risk in a particular new venture, while another person without such
knowledge and experience may view the same new venture as being much more risky. In this view, the
entrepreneur ‘sees’ things that others do not, somewhat analogous to a person wearing prescription lenses
tailored exactly to match one’s own visual acuity. Accordingly, we might call this the ‘clear lens effect’ and
note that one person cannot judge how risky another person’s action is unless they have identically ‘clear’
lenses (not to mention the lack of cognitive biases).
The Ignorance View of Risk Taking
Fiet (1996) notes that entrepreneurs can undertake information search activity to reduce the uncertainty
and risks of a new venture. Shepherd, Douglas and Shanley (2000) argue that the mortality risk of a new
venture depends on the novelty of its product, its production technology, and the managerial requirements.
They explain the ‘liability of newness’ (Stinchcombe 1965) in terms of the extent to which the new venture is
novel in the eyes of customers, producers, and managers. Put another way, new venture mortality risk
depends on the ignorance (of relevant information) in the minds of customers, producers and managers. Here
we are concerned with the human capital of the entrepreneur and other managers, and whether they lack the
general and specific knowledge required to effectively manage the new venture through survival to success.
Accordingly, the mortality risk existing in any new venture will depend on which particular entrepreneur or
entrepreneurial team is managing the new venture opportunity (see also Gifford, 2003).
The ignorance view is concerned with the extant knowledge (or its complement, ignorance) held by the
entrepreneur, and does not examine the relationship between the extent of ignorance (i.e. risk) and one’s
attitude toward this risk. Implicitly, the ignorance view incorporates risk perceptions by the implication that
the risks associated with the entrepreneur’s ignorance are not perceived, but it also ignores cognitive biases
and thus effectively assumes that the entrepreneur is not subject to any cognitive biases.
The Preferences View of Risk Taking
What we are calling the ‘preferences’ view is based upon the utility-maximizing model of career choice
– i.e. individuals form the intention to start a new business if so doing is expected to deliver greater psychic
satisfaction than would the best-available employment option (Eisenhauer, 1995). According to Douglas &
Shepherd (2000) this decision is based on the entrepreneur’s preference (or aversion) for five components of
entrepreneurship, viz: the utility derived from income, independence, and net perquisites offered by a new
venture opportunity, and the disutility derived from risk bearing and work effort associated with that new
venture. They posit that in choosing among different career (including new venture) opportunities, the
individual’s preferences for income, independence, risk, work and net perquisites are parameters in that
person’s utility function. The values of the five variables in the utility function depend on the magnitudes
expected in the context of each career alternative. The total utility for each new venture option is then the sum
of the products of the attitude parameters and the relevant variable in each alternative. The entrepreneur is
expected to commit to the alternative that promises the highest level of utility in prospect.
Thus both risk attitude and risk perception enter the entrepreneur’s utility function. But note that neither
of them is a necessary or sufficient condition for entrepreneurial behavior – it is the sum of the arguments in
the utility function that determines the choice between career options, rather than the value of any one
parameter or variable (Douglas & Shepherd, 2000). Thus, an individual might choose a highly-risky new
venture (in which great risk might be perceived) despite being highly averse to risk, if expecting to be
rewarded by high income levels and/or highly-satisfying decision-making autonomy. Thus, it is not surprising
that studies of intending or practising entrepreneurs might exhibit a variety of risk propensities (Brockhaus,
1980; Douglas and Shepherd, 2002.)
Entrepreneurial avoidance of risk-reducing information-search activity
Why would entrepreneurs refuse to seek additional information that would serve to reduce risk? In the
foregoing we have identified overconfidence (the ‘rose-lens’ effect), limiting information search on these
issues in order to focus on what they perceive to be more important at the time, given the need for speed due
to limited windows of opportunity (the ‘dark-lens’ effect), and superior human capital resources (the ‘clear-
lens’ effect). We now suggest two more reasons that might reinforce the above.
The Urgency for Entrepreneurial Activity
It may be utility-maximizing to ignore the availability of information if securing that information would
have an adverse impact on the entrepreneur’s expected income. Search activity costs money and takes time,
and these aspects of search activity may have a negative impact on the income (and hence the utility) of the
entrepreneur. This will be particularly so if the entrepreneur has a strong preference for income (or the
material goods and services that can be purchased using income).
First, let us consider the impact of search costs. Expenditure on search costs will reduce net income of
the new venture if they do not result in the capture of additional useful information. Thus information that
confirms the entrepreneur’s belief that consumers will buy the new product or service is seen as an wasted
expenditure that simply reduces net income. If the entrepreneur has a positive attitude to income (as expected)
this reduces the total utility of the new venture. Further, we note that the great majority of new ventures are
‘bootstrap’ funded (Winborg & Landstrom, 2000), and thus the opportunity cost of the funds required for
search activity is extremely high, competing with prototype development, the cost of equipment, marketing
expenses, and so forth. When the opportunity cost is added to the direct cost of search activity, it may be
perceived as income maximizing and consequently utility maximizing to truncate information search activity
and channel the funds into what is perceived as a better utilization of those funds.
Second, search activity takes a significant period of time to set up, to undertake, and to review the data
derived. This passage of time may be viewed as an obstacle to winning the race to be ‘first-to-market’ and
subsequently earning superior profits. The first-mover advantages (Lieberman & Montgomery, 1988) of the
pioneer firm are commonly assumed by entrepreneurs to provide competitive advantage, although most
pioneers do not survive or even maintain market leadership (Tellis & Golder, 1995). But we are concerned
with a priori perceptions here – if the entrepreneur expects that pioneering will endow the firm with
significant competitive advantages, any delay due to information search activity might be expected to
negatively affect the net present value of the firm’s income stream, and thus negatively affect the
entrepreneur’s total utility.
Note also that information can be obtained either by search activity prior to launch of the new venture
or gleaned from experience after the launch of the new venture. The learning-by-doing option may be
preferred for a number of reasons. First, it does not delay the start-up in a situation where time is of the
essence because of first-mover advantages. Second, it has no incremental costs and thus does not contribute to
the ‘burn rate’ prior to launch in the situation where cash balances are critical. Third, it is likely to provide
better information and thus be a better use of the limited funds. At the margin, the utility-maximizing
entrepreneur will equate the marginal utility of income with the marginal disutility of risk, such that a dollar
will only be spent on risk-reduction activity if it is expected to increase the entrepreneur’s total utility.
To continue the ‘lenses’ analogy introduced earlier, we might call this the ‘yellow-lens effect’ since the
decision to not undertake information search activity for cost or time reasons is akin to the skier’s decision to
not spend money and time buying ski goggles, but instead hurrying to get out onto the ski run. Ski goggles
utilise yellow lenses to achieve greater clarity of vision in high-glare, low-contrast situations, and thereby
allow the skier to see the moguls, thereby removing some risk from the act of skiing. For the entrepreneur
yellow lenses represent the information that might be gained from market research, prototype testing,
management education, and other activities designed to accumulate more knowledge about the technology,
market and management issues involved in the new venture. The decision to not wear these lenses is no doubt
related to self-efficacy and overconfidence, as noted by earlier authors, but it also appears to be related to the
strength of preference for income in the entrepreneur’s utility function.
The Involvement of the Entrepreneur in the Entrepreneurial Process
We now consider issues that impact the utility function via preferences for non-monetary items
associated with entrepreneurship. The impact of these factors must enter the utility function in the ‘net perks’
element proposed by Douglas & Shepherd (2000). This term encompasses all the psychic costs and benefits
associated with the new venture other than those specifically noted (i.e. income, independence, risk and work
effort). Here we propose ‘unpacking’ two significant elements from within net perks and arguing that they
influence the entrepreneur’s decision to truncate search activity.
First, expenditure on search costs may raise the mortality risk (Shepherd, Douglas & Shanley, 2000) of
the nascent firm – spending scarce cash on search activity prior to launch reduces the cash balances of the
new venture and thereby increases the firm’s risk of insolvency (J anney & Dess, 2006). The prospect of new
venture mortality may be expected to have negative connotations in the mind of the entrepreneur. The
individual may have a fear of failure, and/or want to avoid the ‘loss of face’, the condemnation of
disappointed stakeholders, and the jeers of the naysayer that may be associated with new venture failure.
Thus, considering that the prospect of financial failure probably causes disutility, the entrepreneur will
undertake search activity only to the point where the marginal conditions for utility maximization are met –
i.e. the last dollar spent on search activity generates the same absolute quantum of marginal utility from
expected incremental income as it does marginal disutility from expected failure.
Second, we argue that there should be an argument in the utility function that reflects the passion or
emotional involvement that the entrepreneur has for any particular new venture concept. Cooper, Folta &
Woo (1995:107) argue that entrepreneurs might search less because their ‘entrepreneurial euphoria’ may limit
their ability to assess their own needs for additional information. This euphoria might be related to one’s need
for achievement (McClelland, 1961) and be associated with all types of entrepreneurship, but there is likely to
be a specific source of psychic satisfaction to be gained by being the pioneer in a new market. We will call
this the ‘preference for pioneering’ and argue that it that might be the major component of ‘entrepreneurial
euphoria’ in many cases, particularly where the new product or service is a disruptive innovation (Bower &
Christensen, 1995).
Being the pioneer involves a significant amount of public recognition from the market, the business
press, and society more generally. An entrepreneur with high need for achievement or recognition might have
a relatively strong preference for pioneering, and thus it will have a relatively heavy weight in his/her utility
function. Accordingly, any delays to the launch of the new venture raise the risk that another firm will be the
pioneer and the recognition sought by our aspiring pioneer will be lost. This ‘preference for pioneering’ might
be so strong as to cause extreme haste to get into the market, whatever the risk aversion and the risk
perceptions of the entrepreneur.
To continue the lenses analogy, this is analogous to the orange-coloured lenses (a.k.a. ‘blue-blockers)
that filter out the ‘blue end’ of the visible light spectrum and thus allow better visibility in poor light
conditions (e.g. when driving or playing baseball at night). In effect, they block out that part of the light
spectrum (i.e. information) that the individual feels is unnecessary to allow focus on that part of the business
that the individual thinks is more important. Accordingly entrepreneurs may undertake risky new venture
because it suits their broader preferences to do so. That is, the utility expected to be derived from pioneering,
and/or the disutility expected to be avoided by surviving, outweighs the disutility that is associated with
bearing new venture risk.
Discussion and Propositions
We propose that entrepreneurs ‘act as if’ they know that risk-reducing information might be available to
them, but they also know that information search activity costs money and takes time to accomplish, so they
incorporate into their decision making the impact of additional cost and additional delays on the new
venture’s prospects for survival and profitability. Even under bounded rationality we should expect the
entrepreneur to make judgements about the value of further information search according to the impact he/she
thinks the additional costs and delays will have on the financial success of the new venture. In this paper we
postulate an urgency effect, or ‘yellow-lens’ effect; viz: that entrepreneurs will truncate information search
activity at the point where the marginal income from additional search just equals the marginal cost
associated with additional search (including the loss of future income associated with the first-mover
advantages).
The ‘yellow-lens’ effect might be more or less important according to a number of issues. First there is
the relative cost of information – if information is relatively inexpensive we should expect the marginal
conditions for utility maximization to be satisfied at higher levels of information search. This is a trivial result
in itself, since it follows from the marginal conditions of the utility-maximizing model. For an interesting
result we need to couch the question in terms of the perceived costs of obtaining a specific quantum of
information (e.g. market research to ascertain consumer reactions to the new product or service) relative to
the perceived value of the new venture. From standard economic analysis, we expect more income the
entrepreneur has, or expects to have, the lower will be their marginal utility of income, and thus the lower will
be the marginal disutility of risk, implying that information search activity has been carried to a higher level.
This suggests the following testable propositions:
Proposition 1: Entrepreneurs with greater income, wealth, cash balances, and/or expecting greater
income from their new ventures, will spend more on search activity prior to launch than will other
entrepreneurs/new ventures, other things being equal.
Proposition 2: The higher the perceived cost of a specific information search (e.g. to ascertain customer
reaction to the new product or service) relative to the expected value of the new venture, the less information-
search activity will the entrepreneur undertake, other things being equal.
What kinds of situations militate in favour of higher information cost in the context of new ventures?
Following Shepherd, Douglas & Shanley (2000) we know that new venture risk is based on the ignorance of
consumers, producers and managers, and that reducing this ignorance reduces risk. Consumer ignorance is
reduced by advertising, promotion, product demonstrations, comparative testing, and celebrity
endorsements. Producer ignorance is reduced by technical training, learning by doing, prototype testing, trial
production, and durability and safety testing of the finished product. Management ignorance is reduced by
management education, learning by doing, and consultations with advisory boards and mentors. Considering
consumer ignorance, we note that although this ignorance resides in the minds of potential consumers, the
entrepreneur must act to reduce this ignorance in order to reduce the risk of new venture mortality, and that
this will necessarily include marketing expenditures to build awareness and trust among potential customers.
The amount of marketing that the new firm will need to undertake to inform potential customers about
the new product or service will depend on whether the innovation is a search good or an experience good
(Nelson, 1978; Darby & Karni, 1973). Search goods are those where the quality of the product or service can
be ascertained at relatively little cost to the consumer (e.g. clothing), whereas experience goods typically
require the consumer to purchase the item in order to verify the quality claims of the seller (e.g. movies,
education). For search goods, the seller need simply display the goods, or post information on a website, and
the buyer’s quality risk is soon overcome, whereas for experience goods the seller needs to spend more time
and effort persuading the potential consumer to trial the product. This implies that the new venture selling
experience goods will get less marketing ‘bang for the buck’ (as compared with search goods), and thus
suggests the following proposition:
Proposition 3: New ventures exploiting search goods will conduct relatively more marketing expense
than will new ventures selling experience goods, other things being equal.
We might expect ignorance in all three realms to be higher for firms exploiting a radical or disruptive
innovation, as compared to firms exploiting a creative imitation (Drucker, 1985) or sustaining technological
improvement (Bower & Christenson, 1995). For sustaining technological improvements there is already a
considerable amount of extant information in the relevant market and industry about what the product
category is, what it does, where one buys it, how it works, how it should be managed, and so on. For
disruptive innovations, on the other hand, all three groups (consumers, producers and managers) are likely to
be more ignorant about the (new) product category, its benefits, how it works, how to manage it, and so forth.
In addition, information on technical procedures and management best practice might be less readily available
and hence more expensive for new ventures exploiting a disruptive innovation, because there would be less
information available in the public domain, and a lower probability of leakage of that information. This
suggests the following testable proposition:
Proposition 4: New ventures introducing disruptive innovations will conduct relatively less search
activity (including marketing expense) than will new ventures selling creative imitations or sustaining
technological improvements, other things being equal.
Next, we concern ourselves with the time delays associated with information search activity. The time
spent on information search increases the probability that another firm will be the first-mover and thereby
relegate the entrepreneur to the status of follower rather than pioneer. Entrepreneurs typically strive to be first
to market because winning the race to market is thought to be risk-minimizing, cash conserving, and is
expected to allow monopoly profits at least until followers arrive on the scene. Under what circumstances
might a new venture be more relaxed about the race to get into the market? One that suggests itself is where
rival firms will be unable to imitate the product or otherwise usurp the pioneer’s proprietary technology. First-
mover advantages are expected to be more important for disruptive technologies where alternative
technologies might enter and vie for the industry standard, rather than for sustaining technological
developments. Where patents are the key to a relatively long period of monopoly exploitation of a new
technology (as in pharmaceuticals), the urgency is more focussed on gaining patent protection rather than on
being first to market. If the firm already has patents in place it will be less anxious to establish a foothold in
the new market, since it will be confident that others cannot legally copy its proprietary technology. We note
that service innovations are typically not patentable, and it is therefore easier for followers to imitate the
innovation more quickly. Firms planning to launch new services might also exhibit more urgency to get to
market first in order to get down their learning curves, and to build (hard-to-copy resources including) service
efficiency and reputation. Thus new ventures with service innovations might be more anxious to enter the
market than firms with product innovations. This suggests the following propositions:
Proposition 5: New ventures exploiting technology that is already patented will conduct relatively more
information search activity than will new ventures goods or services for which patent protection is not yet or
cannot be attained, other things being equal.
Proposition 6: New ventures with service innovations will conduct less information-search activity than
will firms with product or process innovations, other things being equal.
Proposition 7: The more important that the entrepreneur perceives the first mover advantages to be, the
less information search activity he/she will undertake, other things being equal.
If a firm already has a strong brand name, due to prior market activity with other products or services, it
will be less anxious to get into the market and start building its reputation and brands. Similarly, if the firm
already has production experience in related manufactures or service provision, it will be less concerned with
getting into business to start moving down the learning curve before others launch their products. This
suggests:
Proposition 8: New ventures introducing their initial new product or service will conduct less
information search activity than will firms introducing their second or subsequent product or service
innovation, other things being equal.
Moving now to the non-monetary issues (perks) associated with being an entrepreneur; we noted that
entrepreneurs might gain utility from the simple fact of being a first mover or pioneer, due to their need for
achievement, for example. Conversely they might gain disutility from the perceived social effects associated
with new venture failure, and thus prefer to speed up the launch process and become an entrepreneur as soon
as possible rather than delay the process while further information search is undertaken. We might summarize
this as the degree of the entrepreneur’s ‘psychic involvement’ in the entrepreneurial process, as opposed to
their being merely a dispassionate observer of the process. This suggests:
Proposition 9: Entrepreneurs with greater psychic involvement (i.e. who place more weight on the
psychic benefits of being an entrepreneur and/or being the pioneer in a new market or industry) will conduct
less information search activity than will entrepreneurs who have lesser psychic involvement in process, other
things being equal.
Proposition 10: Entrepreneurs who are more averse to the negative social consequences of new venture
failure will conduct less information search activity than will entrepreneurs who are indifferent or case less
about the approbation of others, other things being equal.
We now return now to the central question – why do entrepreneurs take the risks that they do? From the
theory of planned behavior (Ajzen, 1991) we expect behavior to be preceded by intentions, which in turn is
preceded by attitudes. In the context of attitudes to entrepreneurial risk taking, previous research, including
the analysis of this paper, suggests that perceptions and preferences might moderate the relationship between
risk attitudes and risk taking intentions and behavior, as follows:
Proposition 11: The influence of risk propensity on entrepreneurial intentions or actions is moderated
by five main indicators of risk perceptions:
a: Positively moderated by overconfidence (rose-lens effect);
b: Positively moderated by the use of decision heuristics (dark-lens effect);
c: Positively moderated by human capital (clear-lens effect);
d: Positively moderated by urgency to gain first-mover advantages (yellow-lens effect); and
e: Positively moderated by emotional involvement in the venture (orange-lens effect).
Note that this differs from the argument of Sitkin and Weingart (1995) who felt that differences in risk
propensities would influence risk perceptions. Subsequently, Forlani & Mullins (2000) found no significant
relationship between the risk propensities and the risk perceptions of entrepreneurs. Here we are arguing that
there are likely to be interaction effects between risk attitudes and risk perceptions as determinants of
entrepreneurial intentions (or actions). This is illustrated schematically in Figure 1. Of course there are other
determinants of entrepreneurial risk taking which are not the focus of this paper (see for example J anney &
Dess, 2006).
[Figure 1 near here]
There remains the problem of how to operationalize these proposed new determinants of risk
perception. The urgency with which the entrepreneur seeks to capture first-mover advantages might be
measured in terms of whether the intellectual property is considered protectable (more urgent if not); whether
the innovation is a service (more urgent if so); whether the innovation is disruptive (more urgent if so); and
whether different technologies are likely to compete for the industry standard (more urgent if so), and so on.
To measure the entrepreneur’s emotional involvement in a particular new venture will require questionnaire
items that seek to measure the emotional involvement or psychic income from the project per se, holding
constant the utility/disutility from other sources such as income, independence, other perquisites, risk
exposure and work effort. Suggested items might include the monetary value of giving up the option to start
that business, measures of work-life balance, and comparisons with other sources of psychic income.
Conclusion
Entrepreneurial research has long had difficulty reconciling the extraordinary risk of new ventures with
the consistent lack of evidence that entrepreneurs are extraordinarily tolerant of risk. The recent focus on the
different perceptions of risk by entrepreneurs has drawn our attention to the fact that entrepreneurs tend to
exhibit overconfidence, thus underestimating the risks that they do see (rose-lens effect). Others suggest that
many entrepreneurs do not see the risk that others see, due to their use of decision heuristics (dark-lens
effect). A third view is that entrepreneurs have their superior knowledge and other human capital resources
including social networks (clear-lens effect). This paper introduced two new lenses through which
entrepreneurs may (or may not) perceive risk in their new venture concept.
First, the ‘yellow-lens’ effect may cause the entrepreneur to truncate information search because search
activity may jeopardise winning the race to be first to market. The perceived urgency of starting the new
venture sooner rather than later relates to higher profits expected as first-mover (as compared to entering the
market later as a follower). The opportunity cost of search activity may therefore be viewed as a reduction in
current income (risking bankruptcy) and/or a reduction in future income (by losing first mover advantages).
The utility-maximizing entrepreneur will equate the marginal utility of income with the marginal disutility of
risk at the margin. It follows that an entrepreneur with a stronger preference for income will prefer to
undertake less risk-reducing information search activity. Put another way, the more materialistic is the
entrepreneur, the more they will care about income relative to risk.
Second, the ‘orange-lens’ effect may cause the entrepreneur to truncate information search activity if
the entrepreneur exhibits a preference for the entrepreneurial process per se, which we call ‘involvement’. If
the entrepreneur gains utility from the process of being first to market and being recognized as the pioneer,
this element in his/her utility function will exert influence on the amount of risk-reducing information search
activity undertaken. In effect there is a trade-off between seeking more information and pressing ahead to
start the new venture (and thus gain recognition and status as the pioneer). At the margin, the utility-
maximizing entrepreneur will equate the marginal utility of pioneering with the marginal disutility of risk. It
follows that an entrepreneur who has a stronger preference for pioneering (or for becoming an entrepreneur
sooner) will undertake less information search activity than one who is content to enter the market as an early
or late follower. In effect, we have formally recognized the ‘entrepreneurial euphoria’ noted by Cooper, Folta
& Woo (1995) by ‘unpacking’ it from the net perks item (Douglas & Shepherd, 2000) in the entrepreneur’s
utility function.
The contributions of this paper include the following. First, we hypothesize two additional determinants
of the risk perceptions of entrepreneurs, by arguing two situations in which the entrepreneur will truncate
information search and proceed ahead in blissful (or nervous) ignorance of the risks that may or may not have
been discovered or reduced by further information search. Second, we offer a taxonomy of lens types that
allows the simple categorization of the determinants of the entrepreneur’s risk perception. This taxonomy
provides an ‘easy to remember, easy to teach’ system for educators and consultants to convey these concepts
to entrepreneurs and potential entrepreneurs. This taxonomy also serves to reinforce the view that individual
risk behaviour is not comparable across individuals due to innate cognitive differences, human capital
differences, and contextual differences. Third, we argue that entrepreneurial risk behavior is concerned with
the entrepreneur’s reaction to perceived risk, which is a complex function of his/her attitude to risk. We
propose that the relationship between risk attitude and entrepreneurial intentions (or actions) is moderated by
the five main determinants (lenses) of risk perception. Fourth, we provide a series of testable propositions that
emanate from the analysis and suggest several items that might be included in constructs for the involvement
and urgency variables.
This paper is a conceptual study that argues a particular model of entrepreneurial risk behavior. Clearly
there is a need for empirical studies to validate the propositions and the constructs suggested. Almost
certainly there remain additional determinants of risk perception that might be discovered analytically or
empirically by researchers as they work to better understand entrepreneurial risk behavior.
CONTACT: Evan Douglas, Brisbane Graduate School of Business, Queensland University of Technology, 2
George St., Brisbane, Qld, Australia 4000; (T) +61-7-3864-1126; (F) +61-7-3864-1299;
[email protected]
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Attitude to Risk
Entrepreneurial Intentions
Human Capital (clear-lens effect)
Over-Confidence (rose-lens effect)
Involvement (orange-lens effect)
Urgency (yellow-lens effect)
Figure 1: Relationship between Risk Attitudes and Entrepreneurial Intentions
Figure 1: Relationship between Risk Attitudes and Entrepreneurial Intentions
Use of Heuristics (dark-lens effect)
doc_187935827.pdf
Within this brief paper about douglas, evan (2006) new venture risk taking perceptions and preferences.
COVER SHEET
This is the author-version of article published as:
Douglas, Evan (2006) New Venture Risk Taking – Perceptions and
Preferences?. In Proceedings Babson College Entrepreneurial
Research Conference, USA, Indiana.
Accessed fromhttp://eprints.qut.edu.au
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NEW VENTURE RISK TAKING: PERCEPTIONS AND PREFERENCES?
Evan J . Douglas
Brisbane Graduate School of Business
Queensland University of Technology
Abstract
This paper clarifies and expands the ‘perceptions’ view of entrepreneurial risk taking and provides two
additional concepts to explain why entrepreneurs undertake risky new ventures. The utility-maximizing
model of entrepreneurship is extended to include these additional concepts. We argue that entrepreneurs will
truncate risk-reducing information-search, firstly because the delay involved in search activity may cause the
loss of additional income associated with first-mover advantages, and secondly because the entrepreneur’s
psychic involvement in the process of becoming an entrepreneur and/or pioneer might be so important that
he/she trades off risk reduction to become an entrepreneur sooner.
Introduction
It is commonly presumed that entrepreneurs must have relatively high tolerance for risk, as compared to
managers of other firms, since it is entrepreneurs rather than corporates who typically start new high-risk
business ventures (Stinchcombe, 1965; Reynolds, 1986; Phillips & Kirchoff, 1988). But empirical studies of
entrepreneurial risk propensities have shown mixed results, with some being quite averse to risk, others are
less averse to risk, and no significant difference found between entrepreneurs and managers of other firms
(Brockhaus, 1980; Brockhaus & Horwitz, 1986; Low & MacMillan, 1988; Palich & Bagby, 1995; Busenitz,
1999). Gifford (2003) demonstrates that what might seem to be risk aversion or preference might instead be
the result of different personal investments in knowledge acquisition. In any case, the lack of a simple
empirical relationship between attitudes to risk and the risk taking behaviour of entrepreneurs is not
surprising, the entrepreneur’s attitude to risk is neither a necessary or sufficient condition for the decision to
behave entrepreneurially (Douglas & Shepherd, 2000).
A more recent view focuses on the risk perceptions of entrepreneurs. Cooper, Woo & Dunkelberg
(1988) found that entrepreneurs exhibit higher self-efficacy than other managers, and consequently think that
they are better equipped to deal with risks than are non-entrepreneurs. Palich & Bagby (1995) found that
entrepreneurs exhibit the cognitive bias of ‘overconfidence’. Busenitz & Barney (1997) and Simon, Houghton
& Aquino (2000) found that while all managers exhibit overconfidence, entrepreneurs exhibit greater
overconfidence than do employed managers. Accordingly, entrepreneurs might undertake risky ventures not
because they are unworried about the risk but because they do not perceive the amount of risk that others do
in that new venture.
The ‘perceptions’ view of entrepreneurial risk-taking may not tell the full story, however. Risk taking
can be defined as undertaking an action without complete information, and the source of new venture risk can
be largely traced to the incomplete information (or ignorance) in the minds of consumers, producers, and
managers (Shepherd, Douglas & Shanley, 2000). Lack of knowledge will mean that at least some risks will be
unperceived, of course. Accordingly, these risks do not even exist for the entrepreneur, and consequently they
undertake new ventures that others, with better knowledge, would not. If entrepreneurs ‘do not know what
they do not know’ then they will, particularly if afflicted by overconfidence, leap in and take risks. We need
to know why entrepreneurs appear to be satisfied with their current quantum of knowledge and why they
typically eschew, or at least truncate, information search activity.
In this paper we provide further answers to the question ‘why does the entrepreneur forsake further
information search activity?’ While Cooper, Woo and Dunkelberg (1988) and others have asked the same
question, the question has been answered in terms of cognitive biases. We examine the issue in terms of the
economics of entrepreneurship and show that there are a series of issues that may reduce the utility expected
from the entrepreneurial process if additional information search activity were to be undertaken. We bring
together psychological and economics thinking to argue that entrepreneurs may perceive lesser risk for both
perceptual and preference reasons.
In the next section we overview the literature on the perceptions view, the ignorance view, and the
utility-maximizing view of entrepreneurial risk taking behavior. In the third section we examine two
additional reasons for truncating information search activity – these relate to the ‘urgency’ and the
‘involvement’ with which the entrepreneur considers the entrepreneurial process. The third section discusses
the implications of the foregoing and suggests a series of propositions that might be tested empirically.
Finally we conclude with a statement of the contributions made by this study.
Literature review
The Perceptions View of Risk Taking
Krueger & Dickson (1994) looked at the relationship between self-efficacy and its relationship with
increased risk taking. When self efficacy is inflated to exceed one’s capability to deliver, it becomes
overconfidence. Palich & Bagby (1995) argued that the operative issue is perceived risk, rather than attitude
to risk, and that entrepreneurs tend to downplay the risk they perceive, expecting to triumph over any adverse
situations that arise. They found that entrepreneurs typically possess overconfidence exemplified by their
consistently looking at new venture opportunities more positively than others (see also Chen, Greene & Crick,
1998; Forbes, 2005). Cooper, Folta & Woo (1995) argued that higher levels of self-confidence were related to
lower levels of information search activity, and therefore greater risk bearing due to the entrepreneur’s
ignorance of the risks being borne. They argued that “the entrepreneur is ‘blinded’ to the need for more
information due to his/her overconfidence.” (1995:110). Saraswarthy, Simon & Lave (1998) and Hillier
(1998) found that entrepreneurs are biased in their perceptions of risk and opportunities. Palich & Bagby
(1995:443) used the term ‘rose-coloured glasses’ to characterize the rosy-hued view taken by entrepreneurs
who underestimate risk due to overconfidence.
Busenitz & Barney (1997) and Busenitz (1999) found that entrepreneurs use cognitive biases and
decision heuristics more than do self-employed managers and accordingly take greater risks without
necessarily knowing that they are doing so. Faced with high levels of uncertainty and pressure to make
decisions before the perceived window of opportunity closes, entrepreneurs adopt simplified decision rules
that allow quick decisions (Tversky & Kahneman, 1974). But simple decision rules might be suboptimal and
thus adversely affect the new venture’s survival prospects. In contrast to the ‘rose-colored’ glasses, we might
say that the entrepreneur dons ‘dark glasses’ to block out the overload of light (i.e. information) that is
potentially available but the processing of which would hinder speedy decision making.
Many studies have attempted to relate individual ‘human capital’ (Becker, 1964) to nascent
entrepreneurship, entrepreneurial intentions, entrepreneurial behaviour and entrepreneurial performance (see
Shane, 2003, pp. 61-95 for an overview). Gifford (1998) posits a model of ‘limited attention’ that explains
why those with greater entrepreneurial ability are more likely to engage in entrepreneurial activity. Shane &
Venkataraman (2000) argue that entrepreneurs who possess proprietary knowledge about new venture
opportunities appear (to those who lack the information) to be willing to accept greater risk. Baron (2000)
argues that entrepreneurs’ lower perceptions of risk relates to their lesser ability to engage in counterfactual
thinking. The human capital literature on entrepreneurship (e.g. Davidsson and Honig, 2003; Kim, Aldrich
and Keister, 2003) argues that individuals have differing capabilities due to their differing ‘general’ human
capital (such as age, gender, years of education and work experience) and ‘specific’ human capital (such as
relevant education and industry experience, relatives who are self-employed, social networks, and so on).
Most recently, J anney & Dess (2006) argue that the entrepreneur may possess specialized knowledge and
idiosyncratic resources that mean that risks perceived by others do not apply to the entrepreneur, who
effectively has superior human capital resources.
Thus, a person with substantial prior education, knowledge and experience in the relevant technology
and market realms may see little risk in a particular new venture, while another person without such
knowledge and experience may view the same new venture as being much more risky. In this view, the
entrepreneur ‘sees’ things that others do not, somewhat analogous to a person wearing prescription lenses
tailored exactly to match one’s own visual acuity. Accordingly, we might call this the ‘clear lens effect’ and
note that one person cannot judge how risky another person’s action is unless they have identically ‘clear’
lenses (not to mention the lack of cognitive biases).
The Ignorance View of Risk Taking
Fiet (1996) notes that entrepreneurs can undertake information search activity to reduce the uncertainty
and risks of a new venture. Shepherd, Douglas and Shanley (2000) argue that the mortality risk of a new
venture depends on the novelty of its product, its production technology, and the managerial requirements.
They explain the ‘liability of newness’ (Stinchcombe 1965) in terms of the extent to which the new venture is
novel in the eyes of customers, producers, and managers. Put another way, new venture mortality risk
depends on the ignorance (of relevant information) in the minds of customers, producers and managers. Here
we are concerned with the human capital of the entrepreneur and other managers, and whether they lack the
general and specific knowledge required to effectively manage the new venture through survival to success.
Accordingly, the mortality risk existing in any new venture will depend on which particular entrepreneur or
entrepreneurial team is managing the new venture opportunity (see also Gifford, 2003).
The ignorance view is concerned with the extant knowledge (or its complement, ignorance) held by the
entrepreneur, and does not examine the relationship between the extent of ignorance (i.e. risk) and one’s
attitude toward this risk. Implicitly, the ignorance view incorporates risk perceptions by the implication that
the risks associated with the entrepreneur’s ignorance are not perceived, but it also ignores cognitive biases
and thus effectively assumes that the entrepreneur is not subject to any cognitive biases.
The Preferences View of Risk Taking
What we are calling the ‘preferences’ view is based upon the utility-maximizing model of career choice
– i.e. individuals form the intention to start a new business if so doing is expected to deliver greater psychic
satisfaction than would the best-available employment option (Eisenhauer, 1995). According to Douglas &
Shepherd (2000) this decision is based on the entrepreneur’s preference (or aversion) for five components of
entrepreneurship, viz: the utility derived from income, independence, and net perquisites offered by a new
venture opportunity, and the disutility derived from risk bearing and work effort associated with that new
venture. They posit that in choosing among different career (including new venture) opportunities, the
individual’s preferences for income, independence, risk, work and net perquisites are parameters in that
person’s utility function. The values of the five variables in the utility function depend on the magnitudes
expected in the context of each career alternative. The total utility for each new venture option is then the sum
of the products of the attitude parameters and the relevant variable in each alternative. The entrepreneur is
expected to commit to the alternative that promises the highest level of utility in prospect.
Thus both risk attitude and risk perception enter the entrepreneur’s utility function. But note that neither
of them is a necessary or sufficient condition for entrepreneurial behavior – it is the sum of the arguments in
the utility function that determines the choice between career options, rather than the value of any one
parameter or variable (Douglas & Shepherd, 2000). Thus, an individual might choose a highly-risky new
venture (in which great risk might be perceived) despite being highly averse to risk, if expecting to be
rewarded by high income levels and/or highly-satisfying decision-making autonomy. Thus, it is not surprising
that studies of intending or practising entrepreneurs might exhibit a variety of risk propensities (Brockhaus,
1980; Douglas and Shepherd, 2002.)
Entrepreneurial avoidance of risk-reducing information-search activity
Why would entrepreneurs refuse to seek additional information that would serve to reduce risk? In the
foregoing we have identified overconfidence (the ‘rose-lens’ effect), limiting information search on these
issues in order to focus on what they perceive to be more important at the time, given the need for speed due
to limited windows of opportunity (the ‘dark-lens’ effect), and superior human capital resources (the ‘clear-
lens’ effect). We now suggest two more reasons that might reinforce the above.
The Urgency for Entrepreneurial Activity
It may be utility-maximizing to ignore the availability of information if securing that information would
have an adverse impact on the entrepreneur’s expected income. Search activity costs money and takes time,
and these aspects of search activity may have a negative impact on the income (and hence the utility) of the
entrepreneur. This will be particularly so if the entrepreneur has a strong preference for income (or the
material goods and services that can be purchased using income).
First, let us consider the impact of search costs. Expenditure on search costs will reduce net income of
the new venture if they do not result in the capture of additional useful information. Thus information that
confirms the entrepreneur’s belief that consumers will buy the new product or service is seen as an wasted
expenditure that simply reduces net income. If the entrepreneur has a positive attitude to income (as expected)
this reduces the total utility of the new venture. Further, we note that the great majority of new ventures are
‘bootstrap’ funded (Winborg & Landstrom, 2000), and thus the opportunity cost of the funds required for
search activity is extremely high, competing with prototype development, the cost of equipment, marketing
expenses, and so forth. When the opportunity cost is added to the direct cost of search activity, it may be
perceived as income maximizing and consequently utility maximizing to truncate information search activity
and channel the funds into what is perceived as a better utilization of those funds.
Second, search activity takes a significant period of time to set up, to undertake, and to review the data
derived. This passage of time may be viewed as an obstacle to winning the race to be ‘first-to-market’ and
subsequently earning superior profits. The first-mover advantages (Lieberman & Montgomery, 1988) of the
pioneer firm are commonly assumed by entrepreneurs to provide competitive advantage, although most
pioneers do not survive or even maintain market leadership (Tellis & Golder, 1995). But we are concerned
with a priori perceptions here – if the entrepreneur expects that pioneering will endow the firm with
significant competitive advantages, any delay due to information search activity might be expected to
negatively affect the net present value of the firm’s income stream, and thus negatively affect the
entrepreneur’s total utility.
Note also that information can be obtained either by search activity prior to launch of the new venture
or gleaned from experience after the launch of the new venture. The learning-by-doing option may be
preferred for a number of reasons. First, it does not delay the start-up in a situation where time is of the
essence because of first-mover advantages. Second, it has no incremental costs and thus does not contribute to
the ‘burn rate’ prior to launch in the situation where cash balances are critical. Third, it is likely to provide
better information and thus be a better use of the limited funds. At the margin, the utility-maximizing
entrepreneur will equate the marginal utility of income with the marginal disutility of risk, such that a dollar
will only be spent on risk-reduction activity if it is expected to increase the entrepreneur’s total utility.
To continue the ‘lenses’ analogy introduced earlier, we might call this the ‘yellow-lens effect’ since the
decision to not undertake information search activity for cost or time reasons is akin to the skier’s decision to
not spend money and time buying ski goggles, but instead hurrying to get out onto the ski run. Ski goggles
utilise yellow lenses to achieve greater clarity of vision in high-glare, low-contrast situations, and thereby
allow the skier to see the moguls, thereby removing some risk from the act of skiing. For the entrepreneur
yellow lenses represent the information that might be gained from market research, prototype testing,
management education, and other activities designed to accumulate more knowledge about the technology,
market and management issues involved in the new venture. The decision to not wear these lenses is no doubt
related to self-efficacy and overconfidence, as noted by earlier authors, but it also appears to be related to the
strength of preference for income in the entrepreneur’s utility function.
The Involvement of the Entrepreneur in the Entrepreneurial Process
We now consider issues that impact the utility function via preferences for non-monetary items
associated with entrepreneurship. The impact of these factors must enter the utility function in the ‘net perks’
element proposed by Douglas & Shepherd (2000). This term encompasses all the psychic costs and benefits
associated with the new venture other than those specifically noted (i.e. income, independence, risk and work
effort). Here we propose ‘unpacking’ two significant elements from within net perks and arguing that they
influence the entrepreneur’s decision to truncate search activity.
First, expenditure on search costs may raise the mortality risk (Shepherd, Douglas & Shanley, 2000) of
the nascent firm – spending scarce cash on search activity prior to launch reduces the cash balances of the
new venture and thereby increases the firm’s risk of insolvency (J anney & Dess, 2006). The prospect of new
venture mortality may be expected to have negative connotations in the mind of the entrepreneur. The
individual may have a fear of failure, and/or want to avoid the ‘loss of face’, the condemnation of
disappointed stakeholders, and the jeers of the naysayer that may be associated with new venture failure.
Thus, considering that the prospect of financial failure probably causes disutility, the entrepreneur will
undertake search activity only to the point where the marginal conditions for utility maximization are met –
i.e. the last dollar spent on search activity generates the same absolute quantum of marginal utility from
expected incremental income as it does marginal disutility from expected failure.
Second, we argue that there should be an argument in the utility function that reflects the passion or
emotional involvement that the entrepreneur has for any particular new venture concept. Cooper, Folta &
Woo (1995:107) argue that entrepreneurs might search less because their ‘entrepreneurial euphoria’ may limit
their ability to assess their own needs for additional information. This euphoria might be related to one’s need
for achievement (McClelland, 1961) and be associated with all types of entrepreneurship, but there is likely to
be a specific source of psychic satisfaction to be gained by being the pioneer in a new market. We will call
this the ‘preference for pioneering’ and argue that it that might be the major component of ‘entrepreneurial
euphoria’ in many cases, particularly where the new product or service is a disruptive innovation (Bower &
Christensen, 1995).
Being the pioneer involves a significant amount of public recognition from the market, the business
press, and society more generally. An entrepreneur with high need for achievement or recognition might have
a relatively strong preference for pioneering, and thus it will have a relatively heavy weight in his/her utility
function. Accordingly, any delays to the launch of the new venture raise the risk that another firm will be the
pioneer and the recognition sought by our aspiring pioneer will be lost. This ‘preference for pioneering’ might
be so strong as to cause extreme haste to get into the market, whatever the risk aversion and the risk
perceptions of the entrepreneur.
To continue the lenses analogy, this is analogous to the orange-coloured lenses (a.k.a. ‘blue-blockers)
that filter out the ‘blue end’ of the visible light spectrum and thus allow better visibility in poor light
conditions (e.g. when driving or playing baseball at night). In effect, they block out that part of the light
spectrum (i.e. information) that the individual feels is unnecessary to allow focus on that part of the business
that the individual thinks is more important. Accordingly entrepreneurs may undertake risky new venture
because it suits their broader preferences to do so. That is, the utility expected to be derived from pioneering,
and/or the disutility expected to be avoided by surviving, outweighs the disutility that is associated with
bearing new venture risk.
Discussion and Propositions
We propose that entrepreneurs ‘act as if’ they know that risk-reducing information might be available to
them, but they also know that information search activity costs money and takes time to accomplish, so they
incorporate into their decision making the impact of additional cost and additional delays on the new
venture’s prospects for survival and profitability. Even under bounded rationality we should expect the
entrepreneur to make judgements about the value of further information search according to the impact he/she
thinks the additional costs and delays will have on the financial success of the new venture. In this paper we
postulate an urgency effect, or ‘yellow-lens’ effect; viz: that entrepreneurs will truncate information search
activity at the point where the marginal income from additional search just equals the marginal cost
associated with additional search (including the loss of future income associated with the first-mover
advantages).
The ‘yellow-lens’ effect might be more or less important according to a number of issues. First there is
the relative cost of information – if information is relatively inexpensive we should expect the marginal
conditions for utility maximization to be satisfied at higher levels of information search. This is a trivial result
in itself, since it follows from the marginal conditions of the utility-maximizing model. For an interesting
result we need to couch the question in terms of the perceived costs of obtaining a specific quantum of
information (e.g. market research to ascertain consumer reactions to the new product or service) relative to
the perceived value of the new venture. From standard economic analysis, we expect more income the
entrepreneur has, or expects to have, the lower will be their marginal utility of income, and thus the lower will
be the marginal disutility of risk, implying that information search activity has been carried to a higher level.
This suggests the following testable propositions:
Proposition 1: Entrepreneurs with greater income, wealth, cash balances, and/or expecting greater
income from their new ventures, will spend more on search activity prior to launch than will other
entrepreneurs/new ventures, other things being equal.
Proposition 2: The higher the perceived cost of a specific information search (e.g. to ascertain customer
reaction to the new product or service) relative to the expected value of the new venture, the less information-
search activity will the entrepreneur undertake, other things being equal.
What kinds of situations militate in favour of higher information cost in the context of new ventures?
Following Shepherd, Douglas & Shanley (2000) we know that new venture risk is based on the ignorance of
consumers, producers and managers, and that reducing this ignorance reduces risk. Consumer ignorance is
reduced by advertising, promotion, product demonstrations, comparative testing, and celebrity
endorsements. Producer ignorance is reduced by technical training, learning by doing, prototype testing, trial
production, and durability and safety testing of the finished product. Management ignorance is reduced by
management education, learning by doing, and consultations with advisory boards and mentors. Considering
consumer ignorance, we note that although this ignorance resides in the minds of potential consumers, the
entrepreneur must act to reduce this ignorance in order to reduce the risk of new venture mortality, and that
this will necessarily include marketing expenditures to build awareness and trust among potential customers.
The amount of marketing that the new firm will need to undertake to inform potential customers about
the new product or service will depend on whether the innovation is a search good or an experience good
(Nelson, 1978; Darby & Karni, 1973). Search goods are those where the quality of the product or service can
be ascertained at relatively little cost to the consumer (e.g. clothing), whereas experience goods typically
require the consumer to purchase the item in order to verify the quality claims of the seller (e.g. movies,
education). For search goods, the seller need simply display the goods, or post information on a website, and
the buyer’s quality risk is soon overcome, whereas for experience goods the seller needs to spend more time
and effort persuading the potential consumer to trial the product. This implies that the new venture selling
experience goods will get less marketing ‘bang for the buck’ (as compared with search goods), and thus
suggests the following proposition:
Proposition 3: New ventures exploiting search goods will conduct relatively more marketing expense
than will new ventures selling experience goods, other things being equal.
We might expect ignorance in all three realms to be higher for firms exploiting a radical or disruptive
innovation, as compared to firms exploiting a creative imitation (Drucker, 1985) or sustaining technological
improvement (Bower & Christenson, 1995). For sustaining technological improvements there is already a
considerable amount of extant information in the relevant market and industry about what the product
category is, what it does, where one buys it, how it works, how it should be managed, and so on. For
disruptive innovations, on the other hand, all three groups (consumers, producers and managers) are likely to
be more ignorant about the (new) product category, its benefits, how it works, how to manage it, and so forth.
In addition, information on technical procedures and management best practice might be less readily available
and hence more expensive for new ventures exploiting a disruptive innovation, because there would be less
information available in the public domain, and a lower probability of leakage of that information. This
suggests the following testable proposition:
Proposition 4: New ventures introducing disruptive innovations will conduct relatively less search
activity (including marketing expense) than will new ventures selling creative imitations or sustaining
technological improvements, other things being equal.
Next, we concern ourselves with the time delays associated with information search activity. The time
spent on information search increases the probability that another firm will be the first-mover and thereby
relegate the entrepreneur to the status of follower rather than pioneer. Entrepreneurs typically strive to be first
to market because winning the race to market is thought to be risk-minimizing, cash conserving, and is
expected to allow monopoly profits at least until followers arrive on the scene. Under what circumstances
might a new venture be more relaxed about the race to get into the market? One that suggests itself is where
rival firms will be unable to imitate the product or otherwise usurp the pioneer’s proprietary technology. First-
mover advantages are expected to be more important for disruptive technologies where alternative
technologies might enter and vie for the industry standard, rather than for sustaining technological
developments. Where patents are the key to a relatively long period of monopoly exploitation of a new
technology (as in pharmaceuticals), the urgency is more focussed on gaining patent protection rather than on
being first to market. If the firm already has patents in place it will be less anxious to establish a foothold in
the new market, since it will be confident that others cannot legally copy its proprietary technology. We note
that service innovations are typically not patentable, and it is therefore easier for followers to imitate the
innovation more quickly. Firms planning to launch new services might also exhibit more urgency to get to
market first in order to get down their learning curves, and to build (hard-to-copy resources including) service
efficiency and reputation. Thus new ventures with service innovations might be more anxious to enter the
market than firms with product innovations. This suggests the following propositions:
Proposition 5: New ventures exploiting technology that is already patented will conduct relatively more
information search activity than will new ventures goods or services for which patent protection is not yet or
cannot be attained, other things being equal.
Proposition 6: New ventures with service innovations will conduct less information-search activity than
will firms with product or process innovations, other things being equal.
Proposition 7: The more important that the entrepreneur perceives the first mover advantages to be, the
less information search activity he/she will undertake, other things being equal.
If a firm already has a strong brand name, due to prior market activity with other products or services, it
will be less anxious to get into the market and start building its reputation and brands. Similarly, if the firm
already has production experience in related manufactures or service provision, it will be less concerned with
getting into business to start moving down the learning curve before others launch their products. This
suggests:
Proposition 8: New ventures introducing their initial new product or service will conduct less
information search activity than will firms introducing their second or subsequent product or service
innovation, other things being equal.
Moving now to the non-monetary issues (perks) associated with being an entrepreneur; we noted that
entrepreneurs might gain utility from the simple fact of being a first mover or pioneer, due to their need for
achievement, for example. Conversely they might gain disutility from the perceived social effects associated
with new venture failure, and thus prefer to speed up the launch process and become an entrepreneur as soon
as possible rather than delay the process while further information search is undertaken. We might summarize
this as the degree of the entrepreneur’s ‘psychic involvement’ in the entrepreneurial process, as opposed to
their being merely a dispassionate observer of the process. This suggests:
Proposition 9: Entrepreneurs with greater psychic involvement (i.e. who place more weight on the
psychic benefits of being an entrepreneur and/or being the pioneer in a new market or industry) will conduct
less information search activity than will entrepreneurs who have lesser psychic involvement in process, other
things being equal.
Proposition 10: Entrepreneurs who are more averse to the negative social consequences of new venture
failure will conduct less information search activity than will entrepreneurs who are indifferent or case less
about the approbation of others, other things being equal.
We now return now to the central question – why do entrepreneurs take the risks that they do? From the
theory of planned behavior (Ajzen, 1991) we expect behavior to be preceded by intentions, which in turn is
preceded by attitudes. In the context of attitudes to entrepreneurial risk taking, previous research, including
the analysis of this paper, suggests that perceptions and preferences might moderate the relationship between
risk attitudes and risk taking intentions and behavior, as follows:
Proposition 11: The influence of risk propensity on entrepreneurial intentions or actions is moderated
by five main indicators of risk perceptions:
a: Positively moderated by overconfidence (rose-lens effect);
b: Positively moderated by the use of decision heuristics (dark-lens effect);
c: Positively moderated by human capital (clear-lens effect);
d: Positively moderated by urgency to gain first-mover advantages (yellow-lens effect); and
e: Positively moderated by emotional involvement in the venture (orange-lens effect).
Note that this differs from the argument of Sitkin and Weingart (1995) who felt that differences in risk
propensities would influence risk perceptions. Subsequently, Forlani & Mullins (2000) found no significant
relationship between the risk propensities and the risk perceptions of entrepreneurs. Here we are arguing that
there are likely to be interaction effects between risk attitudes and risk perceptions as determinants of
entrepreneurial intentions (or actions). This is illustrated schematically in Figure 1. Of course there are other
determinants of entrepreneurial risk taking which are not the focus of this paper (see for example J anney &
Dess, 2006).
[Figure 1 near here]
There remains the problem of how to operationalize these proposed new determinants of risk
perception. The urgency with which the entrepreneur seeks to capture first-mover advantages might be
measured in terms of whether the intellectual property is considered protectable (more urgent if not); whether
the innovation is a service (more urgent if so); whether the innovation is disruptive (more urgent if so); and
whether different technologies are likely to compete for the industry standard (more urgent if so), and so on.
To measure the entrepreneur’s emotional involvement in a particular new venture will require questionnaire
items that seek to measure the emotional involvement or psychic income from the project per se, holding
constant the utility/disutility from other sources such as income, independence, other perquisites, risk
exposure and work effort. Suggested items might include the monetary value of giving up the option to start
that business, measures of work-life balance, and comparisons with other sources of psychic income.
Conclusion
Entrepreneurial research has long had difficulty reconciling the extraordinary risk of new ventures with
the consistent lack of evidence that entrepreneurs are extraordinarily tolerant of risk. The recent focus on the
different perceptions of risk by entrepreneurs has drawn our attention to the fact that entrepreneurs tend to
exhibit overconfidence, thus underestimating the risks that they do see (rose-lens effect). Others suggest that
many entrepreneurs do not see the risk that others see, due to their use of decision heuristics (dark-lens
effect). A third view is that entrepreneurs have their superior knowledge and other human capital resources
including social networks (clear-lens effect). This paper introduced two new lenses through which
entrepreneurs may (or may not) perceive risk in their new venture concept.
First, the ‘yellow-lens’ effect may cause the entrepreneur to truncate information search because search
activity may jeopardise winning the race to be first to market. The perceived urgency of starting the new
venture sooner rather than later relates to higher profits expected as first-mover (as compared to entering the
market later as a follower). The opportunity cost of search activity may therefore be viewed as a reduction in
current income (risking bankruptcy) and/or a reduction in future income (by losing first mover advantages).
The utility-maximizing entrepreneur will equate the marginal utility of income with the marginal disutility of
risk at the margin. It follows that an entrepreneur with a stronger preference for income will prefer to
undertake less risk-reducing information search activity. Put another way, the more materialistic is the
entrepreneur, the more they will care about income relative to risk.
Second, the ‘orange-lens’ effect may cause the entrepreneur to truncate information search activity if
the entrepreneur exhibits a preference for the entrepreneurial process per se, which we call ‘involvement’. If
the entrepreneur gains utility from the process of being first to market and being recognized as the pioneer,
this element in his/her utility function will exert influence on the amount of risk-reducing information search
activity undertaken. In effect there is a trade-off between seeking more information and pressing ahead to
start the new venture (and thus gain recognition and status as the pioneer). At the margin, the utility-
maximizing entrepreneur will equate the marginal utility of pioneering with the marginal disutility of risk. It
follows that an entrepreneur who has a stronger preference for pioneering (or for becoming an entrepreneur
sooner) will undertake less information search activity than one who is content to enter the market as an early
or late follower. In effect, we have formally recognized the ‘entrepreneurial euphoria’ noted by Cooper, Folta
& Woo (1995) by ‘unpacking’ it from the net perks item (Douglas & Shepherd, 2000) in the entrepreneur’s
utility function.
The contributions of this paper include the following. First, we hypothesize two additional determinants
of the risk perceptions of entrepreneurs, by arguing two situations in which the entrepreneur will truncate
information search and proceed ahead in blissful (or nervous) ignorance of the risks that may or may not have
been discovered or reduced by further information search. Second, we offer a taxonomy of lens types that
allows the simple categorization of the determinants of the entrepreneur’s risk perception. This taxonomy
provides an ‘easy to remember, easy to teach’ system for educators and consultants to convey these concepts
to entrepreneurs and potential entrepreneurs. This taxonomy also serves to reinforce the view that individual
risk behaviour is not comparable across individuals due to innate cognitive differences, human capital
differences, and contextual differences. Third, we argue that entrepreneurial risk behavior is concerned with
the entrepreneur’s reaction to perceived risk, which is a complex function of his/her attitude to risk. We
propose that the relationship between risk attitude and entrepreneurial intentions (or actions) is moderated by
the five main determinants (lenses) of risk perception. Fourth, we provide a series of testable propositions that
emanate from the analysis and suggest several items that might be included in constructs for the involvement
and urgency variables.
This paper is a conceptual study that argues a particular model of entrepreneurial risk behavior. Clearly
there is a need for empirical studies to validate the propositions and the constructs suggested. Almost
certainly there remain additional determinants of risk perception that might be discovered analytically or
empirically by researchers as they work to better understand entrepreneurial risk behavior.
CONTACT: Evan Douglas, Brisbane Graduate School of Business, Queensland University of Technology, 2
George St., Brisbane, Qld, Australia 4000; (T) +61-7-3864-1126; (F) +61-7-3864-1299;
[email protected]
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Attitude to Risk
Entrepreneurial Intentions
Human Capital (clear-lens effect)
Over-Confidence (rose-lens effect)
Involvement (orange-lens effect)
Urgency (yellow-lens effect)
Figure 1: Relationship between Risk Attitudes and Entrepreneurial Intentions
Figure 1: Relationship between Risk Attitudes and Entrepreneurial Intentions
Use of Heuristics (dark-lens effect)
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