The Risk Gap: Why Incumbents Stumble as Entrepreneurs Embrace Uncertainty
Having been an Operator, an Entrepreneur and an Investor, I get asked the question all the time why big companies continuously fail to innovate.
If I gave a lecture on the topic it would be called: “How to make bad decisions and not get fired.”
Let’s start with a thought exercise. Imagine getting a call about a “once in a lifetime investment opportunity” from a trusted friend who has an amazing long-term investment track record.
Being a great Investor, your friend has run thousands of scenarios and crunched the numbers to project the risk/return profile of the opportunity. The analysis resulted in the following profile:
– Odds of a complete wipe-out: 60%
– Odds of a 1–3X return in 6–8 years: 30%
– Odds of a 20–50X return in 6–8 years: 9%
– Odds of a 100X+ return in 6–8 years: 1%
The complication: The minimum investment amount would put your entire life’s savings at risk!
Your friend needs to know if you want in on the deal. What do you do?
Most people would pass because the thought of the “wipe-out” happening is terrifying. This is totally understandable even though the math suggests it’s a great investment.
Now let’s change the conditions of the investment a bit and then ask the same question (we’ll call this Scenario #2). What if the minimum investment were reduced such that you could invest 10% of your net worth instead of 100%? Now would you say yes? Just about everyone would except for people busy socking money away in mattresses because they think the men in black suits are watching them.
Let’s change the conditions even more (Scenario #3). What if your friend were able to source 10 investments with the same risk/return profile? In this case it’s even clearer that you’d want to invest and the operative question would switch from “whether” to “how many” investments you would make.
It shouldn’t come as a shock that this type of return profile exists in many ecosystems because new technologies are constantly being created and paradigm shifts are happening all the time. Most professional Investors believe that if anything the opportunity set is increasing.
And while these investment opportunities are available to three separate constituencies (Incumbents, Entrepreneurs and Professional Investors), the only “rational” constituency in the ecosystem is the Professional Investor! Investors take risk in order to generate attractive returns. Without risk there’s no return, so in order to do their jobs well, Investors have to get used to a risk profile that’s comprised of more parts failure than success.
In contrast, Entrepreneurs are people who believe enough in their own ideas that they’re willing to go “all-in”. They refuse to internalize their real odds of success and instead believe with self-certainty they’ll end up in the best 10% of outcomes. They put their lives on hold for years to chase their ideas and sometimes end up wiping out their personal financial resources along the way. If they succeed they look like geniuses, but there’s a very large and deep graveyard of failed Entrepreneurs littering the path to success.
On the other end of the spectrum are the well-established and financially healthy Incumbents in each and every ecosystem. They have the ability to exist in a Scenario #2 or #3 world but somehow can’t figure out how to engage or pull the trigger. If a typical Incumbent is able to put 10% of its excess earnings at risk each year chasing the probabilistic outcomes mapped out above, why do they say “no?” And if they have the opportunity to take the same 10% and spread the investment in 10 opportunities with similar return profiles then why aren’t they? If a rational Leader found out that someone on their team passed on this type of opportunity, they should seriously consider firing them. But Incumbents aren’t chasing these opportunities. Why? Unfortunately, the answer is structural which means it isn’t easy to solve.
Duration mismatch
The common unit of measurement at a public company is either current quarter, next quarter, or current year. You rarely (if ever) hear public company CEOs talk about how the projects they’re working on will pay off in 6–8 years. You might hear a CFO talk about how cost reductions are going to help their ratios in the next year or two, but you rarely hear about longer term bets. But, to build anything meaningful takes time. Real time. 6–8 years’ time, not 3 or 4 quarters’ time.
Accountability issues
Long term accountability doesn’t exist. While many Executives have 20+ years’ tenure at their organization, it’s almost always comprised of many 2-3 year stints in roles with a “rotate and pass the baton” mentality.
Small sample size
No individual Executive assembles enough investments to play the “portfolio odds” game. Without a portfolio to fall back on, the best an Executive can hope for is to back one or two investments that statistically will probably fail. And unfortunately, the adage is true that lemons ripen early, so the failures will likely be the first “results” posted in their risk-taking career.
Misaligned incentives
A typical Executive earns their bonus one year at a time based on goals handed down to them from the powers above. They can earn 90% of their bonus by saying “no” to every risky opportunity and it’s not difficult for them to earn their full bonus by being really good at making marginal changes around the edges. In contrast, an Entrepreneur is underpaid for years, but if they can string together enough “yes” answers and successes over a long enough period of time then they can earn many many multiples of what they would make working at one of the established companies in their ecosystem.
Too much process and too little autonomy
The easiest way to destroy the return profile of an investment is to move slowly. At best, burn stays constant on a daily basis, so when process slows down decision making, it slows down learning and makes the ultimate outcome more expensive to produce. It also makes failures more expensive which is a major driver of an organization’s risk appetite. And, when process creates barriers to “yes” answers it reduces the ability for a team to innovate at all (and crushes job satisfaction as a bonus).
By no means am I suggesting that Incumbents can’t directly drive or at the very least participate in funding innovative business opportunities. The very best organizations do this regularly. What I’m highlighting is that most Incumbents aren’t leaning into risky but disruptive opportunities even when faced with overwhelming evidence that they should. By making “no” easier than “yes”, Executives can and are making poor decisions without any consequences.
The result: More opportunity for Entrepreneurs and Professional Investors!
