This is an extract from Two Speed World – a book I co-wrote in 2010. The topic of effectuation seems little discussed but is a good way to think about how entrepreneurs think and act in new fields where there is little or no past data and so plenty of uncertainty.

Effectuation

As we have noted, Ed Roberts produced the Altair 8800 without having any idea who would buy it, or what they would use it for. In the event it pushed IBM into producing the PC which in turn created 10,000 millionaires from Microsoft employees by the year 2000. One was Rob Glaser who took his money in 1994 with the intention of becoming involved with charitable works and civic projects. He wanted to promote his progressive politics and decided that the Web, plus Mosaic, plus 14.4kbps modems made streaming audio a possible route. Because no-one had done such thing before, there was no pattern to follow and in the event Glaser never did promote his ideas through the Web. He had said that he was not interested in the purely economic end of this ‘anymore than Pavarotti is interested in getting paid to sing’, but he became rich just the same and found another way to promulgated his politics, donating over $2.2 million to pro-Democratic organisations the 2004 US election.

There was no way to make a business plan with a pre-determined goal, because at that time there was no real-time audio streaming on the Web. There was no way to gauge market acceptance in a non-existent market. There could be no measurable risk, no statistical uncertainty, just an unknowable future. On the face of it, it was the worst possible situation, but only from the standpoint where a plan is constructed to maximise expected returns only after comprehensive analysis. Glaser did not have to do that, he was going to invest his money into streaming audio anyway and see what goals emerged. This changed the picture completely.

While Knightian Uncertainty with its unknowable future does not allow us to predict a particular outcome as bystanders, if we control events then we do not need to predict the future, we can create it. This neat inversion is called ‘effectual reasoning’, causing things to happen, rather than ‘causal reasoning’, measuring the causes of external events. In the causal world ‘to the extent that we can predict the future, we can control it’. With effectuation ‘to the extent that we can control the future, we do not need to predict it’. In a position of Knightian Uncertainty, the person who bases his decisions on effectuation has a market advantage, because unlike the causal reasoner, he knows where he is going.

Professor Saras Sarasvathy, a leading scholar on the cognitive basis for high-performance entrepreneurship believes that effectuation is a powerful tool in expert entrepreneurial hands. She uses a simple cooking analogy to show the difference between the two styles of decision making.

 ‘You can start from a recipe and follow it (causal), or you can look in the fridge and rustle up something with what you find (effectual).’

Only by using the latter technique will anything new ever be produced. In the absence of similar products in established markets, it is the only way that such goods can be created.

Sarasvathy believes that Glaser was able to employ effectuation because his payoff from Microsoft enabled him to consider the affordable loss, rather than an expected return; his ten years in the software business provided many opportunities to establish strategic partnerships despite the untried nature of the venture; he could react quickly to unexpected events and benefit from them.

Rather than predicting the future and following it, the entrepreneur needs the logic of control to create the market and thereby define the future. This makes prediction unnecessary, Knightian Uncertainty is destroyed, and surprises can be turned into advantages.

How is control of the future achieved?

Firstly by influencing industry standards, which is made easier by being first.

Secondly by alliances and stakeholder commitments so that everyone is singing from your song sheet.

Finally by continual innovation, because a new industry is very unlikely to be right first time.

Sarasvathy and Kotha analysed Rob Glaser’s company RealNetworks, and its products RealAudio, RealVideo and RealPlayer against the effectuation criteria. They found that because Glaser was prepared to incur an affordable loss, products were brought quickly to market, RealPlayer achieved 80% market share and as a result RealNetworks products became the de facto standards. RealNetworks products sat between the content providers and the computer software suppliers and so it was vital to have alliance to maximise the linkages between the two sides. This RealNetworks did to great effect with150 strategic partnerships agreed in 29 months. Innovation was not neglected, with one third of the staff engaged in Research and Development. By 1997, three years after its creation, the company had revenues of $36.3M and went public. This shows the power of effectuation for the entrepreneur, especially in the presence of an external driver as powerful as the Internet. But as a company moves from start-up to established multi-national, the market becomes mature and causal processes come to the fore. In early 2010, Rob Glaser the entrepreneur stepped aside from day-to-day management, McKinsey and Co conducted a strategic review and management talked in the causal, and some might say contradictory,  terminology of an ‘exciting roadmap for the future’.

References

Two Speed World by Gerald Ashley & Terry Lloyd

Effectuation: Elements of Entrepreneurial Expertise by Saras D Sarasvathy