Starting a business is often seen as a risky endeavour. Yet, on deeper thought, there is little that inherently exposes you to losses about starting up. You can register incorporated a limited liability company for a £100 (was £50 until recently) one-off fee, though there are obligations like tax compliance that do kick in.
Entrepreneurship is, more accurately, risky if you give up stable employment to do so, or enter into debt. Otherwise, it is often a sequence of small, reversible bets. The goal is to keep the cost of each bet low while learning enough to decide whether to invest more.
The risks of going all-in entrepreneurship
Proponents of taking the entrepreneurship gamble often egg others on by saying that you’ll never get rich working as an employee. What they neglect to tell you is that you would probably be richer as an employee. Wasserman (2013) found that the self-employed tended to have 35% lower earnings compared to if they had been in a paid job.
Furthermore, you will almost certainly never go bankrupt as a direct result of being an employee. Your employer takes the downside risks and the worst case as an employee is losing your salary.
However, it’s a false dichotomy between having a stable job and going all-in as a founder, maxing out your credit cards to keep it afloat. That is why entrepreneurship can be seen also as an option, in the financial sense.
Option theory
A financial option in the financial market refers to an instrument that gives the holder the right, but not the obligation, to either buy or sell an underlying security. This is particularly useful to hedge against a risk. For instance, an investor that has bought a share can purchase a put option, which gives them the right to sell the share at a pre-agreed price. If the share price falls sharply, the investor can exercise the option and limit their losses. If the share price rises instead, they can simply let the option expire and benefit from the increase in the share’s value. In return for this optionality without a binding obligation, options usually cost a certain amount. That is known as the hedging cost.
Entrepreneurship as option theory
Pursuing entrepreneurship is a decision that can be informed by option theory. As long as you limit the costs you are willing to sink into a venture, that is all you can lose. Meanwhile, the theoretical upside is disproportionately large, though of course statistically a small proportion of startups achieve an incredible amount of financial success. That said, it also means you can make a bet on new trends, where you can end up as an early-mover if the trends do go the way that you bet on.
The only cost is the years of foregone salary, which does not even have to be the case. It’s wholly possible to start a business on the side while maintaining a full-time career as long as you have a decent amount of leisure time outside of work. That way, you avoid the costs of foregone salary as well. To acknowledge the costs, it will take your leisure time, attention, and any cash you committed (your hedging cost).
In addition, serial entrepreneurs have a higher chance of success, even if they have failed. Experience helps to improve the chance of success later on. Success hence can mean financial freedom, while failing just means your chances for the next time are increased.
If a bet is 51% in my favour, is it not the wisest thing to plonk my entire life savings on the table? Frankly, it would be absolute foolishness to do so. By going all-in on a favourable bet, what you are forgoing is the ability to make future bets in lotteries down the road, which may be equally or even more favourable odds. This practice of managing your bets, or position sizing, is covered by Net Interest, which does an incredible article on position sizing, if you want to read on this tangential topic.
Hold on to your boats
Hernan Cortes is credited with scuttling his boats to motivate his men into exploring the New World. That might not however, be the ideal strategy most of the time. When you burn the boats, you also risk losing due to a siege, or natural calamity beyond your control. The option to live another day, as long as you know your base threshold and are disciplined to follow this, will be more valuable.
We need to stop romanticising entrepreneurship as this massive step that results in epic success. There is no need to go all-in on your first idea. Spend conservatively to test the waters, and allocate more capital to it as you get a positive response.
