Finding the path of lowest cost resolution of uncertainty gives an entrepreneurial team the greatest chance of succeeding. This is the primary objective of a roadmap. A simple process can put this idea into action.
The process that yields the lowest cost resolution of uncertainty has two steps:
1. Choosing the assumptions (or hypotheses),
2. Choosing the order of testing.
The first step is to identify the discrete assumptions underlying the entrepreneur’s business idea. These are the things that have to be true, or made to be true, in order for the venture to succeed — the hypotheses that need to be tested. We can think of all of these assumptions together constituting the entrepreneur’s “theory.” First, and most obviously, this theory must be complete or comprehensive. That is, it cannot be missing any assumptions that are necessary for success (within the planning horizon of the venture). Although there is no detailed checklist, the theory should cover the three pillars of any venture:
· Customers — needs, obstacles to adoption, other relevant characteristics.
· Solution — technology and other aspects of production and distribution including partnerships.
· Sustainable competitive advantage — critical resources such as expertise, intellectual property, relationships, etc.
These three pillars are not necessarily independent of each other.
It is important to think comprehensively about the factors necessary for success, but this is not enough. There are many ways of expressing or articulating the same entrepreneurial theory — many sets of assumptions that are equivalent, but not equally useful as a guide to action. For example, a venture may be thought to rest on the assumption that many people will buy the company’s product for the asking price. If this is true, then the venture is successful. But it would take a full launch to validate the assumption. On the other hand, it is possible to create such a large set of narrow and detailed assumptions that the process of testing would be wasteful and inefficient. The goal is to articulate the underlying assumptions at a level of granularity that allows for meaningful experiments and efficient learning.
The list of assumptions should be comprehensive in that it covers all the factors necessary for the success of the venture and it should be broken down or decomposed into discrete elements to permit efficient learning.
Every well-run new venture will exhibit a pattern of economical tests of the critical unknowns or hypotheses. Coming up with the comprehensive list of discrete assumptions is the first step. The second step is to determine a sequence, a series of steps that the new venture should take. Each step will resolve a critical unknown. This resolution will cause the entrepreneur to continue, to change direction (“pivot”), or, in the worst case, to abandon the enterprise. A change in direction will often cause the entrepreneur to revise the list of unknowns and revise the plan.
The second step is to prioritize the assumptions according to three factors: severity, probability, and cost of resolution.
Severity is the negative impact on the venture of a negative outcome. In the extreme case, the first question is “Is there a need at all?” If the answer is “No,” then the entrepreneur should simply stop. This is the unknown with the highest severity of impact. We can also take a positive perspective of the idea of severity. Rather than thinking of it as the unknown with the potential for the greatest negative impact, we can think of it as the unknown whose resolution may engender the most dramatic change of direction. In any case, the notion of impact may be difficult to quantify or make precise, but the intuition behind it is reasonably clear. The simple rule is that if A has higher severity than B, then test A before B.
Also a matter of judgment is the probability of an assumption being true. We have already seen Knight’s idea that the very essence of entrepreneurship is uncertainty where there is no objective basis for assigning probabilities. Nonetheless, this is exactly what the entrepreneur does — assign probabilities to various unknowns based on inadequate and incomplete information and then act based on those assessments. However, I resist calling this probability assignment a guess or a purely subjective matter. There are real cognitive processes at work — reasoning by analogy, recognizing patterns, extrapolating from experience, etc. Moreover, the more open entrepreneurs are to divergent opinions and different perspectives and the better they are synthesizing these various inputs into a considered judgment, the greater the chance that their assignment of probabilities will reflect reality.
What is counterintuitive to many entrepreneurs is that lower probability assumptions should be addressed first. It seems natural to many people to try to validate the more likely assumptions. Positive feedback always feels good. But this is the opposite of the right approach. If the goal is to minimize the time and money expended before strategy is adapted to reality or, possibly, the venture is abandoned, then the assumptions least likely to be true should be addressed first: if all else is equal and assumption A is less probable than B, then attempt to validate A before B.
The third factor in this stylized process is the cost of resolving uncertainty. This immediately begs the question: What constitutes resolution? What evidence should the entrepreneur take as sufficient to declare the assumption validated? Estimating the cost of resolution for an assumption involves a) thinking critically about what evidence will constitute resolution, and b) thinking creatively about the simplest, lowest cost way of gathering that evidence. Once this thinking is done, we can formulate a third simple rule that goes into our process: if all else is equal and resolving assumption A costs less than resolving B, then address A before B.
Having now considered each of these three factors individually, we can put them together. If we are able to judge both the potential severity of various unknowns as well as their probability, we can construct a rank ordering of the various unknowns. We can imagine a quantity or index that is the product of severity and probability of the assumption not being true, that is, “severity of potential impact times probability of the negative occurrence.” This quantity is what we mean by “risk” in the colloquial sense — risks are things we worry about, and the greater the risk the greater the worry. For example, when we take a walk in the city, the risk of getting hit by a car is greater than the risk of getting struck by an asteroid (higher severity, but dramatically lower probability) and also than the risk of wearing a hole in our shoe (higher probability, but much lower severity).
Yogi Berra is alleged to have said that in theory there is no difference between theory and practice but in practice there is a big difference. While acknowledging this insight, we can press on and say that theoretically our exercise produces a rank ordering of the risks facing a new venture. If we now add an estimate of the cost in money and time to resolve the unknown and thereby remove that item of risk, we can conceptually construct a measure that is risk divided by cost of resolution. This measure will create a rank ordering of the assumptions or unknowns. Addressing the unknowns according to this order will be the path of removing the greatest risk for the lowest cost. Applying this principle produces a sequence of execution for a new venture.
Some practical realities will influence how we put this principle into action. Investors may differ with the entrepreneurs and influence their order of execution if they are to supply capital. The process as I have laid it out yields a sequential path of execution, and the issue of time to market may require more parallelism in execution. The entrepreneur must trade off the risk of being late against the risk of wasted effort. Finally there is the perhaps obvious factor of prerequisite. For example, if an actual implementation of the technology in some form is required to test consumers’ reactions or to interest potential partners, then building a prototype will have to precede resolving the unknown regarding customer response or partner interest.
Experienced investors and mentors have long advised entrepreneurs to focus on “value changing milestones.” The process outlined here puts structure onto this advice and also explains its importance. For a milestone that changes the value of a venture is precisely the resolution of an unknown that removes a significant risk factor. Most entrepreneurs envision ventures that will be highly valuable if successful. What makes the value of the venture so low in the early stages is that the probability of success is so low. The probability of success is low precisely because there are so many large risk factors. As these risk factors are removed, the probability of success goes up. As the probability of success goes up, so too does the value of the venture. Risk and value are inversely related. As value increases, the cost of capital decreases. Therefore, a well thought-out path through the entrepreneurial search space leads to the most efficient use of capital. It minimizes the use of very expensive resources — the time and effort of the founding team and any capital raised.
Read more about the lowest cost resolution in "Knowing what unknowns to know."