Risk
Entrepreneurial risk is the possibility of losing resources committed today in pursuit of uncertain future value and profit.
Every new business begins with uncertainty. An entrepreneur commits time, labor, money, knowledge, and other resources before knowing whether customers will ultimately value what the business produces enough to cover its costs.
The entrepreneur may succeed. Or he may lose some—or all—of what he committed. That possibility of loss is risk.
Risk and Entrepreneurship
Entrepreneurs attempt to create something whose future value cannot be known with certainty. They may open a restaurant, develop software, build a factory, invent a medical device, create a new service, or introduce an unfamiliar product.
Before customers decide whether to buy, someone must usually act first.
Money must be invested. Workers may need to be hired. Equipment may need to be purchased. Products may need to be designed and produced. Marketing may begin. Rent, insurance, utilities, and other expenses may have to be paid.
All of this can occur before the entrepreneur knows whether enough customers will appear. Entrepreneurship therefore involves acting today on a judgment about an uncertain tomorrow.
Capital at Risk
This connects Risk directly to the Key Idea Capital. Capital can increase productivity and create value, but capital devoted to one use cannot simultaneously be used somewhere else.
An entrepreneur who invests $100,000 in a new business gives up the ability to use that $100,000 for some other purpose. If the venture succeeds, the investment may produce additional wealth. If it fails, some or all of the capital may be lost.
Entrepreneurs therefore face both the possibility of gain and the possibility of loss.
The same principle applies to time. Years devoted to building an unsuccessful enterprise cannot simply be recovered and used again. Risk involves committing scarce resources before the outcome is known.
Risk, Profit, and Loss
This connects Risk directly to Profit. Profit rewards successful judgments about how resources can be used to create value for others. Loss reveals that the judgment was mistaken—or at least that revenues were insufficient to cover the costs incurred.
Suppose an entrepreneur believes customers will pay enough for a new product to justify spending $500,000 developing and producing it. If customers value the product and buy it in sufficient numbers, the business may earn a profit.
If they do not, the entrepreneur may suffer a loss. The possibility of profit therefore cannot be separated from the possibility of loss.
Where there is no possibility of loss, there is little meaningful entrepreneurial risk.
Risk and Wealth Creation
Wealth creation requires looking toward an uncertain future. Resources have many possible uses. Entrepreneurs attempt to discover uses that will create more value than the resources consumed. But nobody possesses perfect knowledge beforehand.
A new restaurant may become popular or remain empty. A new technology may transform an industry or be ignored. A product developed after years of work may arrive just as consumer preferences change.
Entrepreneurial judgment therefore involves asking questions whose answers are not yet known: What will people value? What problems need solving? What will customers pay for? Can something be produced more efficiently? Is there a better use for these resources?
When entrepreneurs answer those questions well, resources are redirected toward uses people value more highly. That is one important mechanism of wealth creation.
Risk Is Not Recklessness
Risk-taking is not necessarily admirable. A person can take foolish risks, gamble resources carelessly, or expose other people to dangers they never agreed to bear.
Successful entrepreneurship therefore requires more than a willingness to take risks. It requires judgment.
Prudent entrepreneurs attempt to understand markets, costs, customers, competitors, technology, trends, and possible failures. They test assumptions, gather information, preserve reserves, diversify risks, and change course when evidence shows that their original judgment was mistaken.
The goal is not to maximize risk. The goal is to accept appropriate, calculated risk when the possible creation of value justifies it.
This connects Risk to the Key Ideas Responsibility, Incentives Matter, Business, and Virtue.
Who Bears Risk?
Entrepreneurs are not the only people who bear economic risk. Investors risk capital. Lenders risk not being repaid. Employees risk losing jobs or income. Suppliers may extend credit. Customers can take risks when purchasing unfamiliar products.
But entrepreneurs occupy a distinctive position because they often coordinate many of these resources while bearing responsibility for an uncertain enterprise as a whole.
They make decisions before knowing whether those decisions will succeed. If revenues fail to cover costs, someone must ultimately absorb the loss.
Risk and Reward
Entrepreneurial profits can sometimes become very large. That does not mean every large profit is deserved or that profit proves virtue. But the possibility of substantial reward serves an important economic function: it gives people incentives to commit resources to uncertain ventures that might otherwise never be attempted.
The relationship between risk and reward is therefore important.
People are more willing to accept the possibility of substantial loss when successful judgment also carries the possibility of substantial gain. Without that incentive, fewer people would devote years of work and scarce capital to experiments whose outcomes cannot be guaranteed.
Why Risk Matters
Economic advancement cannot occur without uncertainty. Someone must be willing to commit resources before knowing whether a new idea will succeed.
Entrepreneurial risk is therefore inseparable from innovation and wealth creation. Successful ventures can create products, services, businesses, technologies, and forms of organization that improve the lives of customers and increase the productive use of scarce resources.
Failures matter too. They reveal which uses of resources did not generate sufficient value and encourage capital, labor, and entrepreneurial effort to move elsewhere.
Entrepreneurs create wealth by making judgments about an uncertain future and risking scarce resources on those judgments. Profit rewards successful risk-taking; loss reveals unsuccessful risk-taking. Neither can be understood fully without the other.
