The Expected Value for Entrepreneurial Risk

English: log-logistic density function plot, w...

Image via Wikipedia

As you already know there’s an extreme risk/reward equation for entrepreneurs in innovative businesses. We’ve all heard of the billionaires but that type of outcome is so rare it usually isn’t worth discussing. Let’s look at some simple math for entrepreneurial risk:

  • High achiever young professional who earns $100k/year (for simple math) plus $20k/year of benefits
  • Salary reduced to $20k/year to start a business with no benefits
  • $100k/year contribution in opportunity cost due to lost market-rate compensation until the business can afford to pay previous salary and benefits
  • ~90% of companies never reach $1 million in revenue (source)
  • 10% chance of reaching $1 million in revenue (assuming all things are equal) and the company is worth 3x revenue, so $3 million (this would be a nice valuation for most companies)
  • Assuming no dilution, no investors, no stock option plan, etc the expected value is 10% of $3 million or $300k
  • If the entrepreneur can achieve that company value and do it before giving up $300k in compensation, he or she is better off (assuming they can get by in the interim, the amount they invest directly from savings is $0, and they start generating revenue quickly)

The greater the market opportunity and expected value of the risk, the greater the potential outcome (e.g. a 2% chance at making $100 million produces a $2 million expected value). The entrepreneurial risk/reward equation is a dramatic one that makes sense in the context of a tiny chance to make a large amount of money.

What else? What other variables should be part of the entrepreneurial risk equation?

One thought on “The Expected Value for Entrepreneurial Risk

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.