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2. Theoretical framework
4. The entrepreneurial narrative
5. Analysis and discussion
The primary goal of this paper is to evaluate if experienced and highly successful entrepreneurs, like Elon Musk, prefer to use the logic of effectuation theory (Sarasvathy, 2001) during their own entrepreneurial processes or if they are favoring the traditional, causally shaped, management theories (e.g., Hatch, 1997, Kotler, 2012).
The authors therefore firstly give the reader a brief introduction to the five principles of the effectuation theory. Moreover, they apply the principles on the entrepreneurial process of PayPal, as a representative example of the entrepreneurial career of Elon Musk, to verify the application of the principles. The entrepreneurial process of PayPal is thereby illustrated in the form of a narrative, representing a synthesis of various trustworthy sources.
The findings of the paper show that there are indications for both, effectuation and causal logic, but it is effectual reasoning which was predominantly used during the venture creation. The value of the paper is that it shows precisely how the effectuation theory was used during the whole entrepreneurial process and contributed to the successful establishment of PayPal (respectively more X.com). Therefore, it can be regarded as a role model and thus help other entrepreneurs to adopt this theory on their business development processes.
Keywords: Effectuation; Entrepreneurial Decision-making; Narrative; PayPal.
According to a research by Hoomans (2015), an average adult makes about 35.000 decisions each day. This number might seem a little exaggerated; nevertheless, Hoomans (2015) further claims that according to a research from Wansink and Sobald (2007) our daily choices concerning food are already 226 in total. Since we now unnecessarily know, how many thoughts we just spend on food, it is hard to imagine how many decisions of a significantly more critical manner an entrepreneur has to make every single day concerning his or her business. In most cases, the environment, especially of a new business is unstable and dynamic. So yesterday’s decision might already be wrong today. Particularly at the start of a new company, the entrepreneur or the organization does not have any experience or historical data to rely on and plan with. Hence, it seems nearly impossible to make decisions or forecasts without knowing the concrete consequences in the future. But still, classic management theory (e.g., Hatch, 1997; Sarasvathy, 2001) teaches us, that one must plan rationally and analytically, set a goal and assume a reasonably stable environment to succeed with a business in the future. Although the underlying assumption thereby is, that the future is predictable, and one can control the course of the prospective events.
That this assumption is wrong for businesses in general but especially for new businesses was only recently lined out by Ritholtz (2017) who stated, that “The World is about to Change Even Faster”, the future is not going to be as predictable as we maybe thought in the past. If we also take a look at the figures of new businesses and start-ups, the GEM (Global Entrepreneurship Monitor) report shows a demoralizing picture. There are around 100 million start-ups launched annually according to GEM figure, which attracts over 17 billion US dollars in funding (GERA, 2017). Although, 90 percent of them fail. So why is that? Are these companies unable to apply the classic management principles and thus make wrong decisions or fail to set up solid plans? Or is the planning perspective (also called “causation perspective”) not the best method to use when creating a new business? Saras D. Sarasvathy and Herbert A. Simon, two researchers of cognition and economics, have analysed this question for years by observing successful entrepreneurs in their doing and their decision-making processes and developed an alternative theory called the effectuation theory (Sarasvathy, 2007). This method primarily focusses on the controllable aspects of the future rather than trying to predict it. In contrast to the planning approach, it does not assume that the economic environment is stable and proposes that entrepreneurs should have a look at their available means and start from there rather than setting a clear goal from the beginning and then trying to get there.
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Figure 1 Casual vs. Effectual Reasoning (Read, 2011, p. 74)
The purpose of this paper is to illustrate the entrepreneurial process of PayPal by analysing the main cornerstones through a narrative approach and to further verify if the effectuation principles were used by Elon Musk and his team within their decision-making processes. As PayPal today is a highly successful and globally established company and as Elon Musk went on to found several other prosperous companies like Tesla and SpaceX, the entrepreneurial process taken and the methods used in it can be regarded as a role model for other entrepreneurs.
For this reason, the main question this paper wants to answer is:
How, and more important in which form, did decision making happen during the entrepreneurial process of PayPal? Did Elon Musk and his team try to predict the future and act after the classic management theory and the planning approach or did they shape their future instead and thereby follow the principles of effectuation?
To answer this question, the authors first introduce effectuation theory as the theoretical framework of the paper and differentiate it from causal reasoning (chapter 2). After that, the narrative approach, being the qualitative research approach used in the paper is introduced and the reasons for this selection are outlined (chapter 3). In chapter 4, the narrative about the foundation and start-up phase of PayPal is presented, representing the central subject of analysis. This is followed by a thorough analysis of the narrative by applying the theoretical principles presented in chapter 2 on the entrepreneurial process of PayPal (chapter 5). The main findings are finally concluded in chapter 6.
In this chapter, we take a closer look at the effectuation theory, which builds the theoretical framework of this paper. The effectuation theory emerged as a result of a study in cognitive science evaluating the mental processes of 27 experienced and successful entrepreneurs as well as 37 MBA (Master Business Administration) students in the context of new venture creation (Sarasvathy, 2007). The main findings of this study are, that the majority of expert entrepreneurs uses effectuation most of the time while only 22% of the MBA students used effectuation at all (Sarasvathy, 2007). But what exactly is effectuation and what is the alternative MBA students chose if they didn’t use effectuation?
A definition of Sarasvathy (2001) helps to understand the differences between causational and effectual theory by delineating the processes that come with those theories. She states, that „Causation processes take a particular effect as given and focus on selecting between means to create that effect” (Sarasvathy, 2001, p. 245) whereas on the other hand “effectuation processes take a set of means as given and focus on selecting between possible effects that can be created with that set of means.” (Sarasvathy, 2001, p. 245). But what does this mean exactly? The logic behind causation principles is, that it focusses on what aspects of the future can be predicted. “To the extent we can predict future, we can control it” (Sarasvathy, 2001, p. 251). In contrast, effectuation focusses on aspects of the future which can be controlled and does not try to predict it. “To the extent we can control the future, we do not need to predict it.” (Sarasvathy, 2001, p. 251).
Transferred to the context of new venture creation causation and causal reasoning represents the application of classic, commonly known management theory like Kotler (2012) and Porter (1980). Following casual reasoning therefore intends, that when it comes to business creation the entrepreneurs have to identify potential markets for the products or services the company wants to offer first. This is followed by a segmentation of the market and the selection of target markets. In each target market the company then tries to position itself by pointing out the market specific benefits of their product/service (Kotler, 2012). Other decisions like investment strategies are addressed likewise. This process is analytical and predictive and therefore also called the planning perspective. In Contrast to this the findings of the aforementioned study found a different approach taken by expert entrepreneurs. They mainly used “effectual reasoning to (i) start with a single customer; (ii) generalize the profile of that customer into a larger segment; (iii) add segments in an iterative fashion; and, (iv) end up literally creating a market for their product.” (Sarasvathy, 2007, p. 4). As a result of her studies and the findings that came with it, Sarasvathy formulated five principles of effectuation described in the following. Furthermore, the differences to causational thinking are outlined. These principles form the basis for the analysis of the entrepreneurial processes of PayPal.
The first principle is called the bird-in-hand principle. Its basic message is, that entrepreneurs should not waste their time waiting for opportunities or trying to predict the future, but start with the means that are available right now (Read, 2011). Thereby, entrepreneurs should begin with three categories of means which according to Sarasvathy are available to all humans: “who I am, what I know, and who I know.” (Read, 2011, p. 73). These means in combination with contingencies create opportunities and new possibilities which can’t be predicted but are constructed during the effectuation process (Sarasvathy, 2001).
The affordable loss principle suggests the entrepreneur to rather focus on the calculatable downside of an investment, like resources, money and time that are needed for it (Tüselmann, et al., 2016). As opportunities in new ventures can only hardly be valued upfront. In contrast this is what casual logic teaches us, to maximize the profit of an investment by selecting the best strategy (Read, 2011). By only investing the means he/she can afford, “the effectuator is likely to lose less in terms of investment than the entrepreneur who invests using a causal logic.” (Sarasvathy, 2007, p. 32).
The crazy quilt principle, also called the patchwork quilt principle stresses out the importance of strategic partnership in new venture creation. Thereby the effectual logic believes, that those partnerships that arise out of a commitment (time, money, resources) into the new venture are actively forming the business, like patches of different forms form the patchwork quilt (Randerson, et al., 2016). In contrast to this casual logic is comparable to a jigsaw puzzle, where the form is given from the beginning (like the goal is set in advance) and only specific parts fit (specific partners need to be chosen to reach the predefined goal). So, in effectual logic it is the “partnerships that create the venture and not the venture that dictates partnerships.” (Read, 2011, p. 113).
The lemonade principle is based on the saying “If you come across lemons, make lemonade” and thus means to leverage contingencies - see unexpected events as opportunities instead of being afraid of them and furthermore benefit from them. This is the advantage of not having a long-term goal and strict plans, as arising opportunities and the potential profits that come with it can be perceived. (Kessler, 2013) In contrast, if casual logic and long-term planning is used, unforeseen surprises are mostly bad and require rescheduling.
The pilot-in-the-plane principle is more like a worldview, bringing together the four principles of effectuation in the “central notion of control” (Read, 2011, p. 173). As the principles all indicate, the effectual logic emphasizes control as a key to successful entrepreneurship (Vrdoljak Raguž, Podrug and Jelenc, 2016).
- Starting with the means available gives you more control than acting with means that aren’t available (the Bird in hand principle).
- Calculating with the downside risk of actions is more controllable than calculating with potential profits (the Affordable loss principle).
- Establishing partnerships with people willing to commit to your venture gives you more control than searching for partners matching your predefined expectations (the crazy quilt principle).
- Being able to see the positive in surprises and being flexible provides more control than trying to avoid them towards a goal set in advance. (the lemonade principle).
Applying these principles forms the entrepreneurial process to what is called the effectual cycle (Read, et al., 2017). The starting point are the means available to the entrepreneur. From there the entrepreneur might have a vague goal giving direction. Through interactions with others, this goal is influenced and adjusted and some stakeholders are willing to commit to the venture. Through this commitment new means and even new goals can arise. At any point in this process the environment of the venture can change having either an effect in the form of new means or in the form of constraints, giving the venture a clearer direction. The process might cycle not even once or many times producing a lot of different possibilities for the venture (Read, et al., 2017, pp. 195 – 196).
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Figure 2 The Effectual Cycle (Read, et al., 2017, p. 195)
The paper addresses the research question, given in the introduction, in the form of a narrative approach, being “an alternative way to approach and represent interview conversations” (McCormack, 2004, p. 219). This approach was chosen because it gives the reader a quick and thorough understanding of the main events and cornerstones of the venture creation while at the same time being attractive and not too complex to read (Czarniawska, 1997; Labov, 1972; Gartner, 2007).
Therefore, secondary data sources (Saunders, Lewis and Thornhill 2009), outlined in Table 1, in form of biographies of the main founders Elon Musk and Peter Thiel, as well as interviews with company related people and company history has been evaluated and restructured to a narrative (Saunders, Lewis and Thornhill 2009) telling the entrepreneurial story of PayPal.
illustration not visible in this excerpt
Table 1: Narrative Sources
By not only focusing on the autobiographies, of both founders, but on interviews with people involved in the venture creation as well, the authors ensure the trustworthiness and comprehensiveness of the given insights. The narrative resembles a synthesis of the main events, occurring in the timespan of when Elon Musk first encounters the financial branch in 1990 until the final sale of PayPal to eBay in 2002, as it takes the main events out of several sources and thereby ensures an objective view by taking more than one perspective into account.
The methodology of this paper therefore is of qualitative nature (Polkinghorne, 1995; Bryman and Bell, 2015) as it is based on words rather than on numbers and aims to provide a better understanding of the relevance of the theoretical approach in the context of new venture creation. The narrative is then put into the theoretical background of the paper and thereby examined for evidence of causational or effectual methodology being used during PayPal’s start-up phase. This is done by taking the five principles of effectuation (Read, 2011) one by one and comparing them to the actual steps and decisions taken by the PayPal founders.
“Do you think I’m insane?” (Vance, 2015, p. 1).
In the year 1990 Musk was an intern at the Bank of Nova Scotia, which today became the third largest bank in Canada. During this internship, he, unfortunately, had to experience, that the banking sector is a branch where employees aren’t much interested in disruptive and innovative ideas. Even when Musk came up with a comparatively safe – but new – idea to make “billions of dollars for free”, they rejected the idea just because they had “been burned” on completely different models before and “didn’t want to mess with it again”. So his opinion about the financial branch was therefore rather unkind:
All the bankers did was copy what everyone else did. If everyone else ran off a bloody cliff, they’d run right off a cliff with them. If there was a giant pile of gold sitting in the middle of the room and nobody was picking it up, they wouldn’t pick it up, either.
His bad banking experiences were following him as well during his next internship at Pinnacle Research in 1995. When Musk tried to convince his coworkers, that by using internet technology, the financial sector could get a “major upgrade”, the scientists did not want to listen to him:
[…] they tried to talk him down, saying that it would takes ages for Web security to be good enough to win over consumers. As the researchers at Pinnacle had pointed out, people were barely comfortable buying books online. They might take their chances entering a credit card number but exposing just their bank accounts to the Web was out of the question to many.
So in January 1999, when the sale of Zip2 wasn’t even signed yet, he again thought about, how the internet could be a potential enabler for an opportunity in the financial branch and despite all his past experiences, he started to formalizing his own bank plans, as written in his biography:
This left Musk searching for an industry that had tons of money and inefficiencies that he and the Internet could exploit. […] Musk wanted to build a full-service financial institution online: a company that would have savings and checking accounts as well as brokerage services and insurance.
Since he was aware of the fact that the technology to build an online full-service financial institution was not the only issue, he also concentrated on how one could handle the “regulatory hell”. To succeed with his bank project, he then tried to recruit some of his best Zip2 engineers, while also pitching his idea to some bank officials at the Bank of Nova Scotia. This could be called the “unofficial” starting point of the “PayPal Story”:
In January 1999, with Zip2’s board seeking a buyer, Musk began to formalize his banking plan. The deal with Compaq was announced the next month. And in March, Musk incorporated X.com, a finance start-up with a pornographicsounding name.
After the sale was done, Musk invested around $12 million dollars in his new start-up. There were tax saving motives for doing this, but it is more likely that he was just willing to make a significant bet on himself, in order to convince other external potential investors, as Musk’s former colleague from SGI and Zip2, Ed Ho stated:
That’s part of what separates Elon from mere mortals. He’s willing to take an insane amount of personal risk. When you do a deal like that, it either pays off or you end up in a bus shelter somewhere.
This risk-taking attitude is getting even more apparent when we further take into consideration that he was capable of only small knowledge about the financial branch since he only did one internship in this sector:
Where Zip2 had been a neat, useful idea, X.com held the promise of fomenting a major revolution. […] Musk also began to hone his trademark style of entering an ultracomplex business and not letting the fact that he knew very little about the industry’s nuances bother him in the slightest. He had an inkling that the bankers were doing finance all wrong and that he could run the business better than everyone else.
That was probably one of the reasons why he formed a team around him, which was both, capable of the needed technologic skills and on the other side had the required inside knowledge of the financial sector. Those new members, who all shared the spirit of how they could disrupt the banking industry, didn’t join X.com just as necessary employees. All of them were considered as co-founders of the new company, but still, Musk was the largest shareholder:
Musk assembled what looked like an all-star crew to start X.com. Ho had worked at SGI and Zip2 as an engineer, and his peers marveled at his coding and team-management skills. They were joined by a pair of Canadians with finance experience—Harris Fricker and Christopher Payne.
Nevertheless, there was a significant lack of knowledge about the regulations and that was also one reason, besides the internal conflicts of the founder and the co-founders, why after five months, there was still no progressions visible. This all ended up, in the separation of Ho, Fricker and a few important engineers:
The more the cofounders thought about their plan of attack, the more they realized the regulatory issues blocking the creation of an online bank were insurmountable. […] Just five months after X.com had started, Fricker initiated a coup. […] Musk tried to talk Ho and some of the other key engineers into staying, but they sided with Fricker and left. Musk ended up with a shell of a company and a handful of loyal employees.
Instead of giving up, on this, rationally considered, situation without any prospects, Musk still kept on believing in his idea. He even managed to convince Mike Moritz (an investor from Sequoia Capital, which meanwhile controls $1.4 trillion of combined stock market value), to fund the company, without having a solution for the above-mentioned law problem. With his inspiring vision for what could potentially be the future of banking, he also found a way to persuade new employees. But not only regular employees but some of the future founders of business like YouTube or Yelp, just to give a glance on which category of people he was able to convince. Finally, through the partnership with Barclays, X.com was further able to establish the legitimacy they always desired and so:
Week by week, more engineers arrived and the vision became more real. The company secured a banking license and a mutual fund license and formed a partnership with Barclays. By November, X.com’s small software team had created one of the world’s first online banks complete with FDIC insurance to back the bank accounts and three mutual funds for investors to choose.
As the time went by, one night before Thanksgiving in 1999, the day, Musk was looking forward to all the time, was finally there. X.Com went online, and within the first few months the number of users raised up to more than 200,000 people. The underlying strategy in this growing number was somewhat aggressive since they offered each new customer a $20 cash card to try their new service and for every person, they personally refer to X.Com, they could earn an additional cash card in the value of $10. But as with any good idea, X.Com did not stay alone in the market for a long time. There was a start-up called Confinity, with its founders Max Levchin and Peter Thiel (later known as the first external investor of Facebook Inc.), which originally started with a solution “for owners [of] Palm Pilot handhelds to swap money via the infrared ports on the devices”, but later on they focussed more on “Web and e-mail-based payments”, which they named “PayPal”. Since this was also one of the main value propositions of X.com, the “war” between the companies officially began:
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