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Effectuation Theory

Effectuation Theory is a set of principles to starting a business and entrepreneurship developed by Saras Sarasvathy. 

Effection Theory describes an approach to making decisions and performing actions in entrepreneurship processes, where you identify the next, best step by assessing the resources available in order to achieve your goals, while continuously balancing these goals with your resources and actions.

Effectuation differs from the causal logic, where there is a predetermined goal and the process to achieve it is carefully planned in accordance to a set of given resources. Sarasvathy argues that the causal logic is not suited for entrepreneurship processes that are inherently characterized by uncertainties and risks.

The fundamental world view for effectuation is called the Pilot-in-the-plane, which describes the future as something you can influence by your actions, i.e. you can create your own opportunities.

The four principles of effectuation are:

  • Bird-in-Hand: You have to create solutions with the resources available here and now.
  • Affordable loss: You should only invest as much as you are willing to lose.
  • Lemonade principle: Mistakes and surprises are inevitable and can be used to look for new opportunities.
  • Crazy Quilt: Entering into new partnerships can bring the project new funds and new directions.

 

Bird in Hand Principle – Start with your means. Don’t wait for the perfect opportunity. Start taking action, based on what you have readily available: who you are, what you know, and who you know.

Affordable Loss Principle – Set affordable loss. Evaluate opportunities based on whether the downside is acceptable, rather than on the attractiveness of the predicted upside.

Lemonade Principle – Leverage contingencies. Embrace surprises that arise from uncertain situations, remaining flexible rather than tethered to existing goals.

Crazy-Quilt Principle – Form partnerships. Form partnerships with people and organizations willing to make a real commitment to jointly creating the future—product, firm, market—with you. Don’t worry so much about competitive analyses and strategic planning.

Pilot in the Plane PrincipleControl the controllable. The four specific principles above represent different ways entrepreneurs interact with the environment to shape the environment. Of course not everything can be shaped or controlled, but effectuation encourages you, as the pilot of your venture, to focus on those aspects of the environment which are, at least to a certain degree, within your control.

The world view and the four principles are used in entrepreneurship processes to plan and execute the next best step and to adjust the project’s direction according to the outcome of your actions.

Effectuation Theory is a way of thinking that entrepreneurs use to identify new ideas, opportunities and ventures. It uses a set of decision-making principles that can (even) be used in uncertain situations, in scenarios where the future is uncertain and it’s difficult to make good choices.

These principles will help you think and reason like an entrepreneur rather than the pipe dreams / pie in the sky and castle in the sky logic that is caused by causal reasoning.

Effectuation vs. Causal Theory

 

Causal theory is described as the “normal” theory that people use to plan, whereas entrepreneurs use effectuation to guide their next steps. Effectuation Theory is based on heuristics which is defined as “any approach to problem solving or self-discovery that employs a practical method that is not guaranteed to be optimal, perfect, or rational, but is nevertheless sufficient for reaching an immediate, short-term goal”.

A simple example:
Causation theory: You want to build a block of flats and go looking for investors (something you may never find).
Effectuation theory: You look at the resources you have (Bird in Hand) and make your next move from there.

Causation theory is the opposite of effectuation theory, effectuation theory is used when the future in uncertain, as a startup your future is always uncertain and predicting the future is difficult.

Whereas causation theory is used when the future is predictable, like once you have grown to a medium or large business and you need to grow it or turn it around. Then you can look at causal reasoning and determine goals to achieve and find the resources to do it whereas effectuation is the opposite as you determine goals based on the resources at hand.

It is important to take a step back here, and ask why? Here is why:
Small business: limited resources surviving day by day.
Medium & Large business: existing clients, cashflow this will give you access to finance options to grow, you may also have assets to put up as collateral if needed.
As you can see with a medium and large business things are far more predictable.

In effectuation if you have the resources to only buy and rent out one flat, you will do that, you will not think of building a block of flats because you don’t have the resources. Whereas in causal reasoning you determine the goal to build a block of flats then you go find the resources to do so.

It is very important to take another step back and ask why again. In the movies you see people use causal reasoning all the time going office to office pitching to investors and eventually they get funded. That is in the movies and in a western country. In South Africa if you do not have the resources to start your “dream” business it will stay just that a dream. Banks don’t lend to startups and there is virtually no government assistance.

The person that developed effectuation theory Saras Sarasvathy comes from India where there is a similar macro environment in South Africa: poverty and little government support. It is a better suited framework to use than causal reasoning.

Having worked with small businesses, in South Africa most people without the resources will often have lofty ideas to start a business but will never get off the ground because they use causal reasoning. Why causation does not work in small business is that you don’t have those resources and you do not qualify for bank finance.

But in effectuation you look at your resources and then decide. This is what successful entrepreneurs and small business owners do because they know what is available in the hand and that’s what will have to do. So if they want to build a portfolio of rental properties starting with 1, grow it to the point where there is sufficient income and collateral to finance the building of a block of flats then fine. But if they plan to build a block of flats in a year they will fail due to the lack of resources, in causal theory the requirements are so high that they might not be able to start at all, as projections will say that you need R10 million for build a block of flats but you don’t have it so the work will never start. Whereas in effectuation you will say, I have R1 million. What can you do with R1 million? / Effectuation theory will tell you that you have R1m, start what you can do with R1m.

Using effectuation your thought process will look this:
* You can buy one nice apartment and rent it out adding another one every x years. As the apartment is paid off, and its value increases it can be used as collateral to buy another one and so on.
or
* You can buy two cheaper apartments, that maybe need some work done, fix it up adding another one every x years. As the apartment is paid off, and its value increases it can be used as collateral to buy another one and so on.

* You can still aim for a block of flats by forming a syndicate by saying I can look for 9 more people with R1 million each and we can build a block of flats, when you cannot find 9 people then the “Lemonade principle” can lead you to the above 2 scenarios.

Designing Failure
Failure is part of entrepreneurship and cannot be ignored. Effectuation theory proposes that you understand and “design” your failure. You should know what can fail you, what you can do about it and when to throw in the towel. Effectuation proposes “Affordable Loss” in which you establish what the “stop loss” in your business venture is. In other words you accept you can fail and will therefore stop your losses at a certain point. Do your best but accept that you can fail. So even if you do fail you don’t end up homeless on the street, putting you in a position to plan your next startup in a position to better succeed with the lessons you learnt from failing. This is the concept from affordable loss: pack what you can carry and don’t be stubborn to realise that you can fail and when you are failing at that is part of the risk taken in entrepreneurship.

What is effectuation?

effectuation-3-pager

Credits:
Saras Sarasvathy
Saad T. Hameed