Effectual logic: How entrepreneurs think

Waverly Deutsch

Most of the tools that corporate decision makers employ to validate ideas are based on predictive logic—the idea that if A leads to B leads to C, then in order to validate C, we look for A and B. This is the logical framework used by young entrepreneurs when they approach an opportunity by setting a goal, C, and then try to find A and B—the market demand, technical feasibility, competitive landscape, required resources, etc.—to predict the chances of C’s success. They use surveys, focus groups, expert interviews, analogue analysis, trial balloons, and other tools with which corporate decision makers are familiar.

But are there other ways of thinking about problems and opportunities that corporations can leverage? I was asked to participate in CEO Perspectives, a joint program between Chicago Booth, Northwestern’s Kellogg School of Management, and the Corporate Leadership Center, which brings together the most talented top executives of Fortune 1000–sized organizations in Chicago. This event attracts people headed for their company’s C-suite, perhaps even to the CEO role. I asked the organizers why they wanted me, an entrepreneurship professor, in this program. Their response: executives want to know what they can learn from the way entrepreneurs innovate.

What I talk to those executives about is effectual logic. When a concept is truly innovative, there’s no research that can effectively predict a market for it. One of the most-often-cited quotes on this subject comes from entrepreneur extraordinaire Steve Jobs, who said: “People don’t know what they want until you show it to them. That’s why I never rely on market research. Our task is to read things that are not yet on the page.” It is important to note that Jobs didn’t say he didn’t do market research. He said he didn’t rely on it. He instead showed people things and got their reactions, feedback, likes, and dislikes. He didn’t use market research to predict; he used it to create a market and to improve what he offered to the market. This is where effectual logic comes in. Effectual logic leverages assets on hand, existing expertise, a network of stakeholders, and experimentation to create opportunities rather than discover or predict them.

Saras D. Sarasvathy of the University of Virginia coined the phrase “effectual logic” to describe a way of thinking that expert entrepreneurs rely on to create their ventures. Sarasvathy asked super-successful entrepreneurs—those with 15-plus years of start-up experience, multiple ventures both successful and failed, and at least one IPO—to solve the kinds of problems entrepreneurs face in bringing something new to market. She learned they relied heavily on their power to engage a single customer, experiment until they found the best solution for a problem, and drive that solution into the market they created for it.

The five principles of effectual logic

From her research with these expert entrepreneurs, Sarasvathy derived five working principles of effectual logic. Corporations can and do exhibit these effectual-logic behaviors in launching truly innovative initiatives, but examples are not easy to find and too often come largely out of the technology industry.

1. Bird-in-hand principle—start with your means

Expert entrepreneurs approach opportunity on the basis of who they are, what they know, and whom they know. They work from competence, expertise, and their network to envision possibilities, raazther than target opportunities according to the market size or expected returns.

A corporate example of using the bird-in-hand principle dates to 1996, when W. W. Grainger became the first major business-to-business firm to invest heavily in the internet as a sales engine. In 1996 the internet had only 70 million users, or nearly 2 percent of the world’s population. Just a year before, Forrester Research had written a report in which 50 percent of Fortune 1000 CIOs stated unequivocally that the internet had no applicability to business and, as nothing more than a consumer time sink and security risk, would never be enabled behind their firewalls.

Grainger took a different look at the internet and decided that what it was really good for was information. Amazon.com had launched in 1995 with the vision of making a vast catalog of books, too numerous to house in a store, accessible to anyone, anywhere. What Grainger had was the world’s largest catalog of maintenance, repair, and operations products. Why not put that catalog online and see if customers would use that information source to discover and buy more Grainger products? Despite a complete lack of data about the channel conflict this would create, the willingness of customers to adopt this solution, or the impact on business operations, Grainger forged ahead. Starting with its asset base of information, salespeople, and relationships, Grainger pioneered business-to-business e-commerce.

2. Affordable-loss principle—focus on the downside risk

A common stereotype is that entrepreneurs are risk takers, but entrepreneurs don’t see themselves that way. They say they manage or limit risk. One way expert entrepreneurs do this is by investing, at each step of the entrepreneurial journey, only the time, energy, and resources they can afford to lose. They choose actions and goals in order to learn specific things about their business opportunities, and they pivot, adapt, or cut bait on the basis of what they learn. They find the upside in their experiments, even when those experiments don’t end up becoming booming businesses.

3M is famously known for allowing engineers to spend 15 percent of their time on their own projects, just exploring ideas, whether or not those ideas are in line with the company’s mission. 3M’s management is betting that any loss of productivity is worth the potential gain of supporting ideas in their nascent stages. And that bet has paid off with products including Post-it notes, ScotchBlue painter’s tape, and a lens-manufacturing process that generates more than $100 million in annual revenue.

Google lives the affordable-loss principle by making frequent forays into the market with products that often seem well outside its core business model and retreating just as quickly if the market rejects them. For Google, the concept of affordable loss can involve an awful lot of money. If you google “Google’s biggest failures,” you will find myriad articles on the subject citing dozens of flops—among them Google Wave, Notebook, and Nexus Q, a spherical digital media player. But in every case, Google keeps whatever works from the failure while jettisoning the product itself. Aspects of Google Wave are found in Gmail; Notebook features infuse the very successful Google Docs product; and even Nexus Q, which was Google’s first foray into hardware, helped with the design and launch of Chromecast.

3. Lemonade principle—leverage contingencies

Corporate managers are often obsessed with “what if” scenarios, trying to create plans and define outcomes for every eventuality. Entrepreneurs instead embrace the fact that they have no idea what will happen next, and their very business models could have to change and adapt as they learn from the marketplace. As a result, entrepreneurs view surprises, both good and bad, as ways to make their business cases stronger. In its launch year, Cranium, the game company, missed the annual Toy Fair, where the vast majority of new toys and games are introduced to the market. It mitigated that bad luck by getting into a completely different go-to-market channel: Starbucks. Cranium became the fastest-selling independent board game in US history.

In the corporate world, Pfizer created the category of erectile dysfunction drugs when Viagra failed to treat blood pressure and angina, the conditions for which it was being tested. It was during those tests that volunteers reported significantly more and longer erections when taking the medication, and Pfizer decided to launch trials in that area.

Three quarters of a century earlier, conservative paper-product company Kimberly-Clark found itself with warehouses full of Cellucotton and no market for it. During World War I, Kimberly-Clark had developed Cellucotton as an inexpensive, soft, absorbent wood-based replacement for cotton bandages, but when the war ended, the company had no idea what to do with the stuff until they discovered that nurses in the field had used the Cellucotton to replace sanitary rags. Working with their marketing agency, Kimberly-Clark branded the new product Kotex—short for “cotton textile”—and the disposable-sanitary-products market was born.

4. Patchwork-quilt principle—form partnerships

Entrepreneurs face a lot of nos, especially when bringing really innovative solutions to market. Rather than try to convert the nos to yeses, expert entrepreneurs seek out people who buy into their vision and gather them into a self-selected network of stakeholders who cocreate an opportunity. This might even involve partnerships with organizations that could, from a traditional perspective, be seen as competition.

In 1953, two men sitting on a plane got to talking after they discovered they shared the last name Smith. One was a salesman from IBM, and the other was the president of American Airlines. American was, at the time, struggling with managing reservations, since each flight’s seats were represented by cards in a rotating file that airline employees would mark when a seat sold. When travel agents called in, operators would find a file to see if the flight had sold out. The company was rolling out an electromechanical computer system to track the seats so more operators could quickly learn whether a seat was available, but the system still required a person on either end of a phone line. Meanwhile IBM was experimenting with a communications system for the US Air Force that used computers and teleprinters to input information into a database system.

This conversation could have been dropped and forgotten; but, instead, the president of American invited the IBM salesman to see their reservation system in action to determine if the two organizations could benefit by partnering on a new solution. This is how SABRE (semi-automated business research environment) was born. Launched in 1960, it took over all bookings for American four years later. To increase the value of the solution, American opened it up to travel agents in 1976, which paved the way for the online travel industry. Travelocity spun out of the SABRE initiative in 1996.

5. Pilot-in-the-plane principle—control the future

Expert entrepreneurs don’t see the market as an inevitable tide in which they must catch the wave just right or be dashed on shore. Rather, they believe that the future is created by people, and they have a fundamental faith in their ability to control that future.

Anyone could have told Steve Jobs that there was no market for tablet computers beyond a few forms-based applications such as medical checklists or ruggedized field tablets for oil-rig and construction-site inspections. The technology for tablet computers had been on and off in the market since 1987, when the GRiDPad launched. That was followed in 1991 by the NCR 3125 Notepad. Microsoft got in the game in 1992 when it created Windows for Pen Computing, an operating system specifically designed for tablets. IBM tried with the ThinkPad 700T in 1992, and Apple made its big play with the Newton MessagePad in 1993, only to discontinue it in 1998. Through the early 2000s, products kept coming and going. There was no big market for tablet computers.

But Steve Jobs didn’t care. He decided to show the market something it never thought it wanted. Using Apple’s superior design expertise and massive marketing machine, Jobs brought iPad to the world. The reaction was mixed. Apple devotees lined up to buy it, while Windows proponents scoffed. Some reviewers said it was nothing more than a big, heavy iPhone that couldn’t make phone calls and didn’t have a camera. But it sold 3 million units in 80 days, and it wasn’t long before developers began to turn out new and interesting applications by the thousands for this “new” computing format. The Apple App Store now boasts more than 1 million apps specifically designed for the iPad.

Corporate innovation is hard. Corporations have to deal with competing projects and priorities, budgeting nightmares, existing products and customers, and the ever-present pressure from Wall Street to make the quarterly numbers. Yet, the imperative is there. In a 2013 PwC Pulse Survey of 246 CEOs worldwide, 97 percent of survey participants indicated that innovation was a top priority for their company. Patrick Whitney, design guru and dean of Illinois Institute of Technology’s Institute of Design, says corporate innovation requires three things: first, managers who know when their customers’ needs are not being served; second, fear or pain that drives urgency; and third, executive leaders who are willing to go down a path without knowing exactly where they will end up. Perhaps the tools of effectual logic and its framework of principles, used so frequently by the most successful serial entrepreneurs, can help these leaders overcome some of the obstacles to building innovation into their corporate practice.

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Waverly Deutsch is a clinical professor of entrepreneurship at Chicago Booth.

This article was originally published on the Chicago Booth Review.