A Key Ingredient of the Super-Successful Startup: The Willingness to Assume Risk

A Key Ingredient of the Super-Successful Startup: The Willingness to Assume Risk

by | Nov 26, 2018

In Brief:  A review of administrative data compiled by the U.S. Census Bureau suggests that startups that are willing to take bigger risks than their competitors tend to be higher performers, assuming that these young firms manage to survive.

Why This Matters:  Super-successful startups are a major engine of both job creation and macroeconomic growth. 

The Takeaway:  Risk-taking is often a key ingredient in the emergence of a super-successful firm such as Amazon.

In Depth:  In late 1993, a twenty-nine-year-old recent graduate of Princeton University named Jeff Bezos decided to start “the everything store.” Bezos acknowledged that the idea was a bit impractical, so he made a list of twenty possible product categories. He figured that the best way to launch his online retailer was by selling books. Six month later, Bezos walked away from his cushy job at the Wall Street hedge fund, D.F. Shaw, to start Amazon, which a few months ago, became the world’s second trillion-dollar corporation.

According to Joonkyu Choian economist at the Federal Reserve Board of Governors, who recently completed his doctorate in economics at the University of Maryland, the promising career that Bezos walked away from may well have something to do with the startling success of Amazon. Choi studies firm dynamics and entrepreneurship, and he is particularly interested in the key ingredients of successful start-ups. “Since these firms are important in job creation and productivity growth, my work has implications for the economy as a whole,” he says. In a recent working paper, “Entrepreneurial Risk-Taking, Young Firm Dynamics and Aggregate Implications,” Choi found that young firms whose founders have better fallback options, should their firms fail, tend to exhibit higher growth. One reason is that these entrepreneurs are less afraid to take risk. In the case of Bezos, if his online bookseller had tanked, he could easily have gone back to earning big bucks on Wall Street.   

In this working paper, Choi examined a sample of 1.7 million startups from 1999 to 2014, which operated in 31 states. He created this sample by combining two massive administrative datasets maintained by the U.S. Census Bureau—the Longitudinal Business Database (LBD), which tracks non-farm firms since 1976, and the Longitudinal Employer-Household Dynamics (LEHD), which covers 95% of private sector workers. The empirical study found that firms like Amazon where the founder had better fallback options were actually more likely to fail, but that if they survived, they were likely to experience faster growth than their counterparts without good fallback options. Choi argues that this patterns affects young firms at various stages of development. “Take the example of Amazon, when Bezos was moving from books into other products,” he says. “That step was also potentially hazardous, as he ran the risk of losing existing customers, if the company suddenly flopped.  But that was another risk that Bezos could afford to take.” 

Recently, Choi has also looked at the success of young firms from another angle for a different working paper, “Flying High or Crashing Down: Pre-Entry Knowledge and the Distribution of Startup Performance,” which he co-wrote with Rajshree Agarwal of the University of Maryland, Benjamin Campbell of Ohio State University and Seth Carnahan of the University of Michigan. This empirical study contrasts the track record of startups founded by industry insiders versus those founded by industry outsiders. According to the study’s hypothesis, firms started by industry outsiders are more likely to fail, but if they survive, they are likely to outperform those started by industry insiders. Choi and his co-authors confirmed this hypothesis by looking at a large sample of high-tech startups founded between 1990 and 2008, which were also culled from the LEHD maintained by the U.S. Census Bureau.

The reason for the better performance of the firms started by industry outsiders also has to do with the approach to risk. “Firms started by insiders have a distinct advantage,” says Choi. “Given their experience in the industry, they can implement a business plan more easily. As a result, outsiders face more uncertainty. Outsiders know that they have a higher risk of failing and tend not to enter into the marketplace unless they think their idea has the potential to be a big success. Insiders, in contrast to outsiders, often go with an idea that is likely to be a success, but that idea is less likely to have as big a pay-off in the end.”

Joshua Kendall has written on business and healthcare for numerous publications including BusinessWeek, Fortune.comThe New York Times, The Boston Globe and The Washington Post. For more about his work visit JoshuaCKendall.com.