VENTURE CAPITAL,
2001,
VOL .
3,
NO .
2, 91 ± 106
Embedded fitness landscapes—part 1: how a venture capitalist maps highly subjective risk DOUGLAS D. MOESEL, JAMES O. FIET and LOWELL W. BUSENITZ (Final version accepted 16 February 2001) Sensemaking frameworks are used to develop the metaphor of shifting, multidimensional fitness landscapes mentally embedded in increasing higher levels of abstraction. Cognitive maps illustrate the simplified visualization used by early stage venture capitalists (VCs) to understand venture risk. Risk assessments of new, high-growth potential ventures are often highly subjective. In this first article of a three-part series, we define the nature of the uncertainty and equivocality that VCs face and relate these to traditional approaches to categorizing risk. Next, we introduce fitness landscapes and review two approaches relating these to business strategy. The metaphor is extended to focus on multiple embedded landscapes rather than a single map. Map instability is linked to ongoing sensemaking activities of the VC. Finally, the remaining two papers in the series on cognitive representation and experiential learning of VCs are previewed. The papers in the series all focus on developing a new research approach to understanding the conceptualization and management of highly subjective risk by VCs.
Keywords: venture capital; subjective risk; fitness landscapes; cognitive maps; sensemaking
Introduction Seed and early stage venture capitalists (VCs) are very adept in reducing their perceptions of ambiguity. This allows them to maintain orderly cognitive patterning in dynamic and complex business landscapes. Weick (1995) noted that ambiguity is a broad term used to encompass both ignorance about (the absence of information) and confusion (equivocality or the presence of multiple, conflicting interpretations) concerning the environment. Individual VCs use sensemaking processes that form a key part of the organizing experience in VC firms to gather information and
Douglas D. Moesel, University of Missouri, Columbia, 227 Middlebush, Columbia, Mo 65211-6100, USA; e-mail:
[email protected]; James O. Fiet, Department of Management, College of Business and Public Administration, University of Louisville, Louisville, Kentucky 40292, USA; e-mail:
[email protected]; Lowell W. Busenitz, Department of Management, 307 W. Brooks, Price College of Business, University of Oklahoma, Norman, OK 73019-4006, USA; e-mail:
[email protected] Ventur e Capital ISSN 1369-106 6 print/ISSN 1464-534 3 online Ó http://www.tandf.co.uk/journals DOI 10.1080 /1369106011004565 2
2001 Taylor & Francis Ltd
92
DOUGLAS D. MOESEL ET AL.
reduce equivocality in interpretation. This allows them to notice order amidst the apparent chaos of the emerging industries in which they invest. This is the first article in a three-part series that deals with sensemaking processes of individual VCs in the context of their work for the VC firm. This article introduces the problems of uncertainty and equivocality in the investment environments of the VC. The concept of sensemaking is briefly introduced to show its relation to reductions in uncertainty and equivocality. The paper then distinguishes three forms of risk and relates these to suggestions about reducing risk. A metaphor of fitness landscapes is introduced to understand how VCs might attempt to map business risk. The concept of a fitness landscape is extended to allow for the possibility of multiple, embedded fitness landscapes at four different levels of abstraction. This provides a foundation for a brief summary of the purpose of each of the next two papers in the series. These elaborate on the details of theory behind belief-driven sensemaking processes in the cognitive representation process of the VC (Part 2) and action-driven sensemaking processes in the experiential learning process of the VC (Part 3). The second article helps to explain why a first-mover into a new technology may encounter very different reactions from different VC firms (von Berg and Kenney 2000). The third article helps to lend insight into why VC firms investing in the same emerging industry can extract very different lessons from what appear to be fairly similar investments. The dichotomy developed here is, in many respects, a false one as the effects of cognitive representation and experiential learning can be very difficult to disentangle. In fact, the two processes are highly complementary (Weick 1995, Gavetti and Levinthal 2000). Primarily they are distinguished between to simplify their explication. Together the articles in this series establish a theoretical framework and document a number of questions for future research. Ambiguity in investment environments The nascent ventures that approach VCs for possible funding often can only provide limited information to reduce uncertainty. Further information may be available but may be costly to locate and access. More fundamentally, currently available information may be of unknown validity and subject to such equivocality that it would be senseless to treat it as if it had a clear interpretation. The contrast is illustrated with a mundane example to emphasize the prevalence of both factors. A VC may lack immediate direct access to data on the sale of competitive products or services for a proposed venture, reflecting uncertainty. If an industry is well established, if it is known to vary seasonally and if a major regulatory change occurred 5 years ago that is widely viewed as having had a known effect on industry structure, then an uncertain situation exists that causes little concern for a VC. All that remains to resolve any concern is to access 5 years of information for a limited set of market territories, which would reflect the appropriate seasonality.
EMBEDDED FITNESS LANDSCAPESÐ
PART 1
93
Now assume that a VC views a venture’s competitive environment as much more equivocal. Aldrich and Fiol (1994) note that risk is especially high when there are few precedents for the kinds of activities that entrepreneurs want to found. They view the relative lack of legitimacy as especially critical for new ventures. Where an industry is not clearly established, questions of relevant performance benchmarks rise (Beinhocker 1999). Any production or marketing economies may be unproven, which would make it difficult to understand how widely to collect data. A product may have multiple functions with unknown demand weightings across these functional options. This may make assessment of potential seasonality effects more complex. Getting data may mean selecting from among multiple sources with only crude similarities to the proposed product. Available trends on such crude comparisons may only exist for geographic regions of differing size, fragmented periods of time and differing periodicities. Should a VC choose from among crude comparisons based mainly on similarities in geographic region, time period of interest, or periodicity of data? Which is least likely to raise controversy in interpretation with partners? Can a VC assume that all VC partners will operationalize industry attractiveness primarily on the basis of a sales trend such as this or are partners known to prefer to argue for more multidimensional approaches? If the latter then how idiosyncratic is each partner’s multidimensional approach and to what range of industries do they feel comfortable generalizing these definitions? Clearly, equivocality exists in most forms of information that VCs use. As suggested by the contrast just noted, equivocality is likely to have more constraining effects on VC investment behaviour than simple uncertainty (Daft et al. 1987). A key area of equivocality for VCs involves the definitions of industry and segment boundaries. This affects the inclusion or exclusion of specific products and services and specific firms within a given industry or segment category. Levenhagen et al. (1993) contend that actions by early movers in an emerging industry to construct boundaries can take on a reified form (i.e. become an objective reality by virtue of being taken-for-granted) for industry observers and for the firms (and the financiers of those firms) that enter later. To the extent that a VC firm funds the earliest movers, it can participate in shaping this social construction process for an industry. However, individual VCs in the firm must be able to reach some common basis of agreement that a venture proposal represents the initiation of a distinct new industry or segment. Such agreement is likely to be difficult to build and this will lead many VC firms to pass on such investment opportunities. It may be easier to reach agreement to wait and capitalize on the early legitimization efforts of others by allowing others to fund the first venture (Aldrich and Fiol 1994). A major form of equivocality facing new VC firms is potential for multiple views among individual VCs in terms of which types of productmarket customers and which areas of their product-centred need should be central to the time and energy allocation of a firm’s partners. If some agreement can be reached then a VC firm can begin to channel the attention of its individual VCs toward specific business landscapes and particular dimensions of those landscapes.
94
DOUGLAS D. MOESEL ET AL.
Another major form of equivocality involves the diversity of opinion among partners as to which resource allocations, in a given part of a fitness landscape, link most strongly with the customer needs that have been identified. If some convergence can be achieved in the individual interpretations of the VCs of the value of alternative resource allocations, a VC can begin to invest where others fear to tread. Levenhagen and colleagues (1993) express similar ideas. They model a VC’s representation of a financing transaction between a VC firm and a software firm. This illustrates three sets of beliefs by the VC about the exchange. Beliefs about the venture’s management team are put aside as less relevant to our focus on business risk1 and dwell here on a combination of their other two models. VCs construct mental representations of the products that a firm proposes and also of the end customer and the needs of that customer. The concept of fitness landscape maps is used (Gavetti and Levinthal 2000) to describe such mental representations on an aggregate scale for a VC. A VC gathers data on the state of broad business landscapes to enhance his joint sensemaking with other VCs in a firm. This enables the VCs to develop similar mental models to guide the evaluation of venture proposals. Perhaps the most important function of the similarity in models is that it also allows a VC to sense when new questions need to be asked of fellow partners to reestablish what a VC firm really knows. Sensemaking in ambiguous environments Sensemaking is the process of making sense of one or more environmental cues that are discrepant—that is, the cues are not initially subject to an automatic interpretation based on existing mental schemas or structures. Seed and early stage VCs direct investment funds into ambiguous environments. Such environments are saturated with potentially discrepant cues. Those discrepancies that persist begin to disrupt a VC’s routines and activate a cognitive switch from mindless, routine-driven behaviours to mindful, consciousness of how current mental models must be restructured to restore order (Louis and Sutton 1991). VCs use sensemaking processes to learn which types of information to process and which types of information to ignore, to block from perception, to discard, or to refuse to acquire. These lessons are captured in scripts that automatically guide behaviour, allowing it to become more routinized and efficient. A key advantage of such automatic behaviours is that they conserve cognitive energy, which allows them to be redirected to discrepant clues that might indicate that current behavioural routines need to be reassessed or that entirely new directions of investment behaviour may be more effective. If VCs are to deal effectively with ambiguous environments, they must immerse themselves in sensemaking and frequently reshape their mental models. Given bounded rationality and sensemaking constraints, VCs must develop ways to readily dismiss some forms of discrepancy as irrelevant while remaining highly vigilant for other forms of discrepancy. Any
EMBEDDED FITNESS LANDSCAPESÐ
PART 1
95
attempt to describe their mental model for investing will require careful contextualization as the model might be substantially altered a year later or perhaps even a month later based on continuing reaction to and manipulation of their environment. No formal propositions are offered in this article. Instead this paper aims to review and extend previous approaches to risk, focusing especially on highly subjective forms of risk. Concepts of risk are then linked to the metaphor of fitness landscapes as a type of mental model. Three types of business risk Risk management is the process of enhancing positive outcomes while reducing negative outcomes for an organization. Risk is the potential downside variation of a specific strategic option relative to known alternatives. Comparative risk assessments of new, high-growth potential ventures are often highly subjective. Researchers have recognized this subjectivity (Sweeting 1991, Aldrich and Fiol 1994) but its potential implications have rarely been directly addressed (Knight 1965: 210–211): It is only when our interest is restricted to a very narrow aspect of the behaviour of an object . . . that exact theoretical determination is possible; and only by refined laboratory technique . . . The ordinary decisions of life are made on the basis of ‘estimates’ of a very crude and superficial character . . . It is only in very special and crucial cases that anything like a mathematical (exhaustive and quantitative) study can be made. The mental operations by which ordinary practical decisions are made are very obscure.
In his classic 1921 essay, Knight (1965) acknowledges the critical limitations of cognitive processing capability on decision making well before Simon’s (1947) seminal work on bounded rationality. He recognizes the costs of unrestricted information search, as well as the impossibility of accounting for all applicable risk factors. He suggests that individuals selectively restrict their own efforts to account for factors that influence a risk object; this topic is elaborated further in a discussion of selective noticing (Weick 1995) in the second article in this series. After introducing these limitations, Knight distinguishes between terms such as objective probabilities (measurable risk), also termed measurable uncertainty, and subjective probabilities (unmeasurable risk), also labelled unmeasurable uncertainty. He prefers the term risk for the former and uncertainty for the latter. For Knight (1965: 233), a distinguishing feature of uncertainty is that ‘it is impossible to form a group of (similar) instances, because the situation dealt with is in a high degree unique.’ Note that ventures proposed as first-movers in an industry that does not yet exist would always qualify as uncertain rather than risky on this basis. Knight (1965: 238) believes that individuals will ‘strive to reduce uncertainty, even though we would not want it eliminated from our lives’. He articulates six methods for reducing uncertainty. These include: (1) consolidation or grouping on the basis of nearly any similarity or common element, however imperfect; (2) specialization in terms of specific cognitive approaches to dealing with uncertainty or specific roles in relation the nature of uncertainty to be confronted; (3) controlling the
96
DOUGLAS D. MOESEL ET AL.
future presumably through active intervention relative to aspects of the uncertainty faced; (4) increasing knowledge that would increase the power of prediction based on expected future progress; (5) diffusing the negative consequences of action in the face of uncertainty; and (6) avoiding risk by directing activity toward areas in which a minimum amount of uncertainty is involved. He notes that the ‘capacity for forming correct judgements is the principal fact that makes a man serviceable in business . . . the most important endowment for which wages are received’ (Knight 1965: 229). Our approach builds on Knight’s ideas about uncertainty reduction but the paper clarifys that much of what Knight (and economists generally) would lump under uncertainty is more heavily dominated by what we would call equivocality. For instance, Knight’s grouping strategy is helpful not just for purposes of relative contrast,2 but also for communicating any risk of loss feared and for soliciting subjective information from others until more objective measures become available. Recall that Knight advised initial grouping on any similarity, no matter how crude. Initial grouping on crude similarities should lead to great equivocality in information flowing from such a relative contrast. Knight often seems unaware of the existence of equivocality and its consequences. He appears to imply that role occupants that form part of a larger system can pursue their roles independently with little need for coordinated action. This assumes, at the very least, a common interpretation of what distinct forms of autonomous uncertainty exist in a business’s environment when roles are initially created. Sensemaking will be required to achieve this. Joint sensemaking efforts of individuals in the roles will also be needed in the future if some aspects of the environment become more interdependent over time. In all three parts of this series, Knight’s uncertainty-reducing methods were highlighted while concomitantly exploring the nature of equivocalityreduction which successful use of these methods will require. Effective seed and early round venture capitalists exemplify Knight’s second method. That is, they specialize in what appear to others to be highly uncertain (and highly equivocal) investments. Close examination of the cognitive processes used by VCs and the role that they play in reducing uncertainty and equivocality for other business actors should help contribute broadly to an understanding of the management of business risk well beyond the venture capital management literature. The addition of equivocality concerns suggests that Knight’s framework would be more valuable with the inclusion of a third, intermediate type, which would fit between his risk and uncertainty categories. Uncertainty might be readily ignored if the true level of risk were perceived as unknowable. However, with new or more complete information, what was initially perceived as uncertainty may be transformed to objectively measurable risk once equivocality is removed. Due to the difficulty of assigning the phenomenona of interest either to the category of risk or uncertainty in their ideal forms, three categories are created within Knight’s concept of risk in this series. Two of these categories emphasize the middle or gray area between Knight’s risk and uncertainty. These are
EMBEDDED FITNESS LANDSCAPESÐ
PART 1
97
the areas where we believe most seed and early round VCs spend most of their attention: (1) Irreducible uncertainty risk: this corresponds most closely to Knight’s view of true uncertainty in that it is a loss potential that is not currently measurable nor is it expected to become so in the near future. It represents a state of ignorance or the absence of helpful information regarding a risk object. This characteristic is labelled as a form of risk because the attribution of extended uncertainty in the future regarding a risk object may be altered as new, surprising information arises. However, because a VC does not expect such information to be forthcoming, vigilance toward it is not expected. (2) Subjective risk: this is a loss potential that is difficult for two individuals working independently to comparably measure at the present time but for which substantial convergence is likely in the near future after early public actions. This might be conceived, in Knight’s terms, as the transitional state between uncertainty and risk, in which his uncertainty-reducing techniques are most applicable. A VC is expected to be either highly vigilant or to encourage the vigilance of others toward such risk objects so new cues are likely to be salient. Information is becoming available but any initial information is expected to be highly equivocal. A VC who funds one or more entrepreneurs that are able to provide such information and to assist in substantially reducing its equivocality will help to translate the risk object to a more objective form of risk. As Knight emphasized, such individuals may be in position to profit handsomely. (3) Objective risk: this is a loss potential that may be assessed comparably by two individuals working independently. It is roughly comparable to Knight’s concept of risk. Information is readily available concerning the risk object and the equivocality of this information has been greatly reduced. This is more characteristic of latter stages of VC funding when a venture’s product market acceptance has been demonstrated. Recognizing these three forms of risk enables us to focus on cognitive processes that have, until now, been largely overlooked. For example, how do VCs distinguish between irreducible uncertainty risk and subjective risk? How do they identify those risk objects just starting to make the transition between irreducible uncertainty risk and subjective risk? How do they diffuse their preferred interpretation of equivocal information so that other economic actors, such as latter stage VC investors, perceive objective risk in a risk object that a few months before may have been easily classified as an irreducible uncertainty risk? Our principal emphasis is on how seed and early stage VCs first detect and deal with the emergence of subjective risk out of irreducible uncertainty risk. Thus we will often use the term highly subjective risk to reflect this interface. In the next section, a metaphor to visualize how seed and early stage can understand how to visualize the complexity of their investments and how they can locate investments characterized as highly subjective risks relative to one another in cognitive representations is introduced. This metaphor is
98
DOUGLAS D. MOESEL ET AL.
a type of cognitive map in the form of a hierarchically-embedded series of multidimensional fitness landscapes. Fitness landscapes Wright (cited in Gavetti and Levinthal 2000) may have been the first to introduce the concept of fitness landscapes. He mapped attributes of biological organisms (genes) on the fitness of the biological organism containing that combination of attributes. Thus it represented space in which different attributes of the organism could be compared based on their contribution to overall viability. Kauffman (1993) builds on the concept of fitness landscapes. He emphasizes the degree to which a given landscape is more or less mountainous or rugged (most easily envisioned in three-dimensional view but theoretically extending up to an infinite number of dimensions) based on the distribution of fitness values across two or more dimensions of the entities being compared. Fitness landscapes have also been applied to organizations (Beinhocker 1999, Gavetti and Levinthal 2000). This approach views the underlying dimensions as policy decisions of an organization. It conceives fitness as the overall payoff in some product-market space from applying that combination of policy positions to that environment. Note that this assumes equal implementation ability across organizations for a given policy decision and, in simplified form, ignores the number of organizations competing in the same space. Building from Kauffman (1993), this approach emphasizes that the ruggedness of a fitness landscape surface, in the simple case of two underlying dimensions, is determined by the level of interdependence of the two policy dimensions that form the underlying plane onto which fitness levels will be mapped.3 The more interdependent the two policy dimensions are, the more rugged their environment is. If the two policy dimensions form a rugged fitness surface with many distinct peaks and troughs, instead of a smooth one with a single peak and single trough, this indicates that the two policy dimensions are relatively tightly linked. In this
Figure 1. Smooth and rugged ‘fitness’ landscapes
EMBEDDED FITNESS LANDSCAPESÐ
PART 1
99
case the payoff from one policy decision will depend heavily on the position taken on the other policy variable. Gavetti and Levinthal (2000) make an important contribution by linking fitness landscapes with processes of cognitive representation and processes of experiential search used by managers seeking higher fitness values for their organization. They define cognitive representation as a broad and forward looking search approach relying on abstract but explicit representations (theories-in-action) of what a product-market space is really like. These representations develop over time from sets of routines and behaviours within a firm. Policy choice is complicated by any abstractness in a firm’s representation of its product-market. Many alternative policy choices could reasonably be drawn from one representation or theory. They call this one-to-many mapping meaning that interpretation of the information contained in a firm’s representation is somewhat equivocal. Therefore the task facing a firm is to experiment widely over time across a range of policy choices consistent with the representation of a firm. This involves making bold changes in policy dimensions over time in order to understand which ones have the greatest fitness impact for a firm within the context of its abstract representation. If fitness levels are low for an organization while operating in a specific policy configuration, the equivocality of the representation process allows other interpretations (policy configurations) to be deduced. This facilitates substantial changes in firm behaviour because multiple policy dimensions can be changed at the same time. Experiential search, or experiential learning as it is referred to, is backward looking and relies heavily on what has already been learned from initial policy positions (Gavetti and Levinthal 2000). It involves local search that incrementally varies only one policy dimension at a time in order to retain its tacit, experiential wisdom or absorptive capacity (Cohen and Levinthal 1990) regarding fitness relationships in that specific neighbourhood of a product market. In a smooth landscape, this search approach pays off because small changes in any direction will usually predict the fitness impact of further incremental changes as a firm draws closer to or farther away from a lone peak or trough. In a rugged landscape, local experimentation by incremental change will tend to lead a firm to quickly settle on one of the more proximate local fitness peaks. However, change along multiple policy dimensions, as driven by cognitive representation rather than experiential search, may lead to one of the other fitness peaks that are higher or could result in reaching the global peak— that policy combination more effective than any other. Beinhocker (1999) takes a complementary approach in distinguishing between short jumps or ‘adaptive walks’ and long jumps. His short jumps are identical in intent to Gavetti and Levinthal’s (2000) interpretation of how experiential search plays out in fitness landscapes. His long jumps are similar to their interpretation of the effects of the cognitive representation process in seeking high fitness positions in the landscape. They emphasize the inherent complementarity of the two types of processes. He stresses the principle of mixing short and long jumps in moves across the fitness landscape.
100
DOUGLAS D. MOESEL ET AL.
Beinhocker (1999) also discusses the important principle of parallelism or having multiple ‘parallel’ searches active in the fitness landscape at the same time. He uses Microsoft and their population of strategies in operating systems as well as in other areas as an example of this principle. The obvious corollary in VC investing is the VC firm’s portfolio of investments. Gavetti and Levinthal’s (2000) approach assumes a firm with a single strategy or moving in only a single direction at any given moment in time. This may accurately characterize many of the ventures in which VCs invest. Beinhocker’s approach can be used to emphasize that VC firms (and individual VCs) are associated with multiple venture strategies simultaneously. These multiple investments may serve the purpose for the VC of a ‘platoon of hikers’ or having multiple parallel fitness experiments in process simultaneously trying to locate fitness peaks. Beinhocker’s (1999) principles of mixing short and long jumps and of parallel search have been noted. Another principle that he articulates well that is only briefly touched on by Gavetti and Levinthal (2000) is that the actual phemonena that the individual or firm is trying to map using fitness landscapes are changing. This means that fitness levels associated with a given mapped position will not always remain the same. Thus, fitness peaks can collapse with changes in the environment such as actions by competitors. This is called ‘deforming’ of the landscape. The paper will try to address some of the consequences of landscape deformation for VCs in their investment approaches. Beinhocker’s primary recommendation in this regard is to keep moving to avoid the stasis of being locked into a stable fitness landscape position. This is tantamount to a funded venture continually adapting its declared strategy. Beinhocker might therefore view the need for substantial change in the strategy of each funded venture from the initial business plan as more of a neutral rather than as a primarily negative signal. The application of fitness landscapes is expanded to a VC’s perspective. Although this metaphor could be used to look at policy decisions of a VC firm, fitness landscapes are used as a way to think about how an individual VC organizes his thinking about both future investment possibilities and results of past investments. One additional layer of complexity must be added to Gavetti and Levinthal’s (2000) fitness landscapes to achieve a more realistic model of the VC’s dilemma. Whereas Gavetti and Levinthal conceive of an organization competing in a single product-market through choice along multiple policy dimensions, VCs invest in ventures competing in a range of product-markets, some well established and some just emerging. A VC therefore can be portrayed as maintaining multiple fitness landscapes models as well as maintaining models at various levels of abstractions. Table 1 summarizes four layers of abstraction ranging from the most abstract portrayal of market environments down to the most specific. These include: (1) institutional environments for business; (2) major industry sectors; (3) industries; and (4) industry segments or niches. Sample landscape dimensions are listed for each level of abstraction to provide a way to categorize how a VC may maintain fitness information. Note that a
EMBEDDED FITNESS LANDSCAPESÐ
PART 1
101
Table 1. Sample dimensions of VC fitness landscapes by level of abstraction of the landscape. Level of abstraction Sample dimension of relevant fitness landscape Institutional Environment Industry Sector Industry
Segment/Niche
Tightness of regulation Lobbying intensity Property right protection Technological intensity Type of distribution channel Intensity of value chain relationships Advertising intensity Level of access to related activity in basic science research Level of unionization Size-related economies Duration of life cycle per individual product Dispersion of customer base Switching costs to customer of changing segments Type of quality appeal Durability of product (time to replacement) Customer service intensity after sale
VC greatly simplifies the actual complexity of each environment at each level of abstraction by keying on a few of the dimensions deemed most critical based on that VC’s working theories and past experience in investing. Dimensions at each level of abstraction represent generic causes that drive resulting fitness in a fitness landscape. Fitness landscapes at each lower level of abstraction are greater in number than the level of fitness landscapes above and completely embedded within this higher level so that the relation between fitness landscapes can be envisioned as an inverted funnel. The logic connecting abstraction levels is that dimensions at higher levels of abstraction impose constraints on fitness perceptions in lower levels of a funnel. For example, if VCs negatively perceive tight regulation in an institutional fitness landscape, they will avoid investing in industry sectors, specific industries, or industry segments where they expect institutional regulation to be high. A VC’s views of how fitness landscapes of sectors, industries and segments articulate with each other is especially important. Where do VCs classify a venture proposal that is highly unique (a so-called first-mover) and appears to have the potential to be a distinct industry in the future? Initially VCs may frame this as evidence of the potential for a new segment in an existing industry. If so they can begin by considering causal expectations reflected in the relevant industry landscape at a higher level of abstraction. This provides initial fitness expectations for some policy dimensions. Alternatively, another VC might immediately frame a venture as representing a new industry. To form a fitness landscape for a new industry a VC must look to other industries in the same sector to determine similarities and differences in causality. Each of the above approaches follows Knight’s (1965) recommendation to group and contrast risk objects on the basis of nearly any similarity to begin to reduce uncertainty. Due to equivocality, it is not clear which VC
102
DOUGLAS D. MOESEL ET AL.
approach will be more effective. The latter approach has the advantage of recognizing earlier in the process that a new industry will emerge and shifting the cognitive representation immediately to show this. The former approach may have the advantage of permitting easier communication of the nature of a new venture to partners in a VC firm and may lead to quicker action on a venture proposal. Details regarding dimensions in a subjective fitness landscape may also seem clearer and less confusing to a VC who champions ventures. Quick funding may allow a VC and an entrepreneurial team to impact the manner in which others subjectively classify similar product-market space (Aldrich and Fiol 1994). Once funded, a VC may begin to redefine a venture as representative of a new industry. This may be based on surprising reactions of early stakeholders to the product and its differences. In response, a venture is likely to seek new images and language that are powerful in further enhancing stakeholder perceptions of product differences and that help to evoke simple descriptions of differences (Hill and Levenhagen 1995). As suggested by our earlier discussion of ambiguity in a VC’s investment environments, the visualization of fitness landscapes is always incomplete, representing differing levels of timeliness and equivocality of information in different parts of the landscapes. Areas of the maps dealing with known information that has not been recently updated or that involve
Figure 2. The fitness landscape funnel
EMBEDDED FITNESS LANDSCAPESÐ
PART 1
103
equivocal information that has never been resolved will be fuzzy while those based on recent information for which equivocality is deemed to be removed will be most clear or defined. Where positioning is in a fuzzy region of what is believed to be a rugged landscape, the potential exists for the positioning to represent either a local peak or a local trough or anything in between—hence highly subjective risk will exist in those areas of the map. Beinhocker (1999) also made this point by suggesting that hikers in fitness landscapes will find the view very ‘foggy’ so only the immediate proximity of the current position can be clearly viewed. This fogginess of the fitness landscapes is especially applicable to VCs. Beinhocker (1999) distinguishes between three temporal horizons of growth which he labels in order of future-orientation. Horizon 1 initiatives are aimed primarily at extending existing businesses. Horizon 2 initiatives are focused on driving growth in emerging new businesses and take more time and have greater profit potential than Horizon 1 investments. Horizon 3 initiatives take even more time and have more profit potential than Horizon 2 projects. These are seed options for future growth businesses. Beinhocker links these horizons to the concepts of short and long jumps, implying that long jumps (Horizon 3 investments) will tend to clearly be leaps into the fog whereas short jumps (Horizon 1 investments) will tend to stay within the immediate area visible despite the fog. As VCs are likely to focus consistently on potential Horizon 2 and Horizon 3 investments, VCs represent an interesting test of his admonition to achieve a balanced mix of these three horizons. Whereas Beinhocker contends that most firms err on the side of too much focus on Horizon 1 investments, VCs may sometimes struggle with excessive focus on Horizon 3 investments. The interest lies in the processes that might allow a VC firm to be effective even while focused primarily on Horizon 2 and Horizon 3 investments. As will be discussed in the second article in this series, Horizon 1 investments may constitute a conflict-of-interest for the VC by investing too close with a new venture to an existing funded venture. VCs have a sense of their own competencies and those of their firm in maintaining vigilance along specific dimensions of fitness landscapes and for specific landscapes. Each VC will tend to primarily focus on the landscapes and the dimensions of those landscapes considered areas of personal competence. Secondarily, each VC will focus on other landscapes and dimensions that are perceived to be competencies of other VCs in the same firm. The perceived value of these competencies will change over time. A VC will occasionally shift the dimensionalization of her fitness maps and the amount of focus on newer versus older landscapes or dimensions of those landscapes. Redimensionalization of the fitness maps and the shifting of more attention to new areas of the shifting fitness landscapes occur because seed and early stage VCs continually seek to add value by clarifying rugged areas of their fitness maps that remain fuzzy. In other words, these VCs seek out areas of highly subjective risk and try to convert this over time to fairly objective risk. Shifting fitness landscapes represent a helpful metaphor to better understand the nature of their activity patterns.
104
DOUGLAS D. MOESEL ET AL.
Sensemaking: belief-driven versus action-driven This section provides a brief summary of the theoretical framework and purpose of each of the next two papers in the series. Key elements are highlighted in the theory behind belief-driven sensemaking processes in the cognitive representation process of the VC (Part 2) and action-driven sensemaking processes in the experiential learning process of the VC (Part 3). Weick (1995) provides an extensive review of theory and concepts related to sensemaking in organizations. These concepts are applied to the VC investing context. A major purpose of each of the two papers is to derive interesting research questions about the VC investing process and how VCs mentally deal with highly subjective risk. There are two distinct streams of research as they apply to the bounded rationality tradition (Gavetti and Levinthal 2000). These include deductive search processes that are based on cognitive representation and inductive search processes that are based on experiential search. These processes were described in our earlier discussion of fitness landscapes. These processes are highly complementary with two types of sensemaking described by Weick (1995). Belief-driven sensemaking (Weick 1995) involves a sequence of beliefs leading to actions and then to reinforcement or change in the initial beliefs. This is similar to cognitive representation in that the representation may be based on information from third-party sources that has not been directly tested through personal experience. Hence, beliefs exist but action based on those beliefs may lead to discrepancies that cause concern about the validity of some or all of the initial belief. Sensemaking processes don’t actually come into play substantively until important discrepancies appear based on initial actions on beliefs. Weick (1995) discusses expecting and arguing as alternative beliefdriven sensemaking approaches. The second article in this series highlights both of these approaches. A discussion of initial belief structures in the VC firm leads to an analysis of selective noticing and selecting shaping actions by the VC. Discrepancies from the VC’s expectations and beliefs arise stimulating one or both belief-driven sensemaking processes. The investment behaviour changes arising from these sensemaking processes are especially important as these represent changes in the fitness landscapes perceived and the dimensionalization of those landscapes. Action-driven sensemaking (Weick 1995) involves a sequence of actions leading to beliefs and then to repetition or change in the initial type of action taken. This is similar to experiential learning in that past direct investment actions of the VC have implications for the remapping of fitness landscapes (change in beliefs). The remapped fitness landscapes then guide further investment activity. The authors are especially interested in actions that are not easily explained by the VC. When an action is not clearly tied to a preexisting belief, the VC must create a belief ex post to explain the action taken and its positive or negative results. Weick (1995) classifies committing and manipulation as two actiondriven sensemaking approaches. The third article in this series focuses on these two approaches. A discussion of investment actions by the VC firm
EMBEDDED FITNESS LANDSCAPESÐ
PART 1
105
focuses on how experience is encoded into the memory of the VC firm. Current experiences must be reconciled in some fashion with past experience at the time of encoding. Discrepancies between current experience and what has been encoded in memory stimulate one or both action-driven sensemaking processes. Sensemaking mechanisms include dialogue among investment syndicate members to discern what is happening to the venture around which the syndicate is formed. New beliefs emerge out of the sensemaking process to guide future investment behavior in the same fitness landscape regions. Some of these new beliefs are revised self-perceptions of the VC whereas others are revised views of causal relationships in the investing environments. Conclusion In this first article of a three-part series, key concepts have been introduced about equivocality in the investment environments of VCs; articulated the meaning of highly subjective risk and clarified why it is important for VCs; introduced the concept of fitness landscapes for organizations and have extended this to include a series of hierarchically embedded fitness landscapes; have related cognitive representation processes to the fitness maps and to belief-driven sensemaking processes; and have associated experiential learning processes with fitness maps and with action-driven sensemaking processes. Belief-driven sensemaking processes of VCs are the focus of the second article in this series on the cognitive representation mental mode. Action-driven sensemaking processes are the central theme of the third article on the experiential learning mental mode of VCs. Fitness landscapes can be useful in highlighting differences in the cognitive representations of the same fitness landscape across decision makers. Examining cognitive representation through time should allow focus on changes in the specific landscapes and the dimensions of those landscapes that are actually used by the same decision maker over time. Change in VC fitness landscape perceptions appears critical in facilitating initial investments in ventures involving highly subjective risks and it is probably also critical in sustaining these investments with follow-on funding over time. More theory-driven elaboration is called for of the individual’s inferential process in forming cognitive representations. More must be done to understand how individual VCs test their current representation of their fitness landscapes to better predict the level of persistence of such representations through time. Notes 1. Moesel et al. (2001) distinguish between agency risk, competency risk, and business risk. Mental models of a VC regarding the new venture management team relate to the former two types of risk whereas we focus on business risk here. 2. Note that effective relative contrasts are only readily done when multiple objective measures become available.
106
DOUGLAS D. MOESEL ET AL.
3. Beinhocker (1999) simplifies Kauffman’s approach by only considering three dimensions in his fitness landscape. This implies that all strategy dimensions can be collapsed into only two dimensions. He acknowledges in his reference section that real fitness landscapes contain multiple dimensions. He claims his principles apply equally in higher dimensional space. Gavetti and Levinthal (2000) highlight the multidimensional nature of fitness landscapes for organizations as a central part of their argument.
References Aldrich, H. E. and Fiol, C. M., 1994, Fools rush in? The institutional context of industry creation. Academy of Management Review, 19, 645–670. Beinhocker, E. D., 1999, Robust adaptive strategies. Sloan Management Review, 40, 95–106. Cohen, W. M. and Levinthal, D. A., 1990, Absorptive capacity: a new perspective on learning and innovation. Administrative Science Quarterly, 35, 128–152. Daft, R. L., Lengel, R. H. and Trevino, L. K., 1987, Message equivocality, media selection, and manager performance: Implications for information systems. MIS Quarterly, 11, 355–366. Gavetti, G. and Levinthal, D., 2000, Looking forward and looking backward: cognitive and experiential search. Administrative Science Quarterly, 45, 113–137. Hill, R., and Levenhagen, M., 1995, Metaphors and mental models: sensemaking and sensegiving in innovative and entrepreneurial activities. Journal of Management, 21, 1057–1066. Kauffman, S., 1993, The Origins of Order (New York: Oxford University Press). Knight, F. H., 1965, Risk, Uncertainty, and Profit (New York: Harper Torchbooks) reprint of 1921 essay. Levenhagen, M., Porac, J. F. and Thomas, H., 1993, Emergent industry leadership and the selling of technological visions: a social constructionist view. In J. Hendry and G. Johnson (eds) Strategic Thinking: Leadership and the Management of Change (London: John Wiley & Sons Ltd), 68–87. Louis, M. R. and Sutton, R. I., 1991, Switching cognitive gears: from habits of mind to active thinking. Human Relations, 44, 55–76. Moesel, D., Fiet, J. and Busenitz, L., 2001 Venture capitalists as specialists in risk governance. University of Missouri working paper. Simon, H., 1947, Administrative Behaviour: A Study of Decision Making Processes in Administrative Organizations (Chicago: Macmillan). Sweeting, R. C., 1991, UK venture capital funds and the funding of new technology-based businesses: process and relationships. Journal of Management Studies, 28, 601–622. von Burg, U. and Kenney, M., 2000, Venture capital and the birth of the local area networking industry. Research Policy, 29, 1135–1155. Weick, K., 1995, Sensemaking in Organizations (Thousand Oaks, CA: Sage Publications).
