Alvarez, S. A., & Barney, J. B. (2005). How Do Entrepreneurs Organize Firms Under Conditions of Uncertainty? Journal of Management, 31(5), 776–793. https://doi.org/10.1177/0149206305279486
Summary
Entrepreneurs often have to build organizations before they fully know if their idea will work. In contrast to established companies that make decisions under risk (where outcomes and probabilities are known), entrepreneurs often operate in environments of uncertainty—where neither the outcomes nor their likelihoods are known.
This article by Alvarez and Barney asks a central question: How do entrepreneurs organize firms when they can’t predict outcomes, assign probabilities, or even know what success will look like? The authors show that traditional management theories (like transaction cost economics and incomplete contract theory) fall short under these conditions. Instead, they propose three alternative ways that entrepreneurs can organize under uncertainty:
- Clan-based firms: built on trust and shared values.
- Expert-based firms: organized around a central, high-opportunity-cost expert.
- Charisma-based firms: formed through a visionary leader’s influence.
These three forms provide practical guidance for how to build and govern an early-stage organization when the future is unknowable.
Risk vs. Uncertainty: The Foundation for Decision-Making
The authors begin by clarifying a foundational concept: the difference between risk and uncertainty.
- Risk involves situations where all possible outcomes are known, and their probabilities can be estimated. In these cases, tools like forecasts, spreadsheets, and financial models are appropriate.
- Uncertainty, on the other hand, means you don’t know all the possible outcomes, and you can’t estimate probabilities. This is the world most entrepreneurs operate in—especially when creating new markets, inventing technologies, or experimenting with unfamiliar business models.
Many entrepreneurs mistakenly treat uncertainty as risk, relying on tools that give a false sense of predictability. This leads to flawed decisions, overconfidence, and exposure to unanticipated failure.
Why Traditional Theories of the Firm Fall Short
In the world of business organization, two dominant theories—transaction cost economics and incomplete contract theory—explain how firms should be structured. These theories work well in risk settings but fall apart under uncertainty.
- Transaction cost economics assumes that managers can monitor behavior and allocate resources efficiently. But under uncertainty, you don’t have the data needed to monitor or even define success.
- Incomplete contract theory suggests decision rights should go to the person who benefits most from the venture. But when you don’t know who will benefit—or by how much—you can’t assign those rights effectively.
These theories assume a level of information stability that simply doesn’t exist in most early-stage ventures. Thus, entrepreneurs need alternative models.
Organizing Under Uncertainty: The Three Entrepreneurial Firm Types
Alvarez and Barney introduce three ways entrepreneurs organize firms when the economic value of the venture is unknown:
a. Clan-Based Firms
When partners trust each other deeply, and no one knows what the future holds, they organize as a clan. Leadership is shared. Decisions are made by consensus. Residual profits are distributed based on mutual agreement.
This structure works when:
- Team members are interdependent.
- Personal relationships are strong.
- Success depends on mutual contribution rather than hierarchy.
Clans are often found in founding teams made up of friends, former colleagues, or families.
b. Expert-Based Firms
When trust doesn’t exist, but one individual has high opportunity costs (e.g., a rare skillset or deep market knowledge), the firm may be organized around that expert. The expert receives decision-making authority and may allocate profits.
This structure works when:
- One person’s expertise is critical to the venture’s success.
- Others are willing to defer decisions to the expert in exchange for potential upside.
Examples include startups centered around a visionary engineer, scientist, or creator.
c. Charisma-Based Firms
In the absence of trust and identifiable expertise, a firm may still be organized around a charismatic leader—someone with the ability to create confidence in others despite the uncertainty. The leader inspires others to act, aligns them around a vision, and centralizes authority.
This structure works when:
- No data or expertise can offer clear guidance.
- A compelling narrative or mission mobilizes people.
- Team members “buy into” the leader’s belief system.
Charisma-based firms are fragile but powerful. If the leader’s vision turns out to be valid, the firm thrives. If not, the firm may struggle to adapt.
Entrepreneurial Firms Are Temporary by Nature
The authors emphasize that these forms of organizing—clan, expert, charisma—are often transitional. As the firm matures, gains experience, and uncertainty gives way to calculable risk, more traditional organizational forms (hierarchies, formal contracts, departments) begin to replace them.
For example:
- Clan firms may bring in professional managers.
- Expert-led firms may expand decision rights to other executives.
- Charisma-based firms may lose cohesion if the leader’s vision proves flawed.
The transition is not always smooth. Many firms fail during this organizational shift—especially if founders resist letting go of early control mechanisms.
The Real Purpose of Entrepreneurial Firms
Alvarez and Barney suggest that the core function of an entrepreneurial firm is not just to produce products or serve customers—it is to organize resources in a way that transforms uncertainty into knowledge. In other words, these firms act as mechanisms for learning what’s possible in new markets.
By coordinating talent, time, and capital in an uncertain environment, entrepreneurial firms help bring opportunity into focus. This learning function makes them essential—not only for the founders and investors involved but for economic progress more broadly.
10 Practical Insights for Business Owners and Managers
- Distinguish between risk and uncertainty.
If you can’t reliably predict outcomes, you’re dealing with uncertainty—not just risk. - Don’t rely solely on traditional business planning.
Planning under uncertainty must be flexible and learning-oriented, not rigid. - Organize your firm based on current realities.
Use trust, expertise, or charisma to align the team, depending on what’s available. - Build trust intentionally if choosing a clan model.
Strong personal relationships and shared values can substitute for formal contracts early on. - Defer to experts when information is limited.
If someone has deep knowledge or rare skills, structure around them—but ensure others understand why. - Recognize the power and risk of charisma.
Charisma can inspire action in ambiguity but may fail if not backed by results. - Expect your structure to evolve.
Be ready to transition from clan, expert, or charisma-based models to more formal systems as your firm grows. - Prepare for renegotiation of roles.
As uncertainty diminishes, early arrangements may need to be restructured to reflect new realities. - See your startup as a tool for learning.
Your job isn’t just execution—it’s discovery. Use your structure to accelerate that learning. - Don’t underestimate transition challenges.
Many startups fail not because their idea was bad, but because they couldn’t adapt their organization over time.
Closing Thought
Alvarez and Barney (2005) challenge the idea that there is one best way to build a startup. Under conditions of uncertainty, the path forward isn’t clear, and the right structure depends on what you have at hand—trust, expertise, or vision. These flexible forms of organization allow entrepreneurs to act in the face of the unknown, even when conventional models fall short.
Understanding these entrepreneurial firm types helps leaders make better decisions, adapt faster, and build companies that are more resilient in chaotic environments. The key takeaway? Organize not for control, but for possibility. That’s the essence of entrepreneurial action.