Founder Failure Insurance: Pooling equity(blog.ezliu.com)
blog.ezliu.com
Founder Failure Insurance: Pooling equity
http://blog.ezliu.com/blog/founder-failure-insurance-follow-up/
13 comments
--VCs are going to read that as "You're a loser planning on losing."--
Then I'm going to read VCs investing in lots of companies as losers planning on losing.
VCs hedge their bets, almost by definition. What's wrong with founders doing the same?
I'm not really in favor of this particular proposal, but the idea of one-standard-for-you-another-for-me is a major turnoff.
Then I'm going to read VCs investing in lots of companies as losers planning on losing.
VCs hedge their bets, almost by definition. What's wrong with founders doing the same?
I'm not really in favor of this particular proposal, but the idea of one-standard-for-you-another-for-me is a major turnoff.
If it isn't obvious, I'm not a VC and don't exactly swing that way either, I just try to have a mental model of them that approximates reality.
That's a great argument for proving that startup founders are a braver group of people than VCs.
It's a terrible argument, however, for convincing a VC to fund you.
It's a terrible argument, however, for convincing a VC to fund you.
When did founding a startup become about proving how brave you are? That seems like a very poor standard of evaluation.
All else being equal, it seems to me that a founder with a smart approach to managing risk is a better bet than one who is reckless about it.
All else being equal, it seems to me that a founder with a smart approach to managing risk is a better bet than one who is reckless about it.
> When did founding a startup become about proving how brave you are?
It's not. What I was trying to say (perhaps unclearly) is it seems like you're arguing a moral point, that since VCs can diversify to reduce their risk, it's only fair that founders get to do the same.
And that's true. If you're founding a startup, and want to pool equity with other startups, nobody is going to prevent you. But VCs might be less inclined to fund you too.
So it's a question of what matters more to you -- taking more risk and perhaps getting more funding, or having less of both.
It's not. What I was trying to say (perhaps unclearly) is it seems like you're arguing a moral point, that since VCs can diversify to reduce their risk, it's only fair that founders get to do the same.
And that's true. If you're founding a startup, and want to pool equity with other startups, nobody is going to prevent you. But VCs might be less inclined to fund you too.
So it's a question of what matters more to you -- taking more risk and perhaps getting more funding, or having less of both.
The goals of VCs are very different than the goals of entrepreneurs. Their job is to return at least 3x cash-on-cash in 10 years with relatively low beta. Why should their standards be the same as those of entrepreneurs?
In fact, I wrote a blog post that's very relevant to this point:
http://diegobasch.com/traditional-vcs-and-first-time-entrepr...
In fact, I wrote a blog post that's very relevant to this point:
http://diegobasch.com/traditional-vcs-and-first-time-entrepr...
>Seems like there's an adverse selection problem here.
Agreed. I just wrote an essay about this underlying issue of founder risk management [1], in response to PG's recent essay, and along the way I had this exact idea (swapping equity with other startups), and abandoned it because it seemed too complicated, as well as the adverse selection problem.
If it were to work, a major key would be the OP's first bullet point (in the "Gotchas" section of the original proposal) -- implementing a voting system, to ensure the startups in the pool are high quality.
[1] https://news.ycombinator.com/item?id=4577525
Agreed. I just wrote an essay about this underlying issue of founder risk management [1], in response to PG's recent essay, and along the way I had this exact idea (swapping equity with other startups), and abandoned it because it seemed too complicated, as well as the adverse selection problem.
If it were to work, a major key would be the OP's first bullet point (in the "Gotchas" section of the original proposal) -- implementing a voting system, to ensure the startups in the pool are high quality.
[1] https://news.ycombinator.com/item?id=4577525
One thing you should do at the start of a company is figure out how you will dissolve the company. Every time I've seen someone bring it up, it's shouted down as being negative. More than nine times out of ten, they regret this decision, as there is a bunch of fighting later.
But, like you said, no one wants to admit that they might fail.
But, like you said, no one wants to admit that they might fail.
There's more to it than confronting that you could fail; now there's an incentive not to see your own venture through if a peer's venture has a better chance of being remunerative.
"Advisors" to other companies also have this incentive, but that incentive is a pittance.
"Advisors" to other companies also have this incentive, but that incentive is a pittance.
Stand-out quote:
in a sense, trading any of your company for other companies might be a negative expected value play
In general, insurance is a negative expected value. After all, that's how insurance companies make money: by charging more than they pay out. The key with insurance, however, is that it is purchased to cover a catastrophic event. That is, all the money you pay into it will hopefully be more than the money you get out of it but if you end up needing really expensive medical treatments or your house burns down you need to be able to afford to move forward.
With founders and the "founder failure insurance" there is significantly less of this, though. If you fail you don't get an immediate payout, or even a guaranteed payout, failure is not a catastrophic event (in the sense of needing a lot of money fast) for most, and it's actually possible to do well and make money from this.
Really, a more honest way of describing this is as a bet that you will lose, though that's not a complete picture, either.
Intriguing idea nevertheless and something I'd consider if I were a founder.
in a sense, trading any of your company for other companies might be a negative expected value play
In general, insurance is a negative expected value. After all, that's how insurance companies make money: by charging more than they pay out. The key with insurance, however, is that it is purchased to cover a catastrophic event. That is, all the money you pay into it will hopefully be more than the money you get out of it but if you end up needing really expensive medical treatments or your house burns down you need to be able to afford to move forward.
With founders and the "founder failure insurance" there is significantly less of this, though. If you fail you don't get an immediate payout, or even a guaranteed payout, failure is not a catastrophic event (in the sense of needing a lot of money fast) for most, and it's actually possible to do well and make money from this.
Really, a more honest way of describing this is as a bet that you will lose, though that's not a complete picture, either.
Intriguing idea nevertheless and something I'd consider if I were a founder.
I could be wrong, but I believe insurance companies don't charge more than they pay out. That instead, your premium is equal to how much their actuary tables say they'll have to pay for someone with your level of risk.
They make all their money through their investment portfolio. Essentially, they earn interest on your premium until they have to pay it out.
They make all their money through their investment portfolio. Essentially, they earn interest on your premium until they have to pay it out.
In general, insurance companies derive profit both from taking in more than they pay out and from investing what they take in. Historically speaking the idea is for the insurer to have a positive expected value on the premium alone but some companies (and possibly entire types of insurance? I'm not an expert by any means) these days are willing to lessen underwriting profits in exchange for market share and, therefore, more investment money.
Even still, it would be a negative expected value play for the insured, since they give up the investment returns on their premiums to the insurance company.
Vesting is hard enough with groups of people working together on a common project. How would you solve that problem with a group of different companies, each with different incentive systems?
Apologies for the snark, but if my goal was to maximize expected return, I think I'd probably not do a startup at all and get a nice salaried job with a government contractor. Startups are risky! And it's hard enough for me to judge the risk/reward of my own startup, let alone someone else's.
If I wanted to take out some risk, I'd rather cash out some equity using more traditional means and putting it some place safe (or at least different), not other startups.
If I wanted to take out some risk, I'd rather cash out some equity using more traditional means and putting it some place safe (or at least different), not other startups.
Agreed. It sort of defeats the point of starting a startup doesn't it?
Isn't being "all-in" part fo the reason a startup needs to stick together - especially at the outset?
Isn't being "all-in" part fo the reason a startup needs to stick together - especially at the outset?
First Round Capital did something similar a few years ago with their portfolio companies: http://redeye.firstround.com/2010/01/sharing-and-exchanging....
Speaking personally, I want to own as much equity as possible in a company I start. 3% is a ridiculous amount of common stock to go towards something like this.
Speaking personally, I want to own as much equity as possible in a company I start. 3% is a ridiculous amount of common stock to go towards something like this.
3% of all my companies to date is worth exactly zero.
The idea isn't to say "everyone should throw X%" into a pool. It's for you to pick a number that makes sense for you and find a group of founders that wants something similar.
Founders who are absolutely certain of their future success only do worse by pooling equity. The more likely you are to succeed and succeed big, the less likely you should be to contribute to a pool.
Luckily, founders run the gamut in both skill and risk tolerance, so there are probably people close to you no matter where you fall on the spectrum.
The idea isn't to say "everyone should throw X%" into a pool. It's for you to pick a number that makes sense for you and find a group of founders that wants something similar.
Founders who are absolutely certain of their future success only do worse by pooling equity. The more likely you are to succeed and succeed big, the less likely you should be to contribute to a pool.
Luckily, founders run the gamut in both skill and risk tolerance, so there are probably people close to you no matter where you fall on the spectrum.
And giving away a big chunk of equity like that is a signal to future investors, employees, and partners that you think 3% of your current company will be worth something similar.
Interesting but I think the problem is that most founders are not building companies to minimize their losses, but to maximize their upside potential. Especially for a developer founder, the worst case scenario is you fail and go back to having a high paying day job.
i don't think pooling is about loss _minimization_ so much as accepting that startups are often risky.
the idea would be to give up a VERY small sliver of your upside in hopes of participating on other wins.
I understand founders' desire to "maximize their upside potential", but if you cash out for 100mm, the incremental 5mm you give up has relatively small utility after the 95mm you cashed out.
However, in the more probably 0 dollar scenario, the shavings of the successful startups will be a nice hedge. Probably won't pay your bills, but better than zero.
Hopefully you pool with a group of founders that increases your expected utility (not dollars).
the idea would be to give up a VERY small sliver of your upside in hopes of participating on other wins.
I understand founders' desire to "maximize their upside potential", but if you cash out for 100mm, the incremental 5mm you give up has relatively small utility after the 95mm you cashed out.
However, in the more probably 0 dollar scenario, the shavings of the successful startups will be a nice hedge. Probably won't pay your bills, but better than zero.
Hopefully you pool with a group of founders that increases your expected utility (not dollars).
Risk spreading reminds me of this Dogbert cartoon I came across back when I worked in finance:
http://dilbert.com/strips/comic/2008-12-13/
Basically, risk spreading suffers from unintended consequences. There are however other alternatives to the portfolio approach that do make more sense. My favorite is the concept of a keiretsu ( http://en.wikipedia.org/wiki/Keiretsu ). This approach makes sense, especially when you have potential co-dependencies between startups in a portfolio. The YC portfolio is generally large enough and the group activities create enough comraderie between startups that it functions like a keiretsu because I often hear about one startup using the services of another startup.
I think it could make sense at the level of investor portfolios. If I were accepted into YC, I would be open to the idea of giving up a small percentage into a YC "insurance" fund. The same would apply to a few investors (Sequoia, Kleiner, Benchmark, A16Z, Greylock, etc.), but for anyone other than the top funds, I think such a fund would be a losing proposition.
http://dilbert.com/strips/comic/2008-12-13/
Basically, risk spreading suffers from unintended consequences. There are however other alternatives to the portfolio approach that do make more sense. My favorite is the concept of a keiretsu ( http://en.wikipedia.org/wiki/Keiretsu ). This approach makes sense, especially when you have potential co-dependencies between startups in a portfolio. The YC portfolio is generally large enough and the group activities create enough comraderie between startups that it functions like a keiretsu because I often hear about one startup using the services of another startup.
I think it could make sense at the level of investor portfolios. If I were accepted into YC, I would be open to the idea of giving up a small percentage into a YC "insurance" fund. The same would apply to a few investors (Sequoia, Kleiner, Benchmark, A16Z, Greylock, etc.), but for anyone other than the top funds, I think such a fund would be a losing proposition.
That cartoon is lampooning the MBS pooling that let agencies rate bundles of loans as AAA even though all the underlying securities were more risky. Bundling actually does reduce risk, but in the case of the mortgage meltdown of 2008 it was missing the forest (systemic market-wide mispricing of loans) for the trees (slightly reduced risk).
In this case, the founders already are invested in the dead cow, and so it can make sense to diversify to reduce risk. It's doesn't increase the value of their shares, it just makes the overall portfolio less risky.
The analogue to the MBS fiasco would be if the U.S. hit another depression, the whole YC class would be likely to flop, so the diversification wouldn't help, but in "normal" market conditions, the whole group would benefit from the few winners and get a payout in more scenarios.
In this case, the founders already are invested in the dead cow, and so it can make sense to diversify to reduce risk. It's doesn't increase the value of their shares, it just makes the overall portfolio less risky.
The analogue to the MBS fiasco would be if the U.S. hit another depression, the whole YC class would be likely to flop, so the diversification wouldn't help, but in "normal" market conditions, the whole group would benefit from the few winners and get a payout in more scenarios.
How much of this could be because there is no real way for people to found companies without taking on this risk? Perhaps this might reduce the risk profile of founding a startup enough that family providers or risk-averse developers can feel more comfortable building their ideas.
I once got approach by someone putting together a fund for just this purpose. The rules were something like:
1. You buy into the fund with your shares.
2. The shares had to have had a valuation by a major VC in the past N months (N=4 IIRC).
3. You had to retain X% (they didn't want founders dumping on the fund.)
Finally decided it wasn't worth it. It is very difficult to have faith in other people's valuations of non-tradeable stock.
1. You buy into the fund with your shares.
2. The shares had to have had a valuation by a major VC in the past N months (N=4 IIRC).
3. You had to retain X% (they didn't want founders dumping on the fund.)
Finally decided it wasn't worth it. It is very difficult to have faith in other people's valuations of non-tradeable stock.
This has existed for years... and been structured.
http://ebexchangefunds.com/ is one popular one... :-)
http://ebexchangefunds.com/ is one popular one... :-)
I don't like this way of thinking.
Might be smart to "diversify risk" in an investor sense, but as a startup, you're more akin to a team than an investor.
It seems akin to a pitcher betting against his own team in order to make money himself. Sure, he might come out ahead, but that's not the point of the team.
If you really want to invest in other startups, put up some cash.
Might be smart to "diversify risk" in an investor sense, but as a startup, you're more akin to a team than an investor.
It seems akin to a pitcher betting against his own team in order to make money himself. Sure, he might come out ahead, but that's not the point of the team.
If you really want to invest in other startups, put up some cash.
betting against yourself as a pitcher incentivizes you to perform poorly and fail.
"paying" 3% of your company leaves you with 97%. Trying to drive your remaining 97% in the ground is idiocy.
"paying" 3% of your company leaves you with 97%. Trying to drive your remaining 97% in the ground is idiocy.
Not that I agree with most of GP's message, but generally pitchers come out ahead if they win a game. If they bet a nontrivial but still small amount against themselves it could be seen as a means of hedging an individual game. And strongly frowned upon.
Most founders don't own 100% of their company.
Adverse Selection[1] is a big problem with insurance in general. Insurance of this nature has adverse selection problems in spades.
The people that think their startup is likely to fail will be most likely to contribute to the pool.
[1] http://en.wikipedia.org/wiki/Adverse_selection
The people that think their startup is likely to fail will be most likely to contribute to the pool.
[1] http://en.wikipedia.org/wiki/Adverse_selection
Somewhat relevant: http://paulgraham.com/prcmc.html
This proposal is the same as as that, except no one is putting up any money.
This proposal is more like forming a large conglomeerate xompany startup, or a co-operatively owned incubator.
This proposal is more like forming a large conglomeerate xompany startup, or a co-operatively owned incubator.
Sounds like something that can easily run afoul of securities laws.
From a practical perspective, one largely buys insurance to smooth out either cash shocks or future decreases in earning potential rather than for diversification. Having a startup fail is not going to be a cash shock. Your earning potential if your startup fails should go up, because you're worth six figures on the open market trivially, and you probably were not paying yourself that previously.