Founder Failure Insurance: Pooling equity
blog.ezliu.com
blog.ezliu.com
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.
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.
It's a terrible argument, however, for convincing a VC to fund you.
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.
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.
In fact, I wrote a blog post that's very relevant to this point:
http://diegobasch.com/traditional-vcs-and-first-time-entrepr...
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.
But, like you said, no one wants to admit that they might fail.
"Advisors" to other companies also have this incentive, but that incentive is a pittance.
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.
They make all their money through their investment portfolio. Essentially, they earn interest on your premium until they have to pay it out.
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.
Isn't being "all-in" part fo the reason a startup needs to stick together - especially at the outset?
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.
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 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).
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.
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.
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.
http://ebexchangefunds.com/ is one popular one... :-)
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.
"paying" 3% of your company leaves you with 97%. Trying to drive your remaining 97% in the ground is idiocy.
The people that think their startup is likely to fail will be most likely to contribute to the pool.
This proposal is more like forming a large conglomeerate xompany startup, or a co-operatively owned incubator.