

Founder Failure Insurance: Pooling equity - ccg
http://blog.ezliu.com/blog/founder-failure-insurance-follow-up/

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patio11
Seems like there's an adverse selection problem here. (And, relatedly, a
signaling problem.) This is not an attractive option for companies at the head
of the distribution or anyone aspiring to be there, and to the extent that you
talk about it, VCs are going to read that as "You're a loser planning on
losing."

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.

~~~
waterlesscloud
\--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.

~~~
zachalexander
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.

~~~
waterlesscloud
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.

~~~
zachalexander
> _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.

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masterzora
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.

~~~
ljd
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.

~~~
masterzora
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.

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tptacek
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?

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eli
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.

~~~
joelrunyon
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?

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jfarmer
First Round Capital did something similar a few years ago with their portfolio
companies: [http://redeye.firstround.com/2010/01/sharing-and-
exchanging....](http://redeye.firstround.com/2010/01/sharing-and-
exchanging.html)

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.

~~~
ezl
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.

~~~
jfarmer
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.

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joshontheweb
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.

~~~
ezl
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).

~~~
malandrew
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.

~~~
klochner
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.

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jpdoctor
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.

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davidu
This has existed for years... and been structured.

<http://ebexchangefunds.com/> is one popular one... :-)

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joelrunyon
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.

~~~
ezl
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.

~~~
masterzora
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.

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ljd
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>

~~~
jekdoce
A properly designed simple market would take care of this.

~~~
ljd
I'm not necessarily sure that I follow. How do you create a market for
participant selection?

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ojbyrne
<http://ebexchangefunds.com/exchange-funds/>

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_pius
Somewhat relevant: <http://paulgraham.com/prcmc.html>

~~~
Evbn
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.

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wissler
Sounds like something that can easily run afoul of securities laws.

