Dealing with risk asymmetry between founders and investors

How investors will increase the chances that a startup fails, and how founders can benefit from that dynamic

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Dealing with risk asymmetry between founders and investors

Early stage investors are incentivized to increase the chances that founders fail.

Pre-seed and seed investors practice portfolio theory – they invest in a high volume of companies, increase the risk profile of each, and spread the risk across their investments to maximize the expected value of their portfolio.

For example, Y Combinator is great at pushing all of their portfolio companies to think bigger and take bigger swings. For a good amount of their portfolio (let’s call it 20%), that may result in pivoting themselves into oblivion or crashing and burning what could have otherwise been a successful $50M business. This sucks for those founders, but this is YC’s model working by design. For the 20% of founders who end up with a worse outcome as a result of joining YC, there’s also the 20% who find themselves on a fast track to becoming a $1B company.

For early stage investors, portfolio theory means that they can double the expected value of their portfolio while drastically increasing the probability of each startup failing.

Investors increasing the expected value of startup by increasing the changes of failure +30% lowering the probability of smaller outcomes, and increasing the probability of bigger incomes by just a hair.

As a founder, it’s important to be cognizant of this tension between the interests of investors and founders. Founders have (nearly) all of their risk concentrated in their startup, while investors have their risk diversified, making it easier to think in a high-risk way.

To benefit from this seemingly founder-unfriendly dynamic, founders should (1) always be taking assets off the table after taking investment and (2) cultivate support systems that are not limited to their startup’s lifespan.

Always be taking assets off the table

Once you get funding, you’ll get pushed to grow your startup in a higher-risk way. There will be a bigger chance of it all going to zero. You’ll want to make sure that in the event that it does all go to zero, you’ll have pocketed some assets along the way. 

In later stage startups, founders sometimes reward themselves for continued risk by “taking money off the table.” If a founder is raising a Series B at a $150M valuation, a founder could sell 2% of the company that they own and pocket $3M. Regardless of what happens with the company, the founder now has $3M.

Founders can take assets off the table in the early stages as well, though it’s less literal and not limited to financial assets. Taking these assets off the table rewards founders in the short-term for the increased risk they’re taking when receiving funding, and enables them to carry these assets with them beyond the lifespan of their current startup. 

Examples include: 

  • Salary (make sure you’re paying yourself enough to live and not plunging into debt)

  • Building relationships with other successful founders in their investors’ portfolio

  • Building relationships with experts/mentors that their investors give access to

  • Learnings and domain expertise from other founders and experts/mentors

  • Social capital through making introductions to investors/mentors/founders in their investors’ networks.

Even in the event that your startup fails in 18 months after receiving investment, you can emerge from a failed startup experience without debt, with a strong network, and with deep domain expertise which set you up to be more successful in whatever you do next. Founders are uniquely positioned while building a startup to access these assets, and you’d be remiss if you didn’t pocket some of them when you had the chance. 

Just as investors are using a founder’s startup to distribute risk, founders can use that investment to pocket assets which they can take with them beyond the lifespan of their startup.

Cultivate support that goes beyond the company lifecycle

As soon as someone has a financial interest in your company, they cannot give you 100% objective personal/career advice. Even a lifelong friend who writes a $10K check into your company will be biased based on their financial interest.

Founders need supporters who genuinely do not care about the outcome of the startup and can give them 100% objective career advice. Usually this comes in the form of career mentors and friendships with other founders.

For example, who’s going to tell you when it’s time to throw in the towel? Investors have no incentive to tell you when to give up. Even if you’re completely burned out and there’s a 1 in 1000 chance of the company finding success, investors are still incentivized to let it linger and see what happens – even if that were terrible career advice.

Also, investors are incentivized to maximize expected returns, even if that means taking risks or making decisions that are misaligned with what a founder wants. Having objective advisors – who can help founders think about their own interests – are a necessary foil to investors who are focused on increasing the expected returns.

Founders should make sure they have at least one person in their lives who they trust with objective career advice who will not care about the outcome of their current startup. Ideally they have multiple people with diverse perspectives.

Risk asymmetry is a natural fact of the startup ecosystem and doesn’t need to be an inherently bad thing. But founders should understand this dynamic so that building a startup can be an accelerant for their careers – and not a setback – in the event that things don’t work out.