The Mean, the Median and Startup Equity

Most startups fail. So why would smart people continue to start them? Paul Graham answers that founders are focused on the average outcome, not the median:

If you judge by the median startup, the whole concept of a startup seems like a fraud. You have to invent a bubble to explain why founders want to start them or investors want to fund them. But it's a mistake to use the median in a domain with so much variation. If you look at the average outcome rather than the median, you can understand why investors like them, and why, if they aren't median people, it's a rational choice for founders to start them. Paul Graham, Startup = Growth

The focus on average return makes sense for investors who invest in many startups, at least for the top angel investors and venture-capital firms. Since they invest in many startups, the high average return raises their overall median return considerably. However, it's more difficult to justify founding a startup, since the expected median return is 0 and the founders have no diversification of risk. Since the personal value of money diminishes the more one gets, why should founders rely on a small risk of getting super-rich when a large majority of them will fail? It's not like they'll be 100 times as happy if they get 100 times the money of a normal salary.

Startup founders are usually not just in it for the money, but are passionate about solving a certain problem and creating something that can help a large number of people. They may also want to win for its own sake, or desire recognition or power. This may explain why they are pursuing a startup, but it still leaves the money-median issue unsolved. Shouldn't founding a startup make sense financially?

One possible solution would be for startups of similar caliber to set aside some of their stock for a shared startup pool. This way, if one startup in a group is very successful, the founders (and early employees) of the other startups will also get some returns. This will provide startup founders with the same benefits VCs enjoy and give them insurance against their own startup's failure. (In fact, one of the earliest forms of insurance was for the "startups" of ancient times - dangerous maritime commerce trips.)

As long as founders still keep a large stake in their own company, they will still be incentivized to make their own startup succeed. As a simplified example, 20 startups could each set aside 20% of their company for the shared pool. This still leaves 80% of each company for the founders, early employees and investors. If one startup is a big success and sells for $100 million, every other startup will receive $1 million to share between the founders and early employees.¹

This will also encourage the group of 20 startups to help each other out, since they will all benefit from each other's success. Startups already receive help from their investors, and this will be a way to encourage collaboration among startup founders.

Currently, startup founders could just agree to swap equity with each other. Once the JOBS Act lets non-rich people invest in startups, founders could sell a few shares in their own startup and buy shares in other startups. Investors buy many different stocks to diversify, founders should be able to get a little "insurance" too.

1. Or everyone gets diluted to half their initial stake and then one company sells for $400 Million, netting $2M to every startup in the group.