De-risking startups for founders

A proposal to dilute startup founders’ to dilute the risk and the problems that come along with it.

“92% of startups fail”. Many of us have heard that statement, and as a founder, it’s impossible that it doesn’t give you the chills each time you hear about it. So, we are in a complex game, in which the odds are against us. Why do startups fail? There are many reasons, some are internal like having the wrong team, wrong business model. Others are somewhat external like the product not being a hit or outcompeted. So, we can work to avoid most of these reasons or at least to lower the impact when they hit our startup. There is a bunch written about how to work on those solutions, so I kept thinking about what isn’t done that could potentially improve this situation.

A solution (with trade-offs)

Going back to the idea of being a – serious – game. The stakes are high, it’s not like poker where you have many hands and can look at the cards, you are all in from the start. At the moment to take the leap, many would-be founders decide to stay at their current job. This makes sense since, the majority who take the leap ends up failing, having an economic and mental impact. So the starting point to think this is how to lower the personal stake and maintain the incentives to make their startup great. So if founders dilute their ownership there can be a way to also dilute risk. An idea emerged after hearing two awesome Tim Ferris interviews with Basecamp counter-culture legends David Heinemeier Hansson and Jason Fried. They bootstrapped their startup and reached profitability from the start. After growing it, sold a part to unload some risk and avoid having “all the eggs in the same basket”. They sold part of their company to Jeff Bezos. Jeff got to own part of their profitable business with non-control equity. The founders got kind of a “half-baked” exit, keeping part of the company. This wasn’t a VC investment that required X returns, instead, they would share the profits at the end of the year. And that is a whole other story. Rand Fishkin is trying some variation from this approach with his second startup SparkToro. But, I don’t like constraints, and I’m sure you are on my side. So, why limit everything to one and only path that implies no VC funding and being profitable from the start?

A transversal solution

The only ones that can make the call to de-risk their startup are entrepreneurs. Not everyone can dilute their startup risk by selling to an investor as the Basecamp guys did.

Founders can be equity issuers and receivers with a pool of peers. So, in a way is like playing VC and founder at the same time, with the difference that instead of paying with money founders pay with equity. For this idea to work, the math is pretty easy. Let’s assume the 93% failure rate for a startup is accurate, there should be 13 founders from different startups that join the equity pool. In this scenario, they will have at least 1.04 chances of having one of the founders not failing. The equity to share will depend a lot if the startup wants to go the bootstrapped way or the VC one. As an approximation 2% will work for VC funded startups. Investors will want the founder to have most of their stake in their own company so they still have skin in the game. With that approach, incentives shouldn’t change at such low stakes. The pool of founders will still work as a safety net in the worst-case scenario.

Barriers and downsides

One of the main barriers could be the founders themselves not wanting to leave 2% of their equity at the table. After all, it will still be a high-risk alternative, in which they won’t have much control. All founders think that will belong to the successful minority. A downside will be the administration of these small percentages all entangled between founders. New tools to make this work need to be developed. The third barrier will be capital dilution. Even if a startup is successful and grows to be a big company, the shared equity will get diluted, but this can happen in their own startup too. There could be a free-rider problem, where one of the founders try to take advantage. This is another great reason to keep percentages low. Almost all their stake is in their startup, so there’s no real motivation for not trying as hard as they can to be successful. There could even be potential help between founders because of having shared interested. In the agreement there will be some sort of crossed vesting, so nobody that leaves the ship early.

Conclusion

This is one of those ideas that seem strange at first but makes sense from a game theory perspective. This a first version, and would love some feedback. If there’s another framework to think about or an assumption that could improve/break this model.

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