TL;DR: The world appears to be suffering from a shortage of entrepreneurs. The main reason is the very risky nature of entrepreneurship: Society pays average founder millions of dollars but pays nothing to the median founder. We could build a financial fix (a founders’ mutual) to ever so slightly reduce this risk. This would move hordes of talent from their safer BigCo jobs into entrepreneurship. It could also give society more innovation per venture dollar risked.

Below is an interview organizing my thoughts on the above. Since a more appropriate interviewer was unavailable at the time, I held the interview with myself.

Hi Burak. What makes you think the world has an entrepreneur shortage?

In short: Rising prices.

We as a society keep paying higher and higher compensation to entrepreneurs, probabilistically speaking.

This higher compensation (i.e. higher prices paid for entrepreneurs) is visible in both average founders’ payoff and rising early-stage valuations.

“It seems that the entrepreneurs who ‘hit’ these days are doing it more quickly, making more money, and doing it at a younger age.” — The returns to entrepreneurship, Naval Ravikant

What made you pick up on this?

We run a quantitative momentum strategy in our hedge fund. This meant that over the last year I spent quite some time thinking about price trends across different asset classes such as stocks, bonds, and commodities. So when I saw an article on rising early-stage startup valuations I viewed it a bit differently than usual and wondered: Is the uptrend in early-stage startup valuations signaling us something? If so, what is it?

Conventional wisdom would suggest two reasons:

1- More valuable companies are built faster, increasing expected payouts to investors. This higher payout gets discounted to today (with some appropriate hurdle rate) and leads to higher valuations.

2- Excess returns in startup investing gets competed away. Early-stage investors accept lower returns (i.e. a lower hurdle rate). This would increase prices even if expected payouts remain the same. (Quick aside: Excess returns should not fully disappear since capital will need compensation for the extra risk and illiquidity)

These two reasons are relatively obvious. What is perhaps less obvious is a third potential reason:

3- Founder scarcity. Or more specifically, a scarcity of entrepreneurs who are able and willing to execute the many good ideas waiting to be tested against the market.

Do we really need this third reason to explain rising prices?

I think so. As a thought experiment, imagine Google suddenly fired all its employees and these people decided to start companies instead of finding new jobs. What would happen?

If we hold everything else constant, this would reduce the capital available per backable founder. Many more viable startups would compete for capital. Capital available would spread thinner across good founders/ideas/markets, driving down early stage valuations. This would dilute founders’ share and hence reduce expected payout in an eventual exit.

In short, all else being equal, more founders mean more competition for capital and for customers.

Some would argue there is no founder scarcity. They’d argue that, if anything, there are too many entrepreneurs pursuing poor ideas or get-rich-quick schemes.

That may well be true. I was referring to a scarcity of “good” entrepreneurs. Now, everyone will have a different definition of “good” of course. Some will want aggressive founders with bold ambitions. Some may prefer experts with decades of experience who quit their roles and take risks. Some may want level-headed, humble entrepreneurs who are building small, profitable companies.

Venture capitalists often complain about how rare it is to find the founder/market fit. How they look for great entrepreneurs and rarely find them. How the good ideas are a dime a dozen and execution is what matters.

So regardless of the type of founders people want to see in the world (to fund them, to benefit from their products and services) they appear to find fewer than they’d like.

What is the reason behind this sudden scarcity?

There are excellent essays on this. In short, it looks like the internet simultaneously reduced startup costs and increased their payoff. We have many good, viable ideas that are waiting to be tested against internet scale markets. Costs to test ideas dropped a lot, and capital gets more available every day.

We are left with one bottleneck, one source of scarcity: Founders. The people who are willing to spend years, decades, to test those ideas.

A similar and more obvious scarcity is in software engineering. It is more obvious because rising software engineer “prices” are highly visible with rising total compensation(salary, stock options etc.).

Rising founder “prices”, however, is a lot less visible and obvious. It is expressed in a probabilistic, rather than deterministic, manner: Founders are paid in a highly skewed probability distribution where average payout keeps rising (likely faster than even software engineer salaries).

Ok, so if the market is indeed signaling scarcity for entrepreneurs, what is the fix?

As the saying in commodities goes: “The cure for high prices is high prices”.

High oil demand causes high oil prices. This makes oil drilling more profitable. More drilling increases supply, which eventually matches demand. Prices then stabilize or even fall.

More interestingly, every once in a while, new technologies suddenly cause a plunge in production costs. Fracking is a great example. It allowed drillers to extract oil from rocks and increased supply. This caused a price crash in 2015 from 100$ per barrel to 35$ a barrel, changing the economic outlook for entire countries.

I suspect a similar breakthrough recently happened in software engineering: Like fracking, Lambda School and similar companies are “fracking” a fresh glut of human capital that was trapped in “rocks”.

I suspect the fix for founder scarcity will be no different. Higher and higher prices will eventually fix the scarcity. There is just one problem: Unlike the deterministic pricing for software engineers, society hands out founders a very high-risk compensation package that often pays out nothing.

This makes society’s pricing strategy inefficient. We keep paying more and more, but the higher payout matters less to founders than the extreme risk around those payouts. The gap between median and mean payout is too large, and yet the median is closer to how humans form expectations. This means rising average payouts have less impact on founder supply than they could have.

A relatively straightforward financial innovation could address the gap between median and mean, setting a more efficient pricing strategy, and attract more founders for a given average payoff level.

Ok, so what is this financial innovation?

It is a risk distribution scheme that reduces the gap between mean and median outcomes.

We could call it a “founders’ mutual”. Here is one way to do it:

Let’s imagine a batch of 100 founders, a cohort, that passed some tough vetting process: Founders of Y Combinator’s (YC) Winter 202X batch who also secured pre-seed funding.

Each founder would pledge a small % of their personal stake (e.g. 5%) into a fund. If 50 founders choose to join in this program, each founder would get 2% of the fund’s shares (1/50) in return.

Assuming the founders’ stake in their businesses becomes liquid in ten years, every single founder in the batch would achieve 5% of the mean outcome by the end of ten years.

For example, if average founder payoff turned out to be 30 million USD, due to a handful of billion-dollar outcomes in the batch, every single founder would get 1.5 million USD from the fund, on top of whatever they made from their businesses (often zero)

I believe this kind of “founders’ mutual” would achieve a good compromise: It would retain the large skew in outcomes, incentivizing hard work. But it would also create a safety net and a lower-risk alternative to, say, investment banking or Big Tech software engineering.

It could, therefore “frack” lots of talent from their “rocks”; their lower risk jobs in technology, finance, biotech etc…

It’d benefit those who choose to remain in corporate roles as well: Companies would have to pay up more to retain employees.

If I were a VC, I’d worry about funding a founder that opt-in to such risk-sharing schemes. I’d worry about adverse selection.

That’s certainly a risk. But given the high competition capital is in, some funds would step in to take the risk/reward offered by risk-sharing founders. Such founders would perhaps get funded at lower valuations. Ultimately, if risk-sharing founders manage to generate some dollar outcomes for investors, capital will find them at an appropriate hurdle rate.

Also, let’s not rule out the possibility that risk-sharing founders will achieve better results. Maybe risk-sharing founders will be better suited to build certain type of businesses. Maybe money is not the primary motivation for most founders anyway. Given how complex this domain is, I bet the odds for better/worse performance by risk-sharing founders is close to 50/50.

This scheme looks a lot like a pooled equity obligation, doesn’t it?

Glad you asked.

When the Wall Street pooled mortgages into a bond, they called it a CDO, a collateralized debt obligation.

In this case, we are not pooling debts, but equities. So perhaps we could name it… a “CEO”...

Not sure if “CEO” is technically a “collateralized” obligation. If it is not, then we would have to lose the “C”.

Frankly, in that case we should ask founders to post $1 as collateral so that we can name it “CEO”. It is too perfect a name to give up on due to subtle technicalities.

Isn’t it bad for entrepreneurs if we fix their scarcity?

No. I cannot think of a single party (except perhaps big corporates) that would end up worse off if such risk sharing schemes gain traction.

Venture capital would get more companies and more founders competing for capital. Admittedly these newfound excess returns should eventually get competed away.

Society would get the biggest and most persisting benefits through newer, better, and cheaper services.

Founders would benefit through lower risks and slightly lower but still massive expected payouts.

Employees in big corporates would get higher wages since companies would have to pay more to keep them.

It could only be a negative for corporates; who need to pay more to retain talented people, who now have many more viable entrepreneurial options.

Could such “founders’ mutual” fail?

Absolutely, in many different ways... I suspect if they do fail, the reason will be traceable back to incentives. But markets will run many experiments, some of them should eventually succeed.

Some of the risks to founders’ mutuals are:

  • Perhaps a founders’ mutual isn’t the right level of abstraction to run risk-distribution. (Possible, although I can’t think of a better level)
  • Perhaps setting median at 5% of the mean is too much and it should be 1% instead. (Possible)
  • Perhaps we need additional logic to make incentives less gameable (Definitely!)
  • Perhaps even tiny reductions in risk virtually eliminate expected payoff, where no risk-sharing founder achieves any meaningful exit, rendering such founders unbackable at any valuation. (Unlikely)

If we have a solvable scarcity problem we could fundamentally expect markets to fix it, one way or another. Today we are on a trajectory to fix it by increasing the average payout. But a smarter way could be to de-risk the payout, just a very little bit.

This would make society’s pricing strategy an order of magnitude more effective, therefore ultimately cheaper. If it is indeed a cheaper way for society to buy innovation from founders, then this method should be wildly successful.

Considering the patient, steady pressure of market forces, I bet the emergence of founders’ mutuals are just a matter of time.

And that can only be a good thing.

I use twitter to meet and stay in touch with similar interests. You can follow me there.

When I’m not on twitter, I run a quant hedge fund.

Written by

Founder @ Stylus Capital

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