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You hit it on the head with "irrational [sic] optimists" even though you whiffed it with "typically worthless." There are at least two very much rational psych
by rlucas 11y ago
You hit it on the head with "irrational [sic] optimists" even though you whiffed it with "typically worthless."
There are at least two very much rational psychological pieces at work here. The first is that people who are inclined to be optimistic about a tiny stake are qualitatively different. The second is that the stake's expected value (EV; probability * outcome) is not a sufficient metric upon which to estimate its utility to actual humans.
1. People who are, relative to a theoretically precise EV, optimistic about a tiny stake act qualitatively differently toward the organization than those who are neutral or pessimistic / jaded.
For example, a good friend of mine in school used to argue, "why vote? one vote can't ever move the needle." And he was, after a fashion, right: the expected value of your single vote in terms of affecting the outcome is nil. But if you were looking to build an organization of people to achieve some political or social outcome, you would ceteris paribus want those who DO vote despite that expectation; voting here is a proxy for caring, motivation, social cohesion, deontological orientation, etc., not as the jaded comments here might suggest by analogy, mere innumeracy.
Similarly, and I want to take care to say that I hold this position only toward the case of creating high-growth uncertain ventures (startups) and not as a general prescription for society or the economy, those who eagerly accept and seek even a small ownership stake in the enterprise are going to be qualitatively different. And you may very much want that, just as they want to be part of something they have some ownership in.
2. Convexity and utility functions. Get over the idea that a dollar is worth a dollar. The first dollar to the guy who needs that dollar for a bus ride home in the rain is worth more than the 1001st dollar to a similarly situated guy -- an easy proof of non-constant marginal utility. But if you look into things like indivisibility and status tournaments, there's lots of good research that points out that playing the lottery can be rational even with a negative expectation under certain utility functions.
In other words, a 5% cash raise, to a comfortable software dev whose needs and retirement at a middle-class level are nearly certain, may be less desirable than a smaller EV shot at a life-changing sum. It may well be worth $10k to buy a "lottery ticket" at a one-in-two-thousand chance of a $10 M outcome ($5k EV).
- hapless 11y agoI don't think many employees have a 1 in 2000 chance of a $10M outcome. I'm OK with the 0.005% odds on a multi-billion exit. Let's stick with that. The problem isn't the odds, it's the returns. As another article on HN pointed out, currently, 100% of billion dollar startups (every single "unicorn") have significant investor liquidation preferences. As a result, for a non-founder, a 1% early-stage stake, at the exit of a billion dollar "unicorn", is quite likely to come out as a nice annual bonus at a "normal" firm: $10k to $100k. The one-two punch of dilution and liquidation preference eats up employee equity. a %0.005 chance at $100k comes out to an expected value of $500. Even after we consider the odds, that $100k is four years in the future, with a one year cliff and a lot of individual risks involved, unconnected to the firm's fortunes. The present value is conceivably much lower than the expected value of $500. It's essentially nothing. -- As a postscript: There's nothing intrinsically wrong with offering equity stakes with a negligible present value. Clearly, startups still find talent that satisfies them. The system is working.
- alain94040 11y agoAs a result, for a non-founder, a 1% early-stage stake in the exit of a billion dollar "unicorn" is quite likely to come out as a nice annual bonus at a "normal" firm: $10k to $100k. The one-two punch of dilution and liquidation preference eats up employee equity. Your math has to be completely off. If you started with 1% of a company, even after a lot of dilution and liquidation preferences, a $1B exit will give you north of $3M. Not $10k to $100k.
- hapless 11y agoIt is entirely possible for a $1B exit to leave you with literally $0. Let's say your company has accepted $500 million in funding, with a 2x LP, at a $1 billion valuation. The company exits for $1 billion. Investors take a their 2x LP, for the entire $1 billion. Founders and employees get $0, despite a "billion dollar exit." This is the trivial case. It is not even considering dilution, founders retention of "preferred" shares, the complicated ownership structures that can result from 3-5-10 rounds of funding, or lengthy employee lockouts after an IPO.
- aetherson 11y agoNobody raises $500M with a 2x liquidation preference at a $1B valuation. And if they did, they wouldn't exit at $1B. This is a complete fantasy scenario.
- mahyarm 11y agoWell there is one company relatively recently that has raised $300M on a $1B valuation. I don't know the liquidation preference, but it happens.
- aetherson 11y agoI guarantee you their liquidation preference is not 2x (or indeed above 1x). And 30% is not 50%. Even if for some unfathomable reason the liquidation preference was 2x, and even if for some even more unfathomable reason the company promptly exited at $1B, that would leave $400M to be distributed to everyone else who had stock.
- jschwartzi 11y agoIt seems like a lot of people assume that the success or failure of a startup is entirely random. A statistic is not the same thing as a probability, and it's dangerous to conflate the two. Just because less than 1% of startups succeed to the degree that you can retire on your equity, it doesn't mean that there aren't ways you can tell when your equity is that valuable. You can look at the team, the product, the marketplace, your customers, and your overall gut feeling to decide that. Treating the statistic as a probability ignores all of that valuable information.