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Will proliferating seed companies start looking like micro sub-prime mortgage traders? They operate on the similar assumptions: pooling small, high-risk investm

Will proliferating seed companies start looking like micro sub-prime mortgage traders? They operate on the similar assumptions: pooling small, high-risk investments hoping that these individual bets are unrelated, thus driving down the variance when bundled together. This is probably only true for the seed company that gets to cherry pick first, which seems to be YC as of now. Assuming an initial chance of success of 1/100 for the groups that are selected by YC, the chance that every single one from a group of 100 fails is about .36. That means that on an investment of about 1.5 million dollars (100 * 15,000) they have a 64 percent chance of a success, which I loosely define as a big acquisition or buyout. Also, YC companies seems to prop each other up and drive up success rates through intelligent nurturing and beneficial network effects. I'd guess that the payout probabilities are much higher over a three-four year period. Now I am highly skeptical that the same math extends to other seed companies. Do they get applicants of the same caliber when there are so many second tier seed companies to choose from for a prospective applicant? People are willing to uproot their youthful lives and move for YC, but will they do the same for Techstars or LaunchBox? Probably not, at least not for 15,000 dollars and little else. If I throw in the assumption of a power-law distribution for startups, the quality goes downhill rather rapidly. And additionally, if YC happens to be decently good at identifying truly promising candidates and taking them all into their fold as they claim to, it the median success probability for the rest is going to be rather low. Assuming an order of magnitude drop-off, that gives an payout probability of .09 ( 1-(1-1/1000)^100 if they are operating on same scales as used for YC). The number of seed companies sprouting is surely going to be limited by such math...

Prrometheus 19y ago
>Will proliferating seed companies start looking like micro sub-prime mortgage traders? I question the analogy. Seed funding might become a fad investment, but it will surely be less volatile than the subprime mortgage sector. Subprime mortgage originators and buyers backed their assets (the mortgages) by a large amount of debt. So, if their assumptions were only a small bit off (say defaults were 5.0% instead of 4.0%) the debt holders could demand a large amount of new collateral, more than the companies had on hand, forcing them into bankruptcy. Most venture funds have little or no debt. If they overestimate their return by 25%, that means that they will earn 25% less than expected. They will not, however, go bankrupt.
- ChaitanyaSai 19y ago
  You are right. I don't mean to say they run the risk of bankruptcy. The amounts invested are only in the millions here (seed companies). However, the rationale that led a lot of risk assessors to view the bundling and securitization process of sub-prime loans as meaningful is what I find to be parallel. You are also right that VCs and their investors are sensible as of now. It boggles the mind that highly leveraged companies would buy and hold on to high-risk bets.
pchristensen 19y ago
I like the math but don't love the analogy. In the subprime mortgage market, you're managing failure (how few of our lenders will default) whereas in YC/VC, they're managing for a few big successes. The downside is uncapped for subprime, the upside is uncapped for YC/VC.

Prrometheus 19y ago

>Will proliferating seed companies start looking like micro sub-prime mortgage traders? I question the analogy. Seed funding might become a fad investment, but it will surely be less volatile than the subprime mortgage sector. Subprime mortgage originators and buyers backed their assets (the mortgages) by a large amount of debt. So, if their assumptions were only a small bit off (say defaults were 5.0% instead of 4.0%) the debt holders could demand a large amount of new collateral, more than the companies had on hand, forcing them into bankruptcy. Most venture funds have little or no debt. If they overestimate their return by 25%, that means that they will earn 25% less than expected. They will not, however, go bankrupt.

ChaitanyaSai 19y ago
You are right. I don't mean to say they run the risk of bankruptcy. The amounts invested are only in the millions here (seed companies). However, the rationale that led a lot of risk assessors to view the bundling and securitization process of sub-prime loans as meaningful is what I find to be parallel. You are also right that VCs and their investors are sensible as of now. It boggles the mind that highly leveraged companies would buy and hold on to high-risk bets.

pchristensen 19y ago

I like the math but don't love the analogy. In the subprime mortgage market, you're managing failure (how few of our lenders will default) whereas in YC/VC, they're managing for a few big successes. The downside is uncapped for subprime, the upside is uncapped for YC/VC.