Inequality and Risk -->
August 2005
(This essay is derived from a talk at Defcon 2005.)
Suppose you wanted to get rid of economic inequality. There are<br>two ways to do it: give money to the poor, or take it away from the<br>rich. But they amount to the same thing, because if you want to<br>give money to the poor, you have to get it from somewhere. You<br>can't get it from the poor, or they just end up where they started.<br>You have to get it from the rich.
There is of course a way to make the poor richer without simply<br>shifting money from the rich. You could help the poor become more<br>productive — for example, by improving access to education. Instead<br>of taking money from engineers and giving it to checkout clerks,<br>you could enable people who would have become checkout clerks to<br>become engineers.
This is an excellent strategy for making the poor richer. But the<br>evidence of the last 200 years shows that it doesn't reduce economic<br>inequality, because it makes the rich richer too. If there<br>are more engineers, then there are more opportunities to hire them<br>and to sell them things. Henry Ford couldn't have made a fortune<br>building cars in a society in which most people were still subsistence<br>farmers; he would have had neither workers nor customers.
If you want to reduce economic inequality instead of just improving<br>the overall standard of living, it's not enough just to raise up<br>the poor. What if one of your newly minted engineers gets ambitious<br>and goes on to become another Bill Gates? Economic inequality will<br>be as bad as ever. If you actually want to compress the gap between<br>rich and poor, you have to push down on the top as well as pushing<br>up on the bottom.
How do you push down on the top? You could try to decrease the<br>productivity of the people who make the most money: make the best<br>surgeons operate with their left hands, force popular actors to<br>overeat, and so on. But this approach is hard to implement. The<br>only practical solution is to let people do the best work they can,<br>and then (either by taxation or by limiting what they can charge)<br>to confiscate whatever you deem to be surplus.
So let's be clear what reducing economic inequality means. It is<br>identical with taking money from the rich.
When you transform a mathematical expression into another form, you<br>often notice new things. So it is in this case. Taking money from<br>the rich turns out to have consequences one might not foresee when<br>one phrases the same idea in terms of "reducing inequality."
The problem is, risk and reward have to be proportionate. A bet<br>with only a 10% chance of winning has to pay more than one with a<br>50% chance of winning, or no one will take it. So if you lop off<br>the top of the possible rewards, you thereby decrease people's<br>willingness to take risks.
Transposing into our original expression, we get: decreasing economic<br>inequality means decreasing the risk people are willing to take.
There are whole classes of risks that are no longer worth taking<br>if the maximum return is decreased. One reason high tax rates are<br>disastrous is that this class of risks includes starting new<br>companies.
Investors
Startups are intrinsically risky. A startup<br>is like a small boat<br>in the open sea. One big wave and you're sunk. A competing product,<br>a downturn in the economy, a delay in getting funding or regulatory<br>approval, a patent suit, changing technical standards, the departure<br>of a key employee, the loss of a big account — any one of these can<br>destroy you overnight. It seems only about 1 in 10 startups succeeds.<br>[1]
Our startup paid its first round of outside investors 36x. Which<br>meant, with current US tax rates, that it made sense to invest in<br>us if we had better than a 1 in 24 chance of succeeding. That<br>sounds about right. That's probably roughly how we looked when we<br>were a couple of nerds with no business experience operating out<br>of an apartment.
If that kind of risk doesn't pay, venture investing, as we know it,<br>doesn't happen.
That might be ok if there were other sources of capital for new<br>companies. Why not just have the government, or some large<br>almost-government organization like Fannie Mae, do the venture<br>investing instead of private funds?
I'll tell you why that wouldn't work. Because then you're asking<br>government or almost-government employees to do the one thing they<br>are least able to do: take risks.
As anyone who has worked for the government knows, the important<br>thing is not to make the right choices, but to make choices that<br>can be justified later if they fail. If there is a safe option,<br>that's the one a bureaucrat will choose. But that is exactly the<br>wrong way to do venture investing. The nature of the business means<br>that you want to make terribly risky choices, if the upside looks<br>good enough.
VCs are currently<br>paid in a way that makes them<br>focus on the upside:<br>they get a percentage of the fund's gains. And that helps overcome<br>their understandable fear of investing in a company run by nerds<br>who look like (and perhaps are)...