The Misalignment between Founders and Investors
December 11 2022
There is a fundamental misalignment in incentives between founders and VCs or accelerators like YCombinator. This incentive difference is hard to see, as it requires us to realize some unusual things about how we view and value money. The simple (and mostly correct approach) is this: investors and founders have a similar incentive because they both get paid the same way, through stock. If the stock goes up, that benefits both the investor and the founder, and if the stock goes down, it hurts the investor and the founder. However, that ignores a key factor in incentives: risk.
To explain this, let's take a potential startup idea. This startup idea has a 1% chance of succeeding, and if it succeeds then it becomes a $1 billion company. In this situation, the founder and the investor succeed and fail in the same way, but they massively differ in the risk they are taking on. The founder is working on one company, and so has a 99% chance of failing and going bankrupt. The investor is likely investing in many different companies, each with a different 1% chance of failure, and so has a much less than 99% chance of going bankrupt. This means that the investor is fundamentally much more willing to take that 1% chance at a $1 billion company. The investor would never take a deal that has a 99% chance of causing bankruptcy.
A founder is primarily motivated by the chance to become rich. They don't care that much between making $50 million or $500 million on their company, because both mean that they wouldn't have to work for the rest of their life. The extra money isn't actually useful of incentivizing to them. The only founders that care about building those $1 billion companies are either people who want the power that comes with money or the prestige that comes from “being the best”.
To make this point clearer, lets consider an alternate idea: a startup idea with a 10% chance of creating a $50 million company. The founder would very much prefer this idea, as they have 10x the chance of being rich, but the investor hates this idea because it has a lower expected return. The founder just wants to be rich, whether that is $10 million or $100 million, but 10 vs 100 can be the difference between life or death for the investor.
Investors want to chase the highest returns possible; the billion dollar unicorns that have almost no chance of manifesting. Founders, on the other hand, just want any successful company, even if it becomes a midrange company in the world.
This difference in risk is part of the reason why investors act as they do and why founders act as they do. Investors like VCs and accelerators will tell founders that they want them to be contrarian, or to go for the “big ideas”, or to take massive risks, because those have the highest expected returns. However, founders are not truly incentivized to do those things because the extra returns don't really matter to them. In the end, founders are incentivized to lie about their company and play up how big it is going to be to investors, and try to hide this misalignment from them.