If an angel loses all of their money on their prior round of investments, they will have no more capital to invest in that "single best investment" just around the corner in the next round. That is why they insist on onerous terms--to keep them in the game.
And because no one can predict the future, they must give the same onerous terms to that one "moonshot success" which will give them their 3000x return. They simply don't know which one it is in advance.
Although some founders might pursue high valuation as a way to get validation, the majority or at least good founders pursue high valuations to avoid dilution.
Another big reason would for recruiting. I've seen that's become increasingly common that job offers include options as prices instead of percentages. Eg you'll get $500,000 in stock based on the last round valuation as opposed to saying 0.5%. This is increasingly common in later stage companies and it seems to be very effective. Now companies in early stage with high valuations can do the same.
I am not sure if that is true. That worrying about dilution is a form of downside risk mitigation.
Primarily, if you don't worry about dilution you'll loose control (unless you have some sort of special stock that gives you more voting power). Control for me is probably the most valuable thing I have. And, Although selling stock is not the only way to loose control, if you don't worry at all you'll loose control fairly quickly.
Lastly, your employees will also loose moral as they see VC's own pretty much the whole company.
I wish Sam provided a little more insight into upside risk, such as maybe how an angel investor could best structure his investments to ensure he gets that one 'outstanding investment'. He basically just stated what upside risk was, which has been discussed multiple times over in this forum.
I think Sam knows the Y Combinator investment strategy is best designed to take advantage of power law distributions and getting the very best investments. With crowdfunding and the JOBS act, being able to spread $10k across 50 different companies seems to open the door for everyone to participate in this type of investment strategy. Thoughts?
The way to do it is to have a good reputation among founders, and the way to do that is to a) work hard to help the founders you invest in and b) don't screw them. This becomes very important when the founder you really want to invest in is choosing among lots of offers.
Of course, you also have be able to identify the good companies, which I will write about later.
You won't get in on the good deals with that strategy. You should focus on getting in on the best deals to mitigate upside risk. That, plus getting good basic economics of the round, is what Sam is advising investors do.
Nassim Nicholas Taleb has talked at great length about this and related topics in The Black Swan (2007) and Antifragile (2012) for those interested in the topic.
Can't agree hard enough. He's synthesized who knows how many years (hundreds? thousands?) of human thought on the topic. If you want to understand investment in a non-gambling way it's all must-read.
I wonder what this implies about YC's demo day. The hottest deals offer poor economics but attract the best investors. Besides investing in a YC index fund, those looking to mitigate upside risk could pursue a top-10 strategy. But in that case the economics of the round (what percentage of the company you own for the $) are worse.
While this is true, I would take away from your post an almost opposing viewpoint: That it would be better to invest in more startups, rather than fewer, because of the difficulty in identifying which companies are "good" and "bad" ahead of time.
How do you resolve the conflict between trying to only invest in good companies (almost regardless of price) versus investing in as many startups as possible (so as to increase your likelihood of investing in a good startup since they are hard to find and identify)?
That stops working if your "increase quantity" mechanism sets up a filter on companies with worse terms; it's an adverse selection problem, because the companies that are easiest to buy into are going to include a disproportionate share of the losers.
They stop someone at the street to ask 4 questions. If the person knows the answer, he has to find someone else on the street who also does; if he doesn't know, find someone who doesn't know. Everytime both he and the person he finds either answer correctly or not, the participant gets R$ 250.
Then, after the participant wins R$ 1000, he's offered the chance to find one person on the street who can answer 2 of 4 (trivial) questions correctly to win R$ 2000, or leave with R$ 1000.
The funny thing is that, even when the participants manage to find 4 others who answer all the questions correctly, they refuse the chance to double their money out of fear - even when they proved themselves that the people on the street know the answers!
That's not simple risk-aversion, that's the decreasing marginal utility of gains versus risk. If you need $1000 for something urgently, then $1000 at 100% probability is much more important than $2000 at 50%.
By my math, the probability of one given person knowing two answers out of four to win another R$ 1000 is way higher than the probability of four people answering exactly like the participant required to win the first R$ 1000. So it feels intuitive to take the final chance, specially given how much data/options the participant has (knows all the questions and correct answers already, and can choose any geek on the street).
But I'm being purely rational - R$ 1000 on the hand is certainly worth more than a possible R$ 2000. Maybe if the final prize were R$ 10.000 or more people would chose differently?
Also note: if the participant and their partners got all four questions wrong (but got them wrong together), the particpant still "wins", and moves on to the second round. But in this case, they have no evidence that the people on the street can be trusted to answer questions. If this scenario is common, it could be throwing off your expectations.
To win the first prize, four independent events should happen: the participant has to answer (either right or wrong), and a random person in the street has to answer the same way.
Let an event "QnPmAo" mean "Question n, Person m, Answer o", where n=4, and o can be 1 (right) or 0 (wrong). The probability of winning the first prize would be:
P(Win) = (P(Q1P1A1 ∩ Q1P2A1) + P(Q1P1A0 ∩ Q1P2A0)) * (P(Q2P1A1 ∩ Q2P3A0) + P(Q2P1A1 ∩ Q1P3A0)) * ... and so on, for all four questions.
To win the second prize, only two independent events are need: a participant knowing any two out of four questions. The probability would be:
From a statistical viewpoint, the second scenario seems always more likely than the first, assuming the knowledge of the population about trivial questions follows a normal distribution. If during the first round all four participants know the answers, the odds of a fifth participant knowing at least two are high.
Still, from the episodes I watched, people seem to refuse the second challenge regardless of the outcome of the first round - in other words, they don't seem to make a rational decision.
Hope someone less rough than me in statistics can shed some light if there's a mistake!
> assuming the knowledge of the population about trivial questions follows a normal distribution
This is the assumption I question. Knowledge tends to cluster geographically--people in the same area get the same cable channels, on which are aired the same re-runs of Jeopardy on the same nights.
There is a social-status related concept in psychology as well. it is implicitly assumed that hierarchy, seniority, and weatlth are linear functions of time. going backward is a (rare) and thus high information datapoint. it is therefore, actively avoided. TLDR the consequences of actions are more complex.
That reminds me of a little experiment I did on omegle.com (text chat site). I asked random people this question: "Say you win a lottery, and as your prize you can either have $1M, or a (true) random amount between zero and $5M. Which would you choose?" Perhaps unsurprisingly, everyone picked the guaranteed million.
What did surprise me was that changing the $5M to $50M still resulted in around 90% taking the $1M, and at no amount could I get a majority of people to choose the random option. At a guaranteed $1M versus zero to $100B, it was split about 50/50.
Apparently even a one thousandth of a percent chance of earning less than $1M is enough for many people to "play it safe". Either that or 50% of people don't understand basic math. ;)
It's not logical. You can sell the 0-5m random option for more than 1m (more than 2m!). Or you can buy some sort of insurance where someone pays you if you get a low roll, but you pay them if you get a high roll.
Taking 40% as much money (on average) is some really expensive risk mitigation. There are much, much better deals available.
For the larger amounts of money, the risk mitigation comes at a much higher price and is even more silly.
Exactly. I mean, I assume people operated under the assumption that the risk was non-transferrable, so I can see the logic in taking $1M over 0-5. You're giving up some expected value in order to reduce risk. Especially when you take into account the diminishing marginal value of money, especially around the low to mid millions, it makes some sense.
What doesn't, as you say, is considering a random amount between zero and 100 billion dollars in any way risky compared to $1M. You're probably more likely to take the $1M then to be struck by lighting than you are to take the random option and end up with less. (And even THEN, ending up with $900k isn't the end of the world, so the odds are even lower of a really unfortunate outcome.) So you're giving up an absolutely massive expected value in order to avoid a truly miniscule risk. This is risk-aversion at its most ridiculous IMO.
I agree with your reasoning, but I don't think it's a strong objection to the above. You're assuming that they have the time and legal ability to mitigate the risk. The question, as asked, seems to suggest that the imagined payout would be immediate, with no opportunity to mitigate.
You don't live forever, and many things can only be done a few times, so the infinite-run expected payoff is not entirely relevant to realistic decision making.
Investors also have a hard time valuing optionality, they tend to only see the thing that is currently in front of them. Sure that airbed and couch rental startup might not be a big market but what if they moved into the market for all spaces...
And because no one can predict the future, they must give the same onerous terms to that one "moonshot success" which will give them their 3000x return. They simply don't know which one it is in advance.