Inequality and Risk

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| August 2005(This essay is derived from a talk at Defcon 2005.)Suppose you wanted to get rid of economic inequality. There are
two ways to do it: give money to the poor, or take it away from the
rich. But they amount to the same thing, because if you want to
give money to the poor, you have to get it from somewhere. You
can't get it from the poor, or they just end up where they started.
You have to get it from the rich.There is of course a way to make the poor richer without simply
shifting money from the rich. You could help the poor become more
productive — for example, by improving access to education. Instead
of taking money from engineers and giving it to checkout clerks,
you could enable people who would have become checkout clerks to
become engineers.This is an excellent strategy for making the poor richer. But the
evidence of the last 200 years shows that it doesn't reduce economic
inequality, because it makes the rich richer too. If there
are more engineers, then there are more opportunities to hire them
and to sell them things. Henry Ford couldn't have made a fortune
building cars in a society in which most people were still subsistence
farmers; he would have had neither workers nor customers.If you want to reduce economic inequality instead of just improving
the overall standard of living, it's not enough just to raise up
the poor. What if one of your newly minted engineers gets ambitious
and goes on to become another Bill Gates? Economic inequality will
be as bad as ever. If you actually want to compress the gap between
rich and poor, you have to push down on the top as well as pushing
up on the bottom.How do you push down on the top? You could try to decrease the
productivity of the people who make the most money: make the best
surgeons operate with their left hands, force popular actors to
overeat, and so on. But this approach is hard to implement. The
only practical solution is to let people do the best work they can,
and then (either by taxation or by limiting what they can charge)
to confiscate whatever you deem to be surplus.So let's be clear what reducing economic inequality means. It is
identical with taking money from the rich.When you transform a mathematical expression into another form, you
often notice new things. So it is in this case. Taking money from
the rich turns out to have consequences one might not foresee when
one phrases the same idea in terms of "reducing inequality."The problem is, risk and reward have to be proportionate. A bet
with only a 10% chance of winning has to pay more than one with a
50% chance of winning, or no one will take it. So if you lop off
the top of the possible rewards, you thereby decrease people's
willingness to take risks.Transposing into our original expression, we get: decreasing economic
inequality means decreasing the risk people are willing to take.There are whole classes of risks that are no longer worth taking
if the maximum return is decreased. One reason high tax rates are
disastrous is that this class of risks includes starting new
companies.InvestorsStartups are intrinsically risky. A startup
is like a small boat
in the open sea. One big wave and you're sunk. A competing product,
a downturn in the economy, a delay in getting funding or regulatory
approval, a patent suit, changing technical standards, the departure
of a key employee, the loss of a big account — any one of these can
destroy you overnight. It seems only about 1 in 10 startups succeeds.
[1]Our startup paid its first round of outside investors 36x. Which
meant, with current US tax rates, that it made sense to invest in
us if we had better than a 1 in 24 chance of succeeding. That
sounds about right. That's probably roughly how we looked when we
were a couple of nerds with no business experience operating out
of an apartment.If that kind of risk doesn't pay, venture investing, as we know it,
doesn't happen.That might be ok if there were other sources of capital for new
companies. Why not just have the government, or some large
almost-government organization like Fannie Mae, do the venture
investing instead of private funds?I'll tell you why that wouldn't work. Because then you're asking
government or almost-government employees to do the one thing they
are least able to do: take risks.As anyone who has worked for the government knows, the important
thing is not to make the right choices, but to make choices that
can be justified later if they fail. If there is a safe option,
that's the one a bureaucrat will choose. But that is exactly the
wrong way to do venture investing. The nature of the business means
that you want to make terribly risky choices, if the upside looks
good enough.VCs are currently
paid in a way that makes them
focus on the upside:
they get a percentage of the fund's gains. And that helps overcome
their understandable fear of investing in a company run by nerds
who look like (and perhaps are) college students.If VCs weren't allowed to get rich, they'd behave like bureaucrats.
Without hope of gain, they'd have only fear of loss. And so they'd
make the wrong choices. They'd turn down the nerds in favor of the
smooth-talking MBA in a suit, because that investment would be
easier to justify later if it failed.FoundersBut even if you could somehow redesign venture funding to work
without allowing VCs to become rich, there's another kind of investor
you simply cannot replace: the startups' founders and early employees.What they invest is their time and ideas. But these are equivalent
to money; the proof is that investors are willing (if forced) to
treat them as interchangeable, granting the same status to "sweat
equity" and the equity they've purchased with cash.The fact that you're investing time doesn't change the relationship
between risk and reward. If you're going to invest your time in
something with a small chance of succeeding, you'll only do it if
there is a proportionately large payoff.
[2]
If large payoffs aren't allowed, you may as well play it safe.Like many startup founders, I did it to get rich. But not because
I wanted to buy expensive things. What I wanted was security. I
wanted to make enough money that I didn't have to worry about money.
If I'd been forbidden to make enough from a startup to do this, I
would have sought security by some other means: for example, by
going to work for a big, stable organization from which it would
be hard to get fired. Instead of busting my ass in a startup, I
would have tried to get a nice, low-stress job at a big research
lab, or tenure at a university.That's what everyone does in societies where risk isn't rewarded.
If you can't ensure your own security, the next best thing is to
make a nest for yourself in some large organization where your
status depends mostly on seniority.
[3]Even if we could somehow replace investors, I don't see how we could
replace founders. Investors mainly contribute money, which in
principle is the same no matter what the source. But the founders
contribute ideas. You can't replace those.Let's rehearse the chain of argument so far. I'm heading for a
conclusion to which many readers will have to be dragged kicking
and screaming, so I've tried to make each link unbreakable. Decreasing
economic inequality means taking money from the rich. Since risk
and reward are equivalent, decreasing potential rewards automatically
decreases people's appetite for risk. Startups are intrinsically
risky. Without the prospect of rewards proportionate to the risk,
founders will not invest their time in a startup. Founders are
irreplaceable. So eliminating economic inequality means eliminating
startups.Economic inequality is not just a consequence of startups.
It's the engine that drives them, in the same way a fall of water
drives a water mill. People start startups in the hope of becoming
much richer than they were before. And if your society tries to

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