The Effective Altruism community is quite enthusiastic about startups. 80,000 Hours lists “tech entrepreneurship” as one of their top four careers, notably beating out working as a software engineer for a big company–which requires a similar skill set. Benjamin Todd of 80k has also advocated startup investing as good use of money for people who want to make the world a better place. But lately, I’ve come to suspect startups are being oversold. Here’s why.
About a year ago, a friend of mine was raising seed investments for a startup. I chipped in a small amount of money, he applied to Y Combinator (the startup incubator responsible for AirBnB and Dropbox), got rejected, and the startup promptly went bust within a year. This in itself was not surprising–I knew going that most startups fail, and the reason to found or invest in a startup is for the small chance of a mega-success.
What shocked me was this: while I’d heard that in previous rounds, Y Combinator would interview 10% of applicants and accept 2 or 3%, in the round my friend applied to they only interviewed 3% of applicants. This is in spite of the fact that number of people accepted to Y Combinator grows every round–apparently, the applicant pool has grown even faster. I’ve also heard independently that Y Combinator thinks its quality of applicants has gone up over the years.
In a way, this isn’t surprising. Once everyone knows a career path is lucrative, talent tends to pour in, making the competition much stiffer, and the career path less attractive. Incidentally, 80,000 Hours has written about this too recently. It’s a problem that’s infamously afflicted doctors, lawyers, and college professors (the last of these, while not financially lucrative, offers a pretty nice life to those who can get tenure–yet getting tenure has gotten much harder for precisely that reason).
One thing that makes the situation especially grim for would-be startup founders is that not only has the chance of getting into Y Combinator gone down, the chance of being successful without Y Combinator’s backing may have also gone down. YC partner Paul Buchheit has claimed that YC rejectees rarely go on to become successful, and he thinks its not because YC is so good at picking successful startups, but because Y Combinator’s resources give startups it incubates such an overwhelming advantage.
The key factor may be that once everyone knows all the good startups come from Y Combinator, it becomes much harder for non-YC startups to attract investors and talent. Economist Robin Hanson has, in fact, argued that this “elite evaluator” role may be the main way that Y Combinator, top later-stage VC firms like Andreessen Horowitz, and schools like Harvard make their money. This model should lead us to predict that the startup biz will continue to be good for YC and Andreessen Horowitz for the foreseeable future–but less of a good deal for founders and random individuals who happen to have a lot of money to invest.
I think it’s worth being explicit about how this situation looks from an investor’s perspective. In a world where Y Combinator dominates the startup ecosystem, and getting in is insanely competitive, the would-be angel investor faces the following dilemma: On the one hand, you can invest in a company that hasn’t gotten in to Y Combinator yet, and then have terrible expected return because getting in to Y Combinator is very difficult and the startup won’t be successful otherwise.
On the other hand, if you try to invest on YC’s Demo Day, other investors will be tripping over themselves to invest in the same startups you want to invest in, so you’ll be forced to invest at inflated valuations that also leave you with a terrible expected return. Indeed, I’ve heard Silicon Valley investors complain that YC’s Demo Days are feeding frenzies where it’s impossible to get in on the good deals.
Again, I’ve heard people say that it seems like these days in Silicon Valley, everyone is talking about their angel investments. But if everyone is doing it, it’s probably not an exceptional investment opportunity, at least anymore. As Matt Yglesias said in another context:
By the time the word is out that stocks are a great investment, or that hedge funds can get you 8 percent returns, or whatever else it is it’s probably already too late. Hedge funds had their best moment before they got famous. Once everyone’s rushed in, it’s too late.
I expect many people to dismiss what I’m saying, as it conflicts with Silicon Valley conventional wisdom. Perhaps they’ll cite an old Paul Graham article, or even hard data on the amazing returns to startup investors. The problem is that I’m not claiming startups were never a good deal–just that now that everyone “knows” they’re a good deal, that fact has made them stop being a good deal. The most rigorously-collected data in the world doesn’t matter if the data is out of date.
For example, consider this piece of conventional wisdom: angel investors shouldn’t worry about getting a cheap valuation, they should worry about making sure they don’t miss out on the one company that will give them ridiculous returns. Well, it is true that if only 1 in 10 of the companies you invest in will be a hit, the difference between 20x and 30x returns doesn’t matter. But if competition for angel deals raises valuations to the point where you’re only getting 10x returns, you may as well go play some high-stakes dice games with your rich friends.
This is not to say that no one should invest in startups. I expect Y Combinator will continue to make money for its partners for some time. Nor is it to say no one should found a startup–maybe you have some exceptional advantage over the great mass of would-be startup founders. Of course, you’d better be careful to ask yourself if your “exceptional advantage” is actually something that many thousands of Google employees and recent Stanford grads also have.
I also think there’s a general lesson here: the EA movement needs to be much more careful about giving career advice that is likely to go out of date rapidly. If something sounds too good to be true–well, maybe it was true five years ago, but it might no longer be true to day. Especially if “everyone knows” it’s a great deal.
Correction: An earlier version of this post misidentified a claim by Paul Buchheit as having been made by Paul Graham.
Update 7/21/2015: Current YC head Sam Altman calls angel investments the biggest status symbol in Silicon Valley, bigger than first-name name drops. This should be a warning sign that if you try to do angel investing to make money, you’ll be competing with people who do it for the status symbol.