A Free Call Option on the American Economy

This is an essay arguing that some of the same forces driving Wall Street have affected Sand Hill Road, so that entrepreneurs try to make money without worrying about losing it.

From the backseat’s darkness, the hedge fund manager wasn’t talking to anyone in particular, and didn’t seem to notice no one could understand much of what he said. The Christmas party ended late, and we were giving him a ride to his hotel.

He wasn’t sure when the economy would recover. He wasn’t sure if America would recover. “But,” he said, “it has been a good ride. All these years I’ve basically had a free call option on the American economy.”

We Are All Hedge Fund Managers
I explained to my wife, a doctor, that a call option lets you profit from a stock if it goes up, without actually owning the stock if it drops: hedge fund managers share in the fund’s gains but not its losses. I looked at her as if this was quite a trick. “But,” she said, “aren’t all of you paid in options too?”

It took a moment to realize she was right. Venture capitalists take 20% or more of their fund’s gains, but few risk much of their own money in a loss. At startups, entrepreneurs and executives don’t usually own stock, at least not any they can sell, but options to profit from the stock if the company is bought or goes public. Little if any of the money invested in a startup comes from the entrepreneur.

The hedge fund manager, the venture capitalist, the entrepreneur, the executive are, in this respect, not so different: we are paid to make money, not to avoid losing money. Heads we win alongside the investor; tails, only the investor loses. Who wouldn’t keep raising the stakes in a game like that?

The Ownership Society Becomes The Risk Society
This may be the final irony of President Bush’s efforts to create “an ownership society”: that it often resulted in an ownership-free society, where the leverage to risk others’ assets was more powerful than owning the actual asset. The triumph of leverage over credit is a big reason why markets have become so much more volatile than they once were.

But it wasn’t always this way. Remember the rage of Wall Street’s Gordon Gekko – the symbol of a different era’s greed — when he lost millions on Bluestar Airlines? He smashed his coffee table. As he explained the first time he met Bud Fox, “nothing ruins my day like losses.” Now imagine what kind of unchained creature Gekko would be in the world we have now, where the money he lost wasn’t his own?

For Michael Lewis, the former Salomon trader who profiled a real-life Gekko in his 1989 book Liar’s Poker, today’s meltdown of the financial system is primarily the result of the major banks, all investor-owned by 1999, insulating management from their losses. “No investment bank owned by its employees,” Lewis wrote last month, “would have levered itself 35 to 1.”

We could ask a similar question of startups. If we were funded and controlled by employees, how many would take the risks – or the losses – most startups take today? Who would sign up to generate revenues of $100 million in 5 years?

But that is exactly what a company raising venture capital must do. The first pre-requisite for getting venture capital is a willingness to invest it in a way that must seem reckless to traditional businesses.

One Reckless Company Ruins the Whole Barrel
And once one company in an industry is reckless, we all have to be reckless. Just look at the world in which my company, Redfin, competes. The two startups that in 2005 launched map-driven real estate websites similar to Redfin’s have raised, between them, over $75 million more than Redfin’s $20 million. Whenever I worry about the crazy risks we’ll have to take to earn back our $20 million, I think, “But those guys, now they’re crazy.” (They’re also very good).

Without the pressure from other, better-funded startups, we wouldn’t open a new market until the last one was profitable. We would spend less on research & development so we could reach break-even sooner. We wouldn’t worry about marketing at all. We’d be more likely to survive, albeit on a more modest scale.

To the Pain
But the truth is, I’m not a very modest person, and neither are the many talented people we’ve assembled at Redfin. The VCs aren’t twisting our arms to take risks; they’re letting us do what we wanted to do anyway.

You can’t assemble an army of Turks without marching it out to a huge battle; the army gets restless. I should know: for two years, the dot-com crash left my last company struggling to grow beyond $1 or $2 million in quarterly profits and still waiting to go public.

My old friend and colleague John Hogan would see me in the hallways and ask, “To the death?” “No!” I’d say, in a reference to the prolonged, mutilated existence promised to a villain in Princess Bride. “To the pain.”

What we worried about wasn’t that our company would fail, but that it would take too long to succeed.

Every Startup is a Time Bomb
A lot of startups now find themselves in the same unwilling suspension of disbelief. Every startup is a time-bomb, where all the ingredients of hope, sacrifice and brains can mix for only so long before self-destructing. The best employees are gone well before the money runs out. Redfin, which raised money three years ago, has already used up half its time.

Now that a downturn has focused everyone on survival, everyone is criticizing the unnatural haste — the artificially stimulated appetite for risk — that characterized the way we were only a few months ago. In fact, the whole idea of venture capital – of using other people’s money to build a startup with highly uncertain prospects – has now come into question.

I’ve been on that bandwagon. In a recent essay on how to survive the downturn, my main advice was to act like an owner. And yesterday, while I was putting the finishing touches on this essay, Fred Wilson published a post on spending money like an owner. It was good advice.

But it stopped short of the conclusion I thought Fred was heading for: that entrepreneurs should, as much as possible, start a company with their own money. Because no matter what you tell yourself, there is a big difference between spending money like it’s your own and actually spending your own money.

Mammals and Reptiles
I’ve worked at self-funded companies, and sat on the board of a largely self-funded company. The difference in how it feels is as vast as the gulf between reptiles and mammals: the one with an untrammeled ability to survive, the other capable of long-term thinking.  Both of the self-funded companies were bought for a price that gave the founders a nice return but neither could ever bring itself to take the risks necessary to grow into a huge, stand-alone business.

(Much of the way I am now grew from watching a company smaller than my first employer, worse than us in many ways, grow into a billion-dollar business.)

So while ownership is an important virtue, the willingness to take risks on a big idea is too. The great irony of all this is that Silicon Valley seems in this case to have understood risk better than Wall Street: a college student with a good idea and the ability to develop it has turned out to be a safer investment than many Moody’s-rated securities.

We don’t realize what a temporary historical aberration it is that there is a place and a time where people are willing to fork over millions to a penniless student. That there exists within the world’s vast plutocracy such a fragile meritocracy is still hard for me to believe.

It’s one of the only reasons I think the hedge fund manager is wrong about the economy. The party isn’t completely over. America can keep winning, but only if we’re willing to take bigger risks than the rest of the world.

Discussion

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