The Expected Value of the payoff is higher than ever
Entrepreneurship has always been really hard. Even in the best of times, most people fail. But at the same time, the Expected Value of starting your own tech company has never been higher.
Why? Three key reasons.
Entrepreneurs haven’t had this much bargaining power vis-à-vis capital in a very long time. Second, a growing ecosystem of enterprise software firms continues to bring down the cost of building a tech company, allowing them to scale more efficiently. Finally, growing global internet and smartphone penetration mean entrepreneurs can leverage technology to reach more consumers with less.
Let’s take it back to grade 9 math class (the memory of which you may or may not have repressed) and look into the formula for Expected Value.
In plain language, Expected Value is the result one can expect given the probability of different outcomes. If there is a 50% probability that you will get 70% on a test, and a 50% probability that you will get 90%, the expected value of your mark is 80%.
In the following simplified model, the Expected Value of founding a tech company is determined by summing three cases. Each represents a possible outcome, from total failure and bankruptcy, to unmitigated Silicon Valley tycoon-level success.
Forbes claims that 90% of all startups fail. So, a probability weighting of 0.9 is applied to Outcome 1, where the value of your startup is zero. Let’s hypothesize that there is a 9% probability you’ll build something worth $5 million in 5 years time. Further, let’s say there is a 1% chance you get lucky and work hard and build a unicorn (a private company with a valuation of $1 Billion or more).
In this illustration, the Expected Value of your startup is $10.5 million.
Now imagine the probabilities all remain the same, but instead of having a 1% chance of building a $1 Billion company, you have a 1% chance of building a $3 Billion firm. Using the same formula as before, the Expected Value rises to $30.5 million.
This is a hyper-simplified illustration of what is happening in tech entrepreneurship. While the chances of failure remain very high, the three trends that I’ll now dive into are pushing up the payoff at the top of the distribution.
The most successful entrepreneurs are seeing their valuations increase because capital is cheap. Capital, just like any other resource, is subject to the basic law of supply and demand. So even though many people think of it as just “money”, it can become more or less expensive depending on how much there is to invest in assets. When there is lots of capital and fewer attractive places to invest it in, the cost of capital goes down. Conversely, when capital is relatively scarce, like we see in many developing countries, the cost of it increases.
Right now there is A LOT of capital floating around in the system. This is primarily due to demographics, monetary policy, and fiscal policy. The Baby Boomers are just starting to retire, and for the last ten years they’ve been at the peak of their productive and earning potential. At the same time, they see retirement on the horizon, so they’re consuming less and investing more. In addition, interest rates are near all-time lows, making borrowing cheap and attractive. The big fiscal stimulus in response to COVID-19 has injected trillions of dollars into the system. All of this increases the supply of capital.
While some people have fretted about the risk of inflation, everyday staple goods, like bread, haven’t seen a big price increase yet. This means that the traditional measure of inflation, the consumer price index (CPI), isn’t registering much change.
What we have seen is a huge run-up in the valuation of assets in financial markets. A glut of capital decreases its purchasing power relative to scarce entrepreneurs with great ideas and the ability to execute them. Top start-ups can therefore raise funds at higher valuations. Essentially, the price of good start-ups has gone up.
The Enterprise Software Ecosystem
Just as prices are going up, the cost of building tech companies is going down. According to Mimeo.com founder Jeff Stewart, as quoted on Mashable, “[in the 1990s], when you started a company, more money was pumped into office space, servers and equipment.” The need to build and manage your own servers was hugely suboptimal. When a software company is growing, it can be very difficult to predict customer demand in advance. This left founders with a conundrum. Either they could allocate precious capital to buy more capacity, and risk demand not materializing, or preserve capital, and risk not being able to meet higher volumes of customers. What’s more, these decisions took up management bandwidth, and distracted entrepreneurs from building their products.
Enter, Amazon Web Services (AWS) and Microsoft Azure.
Now, software start-ups can contract cloud services to host their server operations and more. The use of these servers can scale dynamically as the company gains more traction with customers. Firms like Amazon and Microsoft have dedicated tons of human capital and cash to getting really good at this, so entrepreneurs don’t have to.
This reflects a broader theme of specialization in and outsourcing of B2B services. Salesforce helps companies manage their customer relationships. Stripe helps companies facilitate payments. Slack helps employees talk to each other, so companies don’t have to invest in internal communication platforms. Shopify helps companies set-up and run digital storefronts. You get the picture. All these companies help startups launch and grow in a highly cost-effective manner. Taking this trend to its logical conclusion, entrepreneurs are left to worry “only” about their core competency and executing on that really well.
Growing Technological Leverage
At its core, the history of technology, from Antiquity to the information age, can be viewed as the search for leverage. The more humans could supplement manual labor with technologies, the more they could leverage limited inputs and increase productivity. The search for leverage to increase agricultural productivity led to the adoption of technologies like the plow, horse collars and seed drilling. The search for leverage to increase manufacturing output led to the adoption of the steam engine in the industrial age. These innovations are the proto-foundations of modern society. And yet, despite how impactful these technologies were, they still worked within the constraints of a linear system. What do I mean by that?
Without any technologies to help them, humans could plant X number of seeds and expect Y amount of food. With agricultural technologies, humans could plant X seeds, and get Y x 2 food. When humans put X amount of iron into their factories, they got Y amount of widgets. This was easy to wrap one’s head around.
The entire point of this apparent tangent is to illustrate the importance of how modern software is inherently non-linear. In non-linear systems, a small change in an input has a massive impact on downstream outputs. A tiny team of software engineers can build a product in a couple of weeks, and ship it to global markets instantly, with near-zero marginal costs. Software products can now instantaneously reach the world’s 4.66 billion internet users, who have doubled from 2.33 billion since 2013. The number of smartphone users worldwide has quadrupled since 2012, from 1.06 billion to 4.3 billion today.
The leverage that modern software technology provides is hard to put into perspective. Entrepreneurs in 2021 have access to multitudes more customers than they did even a decade ago. This means they can scale rapidly, at low cost, and dominate vast markets. The best ideas compete internationally, not locally.
All this comes together to increase the payoff of founding a tech company at the top of the success distribution. This phenomenon may partly explain the exodus of talent from finance into tech. Would-be founders, as rational economic actors, are increasingly incentivized to give entrepreneurship a shot, even if the pursuit of it is kind of like buying a lottery ticket.
This article was inspired in part by various episodes of the Invest Like The Best podcast. Check it out!