Why is it ever a good idea to found a company?

Question

I have a side project with a few friends that's gradually getting more serious. We're nearly at the stage where we'll be taking some early clients, which is really exciting after about a year of intermittent part-time effort. The product is a web service, and so the startup costs are almost entirely time rather than money.

I have a tight schedule, and this isn't something I do entirely for fun, so I try to challenge myself to justify the investment of my time, from a financial perspective. I'm having trouble! I'm effectively working for equity or stock rather than salary, and unable to resolve the dissonance between this arrangement and prevailing advice that:

• Most startups fail
• It's not a good idea to invest in individual stocks unless you have the knowledge and resources of a large investment firm
• As an early employee of a small company, therefore, prioritize cash compensation over equity, which is effectively "a lottery ticket"

I do have conviction that our service brings a lot of value to the industry where we're introducing it, and get excited about that opportunity, but it just doesn't square with what's become financial common sense at this point.

My question isn't about seeking personal advice, it's this:

For the reasons above, why does anybody ever start a company?

New companies are started every day, so I must be missing something. Are all companies started by people with the hubris to think they're the exception to these rules?

Answer 1

There are a few common errors you are making in your statement. Before I try to address what I see as problems with your line of thinking, take my overall response to the headline of your question as asked:

Why is it ever a good idea to found a company? To make money, to pursue a hobby, or both.

As to issues with your line of reasoning, consider:

(1) A 'company' can informally mean a business or it can mean a corporation. You appear to imply both different definitions. You can have a business, and take on clients, and even do so with other people, without forming a corporation. In which case, 'shares' and 'equity' never comes into it. You can also form a corporation that gathers dust and does nothing but cost you legal fees to set up.

(2) Starting your own business is very different from 'investing in individual stocks'. The former can be as simple as doing some graphic design projects for friends on the weekends, and the latter can mean gambling with your life savings [though I am not implying it always does].

(3) The 'lottery ticket' comes in if you are in a do-or-die industry. If you are already lining up clients for your business, revenue will come in, and you can reap the rewards, be they small or large, regardless of whether you become the next Richard Branson.

In short, there is a difference between trying to implement a tech startup that won't be profitable until 1B+ of revenue (like UBER, which to my knowledge still doesn't earn net income on an annual basis), and simply turning a profit from a hobby you enjoy. There are many different levels of 'starting a business' in between, some of which are risky (because they require you to commit full time and quit your job, or because they require significant up front $ investment), and some of which are not (because they use only your spare time and no $ investment).

Answer 2

It's common knowledge that starting a company is risky, but high-risk, high-reward ventures are not inherently bad choices. Do you keep your money in a hole in the ground? It'll always be there when you need it, but you get nothing back. Do you keep it in a bank? It's almost certain to be there when you need it, but you won't get much return. Do you keep it in the stock market? You might lose money, but you stand to gain quite a bit. Do you put it all into the company you founded? It's a big risk which might not pay off, but the potential upside is enormous. Doing something likely to fail can still be the rational choice if the rewards for success are great enough.

Answer 3

You brought up the often-repeated mantra of,

equity, which is effectively "a lottery ticket"

While that does illustrate the difference between equity and cold, hard, real cash in the form of a salary, equity is arguably only a lottery ticket if you have no direct knowledge of, or connection to, the success of the company. Of course, there's always at least some level of risk in any business, but the "like a lottery ticket" trope is a little inaccurate in the sense that a lottery ticket is - literally - random, while a business's success (and therefore the value of your equity) is at least somewhat based on potentially knowable factors.

So, what it basically boils down to is, people start businesses when they feel they know enough, or offer enough, to reduce the "lottery ticket" nature of equity to a risk level they're willing to accept.

Answer 4

Would you buy a lottery ticket if the average payout was greater than the price?

Yes, many startups fail*. This doesn't mean that on average, startups lose money. Otherwise food banks would be full of starving venture capitalists.

* I may be looking at different years than you, but the figure I found is 56% make it to their 5th year.

Answer 5

They're Young and Foolish

Lots of start ups are run by people straight out of college. They are young and invincible, and are confident that their project is going to be the next unicorn.

Mostly they are wrong, but they weren't going to make huge amounts of money in the first 2-3 years of their working careers anyway, so they chalk it up as experience and move on.

They're Old and Rich

Other people who found start ups might be effectively ready to retire, but enjoy working. Often, these are less "unicorns" and more "doing something similar to my previous job, but without the excess procedures because we're all adults here." These start ups probably aren't going to generate any billionaires, but they can still make serious money.

They Have Funding, and Accept the Risk

If they can convince someone else that this idea is great, they can get funding, which means they can get paid to do this work. They make less than they would otherwise, but judge the risk / reward trade off to be worth it. This is not exclusive of the other two options, though it's more common with the first.

This option is why places like silicone valley produce so many start ups. They attract investors to fund start ups, and young people to work them, and the successful tech companies provide a home for the coders when they decide they're done with the start up scene.

Which is all a long way of saying, "Yes, starting a new company is often not a great way to make money. You need to be a little crazy to do it mid-career."

Answer 6

Markets are very efficient for goods and services that are already being sold at scale, but quite inefficient for ones that haven't been thought up or implemented well yet.

Starting a successful company is virtually always taking advantage of the latter. The average startup typically fails because they try to do the former.

Answer 7

Investing in stocks is different to setting up and running a company, and founding a company is different to being employed by a startup

The "common sense" advice you have listed is relevant for situations where you are investing in the equity markets, or are looking for a job and the companies you are applying to are offering equity as compensation.

You are not either of those situations, you are looking at being a founder of a company. There are a number of reasons people want to found companies:

• Depending on the jurisdiction and the type of company you setup you can limit any excess liabilities to the company (so if the company makes a $100m loss you aren't liable)
• Companies can be structured so that certain shareholders are paid dividends while others are not. For example the Founders would give themselves preference shares, but any employees with equity would have ordinary shares. The ordinary shares can be restricted from dividend payouts while the company is private (while enabling preference shares)
• There can be tax benefits (depending on your jurisdiction) in having earnings paid out via dividends as opposed to salary
• Setting up a company forces you to codify the decision making process and makes it clear who is responsible for what
• Having equity available for a company makes it much easier to get outside investment for your company
• Banks and other financial institutions offer products to businesses that they don't offer to consumers
• There may be tax advantages for buying and renting equipment as a company compared to a consumer
• Equity makes it easier to "get out" (ie sell your shares), without equity you'll have a hard time convincing your cofounders what your equitable share of your collective effort is
• A company structure can help separate your personal relationships from your business decisions

Answer 8

For the reasons above, why does anybody ever start a company?

For the same reason that Bill Gates and Paul Allen started a company. For the same reason that Steve Jobs and Steve Wozniak started a company. Ditto Bill Hewlett and Dave Packard, and Michael Dell, Ted Waitt & Mike Hammond, Emeril Lagasse, and thousands of small business across the world (including my great-grandfather):

to make (hopefully lots of) money, while being the boss.

Why else?¹

¹ We'll ignore businesses run as tax losses.