August 2005(This essay is derived from a talk at Defcon 2005.)Suppose you wanted to get rid of economic inequality. There aretwo 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 togive money to the poor, you have to get it from somewhere. Youcan'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 simplyshifting money from the rich. You could help the poor become moreproductive — for example, by improving access to education. Insteadof taking money from engineers and giving it to checkout clerks,you could enable people who would have become checkout clerks tobecome engineers.This is an excellent strategy for making the poor richer. But theevidence of the last 200 years shows that it doesn't reduce economicinequality, because it makes the rich richer too. If thereare more engineers, then there are more opportunities to hire themand to sell them things. Henry Ford couldn't have made a fortune building cars in a society in which most people were still subsistencefarmers; he would have had neither workers nor customers.If you want to reduce economic inequality instead of just improvingthe overall standard of living, it's not enough just to raise up the poor. What if one of your newly minted engineers gets ambitiousand goes on to become another Bill Gates? Economic inequality willbe as bad as ever. If you actually want to compress the gap betweenrich and poor, you have to push down on the top as well as pushingup on the bottom.How do you push down on the top? You could try to decrease theproductivity of the people who make the most money: make the best surgeons operate with their left hands, force popular actors toovereat, and so on. But this approach is hard to implement. Theonly 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, youoften notice new things. So it is in this case. Taking money fromthe rich turns out to have consequences one might not foresee whenone 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 a50% chance of winning, or no one will take it. So if you lop offthe top of the possible rewards, you thereby decrease people'swillingness to take risks.Transposing into our original expression, we get: decreasing economicinequality 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 aredisastrous is that this class of risks includes starting newcompanies.InvestorsStartups are intrinsically risky. A startupis like a small boatin the open sea. One big wave and you're sunk. A competing product,a downturn in the economy, a delay in getting funding or regulatoryapproval, a patent suit, changing technical standards, the departureof a key employee, the loss of a big account — any one of these candestroy 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 inus if we had better than a 1 in 24 chance of succeeding. That sounds about right. That's probably roughly how we looked when wewere a couple of nerds with no business experience operating outof 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 newcompanies. Why not just have the government, or some largealmost-government organization like Fannie Mae, do the ventureinvesting instead of private funds?I'll tell you why that wouldn't work. Because then you're askinggovernment 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 importantthing is not to make the right choices, but to make choices thatcan 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 meansthat you want to make terribly risky choices, if the upside looksgood 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 overcometheir understandable fear of investing in a company run by nerdswho 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'dmake the wrong choices. They'd turn down the nerds in favor of thesmooth-talking MBA in a suit, because that investment would beeasier to justify later if it failed.FoundersBut even if you could somehow redesign venture funding to workwithout allowing VCs to become rich, there's another kind of investoryou simply cannot replace: the startups' founders and early employees.What they invest is their time and ideas. But these are equivalentto money; the proof is that investors are willing (if forced) totreat 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 relationshipbetween risk and reward. If you're going to invest your time insomething with a small chance of succeeding, you'll only do it ifthere 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, Iwould have sought security by some other means: for example, bygoing to work for a big, stable organization from which it wouldbe 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 tomake a nest for yourself in some large organization where yourstatus depends mostly on seniority.[3]Even if we could somehow replace investors, I don't see how we couldreplace founders. Investors mainly contribute money, which inprinciple is the same no matter what the source. But the founderscontribute 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. Decreasingeconomic inequality means taking money from the rich. Since riskand reward are equivalent, decreasing potential rewards automaticallydecreases people's appetite for risk. Startups are intrinsicallyrisky. Without the prospect of rewards proportionate to the risk,founders will not invest their time in a startup. Founders areirreplaceable. So eliminating economic inequality means eliminatingstartups.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 becomingmuch richer than they were before. And if your society tries toprevent anyone from being much richer than anyone else, it willalso prevent one person from being much richer at t2 than t1.GrowthThis argument applies proportionately. It's not just that if you eliminate economic inequality, you get no startups. To the extent you reduce economic inequality, you decrease the number of startups.[4]Increase taxes, and willingness to take risks decreases inproportion.And that seems bad for everyone. New technology and new jobs bothcome disproportionately from new companies. Indeed, if you don'thave startups, pretty soon you won't have established companieseither, just as, if you stop having kids, pretty soon you won'thave any adults.It sounds benevolent to say we ought to reduce economic inequality. When you phrase it that way, who can argue with you? Inequalityhas to be bad, right? It sounds a good deal less benevolent to saywe ought to reduce the rate at which new companies are founded.And yet the one implies the other.Indeed, it may be that reducing investors' appetite for risk doesn'tmerely kill off larval startups, but kills off the most promisingones especially. Startups yield faster growth at greater risk thanestablished companies. Does this trend also hold among startups?That is, are the riskiest startups the ones that generate mostgrowth if they succeed? I suspect the answer is yes. And that's a chilling thought, because it means that if you cut investors'appetite for risk, the most beneficial startups are the first to go.Not all rich people got that way from startups, of course. Whatif we let people get rich by starting startups, but taxed away allother surplus wealth? Wouldn't that at least decrease inequality?Less than you might think. If you made it so that people couldonly get rich by starting startups, people who wanted to get richwould all start startups. And that might be a great thing. But Idon't think it would have much effect on the distribution of wealth.People who want to get rich will do whatever they have to. Ifstartups are the only way to do it, you'll just get far more peoplestarting startups. (If you write the laws very carefully, that is.More likely, you'll just get a lot of people doing things that canbe made to look on paper like startups.)If we're determined to eliminate economic inequality, there is stillone way out: we could say that we're willing to go ahead and dowithout startups. What would happen if we did?At a minimum, we'd have to accept lower rates of technological growth. If you believe that large, established companies could somehow be made to develop new technology as fast as startups, theball is in your court to explain how. (If you can come up with a remotely plausible story, you can make a fortune writing businessbooks and consulting for large companies.)[5]Ok, so we get slower growth. Is that so bad? Well, one reasonit's bad in practice is that other countries might not agree toslow down with us. If you're content to develop new technologiesat a slower rate than the rest of the world, what happens is thatyou don't invent anything at all. Anything you might discover hasalready been invented elsewhere. And the only thing you can offer in return is raw materials and cheap labor. Once you sink thatlow, other countries can do whatever they like with you: installpuppet governments, siphon off your best workers, use your womenas prostitutes, dump their toxic waste on your territory — all thethings we do to poor countries now. The only defense is to isolateyourself, as communist countries did in the twentieth century. Butthe problem then is, you have to become a police state to enforce it.Wealth and PowerI realize startups are not the main target of those who want toeliminate economic inequality. What they really dislike is thesort of wealth that becomes self-perpetuating through an alliancewith power. For example, construction firms that fund politicians'campaigns in return for government contracts, or rich parents who get their children into good colleges by sending them to expensiveschools designed for that purpose. But if you try to attack this type of wealththrough economic policy, it's hard to hit without destroyingstartups as collateral damage.The problem here is not wealth, but corruption. So why not go aftercorruption?We don't need to prevent people from being rich if we can preventwealth from translating into power. And there has been progresson that front. Before he died of drink in 1925, Commodore Vanderbilt'swastrel grandson Reggie ran down pedestrians on five separate occasions, killing two of them. By 1969, when Ted Kennedy drove off the bridge at Chappaquiddick, the limit seemed to be down to one. Today it may well be zero. But what's changed is not variationin wealth. What's changed is the ability to translate wealth intopower.How do you break the connection between wealth and power? Demand transparency. Watch closely how power is exercised, and demand anaccount of how decisions are made. Why aren't all police interrogationsvideotaped? Why did 36% of Princeton's class of 2007 come fromprep schools, when only 1.7% of American kids attend them? Why didthe US really invade Iraq? Why don't government officials disclosemore about their finances, and why only during their term of office?A friend of mine who knows a lot about computer security says thesingle most important step is to log everything. Back when he wasa kid trying to break into computers, what worried him most was theidea of leaving a trail. He was more inconvenienced by the need to avoid that than by any obstacle deliberately put in his path.Like all illicit connections, the connection between wealth and power flourishes in secret. Expose all transactions, and you willgreatly reduce it. Log everything. That's a strategy that alreadyseems to be working, and it doesn't have the side effect of makingyour whole country poor.I don't think many people realize there is a connection betweeneconomic inequality and risk. I didn't fully grasp it till recently.I'd known for years of course that if one didn't score in a startup,the other alternative was to get a cozy, tenured research job. ButI didn't understand the equation governing my behavior. Likewise, it's obvious empirically that a country that doesn't let people getrich is headed for disaster, whether it's Diocletian's Rome or Harold Wilson's Britain. But I did not till recently understandthe role risk played.If you try to attack wealth, you end up nailing risk as well, and with it growth. If we want a fairer world, I think we're better off attacking one step downstream, where wealth turns into power.Notes[1]Success here is defined from the initial investors' point ofview: either an IPO, or an acquisition for more than the valuationat the last round of funding. The conventional 1 in 10 success rateis suspiciously neat, but conversations with VCs suggest it's roughlycorrect for startups overall. Top VC firms expect to do better.[2]I'm not claiming founders sit down and calculate the expected after-tax return from a startup. They're motivated by examples ofother people who did it. And those examples do reflect after-tax returns.[3]Conjecture: The variation in wealth in a (non-corrupt) country or organizationwill be inversely proportional to the prevalence of systems ofseniority. So if you suppress variation in wealth, seniority willbecome correspondingly more important. So far, I know of nocounterexamples, though in very corrupt countries you may get both simultaneously. (Thanks to Daniel Sobral for pointingthis out.)[4]In a country with a truly feudal economy, you might be able toredistribute wealth successfully, because there are no startups tokill.[5]The speed at which startups develop new techology is the other reason they pay so well. As I explained in "How to Make Wealth", what you do in a startup is compress alifetime's worth of work into a few years. It seems asdumb to discourage that as to discourage risk-taking.Thanks to Chris Anderson, Trevor Blackwell, Dan Giffin,Jessica Livingston, and Evan Williams for reading drafts of thisessay, and to Langley Steinert, Sangam Pant, and Mike Moritz forinformation about venture investing.
