Is Upstart the right way to get college student start-ups funded?

In 2010, the movie “The Social Network” was released, which has had a tremendously positive effect on the computer science department at Yale; and from what I have heard, a similar effect has been observed across the country. My understanding (I have not seen this movie myself) is that the movie’s plot revolves around Mark Zuckerberg and his role in the formation of Facebook. In the time since the movie was released, the number of computer science majors at Yale has nearly quadrupled, and these majors  are increasingly looking at start-ups (either founding their own or joining existing ones) as options for when they graduate (instead of going to Wall Street and working as quants, which has historically been the popular career path for Yale CS majors).

In my opinion, this is unquestionably a good thing. Yale has some of the brightest minds of the next generation, and I feel a lot more confident about the future of our country when I see these great minds being applied to creating new entities and jobs and building something real, instead of being wasted in the zero-sum gain arms race of who can create the automatic trading algorithm that is epsilon better than anybody else’s.

One consequence of this start-up craze is that I get bombarded with requests from students who want to meet with me to discuss their start-up idea. This partly because I teach the “Intro to Programming” course at Yale which has had consistently between 120 and 150 students (many of whom are budding entrepreneurs) enrolled since the release of “The Social Network”, partly because the success of Hadapt is certainly no secret around Yale, and partly because I live on Yale’s campus and part of my job in this capacity is to serve as an adviser and mentor to undergraduates.

When I meet with these students I hear all kinds of ideas. Some of them are good, and some of them are bad. Some of them make me think about an area in a different way, and some of them are carbon copies of something that already exists. Some I could get excited about and some I couldn’t. But just about all of them have one thing in common: the students involved vastly overestimate their probability of success. I suppose this should not surprise me --- after all, these are Yale students that have been successful in just about everything they have ever done in their life. So it follows that they would expect their start-up to be successful. But even when I talk to students at other universities who have start-up ideas --- students who have not necessarily been so successful in their lives --- even they are totally convinced that their startup idea is unlikely to fail. It seems that there is a basic psychological flaw in the human mind --- we so desperately want our dreams to come true that we ignore statistical data about the probability of success and trick ourselves into believing that we are the statistical anomaly and will succeed where others have failed.

Many of these students find out the hard reality regarding their start-up idea when they attempt raise funding. They find out that investors are extremely conscious of the probability of success of a group of students with no experience, no reputation, and a limited network. Most of these start-ups fail to raise funding from professional investors. Some students give up at this point. Other students continue along with limited funding from friends and family in an attempt to create more meat around the bones of their idea and reduce risk for the professional investors. Most will eventually fail, while a rare few will succeed.

The outcome of all this is that despite all of these students eager to be entrepreneurs and start companies, very few student ideas receive funding, and most of these ideas never see the light of day. Whether or not this is a good thing is certainly up for debate, but my feeling is that it is a shame that so few student start-ups get funding.

Therefore, when I first heard of Upstart (I think it was in August), I was quite interested in the idea --- it proposed a way to get student start-ups funded. I signed up to receive e-mail updates, but did not hear from them for several months. However, on Monday of this week I received an update from them that they were open for business. I looked through the profiles of the students who were looking for funding and I saw that no fewer than 4 out of the (approximately) 20 profiles that were available online were from Yale University.

However, a deeper look at the Upstart Website reveals a problematic clause that is attached with the funding of the student start-up ideas. This is not a traditional crowdfunding model where investors receive equity in the start-up in exchange for their investment dollars. Instead, the investors get a percentage of the student’s income for a 10-year period in exchange for the investment. This way, in the likely event that the student’s start-up idea does not work out, the investor is able to receive a nice return on investment by taking a cut from the student’s hard earned salary when the student enters the workforce.

This does not seem right to me. On one side you have students who have an inaccurate view of the probability of success of their start-up, and on the other side you have investors who are looking to profit off of the boundless optimism and dreams of these students. These students, with no experience in the real world, no understanding of what skills are necessary to build a company, and a perception of entrepreneurship built more from Hollywood than the cold realities of business, are more than happy to mortgage a percentage of 10 years of future earnings for a chance to receive some short-term money about which they have no idea how to properly evaluate the costs vs. benefits.

In the traditional model, where the  investor receives equity in exchange for the investment, at least the investor is in the same boat as the student --- their interests are aligned and focused on making the start-up a success. With the Upstart model, you have almost the exact opposite. Since the salary of a founder is typically below-market in exchange for the equity the founder receives, the expected rate of return for the investor is actually higher if the student were to give up on the start-up and get a normal job. This is especially true when the investment rate of return for the investor is capped (as it is in Upstart), so that even if the start-up were to take off and the student were to become very wealthy from it, the return to the investor is not markedly different from what it would have been if the company had failed and the student later received a salary at market value. To exacerbate the situation, the investor-investee relationship in Upstart is supposed to be somewhat also a mentor-mentee relationship, which is particularly dangerous when interests are misaligned.

I think Upstart should be commended for trying to get more funding to college students with ideas for starting companies. And although I don’t know many people involved, the people I do know are good people and I highly doubt they are trying to do anything evil. (Jonathan Eng was a TA for my Introduction to Programming class for me 4 years ago, and he was a good and honest TA). However, I do not believe the people involved in Upstart realize how hard it is for students to accurately evaluate the costs and benefits of receiving funding in this way. Therefore I am highly concerned about this model as a way forward for student entrepreneurship.