Y Combinator cuts its pro rata stake and makes later investments case-by-case
techcrunch.com
techcrunch.com
I find it interesting that they choose to change their investing program instead of changing their application program. Why not keep the program smaller and more exclusive instead?
I do wonder whether this was actually a strategic decision -- if it simply is more profitable to pick winners in deciding whether to participate in follow-on rounds; or perhaps YC would describe it as not picking the companies that don't have a clear path to monetization.
In other words, I wonder whether the "we didn't realize how hard it would be to raise the quantum of capital implied by our initial commitment, and also, it turns out we don't like running a big fund" explanation is not the real reason they're doing this; and whether the real reason is in fact that they've realized that being able to exercise discretion in follow-on rights has a tangibly positive effect on fund returns. Which makes sense!
The question for YC leadership is whether, in a world in which there were no issues with fundraising or fund operations, they would commit to follow-on participation for every company. If that's the case, and they would like to maintain a YC culture of committing to all future funding rounds for all YC companies, why not fundraise a special purpose vehicle for the funding shortfall to fulfill the commitment that was just abrogated? Give first dibs to current LPs....I bet it would be multiples oversubscribed. With that covered, YC could downscale class size to the point they can continue the full funding commitment using LP funds.
1) It's not quite accurate to say that YC is running out of money, though I could see how the article could read that way. YC is fortunate to be well-funded. However, we saw that if we continued our previous pro rata policy, that that could eventually happen someday, so we made a proactive adjustment well ahead of time.
2) One of the consequences of our old pro rata policy was that it left us without control of how much money we spent. Because we committed to investing in every round of every YC company, our spending was dependent on how many companies raised money, which turned out to be hard to predict. Imagine running a company where your monthly budget could vary by millions of dollars and you wouldn't know until the end of the month how much you'd need!
3) As far as I know, no other investor in the world has a programmatic pro rata policy (what YC tried from 2015-2019, which we are stopping now per the article). The whole idea was a bit of a crazy invention, and while its motivation was good, unfortunately it turned out to have too many drawbacks.
Imagine investing in only one round and pretending that you care about, or even understand, the trials of a startup!
(i.e. when we went through in 2009 it did not exist) It also clearly isn't scaleable without infinite capital.
Plus, if you had complete information, why would you ever want to automatically invest any time a company in your portfolio raised money?
My guess is the only reason they made it automatic, was to minimize the impact of a negative signal. It sounds like they hope the new changes will still minimize that signal.
This assumes that automatic pro-rata is a winning investment strategy. YC's goal ultimately is to turn money into more money, or at least that's (almost certainly) the most significant metric of success for them.
(Not a criticism, and I can see the merits of that choice. But, when I talk to my friends about YC that usually comes up.)
that's likely because before the success, there was no way anyone with the network would come to YC as a first port of call. And with technical partners able to judge the incoming seed company on the merits the founders themselves, YC managed to pick the successful ones (mostly - obviously there are failures).
When the success of YC's model became so prominent that it is a culture all on its own, the technical partners no longer work the same way as the old way. I don't think it's possible. So network, and human capital is used as a filter, rather than deal with the massive amounts of no-name people.
They can’t really afford that model, that’s why funding is being slashed: insiders successful in the 2010s are not better poised to be successful in the 2020s than outsiders, even if network and critical mass help them raise and burn money to have a more structured shot.
But, since YC was not providing any additional signal by investing in everyone, the original signal carried so much weight that even obviously failing companies so keep raising rounds based upon the original YC signal.
So the "hack" about letting the market guide YC's later rounds was foiled by the same reason they came up with it in the first place.
I personally enjoy the irony of it.
(but still are the majority so you have to account for them)
as you said pro-rata can't be after the fact. The company needs to know how much equity it is selling and can't allocate to new investors without knowing what the company has available
Everything you say to a VC should be assumed to be public information.
There are a couple of things in this comment that aren't true, and I want to respond to make sure that people reading it don't come away misinformed.
YC does not distribute lists of "top companies" to investors, around demo day or at any other time. Quite the opposite - we take great pains to ensure that investors at demo day see all companies as equally as possible.
About other venture firms being investors in YC, it is true that Sequoia was once an investor in YC's funds, but that was a decade ago. We haven't had a venture firm as an investor in YC in many years to ensure there is an even playing field.
Anybody else think this is a possibility?
Of course, these investors may get a bad score in YCs internal systems, but are other YC companies not going to meet with the VC based on those feedback systems?
TBH, I didn't know YC had a guaranteed follow-on amount. Either way, you just gotta be too good to ignore.
What I have seen - and just once - is that a DD did in fact turn up some major issues, the investors backed out and the startup then made a stink pretending they were stiffed. But the truth on that one will likely never see the light. So not 100% of these can be laid at the door of the VCs either.
I've also had founders back out of accepted term sheets, which is also a pretty shitty thing to do.
Investing is game of information. If an investor can’t figure out who else will be on the cap table, they have much bigger problem.
The way it is going to go down is that investor during meeting will ask if founders think YC is in that round. If founders say something along the lines of YC decides after term sheet, it basically means no.
In the end , the overall result is that less YC companies will raise, but the good once still will, but it was always the case.
Why would it basically mean no? It seems like the new policy makes the answer "Maybe, and there's no way to find out until a lead investor has signed on the dotted line".
If there's a 100% chance YC takes their pro rata stake, then the YC brand is more valuable.
It puts them in a tough spot. If YC partner writes to an investor, this company is awesome, plz invest and then investor asks if YC is going to invest?
And they get back, you commit first and then we decide, it just doesn't look/sound good.
It is important to remember is that a lot of companies in YC batch fundraise on SAFE, so when a priced round comes along probably 90% of them are not even in a position to fundraise, because a product didn't work out, team issues etc.
Also, there is YC Series A program which basically is going to be the sign of approval for investors and I am pretty sure YC is going to follow in 100% of cases for that one.
In the previous system, they had skin in the game, they literally were putting money where their mouth was: same companies, same valuation. If I make money they make money, if I lose money, so do they. You can't beat that.
I kinda feel now it’s just become a numbers game machine.... back as many as possible, some will win. There doesn’t see anything special about the investors or the investors in this model, it’s just about churning out as many companies as possible and playing the numbers.
Am I right or being overly cynical?
Does this not strongly dilute the power of being in YC? Seems nuts to me. Why not just shrink the number of incoming companies?
it makes it hard for startups that would need more money to prove their profitability to lose out on new rounds, or have to give up more for those rounds (as investors will need better incentive to invest without the YC signal).
So I sent 100-200 personalized emails throughout a 4 month period to every single person I could find in the space. Eventually I got one and made a ton of connections just with that alone.
Now I'm also doing a startup and am talking with some big corporations just with getting to the right people and climbing my way to the top to sell my product.
Tyler Bosemany did a great talk about how to sell, i'd reccomend you watch it.
Another tidbit: Distribution kills a company, not the product.
Learn to sell (and make your product great) and everything will work out.
1) A first client to take a chance on you, because no one wants to be the first client, very few companies will buy something that no one else has bought. In my experience your first client (or first few) is the result of some existing personal connection to the client (i.e. a favour/referral), and expect to be at their beck and call for a while, and probably take a bath on the price.
2) You need an experienced sales team that knows how to sell to enterprise/B2B. This is not something you can "pick up" or learn on the job (or at least is very difficult to do). You need to hire someone who has done it before, otherwise you will stumble and spend your way through months-long sales cycles only to have them fail at some late stage because you didn't know how to prepare.
3) You likely need standards certifications and third-party testing. Look into ISO 27001 and other similar standards if you're a software company. Get third-party security testing done up front. Have pre-written answers and "white papers" around privacy, data governance, scaling, deployment, etc..
I've been on both sides of selling into enterprise and medium/large B2B and it's a solid 50/50 mix of your actual product capabilities and your company's ability to navigate procurement and due diligence.
It also depends on what you're selling of course. My experience is in data management solutions (including PII data), and standards/requirements can be pretty demanding in that world.
There is a trick to speed things up a little with Enterprise sales - find out who is an approved supplier for the enterprise you want to sell to and get them to “sell" your product for you under some sort of licensing deal, but where you actually do all the selling. This cuts out a huge amount of pointless activity dealing with said enterprise’s lawyers and purchasing people.
Also in my experience, being able to produce existing docs around your standards and processes, versus producing them on-demand, helps inspire confidence in the prospect's due diligence team, because it shows them you've thought of this before they asked about it. :-)
The article suggests that YC is reducing its stake to 4%, however the quotes presented don’t seem to be really saying that.
I’m not sure if this story is a technical announcement about how they handle pro rata, or an updated version of the YC Deal for newly admitted startups?
Companies can get lucky and look successful for a while, but they crash and burn just as fast.
YC only succeeds if they invest in the home-run companies. The lucky, flash-in-the-pan companies don't provide the returns YC needs.
YC's publicly-stated strategy from the very beginning has been to cast an extremely wide net, knowing that most wouldn't amount to much but the outliers would return enough to deliver a huge outcome overall.
And a key part of their strategy has been to be so founder-friendly that most of the promising startups would want to be part of their program.
If you look at the number of "unicorns" that have emerged since 2005, it's remarkable how many went through YC.
It's also notable that basically none of the spectacular boom-then-busts went through YC.
That's not "dumb luck", it's a well-thought-out strategy that has been proven to work extremely well over a decade-and-a-half.
Without another entrepreneurship catalyst (in the early 2010s it was the rise of mobile app markets and social media) we are unlikely to see the return of the accelerator model in its full glory.
They have no obligation to support the startup beyond the initial 7% investment more so for the Series A. Companies who can't stand on their own two feet and raise money on their own simply don't deserve to survive.
I actually wish YC would take it a step further and offer an option where they don't invest any money at all. You participate in the accelerator, have access to their resources, are part of the alumni but simply don't accept the $150k and 7% equity dilution.
I just know for many startups like mine $150k is basically worthless. It's not enough to hire and you just stay somewhere cheaper and commute into YC for the program.
As I understood it, the original intent was just to pay living expenses while doing the program and developing a minimum viable product. The intent was that the makers would own the company. It has strayed from that for better or worse.
$150k in the grand scheme of things isn't much: YC knows you'll raise a lot more and much faster right after demo day if you need to.
Maybe in the early days it was more like being part of a family that looked after you as you grew older. But now with the batch sizes being so large YC is much more like an industrial machine.
So over a period of time, we might see prorata moving to US startups fairly naturally . Given the other issues around travel in a post-COVID world, this will might to a return to US centric portfolio allocation.
In 2017, it was announced that YC was trying to raise a Billion dollar fund. How did fundraising turn out?
I've lost hope on the Silicon Valley dream and decided to just use my big brain to make money in public markets, which is surprisingly easy given how much effort the government puts into pumping up the stock market.
I used to think YC was great, I applied several times, but YC doesn't really represent what it used to anymore (to me at least).
Just my 2 cents.
It’s never been this easy to start a thing. Build stuff, get some users, see how much they pay. Then go from there.
Most funded startups these days just feel unnecessarily bloated. Over engineered, over staffed, building run-of-the-mill boring stuff you could slap together in a couple afternoons using 3rd party tools and some glue.
It doesn't really matter that I've done well on my own, or that I've been privileged enough to work at a few successful companies. You need either a lot of Twitter followers or a big name VC backing you before anyone will take you seriously.
Who is "they" in this case? Customers? Investors? Recruiting candidates?
In any case, I don't think this is true.
Customers don't buy a product because of who created it (in the vast majority of cases). They buy because it provides them value. Build something valuable and you'll get customers.
Once you have customers via creating something valuable, you have revenue, growth, etc. With this you can win over investors, recruiting candidates, heck even other potential customers.
Social proof might help a little, but probably not as much as you think.
If you want to start a company, you should get good at it.
Another way to think about it is: by writing comments like the one you wrote above, about the unfairness of it all, you're already marketing. You're just doing it badly.
I don't want to sound like I'm picking on you, because this is an incredibly prevalent handicap among smart tech people.
Convincing founders to give you money, finding employees and convincing them to join you, marketing or selling to customers are very important skills. But they are fairly diverse and I don't think there is a lot of overlap in the skill sets.
Even just something like "market to customers" can require very different skills depending on your budget, target customer, market segment and could involve such diverse skills branding, networking, inside sales, outside sales.
I think you're right they're very important but I think devs tend to way overestimate the overlap and underestimate how deep and diverse the knowledge bases are.
Generalizations based upon experience are perfectly valid when the market is not flat.
I suspect that there is lots of capital washing between insiders and very little outside the bubble.
the problem with statistics is you have to look how it's being used to figure out if you've got something lower than a damned lie or higher than an expert opinion. Which requires work and expertise of its own.
It's not really a secret that angel and seed funding has been steadily dropping since the mid-2010s.
With that said, I think that @brenden2 is overvaluing funding. Most people around here build software -- which can be easily bootstrapped. For those in hardware/biotech/energy/etc. it's much harder to get out an MVP without funding.
Overall I see the availability of seed funding as still quite high.
Very much agree with your last point about overvaluing funding. It's never been easier to bootstrap something for a year or two. Get an actual product working, maybe have a few users, and then go for funding to scale up. We see this in the data too with median company ages at the time of seed funding rising.
If you consider all the money thrown at unicorns ... maybe.
The $15-70 million range has been a desert for the past 4 years.
Everybody wants the unicorn or the $1 million 100x exit.
On your second paragraph, you may be amused to note that a popular theme in Matt Levine’s column is that “private markets are the new public markets”.
This story doesn’t add up.
1. VC funded company operates at a loss.
2. All incumbents are pushed out of market.
3. VC funded company has monopoly. They raise prices above the original “competitive-profitable price”.
4. New company enters market at original price.
5. VC funded company goes to the original price or goes bankrupt.
6. Anddd, we’re here again.
That’s just a better company.
Companies that have enough market power to crush smaller competitors tend to also drive the quality of products down. I’d prefer more high quality products to fewer “better companies”.
I’m responding to OP.
>> there is so much vc money sloshing about that one is constantly fighting competitors who operate at a loss to try to build monopolies
He’s claiming that VC companies use their warchest to undercut and ultimately force out incumbents.
> Most interesting companies aren’t building commodities like toothpaste.
Why is price less relative for “non-commodity” companies?
> Companies that have enough market power to crush smaller competitors tend to also drive the quality of products down.
Maybe? Peter Thiel talks about small margins in competitive industries leading to lower quality products because companies lack sufficient resources to innovate. eg, Google’s advertising domination lets them build high quality products like GMaps and GMail.
Note that often this low price for internet companies is 0 and many users will not put up with any price increase, so the VC backed company will fail once their monetisation strategy ( usually it’s “something something advertisers”) doesn’t pan out.
A small profitable business is harmed by the unsustainable competition at steps 1-2 and may struggle to hold out until step 3 (which likely won’t happen; going bust/being acquired and shuttered seem more likely to me) or 6
Another bigger problem is that the monopolist pushes the low cost of delivered goods or services on third parties (see the gig economy). That race to the bottom harms people, but there will always be takers for those jobs in any society without a good social security system.
Off-topic but do you have a recommended starting place or other ideas? I did well with some short positions recently but would love to explore more strategies.
When you are Stripe big, what does YC do for you that you can't do with your own money printing machine? Aside from cash, there must be other advantages to having investors.
Is picking winners difficult? Or is it that the economy has a hard cap on how many winners will occur every year?
Additionally, if you fund 100% of companies equally, if 1 becomes FB and 99 become nothing, dont the winnings from FB pay for the losses of the 99?
2) Yes that is how VC works.
1) People would definitely love a machine that prints gourmet food for them in their house, but it's really difficult to do that. It's so difficult that the amount of money it would take to make such a machine is pronably greater than all of the money in the world. This is what I mean by "the economy has a cap on the number of new ideas that can be funded"
- Product-market fit: Is there demand for our product? Is the timing for our product right?
- Customer acquisition: How can we make customers know that our product exists? How much does it cost to acquire a new customer (through ads, etc.)?
- Market size and profitability: Is the demand and profitability for our product sufficient to sustain a business?
- Building a viable product within the constraints of the runway capital (Uber for dog walking is not as capital intensive as building a self driving car fleet, for example)
I know talking to pre-seed and seed investors that they expect you to have enough data to be able to quantify whether people really love your product.
At that point you basically have customers and traction and so $150k for 7% looks like a major negative than a positive.
Would you say such companies are worth more the $2M on average?
So its a two tier system. We like you gorgeous, but not enough to sleep with you (sorry, invest in you).
Why not just pick the ones you will sleep with (sorry invest in). Why have the half way signal? If investors don't like investing pro-rata, that's not because they don't like making money - its because they think YC is not picking all winners.
Isn't that the problem? Competition?
Edit: Perhaps I need to understand raising finance better. But, re-reading the announcement as quoted, it still seems there is a two-tier system, and it looks to me that YC will have placed a bullseye on its shirt - if they will only pick 1/3 of companies, then any investor must assume YC has some extra information in the market for lemons - in which case the simple solution is just wait for YC to invest / SAFE / whatever, and invest in that. If a YC company tries to raise a round without a letter from YC, it just won't get anything ... ?
Instead of every investor now either making its own decisions, they just wait for YC to signal its own special knowledge.
I would like to see how many companies close a round without YC from now on?
So YC's decisions will impact meaningfully on the ability to raise subsequent rounds.
That probably was true for series B anyway, but now its true at the priced seed round.
I get it - its silly to throw gobs of money at companies that will fold next week, especially if you know they will. But ...
What's changing is the follow-on investments are not automatic. It used to be they would automatically exercise their right to maintain their 7% stake by investing more. Now they're going to maintain a smaller stake, and it's not going to be for every company. Only about 1/3rd of them.