Venture Firms Fret as Y Combinator Soars

Back in the day, top VCs would not be caught dead investing in an early stage seed funding. It was considered undignified. These were the firms that managed the best IPOs, that spawned the greatest tech ventures, that brought a value-add to their portfolio companies that was beyond measure as they would bring their formidable network of contacts into play for the benefit of their companies. And in return for their conferring such benefits on the ventures they expected to control things, or at least to have a formidable say in how things went. Yes, at the time of a successful IPO, they would convert to common stock just like the rest of the equity holders (though even there usually with the privilege of exercising registration rights) but before that they could and would exert liquidation preferences, conversion privileges, and control mechanisms in ways that left no doubt that they had the final say on most everything. And, if their interests clashed with those of the founders, it was not the investors who suffered. Top VCs valued their reputations and would tend to play it straight in not engaging in overt founder abuse. Yet the institutional mechanisms often gave them overwhelming leverage that left founders at a severe disadvantage: 2x, 3x, or higher liquidation preferences, full ratchet conversion adjustments on down rounds, etc. Lower-tier VCs went further and engaged in overt abuse on some occasions, to the point where the name "VC" often would make founders shudder.

Before YC, the only investors who actually took only common stock for their money were unsophisticated friends and family investors who didn't even know what preferred stock was. When YC came along, it took only common stock for its investment. Investors historically would look for ways to gain clout and squeeze founders through tactics such as 2x or 3x liquidation preferences in preferred stock rights, through lopsided conversion privileges used to wipe out founder interests in down rounds, through control tactics by which founders were put in defenseless positions and booted only to have the bulk of their founders' stock bought back at forfeiture rates, etc., etc. The persons being abused in such cases were primarily founders but the tactics wound up destroying or seriously compromising the interests of anyone who held common stock in such a venture. That sort of thing could prove very effective from an investor perspective when founders had no choice but to submit if they wanted the investors' money.

So founders basically had to come hat in hand to the VCs and play the game strictly by their rules, which amounted to the rules of a stacked deck. There is nothing inherently wrong with this. Money does indeed talk and, if founders wanted to take several million dollars as an investment from someone, they did what was needed to satisfy the investor requirements as they found them.

Y Combinator is an "accelerator" and all of that but what it mainly is is a VC firm that made the critical decision to align its interests with those of the founders right from the start.

So, out the window went the idea that a dignified VC would not soil its hands with a seed-stage investment. YC invested right from the start.

Out the window went the idea that a VC would take only preferred stock for its interest. YC took only common.

Out the window went the idea that a VC had to control the board, or at least had to have shared control, or at a minimum at least one board seat. YC left the board in the hands of the founders.

These innovations by themselves would likely have changed nothing but YC also built an incredible following of top founders inspired by Paul Graham and others who sought to build a network structure characterized by the highest level of talent. This too worked and YC companies thus got access to a rich treasure trove of resources that gave a value-add far exceeding that offered by a traditional VC firm. This in turn established YC as an omnium gatherum of much of what was and is best in the startup world.

With its interests largely aligned with the interests of founders, and with a formidable array of top founders populating its ranks, YC has set rules and norms for startup investing to which traditional VCs have had to yield if they wanted to partake in the opportunities. These have consisted of a shaking up of all the old assumptions of what VCs did or could do, with the result that top VCs today will invest early and often in funding for startups right out the gate, that top VCs will invest in convertible notes and convertible securities (SAFEs) in ways that were once unthinkable, and, of late, that top VCs (and other investors) will have to abide by some founder-friendly rules about whether or not they are permitted to use high-pressure tactics in structuring their offers, in whether or not the are permitted to yank term sheets without consequence, and in many other areas as well.

I have no doubt that YC did all this for its own interests as well as for a broader goal of using its investments to further its idea of the startup ideal. I also have no doubt that this phenomenon is fueled by broader developments by which founders are now well-connected and able to know and understand what is going on in ways that founders in, say, the 1990s had no clue about. None of it would have worked otherwise. Yet, founders are now well-connected, they know a sucker-deal when they see it, and they know value when they see it.

YC does not offer value for everyone. Many founders have no desire to give up 7% of their company for a little cash and access to the YC network. But, for many (and especially younger) founders, the value offered is phenomenal. Hence, the huge YC draw of top-talented founders. And that is where the action is. If the traditional VCs want a part of that, they perforce must conform to YC's expectations and founder-friendly rules. And they have done so.

Top VCs will continue to have enormous clout. But it is no longer lopsided the way it was a decade ago and before. It is now far more balanced and one of the big reasons is that a different style of venture firm in the form of YC came along to set new standards that now govern a big part of how the game is played. YC rethought the rules of being a VC and did it radically differently. It has paid off. The venture business will never be the same again.

There are two "black holes" in venture capital right now. One black hole is YC + angel investment. When you're getting started, it's pretty much standard practice to go through YC and/or raise seed capital from angels to get your startup off the ground.

The other black hole are a few top VC firms (off the top of my head, a16z and Sequoia). These firms pretty much figured out that it's impossible to predict success, so they're putting large amounts of capital into companies that are already succeeding. They've essentially eliminated guessing; they can get away with it because they established themselves as the VC firms you go to if your company is succeeding (so they have no issues with deal flow).

Then there are traditional VC firms in the middle, who can actually operate by perpetually losing money due to a slightly weird wider financial climate and the incentives of their LPs (see http://pmarchive.com/truth_about_vcs_part1.html, http://pmarchive.com/truth_about_vcs_part2.html, http://pmarchive.com/truth_about_vcs_part3.html).

So everything is much more complicated (and much more interesting) than the original post would lead you to believe!

Everything, even capital markets can be disrupted (or at a minimum greatly shaken up) by a dedicated player with a technological advantage.

And once the network effects kick in you're going to have a very hard time gaining back lost ground.

I predicted YC moving in on capital providers a while ago and I expect that trend to continue once YC has cashed out on their first batch of major hits. They'll be so flush with money that the only reasonable way to use it will be to do their own series 'A'.

Right now that's not in the cards and they should probably deny such a possibility as strongly as they could. But once the money is in they're going to be very much tempted to broaden the scope and become a two stage rocket even though there are obvious drawbacks to that strategy as well.

What all SV investors should be worried about is crowdfunding. Most of them don't have anything to offer beyond money and that doesn't count for much if users pay millions in advance.

Oculus took VC money but you can bet it was on incredibly advantageous terms due to their millions in kickstarter revenues. A16Z was merely the strongest among the weak and paid for the privilege of investing.

The fact that Oculus was immediately acquired for billions by a company Marc Andreessen sits on the board of is not necessarily a good outcome for the world. A fully crowdfunded Oculus may never had chosen that route.

Perhaps the commentary is transformational enough to make it arguable legal, but it seems entirely wrong to me.

Be sure to click on the annotations to see them.

http://profootballtalk.nbcsports.com/2013/07/12/jay-z-says-h...

It seems like YC currently doesn't have the whole Investor Relations infrastructure (or mindset of dealing with pensions) to get into the mainline VC business. I do think they are protecting their franchise against poor VC behavior though.

How is this different from a VC firm like Andreessen doing Series As for their top 3 seed companies? Isn't signaling part-and-parcel of the startup economy? Why should YC be worried about signaling when a firm like Andreessen isn't?

But come on, you can get over that, and to me this was the first use of Genius I've come across where I thought "Damn that was cool, I'll have to use this for more than the occasional lyric."

This was really cool to me because it provided an interactive forum for multiple relevant parties (Sam Altman and Marc Andreessen) to have a debate. I'll get over the funky UI for that content any day.