Pro Rata
blog.ycombinator.com
blog.ycombinator.com
YC is an innovative venture capital firm whose model depends heavily on its maintaining credibility with the talented founders who run the ventures it funds. In this sense, it has caught the spirit of the age brilliantly and that is why YC stands out as one of the premier investment firms of our era.
A key element in this approach is for YC to do what it has done all along and that is to take common stock instead of the almost sacrosanct preferred stock that VC firms have always insisted on in the past. This radical innovation in VC-style funding has set YC apart from the pack of VC firms, incubators, and any and all other manner of investor wanting to hitch their wagon to the talented founders who are capable of building successful, massively scaling ventures that seek to transform all of world commerce. Its importance cannot be emphasized enough as a key to YC's success. It has enabled YC both to be in the midst of the fray and to stand above it, all at the same time. It is the founder's ally even while it benefits mightily as an investor.
What then to do after the founding stage to avoid dilution to its initial investment stake without jeopardizing credibility with founders? If YC were to pick and choose in participating in early follow-on rounds, this would selectively help and simultaneously hurt the various founders it works with. Almost by definition, the fact of such an investment would brand some YC ventures as in and others out of YC favor, a result that would prove highly damaging to the aura of goodwill that is not only helpful but absolutely indispensable for YC to maintain with its founders.
So how to maintain that goodwill and still avoid subsequent dilution in the various investment rounds that inevitably follow from the inception of star-quality companies?
Well, you can set up some fixed rules, make such follow-on pro rata investments automatic within the defined bounds that make sense for YC, and use that as a way of extending YC's leverage to help it keep the 7% (or whatever) stake it begins with in each venture.
And that is precisely what YC has done here with its pro-rata program.
Founders usually have no problem with early stage investors being able to participate pro rata in later rounds as long as they are significant investors and as long as such participation does not jeopardize their ability to raise later-stage money on good terms.
YC is of course a significant investor.
As to jeopardizing future funding terms, I believe YC has made a judgment call here that the investors it typically works with will have no problem taking something less than their accustomed full pieces in the later rounds to accommodate YC and will therefore continue to finance YC ventures exactly as before. Hence, no prejudice to founders and no loss of goodwill or credibility among founders.
I believe this is a sound calculation. YC has been able to persuade VCs to deviate from a variety of their traditional rules/requirements as part of being a part of the YC universe. This is just one more to be added to the list. It is a world of increased founder leverage and that means investors who want to stay with the deal flow need to adjust and adapt. I think they will do so here as well.
In a worst case for YC, this might prove a failed experiment. But the downside of the experiment's failing is minimal while the upside in being able to avoid later-stage dilution among a vast group of potentially valuable ventures is huge. Thus, this makes eminent sense for YC for sure and probably for its founders too. As for the VCs who will have to adapt a bit, they will survive and very likely continue happily investing just as before. At least that is how I read it.
(Sorry couldn't help myself.)
If a VC wants to own 20% at the end of an A, or 10% after a B, having YC in there with rights to buy back up to their 7% can add real dilution you wouldn't have otherwise wanted or needed to incur. As someone who did a party round seed and had a crowded A, it really does add up; though, it's for sure a first world problem and won't kill you, whereas YC for many companies is when they get serious.
YC is so valuable that this won't turn anyone off at the traditional YC early stage, but I wonder how this will affect things for the "late-early" companies they've been taking more of in the last few batches.
You are right that it does substantially change things for ownership conscientious investors.
There are myriad other issues as well, perhaps the two most interesting are:
1. When I went through YC, it was emphasized that YC had the same equity situation as founders. That's certainly not the case now.
2. Pro rata is often an actively managed situation, I'm curious how YC will handle situations where founders/future investors seek to retroactively adjust pro rata
The VC then has respect for the founder and say "OK, let's do it."
If they don't respect the prorata of the existing investors you need to ask yourself if this is the right VC to have as a partner. If they are so encouraging of you to screw your existing partners, how do you think they will treat you in a down market?
So if you have 30% right now, you would have either 24% without YC taking part or 23.4% if they do.
I may not be fully understanding the situation, but it seems to me that the only time YC exercising their option would create a lot of friction is when the round leader has a problem with YC's participation. While not a red flag, that would certainly be the subject of an important conversation.
In the end, raising money is a founders' bet that the funders are trustworthy.
I've always thought being an LP in YC would be fantastic because of the valuation bump companies get on demo day. Let's say a company could raise money at $5mm valuation, but instead gives 7% to YC, and as a result can raise at a $10mm valuation => (1) founders win by keeping more equity, (2) YC wins by their investments getting cash with less dilution, and (3) post-YC investors pay more (maybe still great investments, but not as good as getting in at $5mm).
But to maintain 7% in companies up to a $250mm valuation, it seems that the vast majority of YC's deployed capital will be in the place of what was previous a "post-YC" investment.
YC should still be in the business of finding great companies, but might not makes sense for them to help get gangbuster valuations at demo day.
"we believe investing in YC companies at post-YC valuations is still a great deal"
but also says this (from the post):
"And by doing this in every YC company, there will be no signaling issue of us supporting some companies and not others."
So how can you have both statements be true?
In other words how can you say "still a great deal" and also acknowledge that you are investing in all companies, not only ones that are a "great deal", simply so there is no signaling?
I can see how this could easily turn out in YC's favor. For one, the really obvious failures often flame out during YC itself and fail to raise follow-up funding, and so YC wouldn't have any obligation there anyways. And the really big successes become worth far more than $250M, enough to subsidize many failures.
The big question for me is what it does to incentive alignment - it seems like YC now has an incentive to ensure that companies it doesn't like don't raise follow-up funds, as well as incentives to get lower valuations on the early funding rounds. It also in theory should make them pickier about their application process, knowing they're committed to participating in any follow-up rounds. On the plus side, they have an incentive to ensure that promising startups do raise follow-up funding (rather than go out of business), it avoids some of their misaligned incentives relative to the rest of the investment community, and they have an incentive to keep helping their investments later in life.
YC already has incentive to do this; their post-dilution stake in wildly successful companies still shakes out as being far from trivial.
That said, it would certainly be fair to say that these changes probably do serve to strengthen existing incentives.
Let's look at a company who takes $120k from YC in exchange for 7% equity. On demo day they get term sheets for (A) $10mm at a $20mm post-money valuation, and (B) $10mm at a $250mm post-money valuation
In either case the pro-rata vehicle has to take down $700k of the $10mm to keep the 7%. As long as the pre-demo day and post demo-day money are coming from the same fund, it's all good
But let's say the terms sheets are: (C) $10mm at a $250mm post-money valuation, and (D) $50mm at a $250mm post-money valuation
Term sheet (C) requires the same $700k, but term sheet (D) means YC has to shell out $3.5mm.
If you're less than excited about this particular company, would you be more likely to mention that "$10mm is plenty of cash and term sheet (C) lets the founders maintain far more equity"?
I doubt it. And conflicts of interest don't necessarily cause problems. But, this clearly going to cause friction at some point.
Whether this is good or bad for a founder depends on what they're using YC for. It may remove the immediate valuation "pop" from the calculus: right now, YC is almost worth it regardless of what they do because whatever equity they take ends up coming out of future investors' shares through the the valuation pop, and that effect may disappear. OTOH, it also means that YC can be expected to help provide advice and introductions throughout later rounds as well, as they maintain their financial incentive all the way up to $250M.
It seems to fit with YC's stated mission of trying to build more sustainable, world-changing businesses, along with other actions they've taken like experimenting with late-stage funding and taking on more partners with operational experience.
I have zero business acumen and have no familiarity with investing or how new companies work.
This is an important part of VC strategy. VCs invest in, say, 10 companies, expecting 8 to fail outright. The 2 winners need to make up for the 8 losers. But the investor can't see into the future to figure out which are the 2 winners. Pro-rata rights give them some optionality: by the time the A round happens, it'll be clearer to the investor whether they should have plowed more money into that company, and pro-rata lets them do that.
The problem for YC is that each YC batch has 30-50 companies in it, most of which will fail. When those companies go to raise later rounds, new investors want to know whether YC believes in them. If YC exercises pro-rata rights on just some of their companies, the ones that don't see the exercise are damaged goods. So instead, YC is committing themselves to pro-rata all their companies (this is a lot of companies) so long as they can afford it.
Does this mean a bunch of money is being thrown away on signaling?
Buying in later rounds if you think it is worth the investment, and spending money on 'signalling' - i.e. money spent to not reveal what you are really thinking.
(This is just an observation. I am not implying that this strategy is like gambling or anything like that)
How / why? I tried Googling this and it's left me more confused. If I purchase 5% of a company, and that company later gets other investors, assuming I do nothing, how can I end up with less than 5% of the company? One of the answers[1] I found says,
> The company creates new shares to sell when the financing event is imminent. Thus every existing holder gets an equal amount of dilution, and the number of conceivable rounds is infinite.
By doing this, how is the company not effectively selling something that isn't theirs? (the portion of the company that I thought I owned, that is now "diluted"?)
[1]: http://www.quora.com/How-does-equity-dilution-work-when-a-st...
In serious financing rounds, the company sells preferred shares which have shareholders agreements attached that might protect investors against dilution, for instance by allowing those shares to convert into common shares at a rate that accounts for any dilution.
In practice, dilution as a simple function of outstanding shares is a fact of life, expected by everyone who invests.
Traditionally YC did not have Pro Rata, which is the right to basically participate in the new round, to retain their original ownership percentage.
Scenario: YC owns 7% New investor comes in and buys 20% YC dilutes 1.4% (which is 20% of their shares)
With Pro Rata, YC could participate in the new round up to 1.4% of the total price of the company to maintain their 7%.
Why this can be important: VCs are like beautiful but often panicky gazelles. They are easily spooked, and find comfort in the direction the herd is going.
If an investor in a company in the previous round doesn't reinvest, this may look bad and cause them to back out.
If YC invests in everyone's Pro Rata, it means that there'll be no apparent signal for the gazelles to act on. They'll hafta rely on their own judgement (crazy, I know.)
Vesting: When you actually get the shares (instead of just being promised you'll receive them)
Dilution: When the pool of shares expands without the existing shareholders receiving a commensurate proportion of the new shares (used to transfer value from existing shareholders to new). Usually occurs after each Round completes.
If you're looking for a really short book with a good explanation of the entire process. The cover is a bit funny as the book is a bit old, but the information inside is still very applicable.
Edit: The content is much more about the sayings and metaphors used within venture capital. It will complement the other suggestions nicely!
For example: this article (http://www.techrepublic.com/article/glossary-startup-and-ven...), gives the definition for "preferred stock" (a random selection) as "stock that carries a fixed dividend that is to be paid out before dividends carried by common stock." As someone not in the startup business (and not knowing much about finance in general), this is not really helpful. I'm not sure what it means for a dividend to be fixed, nor is there a definition of "common stock" anywhere.
I realize this isn't really the right thread to ask, but these things come up all the time so it seems like there might be a respectable reference somewhere online.
How about http://www.accountingcoach.com/stockholders-equity/explanati...
YC did not do it before, but will start doing it now. They do not want to be leading investor, however, b/c if they do follow-up investments in one company but not the other, that would signal other investors their preferences, and will make financing prospects of companies they did not subsequently invest in, difficult.
In the past YC decided not to exercise this right because if they did so selectively, it could be used to indicate what YC thinks about a company, which is mostly bad for those that didn't get re-investment.
The change is that YC is now going to have an objective, public criteria for exercising this right, so it can't be used as a signal, but YC partners/investors can get the benefit of the rights they negotiated for.
It might also be the case that someone else learnt something too.
YC companies to date have raised $3bn in total so far, with a couple dozen above $100m out of just over 800.
Therefore at most YC would have invested $210m if they'd done this from the start.
It basically adds up to a couple hundred thousand on Series A, 0.5-0.8m series B, $1-2m at series C, then at series D you'd hope to be approaching $250m
Given a propertied fund size of $1bn this makes sense in backing winners probably funding 200 companies a year at $200-300m/year, particularly as major pickup in valuation is A to C
A run rate of $2-300m if its a $1bn fund (suppose you'll let everyone know soon!) would make sense
18 YC companies have raised >=$50million - http://www.seed-db.com/companies/funding?value=50000000
http://www.2-speed.com/2014/09/dreaded-major-investor-clause...
Of course, 7% might be enough to overcome the threshold in many cases, but as an angel investors in YC deals, I have lost my pro rata rights following a YC Note/SAFE conversion this way (despite the docs suggesting I am protected).
That blog post is helpful but not the best source of info. For one, it confuses preemptive rights (right to buy a % of future financing) with first refusal rights (right to buy shares from other current stockholders who try to sell). And second, it's rather one-sided. Companies understandably want to limit these rights to only big investors for a number of reasons but especially because (1) it really can be expensive/time consuming to continually contact or chase down signatures from an investor base that eventually might include dozens of people/entities, (2) it can make it really hard to convince new investors that the investment will be worthwhile when there are pro rata rights to buy up a huge chunk of the round and (3) there's a major signalling problem when the prior angels have these rights but choose not to use them (the author mentions that he always demands these rights but doesn't always use them, which can scare off other investors and, what's worse, many angels will decline for innocuous reasons such as a seed-stage only investor who never does follow-ons or a smaller angel who is priced out by a high valuation).
In the universe of unicorns and rainbows, YC's participation puts the rest of a round's participants on their good behavior to reduce risk on future deal flows and the founders get a better deal. The situation in the universe with evil Spock is of course different, but it was going to turn out that way in that universe. In between a founder could probably ask YC not to participate. Since the investment is blind and YC is under scrutiny by potential founders, it may not be in YC's interest to force the issue and suffer Tweets of outrage.
The potential problem is a bad cap table and the first order issue is VC that treats that as an acceptable byproduct of a round it is leading or a company that does not have better options.
Given the rather poor returns of the VC sector overall, I'm not sure you can make this assumption without more qualification.
* ...only not-completely-screwed-up-trainwrecks will raise future rounds...
... companies that aren't able to raise further rounds will fail...
Once you realize that you could either stop funding companies after graduating altogether or invest in all of them, both of which remove the signal. With the funds they have, clearly there is considerable risk tolerance for the latter.
Given YC's history and reputation of being very supportive of founders, any founding team is also probably better off with YC taking a cut in a round that would otherwise go to another investor, especially given that the list of investors who are as founder-friendly as YC is pretty short.
Couldnt that keep outside investors away?
> We will try to do this for every company in every round with a post-money valuation of $250 million or less.
"But starting in the Summer of 2014, we added a pro rata provision to our standard investment documents, and starting now, we're going to aim to support all YC companies in future financing rounds by doing our pro rata. We will try to do this for every company in every round with a post-money valuation of $250 million or less."
Right, because it's a signal that you think the business is worth this round of investment. Since you set this up as not being a useful signal, I think the investors will probably seek out signal from you behind the scenes.
Perhaps this is ok, since it won't be public and won't have the effect of a negative signal for the ones you don't give secret signal to.
EDIT to clarify: I believe new investors "like to see support" because it's a signal. If it can't be used as a signal (as will now be the case), they will seek signal anyway (in informal ways). I think they will do this by feeling out YC through back-channel communications and "kremlinology" type interpretations (even if YC tries really hard not to signal)