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Comment by coherentpony | Hacker News Reader

What does this mean?

I have zero business acumen and have no familiarity with investing or how new companies work.

Funding rounds dilute preexisting investors. One of the possible terms in an investment contract are pro-rata rights for investors, giving them the right during future financing rounds to invest more money to maintain their percentage ownership. Thus an early seed investor who gets 5% of the company for 500k can ensure they retain 5% of the company in the A and B rounds, so long as they're willing to fork over the cash for the top-up shares at the A and B round valuations.

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.

Thanks for the explanation.

> 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?

Yes

How often are pro rata rights not exercised by a VC?

This sounds analogous to poker.

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)

Thrown away? YC will save time and energy required to analyzing the deeper aspects of each startup they might want to invest in. If a YC company raises then someone believed in them enough, so in a way for YC it is more of a positive where they can piggyback on someone elses' due diligence (hopefully).

> Funding rounds dilute preexisting investors.

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...

My interpretation is that now you own a smaller percentage of a more valuable company and in theory your dollar value stays the same.

Your dollar value should actually increase (assuming we're not talking down rounds). You still have the same amount of shares, but an "up round" means that each share is now theoretically worth more than it was when you bought in. Practically, however, it's hard to put a true "value" on the shares until an actual sale of the Company or IPO.

The company is not actually selling "five percent of itself". It's selling shares, and the number of shares in the whole company is a board decision.

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.

It's done with the permission of a majority of shareholders (and any the remaining shareholders had agreed that this is a sufficient condition when they bought shares).

if you are a YC company, they own a percent of your company (usually around 7%). If you raise additional funding later, this will dilute every shareholder's percentage down to accommodate the new investor.

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.)

Thanks for the explanation. Between you and tptacek I think I understand what's going on.

Related: is there some reliable "startup jargon for dummies" page somewhere? I'm often confused with all the talk of rounds, vesting, dilution, and whatnot. I know there are books, but I'm not planning to get into the startup scene; buying a book doesn't seem worth it to be slightly less confused on a website I waste lots of time on.

I second this request. Google took me to investopedia to learn "pro rata", but that wasn't as helpful as reading these comments. The startup community has so many buzzwords. My understanding of the jargon has increased a lot in the past year I've spent time on the site, but I still don't know much.

Round: Some people are purchasing shares of your company. Given cute names to indicate how many "rounds" you've done: Seed, Series A, Series B, Series C, Series D, Series E, etc

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.

literally query that search phrase, and the top 5-10 sites answer your question https://www.google.com/?q=startup%20jargon%20for%20dummies

I've done that, but I was more wondering if there was some place (a blog series or something) that people here would actually recommend. The top hits are all just lists with single terms like "B-to-C" and the like. They're fine if I need to know a single term, but don't really explain much else.

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.

I get your meaning now, fair enough. I think most of what you are interested in are financial/accounting terms, I don't know how specific they are to startups, other than most startups are built upon promises of finances.

How about http://www.accountingcoach.com/stockholders-equity/explanati...

Venture Deals by Brad Feld and Jason Mendelson: http://www.amazon.com/Venture-Deals-Smarter-Lawyer-Capitalis...

http://venturehacks.com/ It doesn't get updated anymore, but I think it should have a lot of the basic venture concepts here.

http://www.amazon.com/Maxims-Morals-Metaphors-Venture-Capita...

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!

Pro-rata means that early investor reserves its right to participate in future financing rounds, up to such amount as to maintain their ownership share.

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.

Early round investors would be diluted by subsequent rounds, so they protect against that by putting the pro-rata provision in the contract that lets them invest in later rounds (so that they can reverse the dilution).

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.

I am sorry, that really cracked me up. I hope you have business acumen > 0, for your sake :)

I'd rather post a question here and learn something with the goal of attaining nonzero (but positive) business acumen than to say nothing and set myself up for a possible failure in the future.

It might also be the case that someone else learnt something too.

of course, I agree, I wasn't critical of your post. I just found it amusing that you think you have zero business acumen. Apparently, those who downvoted me have no sense of humor :)

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