The blogo/twittersphere is abuzz about the recent offer of $150K to every YC startup. You can read about the details here at 90% of Y Combinator Startups Have Already Accepted The $150k Start Fund Offer. You can also read a range of thoughts collected by Jason Calacanis on his blog, Angels+VCs are pissed off about Yuri/Ron Conway/YC deal-big time.
Initially I was miffed about it – it kind of pissed me off. At the last YC, I already felt like I was competing severely to get into investment rounds, having not mentored them and coming in late to their rounds even at the first Demo Day. Now it would be even harder. But then, after thinking about it, I am still sore about it, but that doesn’t mean it wasn’t brilliant.
And brilliant it is. For Ycombinator and its startups, and SV Angel/DST, it is totally the right move. Here’s why:
1. I’ve always felt that every YC class, there were the stars that would get funded no matter what, and there were the ones that would fail no matter what. But, in between the stars and the certain fails there was a huge grey area of the startups who have a harder time to get funded because if only they have a bit more time, runway, money, and advice, they could actually get somewhere fundable with their projects. But, without further support after the YC time period, many would inevitably just wither and die. Now the have a longer runway given the $150K and have more time to prove out their ideas and/or pivot if necessary to something more fundable. Because of this, more YC’s startups have a better chance of survival and, thus, giving YC a better chance at making more money.
2. More power has shifted to the entrepreneurs with this move at least in YC for sure. The world recently had moved from a combination of preferred equity rounds and convertible note rounds with caps to this note without a cap. Convertible notes without caps are very company friendly instruments into which investments are taken.
3. For SV Angel/DST, now they have a bets on most of the YC’s startups and now will be less likely to have been shut out of a round. If you’ve been following YC (I’ve been watching the quality of YC startups since March 2008), you’ll have noticed that the quality of startups has grown dramatically with each new class. It is not an inconceivable notion that there will be a big game changing startup that comes out of YC as time goes on. So creating a relationship where SV and DST can place bets on a lot of them, if not all, before the rest of the world gets to them is a good thing for them.
What about side effects? I’ll throw some out there:
1. I think that the opinion that angels will find it less appealing to invest in YC startups in this class is correct. Here’s why:
a. Before this $150K, YC startups only got $5K + $5K/founder. This mattered most to the startups who began life in/around the YC class. (NOTE: Each class, more startups who have been around for a while and willing to give up substantial common stock for a chance to go through YC are being accepted. For these startups, the $150K matters less.)
Given the ramen nature typical of YC entrepreneurs, that $150K means that many will not choose to raise any more money at all since they can go a long way on that much cash, conceivably ten times as long as their YC investment of ~$15K! So if these guys survived for about 2.5 months for only $15K, would they be able to have 10×2.5 months = 25 more months of runway?
Some of the startups may choose this route and if they are good, then we will miss the opportunity to invest in them now. Some time down the road, they will presumably have more progress and investing in them at that point will undoubtedly mean a higher valuation which is appropriate given their further progress. But higher valuations for an angel means less of chance to make a lot of money.
b. I believe that some of the startups will choose to raise additional capital on the terms of the convertible note w/o cap. This is also less attractive for an early angel investor because it means that we will not have established a potentially lower valuation for the early stage at which we would put money in. Instead, that valuation will come later, also presumably with more progress. Thus, we would put money in and not get any reward for early risk.
Why wouldn’t a startup raise more money with another new convertible note with cap? I think some will, but some will not because they do not want to anger their previous investors, DST and SV with a structure that has more advantageous terms. I have not seen their note, so potentially it may have some terms in it to adopt the terms of succeeding rounds if they are more advantageous.
Some startups will just believe that they are justified in raising further money on these terms and not change. With the infusion of new investors around, I believe they will be able to close their rounds even with some of the more professional or experienced angel investors declining the opportunity.
Still, even if a lot of professional/experienced investors declining, I think there are enough professional/experienced investors will still take the deal, operating on the assumption that there will still be a high probability of a great outcome on a startup which is doing well.
2. This is still OK for venture capitalists. For the later stagers, they wouldn’t have invested in a YC startup at early stage anyways and will just wait for them to come to them after they have matured more, like they always have. The early stage funds might not like getting into a hot YC startup early with a higher valuation, but they probably still have the ability to make money if a startup takes off, especially if they have reserved funds for follow-on investments. The majority of angels, in contrast, rarely make follow-on investments.
3. Paul Graham is highly respected, if not worshipped by all the would-be and current entrepreneurs. What happens in YC inevitably affects the larger community. YC startups have already had their pre-money valuations drift higher and have already moved towards note with caps and we’ve seen non-YC startups do the same. Now I’m sure there will be many that will now try to raise with notes without caps. While the not-so-great startups will try and still be declined, the hotter ones will be enboldened and will hold firm to notes without caps. Because they are hot, they will get funded no matter what. I have not seen any pattern to the contrary on this issue; money is not a problem for startups especially if they are hot and/or popular.
So yeah, I’m still sore that potentially this could mean that it may not make sense that I should invest in some of the better startups in the Valley, which will come out at this next YC class. But like all things in business, you do what you do to gain an advantage over others in your space and Ycombinator, along with SV Angel and DST are doing just that. For that reason, I’m sore, but also I cannot help but applaud their brilliant move.
On the other hand, I’m now, more than ever, thinking on how I can build my own brand, reputation, and value to entrepreneurs so that I can still get into the rounds at the time, terms, and valuation that will make sense for me to participate.