12 January 2022
by Oo Nwoye
Y Combinator (YC), arguably the most prestigious early-stage startup investor in the world recently announced a new deal for participants in their accelerator program. In addition to the agreement that provides $125K in exchange for 7% of the startup, they would be required to take an additional $375K as a SAFE (Simple Agreement for Future Equity).
Since then, every investor tailor worth their Twitter needle has sewn a thread about their thoughts ;).
Two popular ones I linked to above have come to similar conclusions, which more than a few people agree with – “this is kinda good for the founders but it is bad for early-stage investors, especially those in emerging markets”.
But is it?
I’d like to analyse this as someone that knows quite a bit about the early-stage investing ecosystem in Nigeria, one of the key emerging markets of the world and home to more than a few YC portfolio companies (>30). I’m also a stakeholder in a couple YC funded startups on a personal level, and via Ventures Platform which has an overlap of more than 15 companies with YC.
A Quick Overview
First, a rehash of the deal.
- YC gives $125K for 7%. This fairly straightforward deal gives the startup a valuation of $1.785M.
- YC gives an additional $375K in an uncapped SAFE, with a Most Favoured Nation clause. This applies to SAFEs or investments signed after the YC agreement (take note of the after, it’s key to analyzing the why and the fairness of the agreement)
[A SAFE – Simple Agreement for Future Equity is an agreement that allows you to invest in a startup with the equity it purchases defined at a future priced financing event. Typically a Series A.
A SAFE capped at $X means the maximum value of the investment would be at $X. An uncapped SAFE doesn’t have that defined valuation restriction, but usually has others like a discount, or in this new YC agreement, an MFN clause.]
Why did YC insert this new clause?
I’ll quote the announcement:
“It will remove the immediate pressure to fundraise and accept less than favorable terms”
How kind! Lol.
It’s true. But it doesn’t answer why. If it was mainly altruistic, it would have been optional but it isn’t.
YC is not a charity, it’s a business.
To understand why I think they made the move, you have to understand what I call the YC Bump, the YC Premium and the YC Arbitrage.
The YC Bump: This applies if you are a founder or an investor that invested in the startup below a valuation of the $1.785M which the initial deal carries. I have seen many founders go from not being able to afford 2 Million Naira and seeking sub $300K valuation to paper USD millionaires overnight (Hi Shola!). Once you enter YC, it doesn’t matter if you are an idea only, you are now $1.785M.
The YC Premium: Once you are through the 3-month YC program, your startup can raise money at a range of $8M – $30M valuation (for emerging market companies. FINTECHS skew to the higher end of the range). That’s a massive Bump from 3 months ago. And a bloody Premium for local investors that saw you 3 months ago, crawling for a $2M valuation. One man’s bump is another man’s premium.
The YC Arbitrage: Inbetween the initial bump (entering YC valuation) and premium (YC demo day valuation), lies the arbitrage. What is not commonly known about the YC $8-$30M raise is, that amount is what the last cheques come in at. So a company that ends up raising $1.5M at a $15M valuation, probably took the first $225K at $6M valuation cap, the next $400K at $10M, $475 at $13M and the last $400K at $15M val cap.
The reason for that is, you need to build momentum when fundraising. Too many investors are looking for others to go first before they put in money. As a founder, it is a bit unnerving not to have commitments leading up to demo day, so the early bird discount is used to get the momentum going.
In the past few years, a lot of funds have built their entire strategy around this. They contact YC companies while in the program, give them $225K at 3-5x on their YC entry valuation, and watch that do an extra 50%-100% in a few weeks on Demo Day.
Sweeeet! For the arbitrage investor. Niiiice for the founder. Hmmm… for YC who thinks “I am responsible for this bump!”
It is important to note that before now, YC also followed on investing in any of their startups that went ahead to raise a Series A. But what this meant is that YC waited until the company they helped succeed became really expensive again to buy more equity.
As my people say: who be mumu?
The implication and what’s next
With the Most Favored Nation clause, YC is putting another $375K at the best terms you get after you go through their accelerator. This means, if you planned to stagger your post YC raise, you must add $375K to the money you collect at the first step.
Using the same example, let’s compare both scenarios assuming a startup needs to raise $600K.
Pre new YC deal: You would have sold 7.7% of your company for a total of $625K. i.e first $225K at $6M, the next $400K at $10M.
Post new YC deal: You would have sold 10% of your company for a total of $600K. i.e first $225K at $6M + YC’s compulsory $375K at the $6M valuation.
[There is the argument that the startup will no longer have to raise a discounted round since they already have YC’s $375K. So the desperation that would have required the startup to stagger their raise from $6M would disappear. In that case they could raise it all ($600K) at $10M. Meaning 6% only will be sold.]
How will it affect startup fundraising dynamics?
Startups will no longer be ok giving a discount to first movers because of the equity dilution implication. The arbitrage investors will no longer be excited to pursue the strategy as the arbitrage window is essentially closed. Similarly, the investors that need to see investing momentum before committing will no longer see the momentum and will not count the $375K from YC as proof of momentum.
So what gives?
Local Nigerian investors have been grumbling quite a lot about the premium they get to pay post-YC. To be fair, the cost of capital (and the opportunity cost of capital) for Nigerian investors is not the same as their US counterparts. This would limit the participation of local angels post YC.
I very much subscribe to local investors on the cap table, I usually tell founders, “if Goddy hold your FINTECH licence, no be Michael go fit save you o”. Moving forward, there are two choices for local investors and founders who value local investors on their cap table. Olumide, a prolific Nigerian investor put it best.
My concluding thoughts
I think the move by YC though unfavourable to (mostly US based) arbitrage investors and a subset of early emerging market investors, is quite understandable.
If you are an emerging market investor, you should not wait for YC, a firm far away in Silicon Valley to show commitment to a startup before you do. So with this, I see the serious local investors investing with more conviction.
The risk to YC is that that conviction would mean many local investors ok with circumventing YC entirely. “If all you need to raise an A is the $500K YC gives you, we can give that to you too, and then handshake with the foreign larger investors. No need to go through YC”
The foreign investors would similarly, as Balaji likes to say, go direct! No need to wait for YC, go directly to the early-stage emerging market funds and investors.
Remember, one obvious sell for YC was “go through us and in 3 months, we will put you in front of teaming investors, which will give you the $1.5M+ you need to get to Series A”. If they are now saying $500K is all that is needed in the medium term thereby deemphasizing demo day, investors will try to go it all the way without YC.
YC would argue that they bring more than large valuations. That they help the founders build what people want! It is that, which brings money at huge valuations and great. I quite agree! I have seen it so many times. But that value is intangible, thereby mostly unseen.
How you pitch yourself is important. How people understand your pitch is importanter.
Prediction: before summer 2024, there will be a review of this new deal. What will change? Your guess is as good as mine.
PS:
Ha! This post is getting a lot of traction with early-stage investors, especially in emerging markets. If you’re an ACTIVE (> 5 deals in 2021) early-stage investor that bets with conviction, and looking for good African deal flow BEFORE they get into YC, feel free to holla! [email protected] (dot) ng.
1 comment |
Categories: Commentary, Startups, Uncategorized
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Tags: Investing, SAFE, YC, YCombinator
Thoughts on Y Combinator’s New Deal. A Perspective from Emerging Markets.
12 January 2022
by Oo NwoyeY Combinator (YC), arguably the most prestigious early-stage startup investor in the world recently announced a new deal for participants in their accelerator program. In addition to the agreement that provides $125K in exchange for 7% of the startup, they would be required to take an additional $375K as a SAFE (Simple Agreement for Future Equity).
Since then, every investor tailor worth their Twitter needle has sewn a thread about their thoughts ;).
Two popular ones I linked to above have come to similar conclusions, which more than a few people agree with – “this is kinda good for the founders but it is bad for early-stage investors, especially those in emerging markets”.
But is it?
I’d like to analyse this as someone that knows quite a bit about the early-stage investing ecosystem in Nigeria, one of the key emerging markets of the world and home to more than a few YC portfolio companies (>30). I’m also a stakeholder in a couple YC funded startups on a personal level, and via Ventures Platform which has an overlap of more than 15 companies with YC.
A Quick Overview
First, a rehash of the deal.
[A SAFE – Simple Agreement for Future Equity is an agreement that allows you to invest in a startup with the equity it purchases defined at a future priced financing event. Typically a Series A.
A SAFE capped at $X means the maximum value of the investment would be at $X. An uncapped SAFE doesn’t have that defined valuation restriction, but usually has others like a discount, or in this new YC agreement, an MFN clause.]
Why did YC insert this new clause?
I’ll quote the announcement:
“It will remove the immediate pressure to fundraise and accept less than favorable terms”
How kind! Lol.
It’s true. But it doesn’t answer why. If it was mainly altruistic, it would have been optional but it isn’t.
YC is not a charity, it’s a business.
To understand why I think they made the move, you have to understand what I call the YC Bump, the YC Premium and the YC Arbitrage.
The YC Bump: This applies if you are a founder or an investor that invested in the startup below a valuation of the $1.785M which the initial deal carries. I have seen many founders go from not being able to afford 2 Million Naira and seeking sub $300K valuation to paper USD millionaires overnight (Hi Shola!). Once you enter YC, it doesn’t matter if you are an idea only, you are now $1.785M.
The YC Premium: Once you are through the 3-month YC program, your startup can raise money at a range of $8M – $30M valuation (for emerging market companies. FINTECHS skew to the higher end of the range). That’s a massive Bump from 3 months ago. And a bloody Premium for local investors that saw you 3 months ago, crawling for a $2M valuation. One man’s bump is another man’s premium.
The YC Arbitrage: Inbetween the initial bump (entering YC valuation) and premium (YC demo day valuation), lies the arbitrage. What is not commonly known about the YC $8-$30M raise is, that amount is what the last cheques come in at. So a company that ends up raising $1.5M at a $15M valuation, probably took the first $225K at $6M valuation cap, the next $400K at $10M, $475 at $13M and the last $400K at $15M val cap.
The reason for that is, you need to build momentum when fundraising. Too many investors are looking for others to go first before they put in money. As a founder, it is a bit unnerving not to have commitments leading up to demo day, so the early bird discount is used to get the momentum going.
In the past few years, a lot of funds have built their entire strategy around this. They contact YC companies while in the program, give them $225K at 3-5x on their YC entry valuation, and watch that do an extra 50%-100% in a few weeks on Demo Day.
Sweeeet! For the arbitrage investor. Niiiice for the founder. Hmmm… for YC who thinks “I am responsible for this bump!”
It is important to note that before now, YC also followed on investing in any of their startups that went ahead to raise a Series A. But what this meant is that YC waited until the company they helped succeed became really expensive again to buy more equity.
As my people say: who be mumu?
The implication and what’s next
With the Most Favored Nation clause, YC is putting another $375K at the best terms you get after you go through their accelerator. This means, if you planned to stagger your post YC raise, you must add $375K to the money you collect at the first step.
Using the same example, let’s compare both scenarios assuming a startup needs to raise $600K.
Pre new YC deal: You would have sold 7.7% of your company for a total of $625K. i.e first $225K at $6M, the next $400K at $10M.
Post new YC deal: You would have sold 10% of your company for a total of $600K. i.e first $225K at $6M + YC’s compulsory $375K at the $6M valuation.
[There is the argument that the startup will no longer have to raise a discounted round since they already have YC’s $375K. So the desperation that would have required the startup to stagger their raise from $6M would disappear. In that case they could raise it all ($600K) at $10M. Meaning 6% only will be sold.]
How will it affect startup fundraising dynamics?
Startups will no longer be ok giving a discount to first movers because of the equity dilution implication. The arbitrage investors will no longer be excited to pursue the strategy as the arbitrage window is essentially closed. Similarly, the investors that need to see investing momentum before committing will no longer see the momentum and will not count the $375K from YC as proof of momentum.
So what gives?
Local Nigerian investors have been grumbling quite a lot about the premium they get to pay post-YC. To be fair, the cost of capital (and the opportunity cost of capital) for Nigerian investors is not the same as their US counterparts. This would limit the participation of local angels post YC.
I very much subscribe to local investors on the cap table, I usually tell founders, “if Goddy hold your FINTECH licence, no be Michael go fit save you o”. Moving forward, there are two choices for local investors and founders who value local investors on their cap table. Olumide, a prolific Nigerian investor put it best.
My concluding thoughts
I think the move by YC though unfavourable to (mostly US based) arbitrage investors and a subset of early emerging market investors, is quite understandable.
If you are an emerging market investor, you should not wait for YC, a firm far away in Silicon Valley to show commitment to a startup before you do. So with this, I see the serious local investors investing with more conviction.
The risk to YC is that that conviction would mean many local investors ok with circumventing YC entirely. “If all you need to raise an A is the $500K YC gives you, we can give that to you too, and then handshake with the foreign larger investors. No need to go through YC”
The foreign investors would similarly, as Balaji likes to say, go direct! No need to wait for YC, go directly to the early-stage emerging market funds and investors.
Remember, one obvious sell for YC was “go through us and in 3 months, we will put you in front of teaming investors, which will give you the $1.5M+ you need to get to Series A”. If they are now saying $500K is all that is needed in the medium term thereby deemphasizing demo day, investors will try to go it all the way without YC.
YC would argue that they bring more than large valuations. That they help the founders build what people want! It is that, which brings money at huge valuations and great. I quite agree! I have seen it so many times. But that value is intangible, thereby mostly unseen.
How you pitch yourself is important. How people understand your pitch is importanter.
Prediction: before summer 2024, there will be a review of this new deal. What will change? Your guess is as good as mine.
PS:
Ha! This post is getting a lot of traction with early-stage investors, especially in emerging markets. If you’re an ACTIVE (> 5 deals in 2021) early-stage investor that bets with conviction, and looking for good African deal flow BEFORE they get into YC, feel free to holla! [email protected] (dot) ng.
1 comment | Categories: Commentary, Startups, Uncategorized | Tags: Investing, SAFE, YC, YCombinator