Why Seed Venture Capitalists Don’t Like the Terms of Y Combinator’s New Deal

  • Y Combinator has increased the amount of money it invests in startups from $125,000 to $500,000.
  • But investors told Insider that his new investment terms had pushed valuations to extremes.
  • As a result, they said, some venture capitalists are turning away from investing in YC’s latest round of startups.

In January, Y Combinator increased the amount of money it offers to startups in its famous accelerator program. But the terms attached to that cash have prompted complaints from early-stage venture capitalists, who say the changes have made it unreasonably expensive to invest in startups coming out of the accelerator, which counts Airbnb and Dropbox as alumni. .

Y Combinator is now offering startups $500,000, up from $125,000. The money comes in the form of two notes, or financial instruments used by investors that convert VC money put into a startup into an equity stake once the startup raises additional funds.

One of the notes provides $125,000 in exchange for 7% of the future capital at start-up. The other note implies an investment of $375,000, but does not specify a percentage of capital. Instead, under a provision called a “most favored nation” clause, Y Combinator will receive additional capital on terms more favorable to investors than those of subsequent investors in a startup.

For example, if the startup raised new funds at a valuation of $5 million, Y Combinator would receive 7.5% equity on top of the initial 7% awarded.

After YC announced the deal in January, some investors worried that the founders would raise additional rounds after YC’s investment at higher valuations so they could keep more capital in their startups. Y Combinator makes startups agree to sell more ownership of their companies when seeking investors in their next rounds, meaning less of the company is available to sell to those investors.

And it seems that for some seed-stage investors, these concerns are being actualized.

“This is the year that venture capitalists just say no to YC,” Ian Rountree, founder and general partner of early-stage venture capital firm Cantos Ventures, he tweeted in early April. Cantos has invested in several Y Combinator startups, including Solugen, Advano, and Sixfold Bioscience. Other early-stage startup investors echoed Rountree’s sentiment.

Several investors told Insider that these changes had prompted startups to seek higher valuations in funding rounds so as not to give up inordinate capital in their companies. They said the valuations attached to many Y Combinator deals now fall within a range of $20 million to $30 million, well above the $15 million that PitchBook identified as the top percentile of valuations for completed early-stage deals in 2021.

Elizabeth Yin, co-founder and general partner of early-stage venture capital firm Hustle Fund, told Insider that she was reluctant to pay such high prices for seed startups, which typically lack revenue and often have a business that is early and untested.

Hustle Fund has backed Y Combinator alumni like Karat, Doola and Vendease. Yin recounted two instances where she was able to get “great terms” from off-accelerator startups, with valuations of $4 million and $6 million. But now, she said, given the terms of Y Combinator’s additional $375,000 investment, “those companies would just never do that.”

“People can no longer bring in little angels or funds at lower valuations because much of YC’s cash also converts at the same valuation,” he said.

Y Combinator’s expensive offerings come as valuations elsewhere, especially later stages, are cooling off. One seed-stage investor described them as “completely detached from reality.”

“Pretty much all the seed funds I know of don’t invest in YC companies other than those that focus on YC companies,” the investor told Insider.

However, some seed-stage investors are willing to pay those higher prices. Jillian Williams, director of Cowboy Ventures, said the new terms had not alienated the company from her from Y Combinator startups. Cowboy has endorsed Y Combinator alumni like MBX, Seneca Systems, and Ironclad.

But Williams said that for investors who are more concerned about the size of their ownership stake or rising valuations, Y Combinator’s new terms could present a challenge. The accelerator’s move to accumulate larger equity holdings may make it a rival to those companies, he said.

“YC, whatever happens, is competing with funds, especially seed funds, more than they have done before,” he said.

That’s not necessarily a bad thing for the accelerator, Yin said, as larger equity holdings would allow it to reap higher profits from its big hits. And at least in the short term, she added, few startup founders are likely to balk at the extra cash, even if it requires giving up more capital.

AY Combinator “may not really care if angels or venture capitalists underinvest,” Yin said.

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