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YCombinator’s change to the deal terms it grants startup founders has given the famed startup accelerator more firepower than ever. And that’s causing an outcry among the seed investors who comb through its graduating classes to find the next Stripe and Airbnb.
On Monday, Y Combinator said that in addition to its usual $125,000 investment in startups in exchange for 7% equity, the organization would provide another $375,000 at a valuation determined by a company’s later investors. The arrangement, which reflects a trend in venture capital toward much bigger checks, should help founders seeking more cash upfront. It’s also a boon for YC, which will get more equity ownership in nearly 1,000 startups that graduate from its training program each year.
The individuals and institutions that invest in early-stage companies, however, said the new deal could curtail their investments in graduates from the program because YC is more likely to crowd them out of future rounds. Lead seed investors tend to seek at least 10% stakes in startups. With YC getting the right to take additional equity in the financing event following its initial 7% accelerator investment, these early investors say they may find it impossible to get the stakes they want.
“It’s really good for YC but it’s bad for everyone else, including founders,” said seed investor Sheel Mohnot, a co-founder of Better Tomorrow Ventures. “YC is competition for seed investors, not a partner.”
YC’s additional $375,000 comes in the form of an uncapped SAFE, or simple agreement for future equity, with what it dubs a “most favored nation” clause. This phrase means YC can invest the capital on the best possible terms offered in a subsequent phase of investment, typically the seed round, thus increasing its potential for bigger stakes.
“Simply put, we’re giving the company money now but at terms you’ll negotiate with future investors,” YC president Geoff Ralston wrote in a blog post on Monday.
Those terms, while welcomed by some founders, could prompt them to restructure their later rounds because YC is in the mix—leading seed investors who would normally participate might drop out, some of these investors say. For instance, if a seed firm agreed to invest $1 million at a $8 million valuation, an ordinary investment for an early-stage round, it would receive 12.5% of the startup equity. And YC’s $375,000 investment would entitle it to a 4% equity ownership.
The founder then faces a decision: Give up 16.5%, more than the equity dilution in a typical seed round. Or restructure the round with a different lead investor who is willing to take a smaller percentage of equity, but who may be less willing to spend time with the founder.
Some seed investors say they’ll just avoid such deals. That could be an additional hit to the business of these firms, which typically raise funds smaller than $100 million. Over the last two years, they have already grappled with an increasingly competitive environment as deep-pocketed late-stage investors, such as Greylock Partners, move upstream to bet on companies earlier in their lifetimes.
“It just makes it more difficult for small seed funds like us to effectively collaborate with founders without having to overdilute the founder in a pretty serious way,” said Eric Bahn, a co-founder of seed firm Hustle Fund, which manages a $33.6 million fund. He expects to continue to invest in YC companies, however.
‘A Very Big Year’
YC has maintained that it seeks to collaborate and establish good ties with the investors that will capitalize their graduates. Seed investors skeptical of those claims have little leverage to counter what’s become a powerful startup institution.
Years of investing in thousands of startups paid off in earnest in 2020 and 2021, when YC investments, including Coinbase, DoorDash and Airbnb, all completed highly anticipated and lucrative public listings. The windfall has given YC the ammo to invest what amounts, under the new deal, to about $200 million for every batch of 400 companies, up from $50 million in its prior deal.
Adding to its war chest, the firm is expecting even more landmark public offerings. Reddit, a $10 billion valuation platform for online discussion, which participated in the first-ever YC batch, expects to go public in March, Bloomberg reported. And Stripe, last valued at $95 billion, is expected to go public in the next year. Assuming a 7% stake in each business, YC’s winnings would total roughly $700 million and $7 billion at the current respective values for each company. But the firm’s stake size in the companies couldn’t be learned, and stakes of early investors such as YC typically shrink considerably as bigger investors pour money into companies later on.
“The last year has been a very big year for us,” said Ralston in an interview with The Information on Monday. “It’s a really good idea, when there’s massive change and inflection points like we’ve had over the past 20 months or so, to jump into the great companies.”
The accelerator program is poised to continue growing, despite criticism that the value of the program has declined as it expanded. Since it was founded in 2005, its batch sizes have swelled dramatically from a few dozen per cohort to over 400. Its latest round kicked off Monday.
While the firm has adjusted the standard deal several times over the years, it has continued to write relatively small checks—a marked contrast to the sharp acceleration in check size and valuation that has characterized the VC industry over the last two years. Since 2020, YC has kept the size of its checks to $125,000 for 7% stakes, or only $5,000 more than its offer in 2014. Average seed-stage pre-money valuations have risen to more than $12 million last year, up 33% from 2019, according to financial data provider PitchBook.
This time around, Dalton Caldwell, longtime YC partner and its head of admissions, advocated for the dramatic adjustment to its standard deal, which should give companies more cash to buffer against a downturn.
“No matter what happens, it does provide the best founders that we fund to have resilience through any sort of market change or downturn,” Ralston said. “We always take a step back, whether it’s during a 2008–09 event or anything else, and say, ‘Look, if you just invest in the best people, no matter what, they’re going to survive and be resilient through these things.’”
The change should also quell founder concerns over the fairness of the standard deal. In recent batches, founders have internally debated the continued value of giving up equity considering the small check size, according to several recent YC participants.
“Ten years ago, that [deal] was a no-brainer,” said Kevin Fu, who participated in the YC accelerator last summer. In today’s market, however, it’s a different story. “YC has been due for an evolution for some time.”
The change sounded like good news for Fu, who said he lacked connections to Silicon Valley investors and family wealth to kickstart his fintech startup, Repool. The accelerator’s stamp of approval was valuable. But the money helps, too.
The $500,000 investment, he said, gives founders “way more optionality, flexibility, and survivability.”