Why Y Combinator’s Terms Are Poor (But I Still Like Them)

I love Y Combinator. They are scrappy, innovative, entrepreneur-friendly, and created a model that VCs originally laughed at but are now copying. I love Paul Graham’s essays and I like him personally.

Y Combinator invests ~$12k in early stage teams in return for ~6% of the company, implying a typical valuation of about $200k.  Paul Graham says this is a good deal because Y Combinator can increase your value by at least 6%.

While I think that’s true, that’s not the right question. The right question is whether YC’s deal is better than alternatives.

A typical $50k seed-stage angel investment for a team with a promising beta and users, even in this crappy market, is at $1M-$3M pre-money valuation in an equity round and can be as high as $5-6M if you use convertible debt. PlayCafe originally raised $250,000 of convertible debt with a $6M cap. (We eventually switched to a complete equity round when First Round Capital invested.)

Let’s compare the numbers:

[table id=1 /]

A $50k angel investment is almost ten times the better financial deal (9.6 to be exact).

YC asserts that their advice and connections are worth this premium. I respectfully disagree. Advice and connections for even idea-stage entrepreneurs are easy to find with a little initiative, and if you don’t have that, you’ll fail as an entrepreneur. YC’s connections, Demo Day, and brand are indeed value-added, but it’s hard to argue they’re worth ten times an angel and free advice and connections.

YC supporters say their teams are little more than first-time entrepreneurs with ideas. That’s generally true, but YC’s hackers are able to build most prototypes in 3-6 months anyway. Is it worth that time working separately to get a 10x better deal? I think so.

One could say it may be a bad deal but the equity involved is relatively minor. I am open to this point. 6% equity can be quite a lot – it’s $120,000 of equity on a $2M pre-money valuation, or the equity component for 5-10 early hires – but I’d agree it’s not a massive amount. Spending $150 for a restaurant dinner that you can create for $30 may be a bad deal, even considering the value of ambiance, but it’s not a disaster. Small stakes excuse small errors.

How much equity should Y Combinator take? I’d say the fairest method is punting on this question and using a convertible note, which would determine YC’s stake at the Series A valuation. The problem for YC is that $12,000 into a typical Series A pre-money valuation of $3M translates into a paltry 0.4% equity.

One partial solution is warrants that give YC the right to invest more money at a pre-set Series A valuation, such as $200,000 at a valuation of no more than $4M, yielding about 5% equity. We did this with First Round Capital to compensate for the dilution that they would suffer in later rounds.

Thus, recognizing that YC deserves at least a few points of equity, my real suggestion is that Y Combinator should invest more, which given their success so far and a recent $2M infusion from Sequoia, should be more than feasible. If Y Combinator just set their valuations at one-half market value instead of one-tenth, that would suggest Y Combinator invest $60,000 instead of $12,000.

Graham believes that $12,000 is enough to keep founders alive for three months, but I would argue is sub-par for early marketing and development. A good domain name alone can cost $2,000-$20,000+ and is painful to change after release. Getting good early design can cost another $2-5k.

I should note that I may be biased because I am not YC’s market. I have been doing startups for a while and am fortunate to have a decent entrepreneurial network. YC provides a faster lane for first-time founders than I had.

I do think an important metric is how Y Combinator alumni view the terms afterward. The majority seem quite happy with it. Y Combinator is empowering hundreds of entrepreneurs and some very cool startups, and for that, I cheer them whole-heartedly.

Update: I see Sarah Lacy makes a similar argument. It’s interesting to see the backlash.

Update 2: Tweaked some of the #s to be current.

Update 3: Two things happened since I first wrote this post:

a. Y Combinator announced the Start Fund to give an additional $150,000 to every YC company at very good terms.

b. I decided to apply to Y Combinator. The extra funding does make the equity calculation more compelling, but the biggest reason is that several YC friends and the thoughtful replies I received convinced me that I was underestimating the value of YC’s network and advice. We will see what happens. 🙂

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14 thoughts on “Why Y Combinator’s Terms Are Poor (But I Still Like Them)

  1. Steven April 19, 2009 / 7:24 am

    Hi Mark,

    Having just interviewed with, and been rejected by, Y Combinator, I’m interested in your post. Based on your table above, are you saying that an Angel investor would be likely to invest $50k for 2.4% in a “YC-stage”-type company? I had thought that YC investing was really at a pre-seed stage, hence not directly comparable.

  2. Mark Goldenson April 19, 2009 / 12:58 pm

    Hey Steven,

    I agree a pre-prototype company is not worth the same as a prototype with users. My point was that since YC’s hackers are able to build a prototype in 3 months with little financial support, it makes more sense for them to forgo that support, build the prototype by themselves, then seek money after launching the prototype and acquiring some users. If YC’s entrepreneurs were business people who couldn’t code themselves, YC’s money would buy coding/design and be more valuable.

    The difference between these pre- and post-prototype is disproportionally large. When investors can see a site and users playing with it, it not only conveys the idea better than a napkin drawing, it shows the team can execute.

  3. jon bradford April 30, 2009 / 7:04 am

    Can you be so kind as to provide me with a list of angel investors with $50k who are willing to invest in a pre-prototype business at a $1m valuation? 😉

  4. ScottDig April 30, 2009 / 7:19 am

    “my real suggestion is that Y Combinator should invest more”

    You’re missing the whole point right here.

    Y-Combinator is like Twitter. Venture capitalists are like bloggers.

    With Y-Combinator, like twitter, people just didn’t understand how so much value could come out of so little. At first, typing to someone in 140 characters is hopeless. Then you try it, and you realize how much can come out of so little–you become resourceful and cut out the fat you don’t need.

    Hate to liken them to twitter, but hey, everyone’s doing it… (best reasoning ever)

    – Scott from http://scottdig.com

  5. Breck April 30, 2009 / 8:58 am

    I think you make some solid points. I agree that ~$15k doesn’t last long. Also, it is relatively easy to raise bigger sums from other angels if you know what you are doing. But I don’t think the terms of the YC deal are bad.

    I would argue that with YC your premoney valuation in the next round is likely to be higher. This is because: 1) there’s likely to be more competition for the deal 2) you’ll get great strategic and tactical advice from PG, YC, YC alums, etc.

    Let’s do an example. Company A takes YC(15k at a 250k post, leaving the founders with 94%), B doesn’t. All else equal.

    They both raise a $1M series A.

    Company A is able to get a $4M premoney thanks to YC, while Company B only gets a $3M premoney. Now Company A founders are left with 75.2% while company B has 75%.

    In this (albeit contrived) example, taking YC money actually leads to more equity for the founders.

    Disclosure: I’m a YC founder.

  6. Ivan Kirigin April 30, 2009 / 10:33 am

    Tipjoy is in YC. I’d gladly do it again with zero money, only granting advisory shares. That’s how good the advice/alumni network/rolodex is, and your accounting doesn’t cover it.

  7. Art April 30, 2009 / 10:36 am

    I agree with a lot that you said, but for some pre-prototype companies, the hackers are very inexperienced, maybe so much so that they can’t balance learning the connections and getting resources with hacking up a prototype.

    I feel that YC is great for really inexperienced entrepreneurs, who would take this opportunity to learn. Maybe the company succeeds, but in their next ventures I doubt they’d ever need the tools of YC anymore, and an angel investor would be a smarter choice.

    How easily found are the resources otherwise?

  8. Gordon Shephard April 30, 2009 / 12:05 pm

    Points well made, and understood. But I think the key to this extraordinarily well written essay is here:

    “Advice and connections for even idea-stage entrepreneurs are easy to find with a little initiative, and if you don’t have that, you’ll fail as an entrepreneur.”

    You might fail the Fund Raising/Business Development stage of your business, and, in fact, I would argue that if you have a strong entrepreneurial team member on your team, someone like yourself, the value that YC can provide is greatly diminished, and needs to be analyzed on a more traditional basis (as you have done in your essay.)

    What I think a lot of people continue to fail to understand (And I’m not sure why – that’s the hard part), is that YC targets Hackers.

    People who create. People who can work hard and have great ideas. YC does NOT target MBAs, Finance Types, etc…. To some degree YC becomes a “Silent Employee” – the Shadow CEO/CFO/BizDev guy that also injects a tiny amount of Ramen Capital (to misuse the phrase) just to keep the bellies full for 90 days.

    YC Makes no sense for people like yourself, and, I would suspect, that most successful YC entrpreneurs don’t typically avail themselves of YC seed funding again – because they no longer need to. Now angel funding makes more sense for all the reasons you outlined above. That’s the YC mission (from my perspective) – educate, develop, connect, and, to a small degree, fund hackers so that next time around, they can do it themselves.

  9. Arthur Chan April 30, 2009 / 7:11 pm

    What about legal work? The problem with doing startups is that lot of engineers are fearful of all the business and legal hassles of it getting it set up. YCombinator seems to be trying to help them get over that hump, or at least sucker them in and then they don’t find out till later what they’ve gotten into. 😉

  10. Tom May 1, 2009 / 3:20 am

    “Advice and connections for even idea-stage entrepreneurs are easy to find with a little initiative”

    A big statement. It wasn’t easy for us here in Melbourne Australia, and I dare say it wouldn’t be much easier for people in the USA who aren’t already in a startup hub. Establishing a network is “easy” for people to whom this skill comes naturally. YC is for everyone else.

    The $15k we got for our 2-person startup lasted us perfectly for the 3 months. Had we received any more, we may have been tempted to waste it on stupid crap like, well, domain names and overpriced design work. As it was, we’ve been widely praised for our cool domain (which cost us $9.95 from GoDaddy), and our exceptional UI design (which cost us well under $2k fully coded).

    The equation for YC is fairly simple; they could invest more per startup and invest in fewer startups accordingly. YC prefers to invest in as many startups as possible so they can give more founders a start and take more risks. But they have to take a big enough cut that the risk pays off to allow them to keep doing it.

    Your assumption that they’re swimming in cash and can easily afford to more than quadruple the investment is utterly fallacious. The result of doing this would simply be to dramatically increase waste and reduce the number of startups – both of these outcomes are completely at odds with YC’s objectives.

    Time will tell if we end up being successful, but so far we couldn’t be happier with the value YC has helped add to our business.

  11. Erik Unger May 3, 2009 / 5:57 pm

    Tom :
    “Advice and connections for even idea-stage entrepreneurs are easy to find with a little initiative”
    A big statement. It wasn’t easy for us here in Melbourne Australia,

    Hi Tom, I just started http://startupmelbourne.com
    maybe that helps in the future…

    -Erik

  12. Lazaro June 7, 2013 / 12:17 pm

    Hi just read this post and want to say it was wonderfully
    written. You have a new fan :).

  13. Mia July 28, 2013 / 2:00 pm

    Hi there just wanted to give you a quick heads up. The text in
    your article seem to be running off the screen in
    Chrome. I’m not sure if this is a formatting issue or something to do with internet browser compatibility but I figured I’d post to let you know.

    The style and design look great though! Hope you get the problem solved soon.

    Many thanks

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