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:
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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. 🙂