Is Yuri Milner A Threat To Silicon Valley?

Editor’s note: Guest author Chris Yeh is an independent angel investor and VP of Marketing for PBworks, one of his investments. He has been involved with Internet startups since 1995. His Twitter handle is @chrisyeh.

Update: This post originally referred to DST as the investor in Start Fund when it actually is Yuri Milner personally investing, along with Ron Conway’s fund SV Angel.

Update II: This has been corrected below.

The big news this morning is Yuri Milner’s announcement that he and Ron Conway will be investing $150,000 in *every* Y Combinator startup on a no-discount, no-cap convertible loan.

Many people have already weighed in with instant reactions—”It’s a bubble!” “It’s the greatest thing to happen to the US economy!” As usual, these off-the-cuff reactions focus on a single part of the story, rather than looking at the big picture.

Let’s walk through the news, step-by-step, and see what it really means. Ultimately, my take is that it’s good for Y Combinator and Milner, but bad for the rest of Silicon Valley.

1) “Yuri is a fool who believes he can sell to a greater fool.”

Many people mocked DST when it began investing in companies like Facebook at “outlandish” valuations. DST invested in Facebook at a $10 billion valuation; with the valuation now above $50 billion, I’d say Yuri is having the last laugh (for now).

If Milner is investing in YC companies on these terms, it’s because Milner believes it can make money on these terms (more on this later).

2) “I can’t believe all the money going into YC’s dipshit companies.”

Once upon a time, Y Combinator’s companies were features masquerading as companies. But anyone who still thinks that isn’t paying attention. The quality of YC companies has risen considerably; the companies graduating from YC these days are much more polished and accomplished. And with monster successes like Dropbox and AirBnB (along with Heroku’s exit), YC’s company quality is looking better and better.

3) “Finally, someone who’s willing to take risks, unlike today’s pantywaist angels and VCs!”

Now we’re getting to something more substantive. There seems to be a feeling among entrepreneurs that investors are no longer willing to take risks, and that no one is willing to invest in ideas any more. My response to that is simple—if startups are really so low-risk, why is it that only a tiny fraction of the companies that do get funded (which are presumably “no-brainer” investments for all the cautious VCs) actually return any money to investors?

Of course I try to invest in companies that I expect to be “sure things,” but I also know that history predicts that at least 60% of my investments are going to be complete financial failures. The reason Milner is willing to take on such risk is simple—in addition to the actual investment, it’s also buying option value.

Option value is what makes the VC system work—by investing in stages, investors are able to abandon companies that don’t look likely to succeed. This is why startups are so much more effective than big companies at innovation—a big company’s internal politics make it difficult to try lots of things that will probably fail. Milner has additional option value available to them that traditional angels do not because of its ability to invest at later stages. By investing in the seed round, Yuri – and DST – gets the inside track on any future financings.

Let’s say that I was lucky enough to invest in Facebook’s seed round (I wasn’t). As the company raised further rounds of funding at $100 million and $10 billion valuations, I would have to come up with increasingly large checks to maintain my ownership position. Buying 0.1% of the company is pretty easy at a $5 million valuation (that’s just $5,000). It gets harder at $100 million ($100,000) and $10 billion ($10,000,000).

For Milner, however, investing a few million in YC companies is well worth it if it gives him the inside track to do a $100 million expansion round in the future. Moreover, is Milner really making it easier for entrepreneurs to raise money? I was not under the impression that YC grads were having difficulties raising money. It’s not like Milner is giving $150K to anyone who asks—the investment is reserved for companies which pass YC’s rigorous screening process.

4) Okay, Mr. Smarty-Pants, why is this bad for Silicon Valley then?

In the TechCrunch comments, Ted Rheingold of Dogster fame says simply, “This is not going to be healthy for the ecosystem.” I think he’s right, but the reasons he’s right are subtle. Allow me to explain.

a) Independent angel investors need to be able to invest at reasonable valuations.

As I explained in (3) above, folks like me need to be able to invest at reasonable valuations. That means either priced rounds or convertibles with valuation caps, and seed round valuations of $1-3 million. We don’t have the money to stay in the game with the VCs and DSTs of the world, so if seed funding shifted to a model of no-cap convertibles, we would be priced out of the ecosystem.

In today’s environment, many companies skip straight from a seed round to $20 million+ valuations, and angels simply won’t get rewarded for the extra risk they assume without priced rounds or caps.

b) The Milner/YC partnership could end up upsetting this delicate balance

As I’ve argued in the past, angel investing is a fragmented game. No one has enough power to collude on valuations. However, someone who is influential enough can influence what is and isn’t considered “standard.”

Once upon a time, there was no such thing as a convertible note with a cap. There were convertible notes, and there were priced rounds, and nothing in between. Then a few years ago, a number of prominent players in the ecosystem (YC included) began pushing the concept of a capped convertible. Today, even though there are plenty of angels who despise any kind of convertible note, capped or not, the capped convertible is pretty much the standard seed financing instrument.

Now imagine the impact of YC, the most influential incubator, standardizing on uncapped, no-discount convertibles. It’s not difficult to envision a scenario in which the entire industry moves in this direction. The problem is that this shift eliminates the incentive for independent angels to participate in the ecosystem.

Angels play an important part in the ecosystem because we are willing to take on more risk than the VCs. Some of that is non-economic behavior, but some of that is also due to the fact that we get compensated for that risk-taking with much lower valuations. Eliminating that compensation will surely reduce the number of independent angel investments.

The irony is that the Milner/YC deal didn’t have to cause problems for independent angel investors. If Milner committed to providing $150K to every YC company, at whatever terms were determined by the lead investor in the syndicate, he wouldn’t be pricing the angels out of the ecosystem.

c) Removing independent angel investors from the ecosystem is a bad idea

Naturally, angels like me will be upset about getting shut out of the ecosystem, but why is that bad for Silicon Valley? After all, between YC, TechStars, the Founders Institute, and all the other incubators and quasi-incubators, who needs us? Let the incubators pick the winners, and let the DSTs fund them.

The problem is that the chaotic, fragmented, Darwinian nature of Silicon Valley is an integral part of what makes it great. We need those random mutations to generate innovation, especially breakthrough innovation.

If we concentrate the decision-making on who does and doesn’t get funding in the hands of a small number of institutions, we hurt Silicon Valley as a whole, no matter how smart those institutions are.

I tell many people that Paul Graham is a genius. He saw the opportunity to start YC, and he’s done the Valley a huge favor by broadening the pool of company founders. But I don’t want Paul to be one of a small group of people who decides which companies get funding—not because he isn’t smart (he is) or a great guy (he is). When it comes to innovation, central decision-making is bad, no matter how good the decision-makers are.

For all our flaws, independent angels serve the important role of enabling the “genetic diversity” of the startup population. That diversity is at the heart of Silicon Valley’s success, and that’s something we don’t want to lose.