Has Y Combinator’s new deal changed the early-stage investing game?

Y Combinator’s newly announced plan to invest more capital into startups that take part in its accelerator program is more controversial than many first assumed.

By raising its so-called “standard deal” to include an additional $375,000, the U.S. program and investing group with hundreds of companies in each of its accelerator classes may have materially changed the earliest stage of investing. Professional early-stage investors around the world may see their offers lose luster, possibly changing how the youngest startups that take part in Y Combinator interact with external capital.

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Prior to the change, Y Combinator offered $125,000 to its accelerator participants in the form of a simple agreement for future equity, or SAFE, that reserves 7% of participating startups’ equity on a post-money basis. The new $375,000 SAFE, now part of YC’s regular transaction, is uncapped – meaning that the dollar amount will not convert into an automatic percentage stake of the company in question.

Stacked up against today’s myriad mega-rounds — those nine-figure checks that seem to touch down at every hour of the day — and the huge unicorn horde waiting by the private-market exits, an extra $375,000 may not seem like a big deal.

But early-stage investors are paying attention. According to Mike Asem, a partner at the Midwest-focused M25 venture capital shop, the new terms help Y Combinator, but come with “tradeoffs” for the group and founders themselves.

Naturally, Asem is talking his own book, but the fact that investors across the globe are less than enthused by the change is worth considering.

Has Y Combinator truly changed the early-stage startup investing game, perhaps in its own favor? Or did it merely provide more time to its portfolio companies to reach their next stage of maturity? Given the sheer number of checks that Y Combinator writes, and how much weight its imprimatur carries around the world, there may not be a more important early-stage question this year.

We asked investors and founders to weigh in on the matter. Notes follow from Asem; Pejman Nozad of Pear VC; Iris Choi of Floodgate; Nathan Lustig of Magma Partners; Siggi Simonarson, co-founder of BuildBuddy, which took part in a 2020 Y Combinator class; and Torben Friehe, co-founder of Wingback, which is part of the Winter 2022 YC batch.

We’ll examine the impact that the new deal may have on startup founders, both experienced and not. We’ll also discuss what the new transaction terms mean for Y Combinator itself, whether the change was overdue, and what negative impacts could crop up around the world at different investing stages. Let’s go!

How will the new YC standard deal impact founders?

More capital is more capital, and some founders will benefit greatly from the new standard Y Combinator deal.

Floodgate’s Choi – perhaps the single most popular guest on the Equity podcast – told The Exchange that the “precommitment” into a startup’s Series A “with the uncapped SAFE note is a vote of confidence for founders, especially maybe those who decide to go through YC in part because it derisks their future fundraises,” perhaps even more so when compared with “founders who would have no trouble raising.”

Magma’s Lustig found much to like about the new terms for one particular set of companies: “The new deal is going to be great for the Latin American companies that are extremely early, with no traction, and don’t have access to U.S. networks. The extra money will help them.”

The same investor wrote that the startups that are not “hot,” that feature an “underestimated founder,” or that simply want to chart their own path forward largely on the back of revenues could be winners from the new terms.

Thus far, then, things seem pretty good — the new terms could help startups raise, especially those companies with founders that don’t have a Stanford network or an office near South Park in San Francisco.

The founder perspective

We’ll get back to investors shortly, but let’s hear from a few founders that have taken part in Y Combinator.

BuildBuddy‘s Simonarson called the new terms “pretty exciting” because they may provide “founders more leverage.” How so? In Simonarson’s view, there was “a lot of pressure coming out of the batch to fundraise or risk running out of money” under the old investment terms.

“Now founders can wait until they have the traction [or] revenue [or] user metrics that allow them to raise on good terms,” he added. In the case of BuildBuddy, Simonarson said that had the company had access to a similar deal, the “money would have lasted [his company] well over two years,” which he said was quite a lot of time to build a product, learn, and make resulting tweaks.

Friehe of SaaS startup Wingback said that the new deal terms are “great news for the whole [Y Combinator Winter 2022] cohort, especially those companies which haven’t previously raised capital yet.”

Wingback didn’t need the capital, Friehe said, noting that his firm had “already raised a pre-seed round before coming into YC,” but added that the “extra cash will be helpful and allow us to grow faster than we previously anticipated.”

Friehe went on to say that from his perspective as a founder, the changes to Y Combinator’s regular deal “shows” how the organization “is evolving.” That evolution could prove fruitful, with Simonarson writing that the changed terms made him more likely to participate in Y Combinator again in the future.

“Taking $500,000 from YC is just about the best money you can have on your cap table as an early-stage company,” he wrote.

Are the new terms good for Y Combinator?

The consensus is that yes, the new terms will bear out well for the accelerator.

M25 investor Asem said in an email that “generalist accelerators have lost their luster over time as more accelerators and pre-seed [and] seed funds have emerged — making it easier for ‘pre-everything’ founders to access capital and network from there.” How do the new terms come into play? In Asem’s view, they will “pretty clearly [help] YC stand out and perhaps box out more competition.”

Simplified: Y Combinator is going to get a larger bite at the startup apple, meaning that it will own more of all its winners in the future, at the cost of potentially larger write-offs per batch. Choi noted the latter piece of the puzzle, saying in an email that the term changes are good for companies where YC “would have wanted to double down,” but “bad if YC would rather not own more.”

In that context, it might have been good for YC to let founders opt out of the program or choose the amount they get. Founders might have appreciated this, too, and it is hard to argue that it wouldn’t have been better for them — options typically are. But Asem said it would have been a mess to manage: “For one thing, you don’t want to be managing so many one-offs, and it makes the portfolio structure and model more of a nightmare as well.”

However, we do have at least one counter-example: Pear VC, whose accelerator gives founders flexibility. Pejman Nozad sent a statement about it, which he asked us to use in full:

We’re glad that there is more capital than ever available to early-stage founders both within and outside of accelerator programs. As an early-stage investment vehicle, accelerators offer more than just funding and founders largely make their decision to join an accelerator based on a variety of things such as what form of support they will receive.

At Pear, we are tailoring our own accelerator to help founders find product market fit. We have a small number of very early stage companies (15), we surround them with a lot of personalized attention (two partners per company), offer highly personalized and customized guidance, and support for a growth-catalyzing seed round. To give each company the opportunity to choose the best funding for their own needs, we offer $500k-$750k on a $10M cap, and the founders choose the amount.

An unexpected consequence might be that competing generalist accelerators will find new ways to differentiate themselves from Y Combinator. Instead of offering similar terms, they may embrace operating under other terms — for instance, by being much more hands-on than giant batches can be. That’s what Entrepreneur First’s Matt Clifford expects.

He told Sifted: “As YC scales, the way people will compete is by becoming the ‘anti-YC’. Small, curated and personal.”

Thinking internationally

The new capital could change the game for startups outside the U.S., and perhaps not always in a positive way.

Lustig said that there is a chance that Y Combinator will lose the benefits that alumni and Latin American angels and smaller funds “contribute to successful rounds at Demo Day.”

As we noted before, here we have an investor talking their book. But as with Asem, Lustig makes a pretty reasonable point: Having local connections to investors in your home market is important, and if Y Combinator makes it harder for those investors to plug into the next generation of startups being built inside their borders, it could get messy.

Asem echoed the issue of landing local investors for international startups, saying that while “international seed-stage companies will benefit greatly from being able to get their first $500,000 much easier,” he’s concerned that “for many non-U.S. companies, an important goal is to get as many United States-based investors as you can,” and that the new terms “will make that much harder to do.”

But it’s also easy to argue that Y Combinator, in putting more cash into the hands of startups, is forcing early-stage investors to make a stronger pitch to upstart companies.

Venture concerns

Asem and Lustig are not alone in their concerns about the impact of the changed Y Combinator funding terms.

Quoted in a piece by The Information, Sheel Mohnot of Better Tomorrow Ventures said that the new terms are “really good for YC, but it’s bad for everyone else, including founders.” How common is that perspective? Asem echoed that in an email, saying that for his side of the startup-investing coin, the new terms are “generally not good, particularly for early-stage investors, as it makes YC more incompatible to invest with than it used to be.”

Just how the new capital disbursement from Y Combinator will impact other investors, however, depends on their stage. In the post that we cited above, Lustig argues that Y Combinator “Alumni Angels” will suffer, as writing smaller checks at lower caps will become harder due to those investments possibly “triggering YC’s SAFE [at a] low valuation.” He also anticipates that angel money will lose some of its attractiveness, especially from single investors that don’t bring much more than capital.

Choi said that the dollar amount now on offer from Y Combinator “isn’t so large that it should cause a seed lead to fear they won’t be able to get their target ownership.” Others noted that hitting investor ownership targets would become more difficult with the extra Y Combinator money in its batch startups. (Ownership targets are part of how fund models work, in simple terms, so any changes have big possible impacts on how funds perform.)

What’s ahead

It’s hard to worry too much about founders having more access to capital earlier, and at terms that are pretty reasonable. That some investors are concerned is not a surprise, but the evolution at Y Combinator is just one part of the overall changes in the startup investing game.

Expect other investors to adapt and founders to make intelligent choices about their cap table. We’ll collect data and observations from the next few Y Combinator batches to learn more. Today the vibe seems to be happy founders and somewhat unsettled investors. But what market innovation didn’t leave incumbents at least slightly discomfited?