YCombinator announced that they are making changes to their standard deal. This is big news for startups and will have wide ranging consequences, both positive, negative and unintended, for Latin American startups, VCs, angel investors, not to mention YC itself. So far, YC has been a huge force for good in Latin America, between helping companies in the program, and making it ok, and now sexy to invest in Latin America.
YC announced this change on Jan 10th 2022, on the first day of their latest program, and it’s giving current batch startups a week to decide if they’d like to take the extra money or not. It seems like it’ll be mandatory for future batches.
So what happened? And what should founders in this and future batches be thinking about?
- $125,000 for 7%
- Pro rata right to invest 4% of the next equity round
- $125,000 for 7%
- $375,000 SAFE at the same terms as the lowest SAFE you accept from anyone else during YC’s program (Most Favored Nation or MFN terms)
- Pro rata right to invest 4% of the next equity round
Sounds great, right? YC companies get $500k instead of $125k.
It is a big win for many LatAm startups, and probably doesn’t change much for many others. But this change might have unintended or negative consequences for some YC founders, especially from Latin America and other emerging markets.
My personal bet is that YC Alumni angels, LatAm operator angels, LatAm funds and high signal syndicates are much more important to Latin American YC companies than they are to US companies. Most non-elite LatAm founders are doing YC specifically to buy the network, which ends up helping them while they build their business.
Nearly all of the founders of the best Magma-YC companies (both before, during and after demo day investments), got a ton of help from these small checks. This change could hurt more LatAm companies more than companies from other regions.
I also recognize that I’m clearly biased, as a fund that invests early in LatAm companies, including many before, during and after YC, and that this new deal will make investing during YC potentially harder for us, although it may make it easier for us to lead rounds at demo day.
Big winner: YC short term
They get to invest more in their best startups, which will drive big returns from the best startups
Big winner: Cockroach startups and “non-hot” startups
Extremely early stage startups, underestimated founders and founders without access to funding get an extra $375k automatically
Short term losers: founders in this class suffering from Demo day uncertainty
The old way of raising small checks at ever increasing caps no longer works. This batch’s founders are the YC guinea pigs. It will be great for some, pretty bad for others.
The old way of raising was the best way for underestimated founders with great traction to get on US VC’s radar
Big losers short term: YC Alumni Angels
YC angels used to be able to invest small checks at low caps, they can’t anymore without triggering YC’s SAFE on low valuations.
Big losers: undifferentiated angels
There’s a big group of angels that don’t add any value. They’re now likely priced out. This isn’t a bad thing for founders necessarily, it might make their demo day easier.
Potential Losers: LatAm Angels/Micro Funds that add value
Some funds, Magma included, will likely get priced out, leaving LatAm companies with no LatAm help on their cap table
Potential Losers: Pre-seed funds and seed funds that don’t lead rounds
US and LatAm Pre-seed/seed funds invest at lower caps and help founders, similar to YC Alumni angels. Most of us, Magma included, will get priced out of many deals.
Potential winners: Seed funds that lead rounds
Valuations at demo day will likely go down for a significant number of companies, at least short term, since they won’t be able to drive investor Fomo from increasing caps. This could help funds like Magma that like to lead rounds.
Potential loser: YC medium/long term, risking the Golden Goose
The current process works for many companies, driving massive FOMO at Demo Day. It might not work as well with the new incentives.
The YC community is everything. If Alumni angels are unhappy, they might not have as much incentive to help each other out.
Top LatAm companies with lots of traction that only did YC to access capital might not want to take the extra dilution and pass on the program.
2nd time, successful founders who already have the network, will be less likely to take this deal. Although they might not be doing YC already anyway.
It will be interesting to see how this shakes out. It’s clearly good for YC short term and for many of the very early LatAm founders. But as valuations continue to rise, more US funds get comfortable investing early in Latin America, and LatAm funds get more money to invest, if YC continues to take 7% for $125k, plus the new additional dilution, the deal may not look as good in the long run, especially to high end founders in Latin America.
If done well, this could be a huge boost to YC founders, and allow them to focus on building and finding a lead investor at Demo Day, rather than perfecting their Fomo skills.
How I’d think about the new deal
If you’re a founder in this batch, you should talk to current investors, lawyers and your core advisors. Here’s how I would think about it:
Very early stage, low/no traction, underestimated founder – take the money, don’t think twice
Elite status founder – If you’re likely to raise, think about not taking it in this batch and using the old method of raising from angels/funds during the program.
High traction, good numbers, only doing YC to get access to US capital markets – Likely say no to the new money
If anyone in the current batch would like to think it through, feel free to reach out.
Deep Dive: How YC’s changes may affect Latin American startups, VCs, Angels and more
For those who aren’t familiar, here’s how YC works for most Latin American companies.
There are generally four sets of companies that get into YC:
- Extremely early stage, underestimated founders, without access to US capital
- Extremely early stage, elite status founders, with access to US capital
- Laterer stage, high traction, underestimated founders, without access to US capital
- Late stage, 5+ years in the market companies with good numbers trying to access US capital
Each type of founder is doing YC for different reasons, and likely has a different strategy for the program. Generally, this is how it works:
YC generally tells founders they shouldn’t take any money from funds during the program, waiting until Demo Day to make deals with funds. They tell founders to take a few angel checks from successful YC founders, generally during the program.
In practice, the best YC companies start raising very small checks from YC founders, influential angels and small funds at ever increasing caps to generate fear of missing out (FOMO), and drive higher valuations. Some of them make mistakes and sell too much to poor angels or bad funds at low valuations and regret it later. Others run the process and take very little dilution until Demo Day.
Some founders end up taking money from a lead investor at Demo Day, others raise party rounds with as many as 20 different SAFEs at different, ever increasing valuations. A chunk of companies don’t raise much money or struggle to raise.
But generally, the best practice has been to start giving small $5k-$25k checks at low caps to founders/angels, and then $100k-$250k type checks leading up to demo day.
YC founder 1 – $5k at $3M
YC founder 2 – $10k at $4M
YC founder 3 – $25k at $6M
YC founder 4 – $50k at $8M
Micro Fund 1 – $100k at $10M
Micro Fund 2 – $250k at $12M
Demo Day Fund – $3M at $15M-$25M from a lead investor OR multiple SAFEs at ever increasing valuations in a party round, going as high as $100M for the hottest companies.
You get the idea. Founders build a base of YC founders, famous angels and small funds who help them raise the cap, navigate YC’s program, scale quickly etc.
The hottest LatAm companies might end up raising their last SAFE at a $100M cap. The least hot companies might raise $500k at $10-15M and that’s it.
This new deal obliterates the current YC strategy, with wide ranging consequences for all stakeholders. So let’s look at it from different perspectives:
LatAm Founders in the Current Batch
This new deal introduces a huge amount of uncertainty into the equation. Founders can no longer follow the tried and true model to raise money during YC. They are flying blind this batch.
Early Stage, no traction, non-elite startups: Big winners
These are the biggest winners. If you are now guaranteed $500k by going to YC, you get a ton of extra runway, even if you don’t raise. The secret of YC companies that most founders don’t know is that there’s a decent chunk of companies that raise between $300k-$1M after YC, after having given YC 7%.
Hot YC Companies: More risk, but probably not much difference
They will need to figure out other ways to drive signaling other than showing who is already invested, but some companies will still be hot. The new deal either won’t affect them, or it will be a slight annoyance, as bigger VCs will still want to take their ownership, forcing founders to take more dilution, or the big VCs to take less equity.
Middle YC Companies: Big risk, big downside
The non-hot companies, which are the majority of YC companies, will need to make a decision during YC. Will they accept $1M at $10M or $12M before demo day? And take YC’s extra $375k dilution? Or will they hold out to try to get $20-25M at demo day so that YC gets less dilution?
My guess is that the vast majority of middle startups will be like the NBA draft. Every year, many highly talented players leave college to do the draft, as they think they’ll go in the lottery or at that the first round. And many of them don’t get drafted.
In YC, there will be many companies that say no to $1M at $12M, and then can’t raise at $25M. Many of those investors who offered at $12M won’t be happy invested after they tried to go after a higher valuation and couldn’t get it.
These companies are hurt the most by not being able to offer small tickets at very low caps to YC founders and small funds.
Many YC alumni invest in YC companies each batch. They generally get to invest at very low valuations in exchange for letting startups use their name, along with helping guide them through the YC process, and make intros to funds.
These alumni now either don’t get to invest, or have to invest at 2-5x higher valuations.
YC’s decision basically tells YC Alumni they have to pay higher prices to give YC more equity. YC is clearly betting that shutting out their alumni angels doesn’t kill the community. It’s a very big bet.
Non YC Alumni Angels
There are a wide range of angels that invest during YC. Some are amazing. Others are terrible. It’s likely this new deal structure kills most of these angel investments, or forces them to invest at 2-5x higher valuations. Most likely it shuts them out completely.
YCombinator: Big winners short term, unclear long term
YC is a clear winner in the short term. They are able to get $375k additional allocations in all companies, which will generate huge returns from the top 5-10 startups in each batch.
Look at the leaderboard and imagine investing $375k at between $10M-$25M valuations, and look where they are today. YC will make millions, or Billions just by getting more money into the top 5-10 companies per batch.
Also, by giving more money to all companies, they’re also raising the possibility that cockroach companies will be more successful and giving middle companies the chance to get more traction.
In the short term, YC will likely start losing some of the top Latin American companies. Every YC batch, there are extremely early companies, companies from small countries that have struggled to raise, but have great traction, and companies that have really high end traction, but are underestimated founders generally from small countries.
These companies were willing to do YC and take the 7% dilution because they knew they’d raise at high valuations at demo day. These mature companies take the deal because they can’t access US money without YC’s blessing.
With more US funds investing earlier in LatAm and premium valuations, and LatAm funds like Kaszek, Monashees, Valor, Softbank Atlantico, Wollef, Canary and more have $1B-$100M+, they will start funding many of these previously YC-bound companies faster. As US funds realize that they should be investing earlier, they can offer significant deals that will equate to lower dilution than YC’s new deal.
How will it shake out?
This class of YC founders will need to deal with lots more uncertainty. The batch is the guinea pigs for this new deal. Some will love it. Some will grudgingly accept it, others will be hurt by it.
As YC continues to scale, we’ll see more creative ways for Alumni angels and funds to get into these deals that don’t run afoul of this new YC deal, and hopefully the whole process is more based on fundamentals, rather than FOMO. It will be interesting to see how it shakes out.
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