Y Combinator (YC) is the most successful startup accelerator in the world. With the first outside stake in companies like Airbnb, DropBox, and Stripe, it has proven that it can repeatedly identify breakthrough companies well before they take off.
Until now, YC has focused on its accelerator program. Post-YC, companies get funded by venture capital funds and YC’s stake in these companies gets diluted. The traditional justification for the lack of a larger YC fund to make follow-on investments was that if such a fund were created, it would create an adverse signaling problem. The companies where YC decides to invest after the accelerator program would be viewed more favorably by outside investors than those companies where it doesn’t invest. YC would be differentiating amongst its startups and this would make the program less attractive to future applicants.
The problem with this argument is that other VC’s are currently filling the role that YC is avoiding. Specifically, funds like Sequoia Capital (an investor in YC), Founders Fund, and Andreessen Horowitz provide the same signaling that YC has refrained from sending. When a YC startup gets money from one of these funds, it’s clear that they’re a much more promising startup than the ones who don’t get money from a top-tier fund.
If YC doesn’t send a signal, other funds do. So by not participating in the subsequent funding rounds of companies that go through its accelerator program, YC is simply leaving money on the table. Until now.
YC is currently putting together a billion dollar fund to perform follow-on investments in its companies. It’s still choosing to avoid the signaling problem by retaining its pro-rata in the follow-on rounds of all of its companies below a post-money valuation of $250M. However, in this way at least it will avoid the dilution of its stake in the future Airbnb’s, DropBox’s, and Stripe’s of the world. I think it needs to go one step further by also starting to differentiate whether and how much it follows on in each of its companies.
YC’s current move, and any future move if it were to start doing more than its pro-rata in winners and not following on in others, will come at the expense of traditional downstream investors in YC companies. The impact will likely be greatest for Sequoia Capital, an investor in YC with the resulting priority access to its startups. Sequoia has participated in the first post-YC funding rounds of each of Airbnb, DropBox, and Stripe.
The upcoming billion dollar YC fund should have been established a long time ago. It’s simply the natural evolution of things. As The Information put it in their coverage of the upcoming YC fund , “as capital gets commoditized, access becomes more important. Early investors have an edge”. Specifically Y Combinator has an edge.