A chill has descended onto the global startup market, albeit not evenly. Venture capital totals are sagging in most geographies, and falling share prices for tech companies large and small have soured sentiment on the future value of high-growth and often cash-hungry startups.
The end of the lengthy startup boom that first formed in the wake of the 2008 financial crisis and largely powered through until the final months of 2021 is shaking out, changing how the market views certain entities.
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Every business cycle has winners and losers, heroes and villains. Some earlier winners turned out to be losers. Tiger, the mega-crossover fund, has evolved from a market-dominating change agent in technology financing to a bag holder. SoftBank’s various Vision Fund efforts are suffering. And some crypto investments that looked to be massive wins have sputtered.
Torben Friehe, CEO of Wingback (YC W22), told TechCrunch earlier this year that many founders that he has spoken to have decided to hold off on fundraising in the current climate, adding that other founders from “across the ecosystem” are saying “that if you have to fundraise right now, you basically have to cut whatever you’d planned to raise back in January in half.”
The winners and losers scorebook isn’t that hard to draw up. But the heroes and villains ledger is a bit more difficult. But with the startup market so changed, so quickly, whiplash is setting in among the investing class. And some are pointing the finger not just at late-stage capital pools that poured too much liquidity into the startup market — some startup players are irked at accelerators, Y Combinator in particular. Let’s talk about it.
The return of fear
The latest missives from venture players are once again downturn letters. We last saw a round of these notes when COVID-19 first hit the world outside of China, leading to economic calamity and lockdowns. Investors warned startups to buckle up for bad times. But, as we now know, the bad times never came for most of them.
Instead, ironically, the pandemic became an accelerant of sorts, pushing more business toward tech companies that helped other concerns operate remotely; an accelerating digital transformation was another tailwind bolstering the tech sector, giving startups a shot in the arm.
The most recent round of warnings from venture capitalists appears more frequent than we saw in 2020, leading our own Natasha Mascarenhas to note over the weekend that “everyone is drafting their own startup Black Swan memo.” Among the various firms that sent advice to their portfolios was Y Combinator.
Y Combinator, or YC for short, is the world’s best-known accelerator. Its expanding cohort sizes, twice-yearly cadence and “standard deal” made it a trendsetting startup program; one that has sufficient heft to influence the overall direction of the early-stage market for funding upstart technology companies. And, after starting life offering “about $20,000 for 6% of a company,” YC raised its terms in 2020 to “$125,000 for 7% equity on a post-money SAFE,” along with reduced pro-rata rights “to 4% of subsequent rounds.”
That changed again in early 2022, when YC added a $375,000 note to its deal, offered on an uncapped basis but with most-favored-nation status. In essence, YC conserved its ability to collect 7% of startup equity early, with extra capital provided to its portfolio companies to put to work.
Over the last few years, YC has raised the valuation bar for its startups, from around $333,333 (6% of a company for $20,000) to $1.79 million (7% of a company for $125,000). Even more, the additional capital it now offers on an uncapped basis likely worked to cement early-stage startup expectations that their accelerator valuation was market valid.
Abhinaya Konduru, an investor at Midwest-focused venture fund M25, told TechCrunch that her firm has “been skeptical of a couple of national accelerators’ valuation practices from an investing standpoint even before the last couple of years,” adding that changes to early-stage valuations from select accelerators — she did not call any program out by name — “made it even harder to consider those companies for an investment to the point where [M25] stopped looking at them.”
YC companies from the last few batches, then, are now swimming in a dramatically changed market with 2020 and 2021 prices around their necks. How many will manage to keep their heads above water, avoiding down rounds or shutdowns, won’t be clear for some time. But that hasn’t stopped discontent from bubbling up among some investors and startup operators on public forums like Twitter, pieces of it aimed at YC for what some consider to be a role in helping inflate startup asset prices for early-stage concerns past the point of reasonableness.
Startup investor and operator Danielle Strachman noted that “YC’s batten down the hatches email has 10 bullet points on handling the downturn,” but included “no word[s] apologizing for advising founders to overvalue their companies in what was an insane previous market.” She went on to say that it is “not just limited cash that kills companies, it’s impossible caps to grow into.”
By caps, she is referencing the terms at which Y Combinator invested into its latest cohorts.
No trend in a global market is driven by a single player, meaning that YC is at most a participant in a market that lost its grip on fundamentals last year. That said, it is a huge brand for a reason.
Spider-Man pointing at Spider-Man
A lot of the discontent being voiced on Twitter seems to concentrate on YC not repenting for having updated its standard terms. At the time, we looked into the rationale behind the change, and the consequences to expect for the early-stage investing landscape. But most of the concerns were still hypothetical, so the situation is worth revisiting with the benefit of retrospect.
Has Y Combinator’s new deal changed the early-stage investing game?
Since Y Combinator’s winter 2022 batch, YC W22, each participating startup gets a total of $500,000 from the accelerator. Our take at the time was that the terms were mostly good for beneficiaries and self-serving for YC, thanks to the “most-favored-nation” clause attached to the larger of its two checks, which ensures YC gets as good a deal as anyone else in a later conversion.
What is good for YC, though, might not have been a net positive for the startup world as a whole. The move certainly left many investors unhappy, which wouldn’t be a big deal if some of the worries they expressed at the time weren’t coming true now.
First in closed circles, and now more publicly, early-stage VCs expressed concerns that YC’s new terms would result in overpriced startup valuations. And while determining the right valuation is no easy feat, all we can say is that 2021 valuations are proving hard to stomach in 2022.
It would be unfair to put all of the blame for overvaluation on YC. The market played a part. Indeed, Matt Levine, formerly of a16z and JP Morgan, wrote on Twitter that folks defending Y Combinator by saying that the accelerator did not tell startups what price to raise at “miss [the] point,” going on to say that when the market “went irrational,” funds from Y Combinator became expensive, leading to startups trying to “earn back” YC dilution by hunting for higher prices. He cited the MFN clause adding to the issue.
Adding to the mix, crossover funds created quite a few overnight unicorns that are now struggling. But when it comes to early-stage, YC often acts like a trendsetter, with many taking cues from its stances or lack thereof. If it’s fine by YC, why question things?
The problem now with YC’s new memo is that it makes its past silence blatant. For instance, it includes the following word of warning: “If you are post-Series A and pre-product-market fit, don’t expect another round to happen at all until you have obviously hit product-market fit.” Well, perhaps raising a Series A pre-PMF was a bad idea in the first place, except perhaps in deep tech or biotech. YC could have said something? Or at least acknowledge it now?
Or as rali_cap investor Kyane “Omowale” Kassiri said on Twitter:
— Kyane Kassiri "$300k at idea/pre-seed" (@kyanekassiri) May 19, 2022
The obvious retort is that YC didn’t have to speak up because it wasn’t bad for its participating startups. But we’d argue that things are more complicated.
Who gets hurt?
YC’s memo makes it clear: Even its alumni won’t have it easy. Its new terms are both aggravating and alleviating the problem, depending how you look at it.
Ever since the new terms were disclosed, we heard that high valuations represented a risk for some YC grads, and, more specifically, the growing cohort of startups based in emerging markets of Africa and Latin America. There, angel investors typically play a key role in bridging the post-YC and pre-PMF gap. But with valuations they considered unworkable for them, these players did the same as Konduru: They simply started passing on YC startups.
On the other hand, having more cash means that the latest batch of YC companies have more runway before they need to raise again. And since part of the investment is a SAFE, they have quite a bit of flexibility when it comes to term sheets and valuations.
The problem, in our view, occurs when you translate YC’s advice into less abstract terms. Startups are made of people. Extending the runway often means cutting costs. And in a world where office space is already out of the picture, this really, really often means layoffs.
Layoffs are the reason why we’re not keen on letting Y Combinator and others avoid partial blame so easily. At the very least, we’d love to hear how they’d avoid making the same mistake. The first step would be an acknowledgment of past oversights. After that? Some resolutions for the future.
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