Y Combinator presents its $2 million season at SAFE (Secure And Fnothingly Environments) with a limit of $20 million. While many investors have spoken out against such increases, YC partners in general they remain in this strategy and even YC founder Paul Graham talks to his puddening.
Many founders can be seen making fundraising decisions without realizing the long-term impacts on their companies. Since several seed investor models exist, it is important for founders to understand the underlying incentives and biases of different investor archetypes, ranging from YC to seed companies to multi-stage companies.
A summary is in the following table, which is then analyzed in greater detail.
COMPARISON OF THE SEED INVESTOR MODEL
And Combinator
There is no doubt that, overall, YC is a strong credential for founders in their early days and they have a great crop of winners. The question for early-stage founders is: “What is the hidden cost of YC fundraising?” Is the benefit distributed equitably?
Companies that secure a spot on YC not only receive a seal of approval, but also gain access to a network of high-quality peers and alumni to learn from. In exchange, YC gets a good deal: it invests $125.000 for 7% of the company and then a MFN (Most Favored Nation, a preferred option), allowing them to invest $375.000 in the future on favorable terms.
What's important to understand is that YC's goal is to find extreme outliers and invest in them.
YC's own Garry Tan recently shared that “we only make money when the company becomes huge and really valuable. Like Coinbase, Airbnb or DoorDash.” On the other hand, what happens to non-rocket companies, especially in a post-ZIRP (zero interest rate policy) environment?
The answer is that they are out of luck: the YC model is “survival of the fittest,” and struggling companies will likely go extinct. While this strategy has proven successful for their financial model, it certainly influences the way they advise and support businesses.
Setting prices too high at an early stage is plagued with problems that can affect the growth of the company if it does not work perfectly.
Raising a $2 million SAFE with a $20 million cap, whether on the advice of a YC partner or peer-induced fear of missing out (FOMO) from your groupmates, limits the type of investor that it can propose (whether the company realizes it or not) and raises the bar of the milestones necessary to build a Serie A.
Given that most Series A investors would seek at least double the initial raise valuation, consider the milestones that would be sought in a scenario to justify a $20 million valuation doubling to $40 million, compared to a $12 million valuation doubling to $24 million. .
Furthermore, when raising $2 million in a $20 million round, startup cap tables are usually filled with angel investors and two or three high-volume seed funds along with YC, and if they encounter any obstacles in their journey, There is no additional financial support for this.
High volume seed company
High-volume seed companies invest in between 30 and 100 deals per fund, and because they seek returns on a handful of massive successes, they are more focused on achieving a larger footprint of business coverage in a particular sector, geography or region. That is, another strategy than optimizing the ownership of a particular company. This leads them to invest with low or even no ownership requirements.
The nature of partnering with a high-volume seed company is that their strategy provides limited practical resources to support their portfolio companies. Given their exposure to so many startups, these companies often focus on content and community initiatives. In this sense, they actively connect founders and executives of portfolio companies with tactical crowdsourcing guidance.
In this model, portfolio companies occasionally spend time with partners who work with a large number of early-stage companies. So if a common question comes up about hiring or scaling, they see so many things that they'll usually have a helpful point of view or a founder who's been through a similar situation to draw on.
The problem is that, given the limited bandwidth that partners can provide, when companies face an inevitable challenge that is unique to their situation or that requires specialized knowledge outside of the partners' background or core experience, they are faced with forced to fend for themselves. Additionally, because this fund model focuses on making high-volume investments and then placing additional capital into some of the notable winners, there are limited financial resources to support distressed or not-growing portfolio companies.
Multistage inverters
Especially in this environment, it has been popular among multi-stage Silicon Valley companies, which typically invest in Series A and B, and which, in this environment, occasionally approach seed rounds. During the 2022 reset, early-stage investments were perceived as a safe haven (given relatively smaller check sizes) while licking their wounds after deploying excessively high volumes of capital in 2021. While raising funds from a company multi-stage seems like a very positive move, there is a big inherent risk in working with them in the early stage rather than waiting until Serie A.
On the plus side, raising funds from a multi-stage company gives seed startups great brand clout, a big check, and a high valuation. These factors can collectively be net positives if the startup's metrics and performance demonstrate sufficient rapid growth for a large Series A on good terms.
However, while multi-stage companies often tout early-stage investments as important and get the full support of their company, in reality they have limited time with their partner and limited access to broader company resources. . It's simply too small a check relative to the size of their fund and too early a stage of the company to align with the support they can or will offer.
The most important point to keep in mind with multi-stage companies is that early stage investments are only an option for them. Raising a seed round at a high valuation implies much higher milestones in ARR, customers, and overall business progress to raise a Series A, and if a company doesn't perform at astronomical levels, it will be left unsupported. It is difficult for companies to recover from the negative signal of a multi-stage investor pulling back along with failing to achieve breakout metrics for growth.
Concentrated seed investors
Last but not least, concentrated seed investors take a clear-cut investment view, often delving into specific geographies, specialized sectors and/or approaches based on defined thesis. Since these companies only make between 15 and 30 deals per fund, they are betting that each investment generates a significant return.
Technically, this capital is more expensive than the other options above, since concentrated seed companies require a high level of ownership, often between 15% and 20% (implying lower valuations), and prorated rights to be able to continue investing in its winners and generate strong long-term returns. So YC companies, as an example, raising $2 million in $20 million rounds is not a good start for them.
While they face greater net dilution, the trade-off is that founders receive much more practical support throughout their growth process, since the success of each company depends on its financial impact and its reputation. Concentrated seed companies offer support ranging from contracting services, marketing advice, technical support to help with product development among others. For first-time founders, this additional support can be a game-changer in the survival of their company. Even for repeat founders, the added boost of early support can help them achieve more milestones in a shorter period of time.
Additionally, concentrated seed companies help raise additional capital beyond the seed round. This can be in the form of providing financial support to distressed companies that need an expanded runway, supporting the raise of a seed extension round, or taking a hands-on approach to securing a Series A raise, including crafting the narrative, creation and review of collateral and make specific risk capital introductions.
Conclusion
Ultimately, each business archetype offers its own limitations, biases, and benefits. It is important for founders to know each of them so they can vet and select the best investor for their “decade-long marriage.”
Even if it is partial, it is advisable not to raise a SAFE of 2 million dollars with a limit of 20 million dollars. Setting prices too high at such an early stage is fraught with problems that can affect the growth of the company if it does not work perfectly. As explained above, it scares away investors who can have the most impact during the inherently riskier periods of a company's life.
General advice is to trade an incremental amount of dilution for the opportunity to work with a concentrated seed specialist with a hands-on support model that can help amplify initial efforts. However, it is crucial that a concentrated seed company has deep, domain-specific expertise that aligns with the startup's focus. This will ensure that the investor can provide the most relevant support and understand the appropriate KPIs to measure the health of the business. Founders can determine this suitability by doing their own due diligence and asking:
- Did this investor show knowledge of the market and ask thoughtful questions?
- Are you interested and excited about my category?
- Did you understand the differences between me and my competitors? ¿
- What milestones are you looking for to lead my seed?
