Y Combinator Alters Investment Package to Avoid “Contested Divorces”

11/26/12Follow @wroush

Startups admitted the Winter 2013 class at Y Combinator, the prestigious startup accelerator in Mountain View, CA, will be greeted by a smaller investment package. Under a new program outlined in a blog post today, startups will get $80,000 each from a group of four outside venture investors, in addition to Y Combinator’s investment of $11,000 plus $3,000 per founder.

That’s quite a drop from the $150,000 invested in startups admitted to the last four classes—but according to YC co-founder Paul Graham, there are some good reasons for the change. The main one: the larger package was causing troublesome money disputes inside fizzling startups.

Y Combinator’s biannual program offers mentorship and product development help to about 75 startups per class. About a third of those startups dissolve within a year of exiting the program, according to Graham. That’s not an outrageously high rate—YC knows and expects that quite a few of the entrepreneurs it admits will fail to get their risky ideas off the ground.

But the more money is at stake, the harder it can be to wind down a startup. “In the case of the startups that were falling apart, it sort of turned into a divorce where there is a large fortune a stake,” Graham told Xconomy this morning. “Because they had this pile of money on the bank, they ended up fighting over it, and we wound up being in the middle of these disputes.”

Graham said that in recent years, YC co-founder Jessica Livingston (who is also Graham’s wife) has spent “a majority of her time” trying to mediate financial disputes between the founders of failing startups.

Graham thinks the new amount, $80,000, will be just enough to keep promising startups afloat for the first year after they exit Y Combinator, but not so much that the unsuccessful startups will have lots of money left to quibble over.

In setting the amount, Graham says, YC was particularly concerned about making sure that startups he calls “ugly ducklings” have enough time to experiment.

“There are three cases for [YC] startups,” Graham explains. “There are some startups that raised tons of money after Demo Day but don’t really need it; it’s just sort of insurance. There are other startups that don’t raise money after Demo Day, and are never going to, because they are never going to succeed, and for them it’s just a loss. But there is this middle ground where you have a startup that doesn’t raise money on Demo Day, not because they suck but because they are working on such an outlier of an idea that it doesn’t look attractive on Demo Day. I call this the ugly duckling scenario. The whole point of this money is for those startups. The goal is to give them enough money so that if they are working on an experiment that hasn’t achieved results by Demo Day, they can keep working and they don’t have to shut it down prematurely.”

There’s an interesting history to the blanket funding offer that recent Y Combinator startups have received. In early 2011, Moscow-based investor Yuri Milner and San Francisco-based angel firm SV Angel banded together to create a new entity called Start Fund, and pledged to invest $150,000 in every startup admitted to Y Combinator, on extremely easy terms. The money came in the form of a convertible note with no valuation cap, meaning the percentage of each startup’s equity going to Start Fund would remain undetermined until the startup’s valuation was set in a seed or Series A funding round.

Up to that time, the only money coming to YC startups had been YC’s own investment of $11,000 to $20,000 per company—an amount intended merely to help cover founders’ living expenses during the three-month program. (The exact amount depends on the number of founders involved.)

The Start Fund offer changed the dynamics of the program considerably, giving startups more breathing room or “runway,” to use the Valley lingo. It enabled many startup teams to spend more time on product development and customer outreach and less on fundraising.

But Graham says Start Fund didn’t consult with Y Combinator when it picked the $150,000 figure—and he says that if he’d been involved, he would have recommended a lower number from the beginning. He says successful startups don’t need that much, and unsuccessful ones just end up arguing over it.

“When Yuri and Ron were talking about how much they wanted to invest between them, if I remember correctly the original number they were talking about was even higher,” Graham says. “I said no, all you need is enough to keep the founders working for a year. The funny thing is that the $150,000 amount was designed to help the groups that are in the middle”—the ugly ducklings—“but where it was causing us trouble, and made us decrease the amount, was in the third case, where things are falling apart.”

Along with reducing the size of the outside investments, YC announced some changes to the way the new “YC VC” program will be run. SV Angel is out of the picture; Graham said in a comment on YC’s Hacker News website that “it just didn’t make sense with their fund size to keep doing these investments” at the new amount. The money will now come equally from Yuri Milner, Andreessen Horowitz, General Catalyst, and Maverick Capital. YC itself will handle the money and the associated paperwork—something that was already happening in a de facto way with Start Fund, Graham says.

On top of that, the four outside investors will hold formal office hours to meet with startups. “Last batch, we tried this experiment where we invited a bunch of VCs to do office ours, and we rewrote our [scheduling] software so that third parties could use it, and that worked really well,” Graham says. “So as long we were redesigning this thing, we decided to make that part of it.”

I asked Graham whether halving the size of the investment package offered to YC startups might make the program less attractive to founders. For most startups that apply to the accelerator, he says, the money is a secondary consideration. “After Yuri and Ron start doing this, I asked the second batch of startups, on the day after we had accepted them, how many of them knew about the Start Fund. Only about half of them even knew about it. So it might be a factor for some startups, but I don’t think so for most.”

Graham says he hopes $80,000—which will still be offered as convertible notes with no valuation cap—“will still be enough to pay the living expenses of the guys in the ugly duckling case, and decrease as much as possible the contested divorce case.” But YC might raise or lower the amount in the future depending on what it learns from the incoming batch of startups. Interviews for the Winter 2013 batch start tomorrow.

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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