[Updated 10/19/15, 2:26 pm, with comments from Y Combinator.] Y Combinator, the 10-year-old pioneer of the now-ubiquitous startup seed accelerator model, is evolving to invest in later-stage companies that have graduated its program.
The question is what happens when early-stage accelerators enter the space normally occupied by traditional venture capital firms. Clearly, it opens up greater moneymaking possibilities for the accelerator, the new fund’s investors, and the companies that get funding. But it remains to be seen how the move will affect the startups and VCs that get left out of those deals.
Y Combinator, or YC, recently raised a $700 million “continuity fund” that will invest in each round raised by all of the companies that participate in the accelerator and are valued at up to $300 million. The fund will selectively cut bigger checks to portfolio companies valued at more than $300 million. The new fund’s backers include Stanford University and the firm overseeing Michael Bloomberg’s investments, Willett Advisors LLC, according to the Wall Street Journal.
Michael Greeley, a Boston investor with Flare Capital Partners, wasn’t surprised by the news.
“I think it’s the natural evolution of small funds that have proprietary deal flow,” Greeley says in an interview. “Large institutional investors want to have access to that.”
Indeed, YC’s move follows another well-known startup accelerator, Techstars, raising $150 million earlier this year for its third fund, which is making seed and early-stage investments in startups that have graduated from the accelerator or have other ties to the program. And a few days before the YC fund was announced, AngelList—the online portal where startups can raise money from a crowd of accredited investors—said it raised a $400 million fund backed by one of China’s largest private equity firms, CSC Group.
Raising these funds now is a smart play because it might not be so easy to snag truckloads of cash when the frothy venture fundraising climate inevitably changes. (Greeley, for one, is reading the tea leaves and wondering if the end is nigh.) When that happens, YC and its peers will still have the money to support companies.
“I can count on one hand the incubators that have the ability, the brand, and the proprietary deal flow that could do this,” Greeley says. “Just because you’re an incubator, doesn’t mean you have the ability to go raise a big fund. But the obvious ones have now done that.”
“Maybe this is a new disruptive force in the venture industry,” he adds.
Y Combinator looks a lot different today than it did when entrepreneur Paul Graham and his girlfriend, Jessica Livingston (now his wife), started it in Cambridge, MA, in 2005. For its first four years, the accelerator rotated sessions between Cambridge in the summer and Mountain View, CA, in the winter, until its leaders decided to run the program in Silicon Valley year-round.
Sam Altman was put in charge of the accelerator last year, and his moves have included increasing the number of companies accepted into the program to more than 100 per year, the Wall Street Journal reported. (Graham, reached via e-mail, says he is no longer involved in YC’s day-to-day operations.)
Selected companies, primarily in software and mobile apps, receive $120,000 in exchange for a 7 percent equity stake. The startups also receive three months of business training and connections to investors, alumni companies, and other resources. At the end of the session, startups pitch to a room full of potential investors. Well-known program graduates include Reddit, Airbnb, and Dropbox.
The $700 million fund is a big step for Y Combinator, and it raises two concerns for Greeley.
First, he says, it potentially means new competition with venture capitalists because YC was previously only focused on making identical seed investments across the companies that go through its accelerator program.
“I think the friend or foe question is now a real question,” Greeley says. “Before, they were friends because they were so early, they embraced venture firms, they worked with them very carefully.”
Now, if an accelerator graduate is raising a round, and YC invests half of that money, that’s money “that another independent venture firm didn’t get to invest,” Greeley says. “It ultimately is a zero-sum game, and there’s a crowding-out effect.”
The other concern, Greeley says, is the “negative signaling” that could hamper a YC portfolio company’s ability to raise capital if the new fund passes on investing in a bigger round for that startup. That could be a red flag for outside investors like Greeley.
“Before, you never worried about Y Combinator having an inside track on something,” Greeley says. “But now, I think I would say if a Y Combinator company came out and was raising a big round and the Y Combinator Continuity Fund passed, I would ask a lot more questions just about that one issue.”
Ali Rowghani, the former Twitter chief operating officer who was tapped to run YC’s new fund, shrugged off both of those concerns in an interview with TechCrunch. He said the fund won’t do early-stage funding rounds, and he pointed out that later-stage rounds are “larger and more collaborative,” and “aren’t typically winner-take-all situations.”
As for the negative signaling concern, Rowghani said that’s more of an issue when companies have just graduated from the accelerator program and YC has more inside information than other investors. Avoiding that situation is partly why the new fund will invest at later stages, he told TechCrunch.
Rowghani shared more of his perspective in an e-mail message to Xconomy on Monday afternoon.
“Investors value later-stage companies based on each company’s own performance metrics,” he says. “We don’t believe that YC investing/not investing creates meaningful signaling issues for companies that have a track record of performance by which investors will judge them. These metrics are much more important than any signal, positive or negative, that a follow-on investment from YC would send.”
