The most elite school for Silicon Valley startups just threw a wrench into the works
Y Combinator has spawned some of the biggest startups in Silicon Valley, like Airbnb and Dropbox, only to push them out of the nest when they graduate the three-month accelerator.
Y Combinator graduates get an even $120,000 investment in exchange for seven percent of equity. From there, the alumni network helps take care of their own, but there's no more financial support from the program.
The system has worked. The elite startup school that has funded more than 800 startups since 2005.
But the system changed dramatically this week.
On Thursday, Y Combinator President Sam Altman announced that the accelerator had raised a $700 million "Continuity" venture fund to do just what its name implies.
Run by Twitter's former COO and YC partner Ali Rowghani, the Continuity Fund will invest only in Y Combinator alumni after they've graduated from the accelerator.
In other words, the startup school that used to groom and present companies to other VCs to help them grow is now going to compete with those very same VCs a few years down the road.
How the fund will work
The first way the Continuity Fund will invest is by exercising Y Combinator's "pro rata rights," a venture capital term that means a fund can continue to participate in future rounds to maintain its same ownership share. The fund has promised to exercise those rights on any Y Combinator company's raise if it is below a $300 million valuation.
Above that, the fund is reserving its rights to be more selective.
"Its actually somewhat unusual for an investor like us to not continue to do pro rata," Altman told Business Insider. "So the founders were saying 'Can you continue to support us?' and we just didn't have the money to do it."
Y Combinator first decided it would just do the pro rate piece, Altman said, but as it started raising money, it found many "hard tech companies" — like nuclear power or rockets — have trouble raising large rounds of capital in their later stages.
"Somewhere between very hard and impossible actually. There just aren't that many investors who are willing to do that," Altman said. "So we're thinking to ourselves, if we're going to keep putting these companies through our program, it's important that we continue to support them and help them raise large amounts of capital later."
At the later stage rounds, the Continuity Fund starts looking like more of a competitor in the funding landscape.
The fund will invest in growth stage rounds — the ones typically a few years before an IPO where nontraditional investors like Goldman Sachs or T. Rowe Price participate. In a Q&A with Y Combinator, Rowghani, the fund's lead, said it will even lead rounds and join a board seat.
"Most VCs don't love the growth rounds. Most VCs love the A and the B rounds which we've said we're not doing," Altman said.
Not picking favorites...at first
Fellow venture capitalists, especially in the earlier stages, aren't really concerned about the change. One venture capitalist said it "makes sense" that the accelerator that that has built its reputation on supporting its investments in so many other ways would continue to do so in a financial way. This same investor also applauded Y Combinator for its transparency in how it will keep the field level for investors in the earlier stages to still come in and lead rounds.
"We will still look to Y Combinator graduates as great potential investments at the early stages where we take active board roles and help the founders build their companies," Greylock partner Josh Elman told Business Insider in an e-mail. "At the later stages, it seems that growth investors will have to compete with the Continuity fund which may have inside knowledge on the companies."
Jumping into the late-stage game will be fun to watch for many of the early stage investors who have come to know the accelerator as only the starting point of some of the highest-valued startups in tech.
"I'm really excited to see how Sam's planning on adding value to late-stage companies," said Tim Young, a founding general partner at Eniac Ventures.
This is a big bet on startups, and not all of Y Combinator's companies will make the later stage.
Altman doesn't see this as picking his favorites from a batch, and will keep a careful eye to make sure there's no unintended consequences, he said.
"There are a bunch of other firms that pick their favorite children at the end of the program, and that's just absolutely disastrous. We would never do that," Altman said.
However, he acknowledges that startups may change their view of Y Combinator over the years. What was their launch pad and debut into the startup scene will become a cash source in the future. Altman hopes he's set it up so that companies will continue to come to Y Combinator for advice on both their highs and lows, but that may change down the road when the company looks more like a potential investor and board member.
"Once a company is 3 or 4 years out, and raising a round at half a billion or a billion dollars, yeah at that point they're going to view us as potential investor and probably treat us differently," Altman said. "But during the program, as we designed this, we limited our own economic upside so it doesn't change for these founders."
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