
Pro Rata - craigkerstiens
http://blog.ycombinator.com/pro-rata
======
grellas
We live in an era where major founder leverage is a fact of life in the
startup world. Unlike the bubble era, founders today - or at least those that
are among the most talented - have substantial power in determining the
direction of their ventures and the investors who most benefit from this are
those who win their favor and align their interests along with those of such
founders.

YC is an innovative venture capital firm whose model depends heavily on its
maintaining credibility with the talented founders who run the ventures it
funds. In this sense, it has caught the spirit of the age brilliantly and that
is why YC stands out as one of the premier investment firms of our era.

A key element in this approach is for YC to do what it has done all along and
that is to take common stock instead of the almost sacrosanct preferred stock
that VC firms have always insisted on in the past. This radical innovation in
VC-style funding has set YC apart from the pack of VC firms, incubators, and
any and all other manner of investor wanting to hitch their wagon to the
talented founders who are capable of building successful, massively scaling
ventures that seek to transform all of world commerce. Its importance cannot
be emphasized enough as a key to YC's success. It has enabled YC both to be in
the midst of the fray and to stand above it, all at the same time. It is the
founder's ally even while it benefits mightily as an investor.

What then to do after the founding stage to avoid dilution to its initial
investment stake without jeopardizing credibility with founders? If YC were to
pick and choose in participating in early follow-on rounds, this would
selectively help and simultaneously hurt the various founders it works with.
Almost by definition, the fact of such an investment would brand some YC
ventures as in and others out of YC favor, a result that would prove highly
damaging to the aura of goodwill that is not only helpful but absolutely
indispensable for YC to maintain with its founders.

So how to maintain that goodwill and still avoid subsequent dilution in the
various investment rounds that inevitably follow from the inception of star-
quality companies?

Well, you can set up some fixed rules, make such follow-on pro rata
investments automatic within the defined bounds that make sense for YC, and
use that as a way of extending YC's leverage to help it keep the 7% (or
whatever) stake it begins with in each venture.

And that is precisely what YC has done here with its pro-rata program.

Founders usually have no problem with early stage investors being able to
participate pro rata in later rounds as long as they are significant investors
and as long as such participation does not jeopardize their ability to raise
later-stage money on good terms.

YC is of course a significant investor.

As to jeopardizing future funding terms, I believe YC has made a judgment call
here that the investors it typically works with will have no problem taking
something less than their accustomed full pieces in the later rounds to
accommodate YC and will therefore continue to finance YC ventures exactly as
before. Hence, no prejudice to founders and no loss of goodwill or credibility
among founders.

I believe this is a sound calculation. YC has been able to persuade VCs to
deviate from a variety of their traditional rules/requirements as part of
being a part of the YC universe. This is just one more to be added to the
list. It is a world of increased founder leverage and that means investors who
want to stay with the deal flow need to adjust and adapt. I think they will do
so here as well.

In a worst case for YC, this might prove a failed experiment. But the downside
of the experiment's failing is minimal while the upside in being able to avoid
later-stage dilution among a vast group of potentially valuable ventures is
huge. Thus, this makes eminent sense for YC for sure and probably for its
founders too. As for the VCs who will have to adapt a bit, they will survive
and very likely continue happily investing just as before. At least that is
how I read it.

~~~
petervandijck
1 copywriting quibble: "We live in an era where major founder leverage ..." ->
it's not an era, it's more like a few years and it could flip pretty quickly.

(Sorry couldn't help myself.)

------
frisco
Maybe I'm reading something wrong here, but I think this actually
substantially complicates the YC decision calculus. YC today is an
overwhelmingly good proposition and so I do think they can add this without
turning any off, but this does make further rounds either slightly harder or
more expensive.

If a VC wants to own 20% at the end of an A, or 10% after a B, having YC in
there with rights to buy back up to their 7% can add real dilution you
wouldn't have otherwise wanted or needed to incur. As someone who did a party
round seed and had a crowded A, it really does add up; though, it's for sure a
first world problem and won't kill you, whereas YC for many companies is when
they get serious.

YC is so valuable that this won't turn anyone off at the traditional YC early
stage, but I wonder how this will affect things for the "late-early" companies
they've been taking more of in the last few batches.

~~~
sama
The numbers are pretty small. Pro rata doesn't apply to employee option pool
dilution, so it's really probably only 5% of a round. If a VC says they will
do an investment if they can own 20% but not 19% of a company, I believe they
are lying.

~~~
jasonmcalacanis
Sam is right.... VCs put a line in the sand and everyone gets into a tizzy.
Then you say to them "listen, I gave prorata to my early supporters and I
intend to keep my word and reward them for their support."

The VC then has respect for the founder and say "OK, let's do it."

If they don't respect the prorata of the existing investors you need to ask
yourself if this is the right VC to have as a partner. If they are so
encouraging of you to screw your existing partners, how do you think they will
treat you in a down market?

------
staunch
YC has forgone billions by not maintaining their pro rata share in the past.
Later VCs got that extra money. Now YC will get it. Seems fair, correct, and
much better for the world. They'll do useful things with it. Another very
impressive improvement. Keep 'em coming!

------
jparker165
This may greatly change incentives for YC.

I've always thought being an LP in YC would be fantastic because of the
valuation bump companies get on demo day. Let's say a company could raise
money at $5mm valuation, but instead gives 7% to YC, and as a result can raise
at a $10mm valuation => (1) founders win by keeping more equity, (2) YC wins
by their investments getting cash with less dilution, and (3) post-YC
investors pay more (maybe still great investments, but not as good as getting
in at $5mm).

But to maintain 7% in companies up to a $250mm valuation, it seems that the
vast majority of YC's deployed capital will be in the place of what was
previous a "post-YC" investment.

YC should still be in the business of finding great companies, but might not
makes sense for them to help get gangbuster valuations at demo day.

~~~
sama
It is a statement that we believe investing in YC companies at post-YC
valuations is still a great deal.

~~~
jacquesm
I notice you use the words 'aim' and 'try' in your message, what do you think
is the risk that if YC does not simply always do this it will be perceived as
a very negative signal by other investors in later rounds?

~~~
larrys
I'd like to know the answer to your question but note the fact that sama says
this:

"we believe investing in YC companies at post-YC valuations is still a great
deal"

but also says this (from the post):

"And by doing this in every YC company, there will be no signaling issue of us
supporting some companies and not others."

So how can you have both statements be true?

In other words how can you say "still a great deal" and also acknowledge that
you are investing in all companies, not only ones that are a "great deal",
simply so there is no signaling?

~~~
nostrademons
I assume that he's running the calculation as a whole, on the entire body of
startups. In other words, _given_ that these pro-rata investments must be all-
or-nothing to avoid signaling risks, what're the financial returns of
investing in the entire body of YC startups that raise follow-up funding,
regardless of whether they're actually a good deal individually?

I can see how this could easily turn out in YC's favor. For one, the really
obvious failures often flame out during YC itself and fail to raise follow-up
funding, and so YC wouldn't have any obligation there anyways. And the really
big successes become worth far more than $250M, enough to subsidize many
failures.

The big question for me is what it does to incentive alignment - it seems like
YC now has an incentive to ensure that companies it doesn't like don't raise
follow-up funds, as well as incentives to get lower valuations on the early
funding rounds. It also in theory should make them pickier about their
application process, knowing they're committed to participating in any follow-
up rounds. On the plus side, they have an incentive to ensure that promising
startups _do_ raise follow-up funding (rather than go out of business), it
avoids some of their misaligned incentives relative to the rest of the
investment community, and they have an incentive to keep helping their
investments later in life.

~~~
rl3
> _On the plus side, they have an incentive to ensure that promising startups
> do raise follow-up funding (rather than go out of business), it avoids some
> of their misaligned incentives relative to the rest of the investment
> community, and they have an incentive to keep helping their investments
> later in life._

YC already has incentive to do this; their post-dilution stake in wildly
successful companies still shakes out as being far from trivial.

That said, it would certainly be fair to say that these changes probably do
serve to strengthen existing incentives.

------
coherentpony
What does this mean?

I have zero business acumen and have no familiarity with investing or how new
companies work.

~~~
theOnliest
Related: is there some reliable "startup jargon for dummies" page somewhere?
I'm often confused with all the talk of rounds, vesting, dilution, and
whatnot. I know there are books, but I'm not planning to get into the startup
scene; buying a book doesn't seem worth it to be slightly less confused on a
website I waste lots of time on.

~~~
ohitsdom
I second this request. Google took me to investopedia to learn "pro rata", but
that wasn't as helpful as reading these comments. The startup community has so
many buzzwords. My understanding of the jargon has increased a lot in the past
year I've spent time on the site, but I still don't know much.

~~~
jsprogrammer
Round: Some people are purchasing shares of your company. Given cute names to
indicate how many "rounds" you've done: Seed, Series A, Series B, Series C,
Series D, Series E, etc

Vesting: When you actually get the shares (instead of just being promised
you'll receive them)

Dilution: When the pool of shares expands without the existing shareholders
receiving a commensurate proportion of the new shares (used to transfer value
from existing shareholders to new). Usually occurs after each Round completes.

------
memossy
To put this in context YC is pro-rating its 7% to maintain that level until
companies have $250m valuation.

YC companies to date have raised $3bn in total so far, with a couple dozen
above $100m out of just over 800.

Therefore at most YC would have invested $210m if they'd done this from the
start.

It basically adds up to a couple hundred thousand on Series A, 0.5-0.8m series
B, $1-2m at series C, then at series D you'd hope to be approaching $250m

Given a propertied fund size of $1bn this makes sense in backing winners
probably funding 200 companies a year at $200-300m/year, particularly as major
pickup in valuation is A to C

~~~
sama
The math is off here; YC companies have raised more than double that amount.

~~~
memossy
Sorry, was looking at last summers amount [http://blog.ycombinator.com/yc-
portfolio-stats](http://blog.ycombinator.com/yc-portfolio-stats)

A run rate of $2-300m if its a $1bn fund (suppose you'll let everyone know
soon!) would make sense

------
leelin
Does that mean YC will fight against the "Major Investor" clauses in funding
rounds that only allow pro rata rights to investors who have X% ownership?

[http://www.2-speed.com/2014/09/dreaded-major-investor-
clause...](http://www.2-speed.com/2014/09/dreaded-major-investor-clause/)

Of course, 7% might be enough to overcome the threshold in many cases, but as
an angel investors in YC deals, I have lost my pro rata rights following a YC
Note/SAFE conversion this way (despite the docs suggesting I am protected).

~~~
hobbyjogger
It depends on how the YC pro rata rights are documented. It's entirely
possible that their pro rata right will be completely independent of any later
pro rata right for major investors (i.e., the major Series A investors might
get their pro rata rights _in addition to_ the continuing YC pro rata).

That blog post is helpful but not the best source of info. For one, it
confuses preemptive rights (right to buy a % of future financing) with first
refusal rights (right to buy shares from other current stockholders who try to
sell). And second, it's rather one-sided. Companies understandably want to
limit these rights to only big investors for a number of reasons but
especially because (1) it really can be expensive/time consuming to
continually contact or chase down signatures from an investor base that
eventually might include dozens of people/entities, (2) it can make it really
hard to convince new investors that the investment will be worthwhile when
there are pro rata rights to buy up a huge chunk of the round and (3) there's
a major signalling problem when the prior angels have these rights but choose
not to use them (the author mentions that he always demands these rights but
doesn't always use them, which can scare off other investors and, what's
worse, many angels will decline for innocuous reasons such as a seed-stage
only investor who never does follow-ons or a smaller angel who is priced out
by a high valuation).

------
jacquesm
I don't presume to know more about this stuff than the YC people, who are
scarily good at it but this is a significant departure from 'our goals are
100% aligned with those of the founders, what's good for them is good for us'.

~~~
brudgers
I guess it's a question of whether on average YC is as good or better a post
seed stage investor as the average VC who invests in YC companies. If YC is as
good or better, then the _pro rata_ is aligned with founders' interests since
the founders are raising X dollars at Y valuation either way and it's just a
question of which pocket the money comes from...it's still the same color.

In the universe of unicorns and rainbows, YC's participation puts the rest of
a round's participants on their good behavior to reduce risk on future deal
flows and the founders get a better deal. The situation in the universe with
evil Spock is of course different, but it was going to turn out that way in
that universe. In between a founder could probably ask YC not to participate.
Since the investment is blind and YC is under scrutiny by potential founders,
it may not be in YC's interest to force the issue and suffer Tweets of
outrage.

The potential problem is a bad cap table and the first order issue is VC that
treats that as an acceptable byproduct of a round it is leading or a company
that does not have better options.

------
tyrick
"We will try to do this for every company..." If for some reason this term is
not exercised, it will now unequivocally reflect badly for the company. I
don't question the good nature and authenticity of a YC "try", but the
sentence does naturally express doubt.

~~~
sama
We will do it whenever we possibly can--our goal is 100%. There have been
occasional instances where a company doesn't get us docs until 3 hours before
a close or something.

~~~
Skrypt
Is that the only reason? Or will there still be some sort of veto power by YC
partner(s) to opt out of the future round in extraordinary cases?

------
brayton
Who are the LP's of this follow on money?

------
jim_greco
The pro-rata provision is only for raises of $100M or more post-money. Is YC
only going to do these transactions for post-money between $100M and $250M? Or
will you ask to be part of raises below $100M?

~~~
snowmaker
Is that true for the provision for companies in S'14 or later? The new policy
will only apply to those companies.

~~~
jim_greco
It's true for W15.

------
foobarqux
Is the cash coming from the new growth fund that YC raised recently? Does that
fund have non-YC LPs?

------
ub
I guess this is a way for YC to participate in the upside of the most
successful companies without creating signaling risk. But from a pure
investment perspective, there's a possibility it might not end up being that
prudent. It will all depend on the home runs. If YC can create a few multi-
billion dollar companies, this will work out well.

~~~
briholt
Looks like there's a useful built-in selection bias. YC commits itself to
investing in future rounds, but only good companies will be able to raise
future rounds, so they probably won't get stuck doubling down on too many
failing companies.

~~~
_delirium
> only good companies will be able to raise future rounds

Given the rather poor returns of the VC sector overall, I'm not sure you can
make this assumption without more qualification.

~~~
briholt
Fair enough:

* ...only not-completely-screwed-up-trainwrecks will raise future rounds...

------
philipodonnell
I have noticed this language about avoiding signaling in previous YC
announcements and I think its a great thing to be cognizant of. Setting aside
the fact that YC itself is an enormous signal, its a sign of maturity to
realize that even your inaction is a signal. I imagine there was feedback from
past YC classes who didn't receive follow-investments that were suffering more
from the absence of YC than simply the lack of those funds.

Once you realize that you could either stop funding companies after graduating
altogether or invest in all of them, both of which remove the signal. With the
funds they have, clearly there is considerable risk tolerance for the latter.

------
lpolovets
Just curious, will this change how SAFE docs are structured? IANAL, but right
now SAFEs make it challenging for seed investors to get pro rata. That has
already been frustrating, and becomes a little more frustrating if YC
automatically gets pro rata on top of that. I know it's a free market, and I
don't have to invest if I don't like the terms, and so on, but it feels weird
for me if YC takes pro rata by default, while their default docs for seed
investors are stingy with pro rata rights.

~~~
MatthewMcDonald
The default SAFE docs [0] already have pro rata rights agreements in them.

[0]
[http://www.ycombinator.com/documents/](http://www.ycombinator.com/documents/)

~~~
lpolovets
Interesting. I wonder if the docs evolved at some point. In the first few
SAFEs that we did, we had to get side letters/special agreements for pro rata
rights.

------
lmeyerov
I wonder if this is truly founder friendly. Pro rata is a right given, and 7%
changes a _lot_ of the calculus when doing a round that is probably 20% to
begin with. Hopefully this goes along with YC asking for less equity, or some
other allowance. (IMO, most incubators already ask for much more than they're
worth, though YC obviously being a bit different.)

~~~
hobbyjogger
Eh, it's really not such a big deal. Maintaining 7% in a round for 20% total
only lets YC buy 1.4%. As sama said elsewhere, the difference between 20% and
18.6% (with an equivalent reduction in their $ invested) shouldn't change much
for a serious VC.

Given YC's history and reputation of being very supportive of founders, any
founding team is also probably better off with YC taking a cut in a round that
would otherwise go to another investor, especially given that the list of
investors who are as founder-friendly as YC is pretty short.

------
dataker
Is the Pro Rata agreement going to work only after receiving further funding
or is it once you join the program?

Couldnt that keep outside investors away?

------
thomasrossi
I don't see the reason to send no signals. There must have been at least one
situation where investing in a followup was bad. Declaring a strategy like
that is puzzling, I assume they have run a simulation

------
cfarm
What do early stage founders think of this? Like, hate, neutral?

------
1arity
So cool. YC is revolutionizing itself these days. YC Fellows, Pro Rata. Many
things people have suggested they might or would do are now coming to pass.
What's next ?

------
snakeplinkskin
What is the official success & failure rate for Ycombinator companies? What
percentage of companies succeed?

------
tonyhb
Are YC becoming a standard VC firm?

------
cdelsolar
Can this be applied retroactively?

~~~
devNoise
I don't think so since the pro rata wasn't in their "standard investment
documents". Thus YC doesn't have a clause that allow them maintain their 7% in
future funding rounds. Trying to maintain 7% on previous YC alumni, may caused
the mixed signals they are trying to avoid with this change.

------
jsprogrammer
No terms available?

~~~
loumf
The terms are usually the same: invest at the new round's valuation such that
ownership percentage is maintained. They will only follow, so the valuation
will be set by others.

~~~
jsprogrammer
Would be nice to see it in writing instead of assuming it's 'the usual'.

~~~
loumf
[http://www.ycombinator.com/docs/Series_AA_IRA.docx](http://www.ycombinator.com/docs/Series_AA_IRA.docx)

------
SandersAK
an announcement internally would have been nice...

~~~
sama
Doesn't apply to you--as mentioned in the post, only companies from S14 on.

~~~
beambot
Announcement says you have the pro rata provision baked into docs in S14
onward... but from your statement, it sounded (to me too) like founders from
previous rounds could also count on YC's participation if the startup
voluntarily holds open some room for YC in subsequent rounds:

> We will try to do this for every company in every round with a post-money
> valuation of $250 million or less.

~~~
sama
Fair; updated the wording. Thanks.

------
loumf
> Many new investors really like to see the support of existing investors.

Right, because it's a signal that you think the business is worth this round
of investment. Since you set this up as not being a useful signal, I think the
investors will probably seek out signal from you behind the scenes.

Perhaps this is ok, since it won't be public and won't have the effect of a
negative signal for the ones you don't give secret signal to.

EDIT to clarify: I believe new investors "like to see support" because it's a
signal. If it can't be used as a signal (as will now be the case), they will
seek signal anyway (in informal ways). I think they will do this by feeling
out YC through back-channel communications and "kremlinology" type
interpretations (even if YC tries really hard not to signal)

~~~
URSpider94
One argument would be that VC's are starting to feel like ALL YC investments
are overhyped, and that YC is generating its own returns via demo day.
Participating pro-Rata in all future rounds is a signal that YC continues to
think its participants are a good investment even after demo day.

