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Ask HN: Will Y Combinator taking Sequoia investment hurt the YC companies?
38 points by bravura on Oct 22, 2009 | hide | past | web | favorite | 41 comments
Does taking YC money blended with Sequoia money lead to unfavorable terms down the line if raising VC?

As you probably know, YC is taking money from Sequoia to help fund YC companies this term: http://ycombinator.com/party.html

Chris Dixon (http://www.businessinsider.com/the-problem-with-taking-seed-money-from-big-vcs-2009-10) and Venture Hacks (http://venturehacks.com/articles/options-open) put forward the following argument: Although Sequoia does not get right of first refusal, having a single VC participate in a company's seed funding can nonetheless hurt the company in the long run.

What do people think about this potential downside?

Top tier firms like Sequoia already have a de facto right of first refusal on the entire startup market. They already see every deal. So if Sequoia passing on a deal deterred other funds from investing, they wouldn't be able to invest in anything.

Which in turn is why Sequoia was willing to invest in us without imposing any conditions. Because the top tier funds already see every deal, it's in their interest merely to increase the number of startups, just as, because Google has such a big percentage of the search market, it's in their interest merely to increase Internet usage.

Sequoia does get an early look at all the startups, but this was not a condition of the deal. They always have. (All the speakers get an early look at the startups; it would be hard for them not to; and since winter 2006 the VC speaker has always been Greg McAdoo.)

My understanding of the Chris Dixon + Venture Hacks argument is: VC participation in a seed round means that they have a deeper understanding of the company than if they merely see a deal and pass on it. This implied deeper understanding gives them greater leverage in controlling the terms of a future financing.

So Sequoia passing on a deal doesn't deter other VCs because they might just say: "Well, Sequoia might not have given this deal enough scrutiny to see the value." But if Sequoia is already a seed investor, it is more difficult for other VCs to convince themselves of that.

Please correct me if I'm wrong here.

Sequoia doesn't participate in the seed rounds in this case. They have the same relationships to the startups we fund that Sequoia LPs have to startups they fund. They're entitled to a percentage of our returns, but they don't pick the companies or own stock in them.

Also, within the industry the phrase "passing on a deal" does not mean anything as casual as it sounds. It implies that an investor has scrutinized it fairly closely and made a conscious decision not to invest.

Founders who can't take a "pass" and investors who can't stomach investing in one will not make it long term anyways. Those are just egos talking. Great teams will breed success and Sequoia is another great team to add to the YC concept.

>They already see every deal. So if Sequoia passing on a deal deterred other funds from investing, they wouldn't be able to invest in anything.

True, but you can't deny the fact that it's now more likely Sequoia will back YC-funded companies. As a result, other VC's will have some additional reason for concern when Sequoia doesn't invest.

you can't deny the fact that it's now more likely Sequoia will back YC-funded companies

Why should they be any more likely to back YC funded companies? They already funded all the ones they thought were good enough.

Are you saying they'd now start to fund borderline cases in order to increase returns from their share of our returns? If you run through the math it's obvious that would be a stupid move.

Why would it be a stupid move to invest in a company whose success would make you more money?

If I were Sequoia, choosing between two companies with the same credentials and equally good business models, I would choose the one backed by YC because its success could potentially make me more money in the long run.

Because if the startup wasn't one they'd have funded otherwise, it would be the world's most extreme case of throwing good money after bad. They'd be investing millions to improve their return on an investment of tens of thousands.

PG is right on. Sequoia didn't get this far by dumping money into failing companies just because they had previously dumped money into them.

Makes sense to me.

Welcome to the difference between theory and practice. In theory you are right. In practice you are not.

I don't know the terms of the deal, but suppose that Y-combinator had a 10% stake in a startup, and Sequoia gets 1/4 of that. Let's suppose you're looking at a round of financing that would dilute that ownership by half. Then Sequoia's investment amounts to an extra 1.25% stake in the company post deal. So if they could get a 50% stake in another company that has a 2% better returns, they would get a 1% better returns from the better company and a 1.25% better returns from their stake, and therefore should go for the Y-combinator company. Right?

Wrong. Sequoia knows that if they pass on something that is almost good enough for them, it is still likely to be picked up by someone else. (Particularly if they let people know that it was borderline.) So they have to think through the difference of having them versus the next VC investing in that opportunity. There is a difference, but it is not actually that big. Therefore even a 1% difference in the two companies should not change their decision.

And when they are making these decisions, there is no way they are trying to measure things to 1% accuracy. So the right thing for them to do is ignore their stake in the Y-combinator investment entirely.

It's not like Sequoia is capital restricted and has to choose between multiple good investments. They have way more money than good opportunities. If they see two companies that are equal they are probably investing in both or neither.

Disagree. Chris's point regards direct seed-stage investment from a VC, where a "pass" on funding an A-round indicates that the VC lost interest over time (suggesting that they might be disappointed in execution, think the market is no longer there, etc.).

My understanding is that Sequoia is simply providing more capital to YC, and that YC handles all the decision-making with regards to company selection and investment. For Sequoia to "pass" on investing in a YC-funded company after the seed stage is not the same situation.. they never "selected" the seed-stage funding recipient in the first place.

Edit: Regardless, this is all a silly thing to be concerned about. If your idea is even remotely viable, your execution is solid, and you have determination, you will find traction and success (and investment, if you really want it). If you're sweating things like this, you're getting distracted from the things that matter.

>If you're sweating things like this, you're getting distracted from the things that matter.


When your existing investors don't maintain their pro rata in a new financing, prospective investors will wonder why. This assumes that the existing investors: (1) Have already invested in your company (duh), (2) Have some knowledge of the company (e.g. served on the board), (3) Make it a habit to invest in follow-on financings like yours.

You can still get around this if you have a good excuse, e.g. "Our existing investors are out of money". And your existing investors confirm your excuse when prospective investors inevitably call them.

So if USV didn't participate in the latest Twitter round, the company and USV probably had a good excuse, e.g. "Our fund isn't structured to make acceptable returns at $1B valuations". When a random angel who isn't on your board doesn't invest your Series A, most prospective investors won't wonder why.

Regarding YC-Sequoia:

The firms who are likely to invest in post-YC companies are likely to be mavericks who can think for themselves. That's the kind of investor you want anyway. You don't want to tell prospective investors that Sequoia spent three weeks intensely studying your company and decided to pass. But the fact that Sequoia could have looked closely at your company, but didn't, will probably be irrelevant.

On the other hand, if Sequoia and other YC insiders are cherry-picking the best YC investments before they hit the mass market, good investors are going to get less interested in demo days. That will hurt YC companies.

I don't know how these forces and other forces will play out in the marketplace. And since we're talking about game theory, the existence of this thread will influence the outcomes.

I don't see the direct harm to YC here. If Sequoia and other YC insiders are cherry-picking the best YC investments before they hit the mass market, incoming entrepreneurs will correctly see YC as an awesome automatic networking opportunity. Sure, the opportunity doesn't always work. But the chance is valuable.

If there is any possibility of damage it would be because YC could come under pressure to recommend companies to go the VC route when that is not in the company's best interest. Why would that not be advisable? Well VCs interests are not always your own (see http://www.paulgraham.com/venturecapital.html) and particularly not if there is an opportunity for a direct acquisition (see http://www.paulgraham.com/vcsqueeze.html).

The issue is around how many deals Sequoia funds. If other investors think that Sequoia already has the best 3 companies in any class sewed up before demo-day, why come to pick up the less interesting companies.

Chris Dixon wrote a good post on this recently: http://cdixon.org/?p=1746

Interesting, but can you give some background for the uninitiated?

As a Sequoia company I can tell you that if you have the chance to take their money do it. Quickly.

Being an SC company has given Mahalo a HUGE advantage... let me count the ways:

1. We got a much higher valuation on our Series B.

2. We get constant pings from VC firms that like to follow SC.

3. We get a constant flow of potential team members who want to work for company that is backed by the company that invested in YouTube/Apple/LinkedIn/Google/Yahoo/Zappos/Atari/Cisco/etc.

4. The partners at SC are amazing... Roelof Botha is on our board and he has been tremendous.

5. We get an absurd amount of press due to our Sequoia affiliation.

6. We can get any meeting with any company, organization or advertising agency by saying "we're backed by the VC who backed INSERToneOFtwentyAMAZINGcompanies." You can be absolutely sure I do this all the time.... and it works.

7. We get massive discounts from vendors due to the affiliation (i.e. think a technology provider who would like to build a relationship with Sequoia).

As far as I'm concerned YC + SC = DREAM COME TRUE for entrepreneurs.

If anyone ever wants to talk to me about Sequoia as an investor you know my mobile number: 310-456-4900. I love these guys.

best jason@mahalo.com http://www.twitter.com/jason

The investment means YC will now advise more companies in every batch, so it will have to spread itself thinner when it comes to advice and introductions.

It's not true we have to spread ourselves thinnner when it comes to advice. The startups we fund book office hours with me online. I can tell when demand is satisfied, because there are slots still open.

And we couldn't spread ourselves too thin with introductions, because the supply of those is not even limited. Later stage investors are delighted to hear about any good startup we can send them. If we send an investor twice as many good deals, they're twice as happy.

I see.

Are office hours a good measure of advice? What about the dinners?

Is the advice really completely stateless?

Some of the benefit of YC comes from networking between the teams. I think this benefit may diminish as the group grows.

Just thinking up objections.

I don't think my advice has gotten any stupider. If anything, probably better, because I've seen so many startups' paths now.

It's funny you should use the word stateless, though, because one of my tricks for scaling is to keep all the state on the client. E.g. I tell the startup "remember to tell me x next time we talk." I've been doing that for a while, and it seems to work fine.

Networking between the startups has actually increased. The more startups there are, the more likely you are to be in the same batch with another one that would be a natural beta user for your product, or that happens to be expert in some technology you have questions about. Maybe there would be problems with startups connecting if there were 1000 in every batch, but between 8 (summer 05) and 26 (summer 09) things just get better.

Very cool, thanks for those responses.

I remember 'stateless' from last year's 'Be Good' startup school talk.

Ironic; I didn't.

Not ironic, since you are following your own advice.

Earlier on this year I was having dinner with a bunch of start-up founders in London (all non-yc I believe, but well connected with the yc community), and your comment on statelessness was bought up, I think you managed to get it stuck in quite a few heads.

Shared processor, multiple memory sequential computation....

Whoops, meant to upvote but hit down instead. The human web app analogy is hilarious.

Here is an informed discussion on this issue by a serial-entrepreneur-turned-VC fellow who specifically addresses the points raised in Chris Dixon's piece and generally comes out in favor of startups being able to take VC seed funding without serious risks: http://www.bothsidesofthetable.com/2009/10/18/vc-seed-fundin....

This is a useful discussion.

"I’d also say that I’m not quite as negative about funding someone else’s seed deal anymore. I now know that the mega funds that did too many seed deals aren’t paying enough attention to them. So I’m not put off by the fact that I’ll be used as a stalking horse or that there is something wrong with the company provided I’ve spent quality time with management and can make my own assessment about the team and business."

Perhaps as entrepreneurs become more educated about the Chris Dixon and Venture Hacks argument, they can essentially use this argument to justify to other VCs why the first VC passed on the deal ("First VC wanted to low a valuation, knowing that they could signal to other VCs not to take the deal unless I agreed to their low valuation"). However, some other commentators on this thread have mentioned the VC "herd mentality" syndrome, so perhaps it requires a shift in VC mindset too.

I don't think there's that much mystique around getting rejected by VCs right after coming out of YC -- most of the YC companies don't raise VC immediately.

If I interpret their argument correctly, they are not talking about raising VC immediately after YC. Their argument is that, at some point down the line, if you try to do a VC round then the sole VC that participated in your seed round has undue control of your first VC round.

I think that's a misunderstanding of the YC / Sequoia relationship. YC raises from Sequoia just like a VC raises from their limited partners. What you're describing sounds more like if YC were doing a syndicate seed investment with Sequoia, which isn't the way the deal works.

This clarification makes a lot of sense to me.

What if the founders don't seek investment from Sequoia after the initial YC investment. In this case Sequoia would never have had the opportunity to pass.

I imagine there is no 'you have to request funding from Sequoia' clause that comes with the YC money. In fact, from my understanding, you don't have to take any investment in the future if you so choose.

"... What do people think about this potential downside? ..."

The downside is more than balanced by the upside of having VC connections post YC funding.

Many applicants; few chosen. Since almost all are passed anyway, the Sequoia factor is noise.

I think the argument is that since they're all passed anyway they are now passed by Sequoia which may hurt their further chances for VC.

Presuming some superior ability by Sequoia to choose wisely. If in this particular case Sequoia is already "ambulance-chasing", hanging around YC's alley door hoping to pick up strays, I presume they are relying on YC's expertise, and simply expanding the opportunity to invest in worthy startups YC could not affort to fund. Otherwise why aren't they running their own show? Not to criticise Sequoia; I've been in 2 startups they funded. But VCs are notorious for herd mentality.

> If in this particular case Sequoia is already "ambulance-chasing", hanging around YC's alley door hoping to pick up strays,

That's a wonderful analogy, thank you for that one!

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