More money, more problems

Y Combinator’s New Sweetened Deal Could Leave Sour Taste With African Startups

By  |  January 11, 2022

“New Year, New Me” is a time-honoured corny line these days, but this new year, 2022, pretty much has the world’s most famous startup accelerator screaming: “New Year, New Deal!”- though this new deal appears to be drawing some criticism.

On the first ‘real work Monday’ of the year, Y Combinator (YC), the renowned Silicon Valley startup accelerator, announced changes to the deal terms it grants startup founders which put the accelerator in a stronger position than ever.

The new deal, which would provide accepted startups with another USD 375 K at a valuation determined by a company’s later investors, in addition to the standard  USD 125 K for 7 percent equity, has drawn a bashing from sections of seed investors and other industry stakeholders.

Why? Well, the criticisms are based on concerns that the new deal seeks to better YC’s position while putting both international founders and local early-stage funders at a significant disadvantage.

After years of lukewarm attention, YC is increasingly selecting African tech startups to take part in its programme, and its alumni feature continental royalty such as Paystack and Flutterwave (as well as others like Cowrywise MarketForce, Kudi, Kobo360, WaystoCap, WorkPay, BuyCoins, Trella, 54gene, CredPal, NALA and Breadfast.

As of 2021, YC has invested in 60 African startups. Of course, that number is only a small fraction of the over 3,000 companies that YC has invested in so far, but YC’s intensified interest in African startups is exemplified by the fact that it’s accepted more African startups in the last three years than in the entire six years prior to that, combined.

For startups in Africa and beyond, the YC halo is usually a ticket to funding deals, great attention, huge hype, immense resources, and powerful networks that can catalyse a startup’s rapid rise.

And for both local and international investors, the YC badge is often the go-signal to throw money at a startup, though this can be problematic as it has been argued in the past that the YC influence adversely affects valuations while chipping away at local investor confidence.

The ins and outs of the new YC deal

The announcement of the terms of the new deal – while being in tune with the trend of venture capital moving towards bigger cheques and founders seeking more cash – has amplified some reservations about YC’s strategy, leading to question marks about its well-sold mantra of being founder-friendly.

The new YC deal can be thought of as two offers both of which must now be accepted by startups before they are accepted into the accelerator. There’s the standard deal of USD 125 K for 7 percent startup equity and an additional USD 375 K at an uncapped SAFE with an MFN.

In startup funding lingo, SAFE stands for “Simple Agreement for Future Equity” – an agreement between an investor and a company that provides rights to the investor for future equity in the company when a priced round of investment or liquidity event occurs.

MFN, on the other hand, stands for “Most Favoured Nation” – essentially a clause that gives an investing party (YC, in this case) the right to invest the USD 375 K with the same terms as a subsequent investor with the best terms. Essentially, YC gets the most favourable terms any investor that invests in a startup post-YC gets.

Put together, an MFN SAFE is a SAFE with no valuation cap. Instead, it dictates that the investor proposing the arrangement gets the same/best terms that you give any subsequent investor. 

Making sense of it all

The new deal brings up YC cheques to USD 500 K in total; seems like a good deal and free, extra money on the surface. But while it gives YC the benefit of getting more equity ownership in nearly 1,000 startups that graduate from its programme each year, it could mean significant disadvantages for both founders and early-stage investors, as industry stakeholders have pointed out.

“So in the past, you might raise USD 100 K to USD 200 K at say USD 6 M to USD 8 M post-money valuation ahead of Demo Day (the finale of the YC programme) to bring in smaller checks: Angels and micro-funds who are more valuation-sensitive. This would’ve been maybe 3 percent dilution — or less even. Now if you brought in say an angel for USD 10 K at USD 6 M post-money valuation, YC would also invest USD 375 K at USD 6 M post-money. So, instead of 0.1 percent dilution, you’d now take an additional 6 percent dilution!,” Elizabeth Yin, Co-Founder/General Partner at Hustle Fund, shared in a series of tweets.

“This means in total, in this example, YC would have a total of 13 percent of the cap table before you’ve really started your raise. This means a lot of small angels and funds will pare back on investing in YC companies,” she added.

Similarly, Moe Odele, a Nigeria tech lawyer and Founding Partner at the law firm, Vazi Legal, also highlighted that the new deal could be problematic for international founders (those outside the U.S.) who often have to give sweetheart deals to local investors because they need those networks as they scale locally.

It cuts two ways, though. On the part of international founders, there is the already-mentioned conundrum of the new YC deal making it harder to bring local early-stage investors on board for strategic network reasons. For both local and international pre-seed investors, the new YC deal essentially forces them to be very, very early; they would have to now find companies before YC by being part of the first set of cheques in – before YC. And these implications have drawn some reservations.

“YC has created this deal to seal in its position – which is great. But to make it more equitable for most founders, especially in line with YC’s ethos as being “founder-friendly”, the additional USD 375 K MFN SAFE should be optional,” she tweeted.

“Founders, especially international founders should be given the choice. USD 500 K is a lot of money for runway but many founders from Africa are able to raise much more than that post YC. Locking them in like this with no choice isn’t ideal,” she concluded.

Industry players talk implications

In the past, many YC companies (especially those in developing markets) would raise a small amount of money from angels at better terms pre-Demo Day than post-Demo Day. And then, they would go on to raise further funding in moderate amounts post-seed and possibly raise much bigger sums further down the line. But the new YC deal might well distort the balance on multiple levels.

For one, the new structure of the YC deal has been described as something that encourages founders to do their full raise at a high cap; since USD 375 K is insignificant at, say, USD 20 M post-money valuation.

According to the critics, the new setup encourages founders to raise high-valuation money, and that’s only possible when one can call upon a great crop of investors, which is realistically only possible for a few startups in each YC batch.

“In particular, I think this will affect international founders more than U.S. founders. There are often fewer choices locally for raising USD 500 K. But for international founders, it’s often more important to get more, not fewer US investors around the table to help with network,” Yin emphasized.

“Most investors are also not willing to pay such high valuations for international companies. That’s just the reality of it — the exit potentiality is seen as much lower or the geography is ‘out of realm.’ So there’s a smaller supply of international investors,” she tweeted.

Founders may also find themselves at a disadvantage on the local front in a world where there are now a lot of angels, syndicates, micro-funds – all propping up collaborative rounds which are often strategic and good for network for many founders.

“Understand that you can’t do sweetheart deals [to local investors whose networks are needed as startups scale locally] after signing the YC MFN SAFE unless you run the risk of major dilution,” Odele mentioned.

The new deal does make sense for the YC model which has “international” as part of its core strategy as it would be a way to shut the door on would-be competition. And it might well bring about a situation where savvy founders see the new offer as a good way to set themselves up to raise large rounds from traditionally later stage investors.

But as things stand, it appears founders who want smaller checks from operators/micro-funds/angels etc. on their cap table for strategic reasons would now have to raise those before YC, or perhaps not at all.

As Odele advised, it would be expedient for startups founders to get all their angel checks and sign those documents before signing the MFN SAFE with YC as this could make all the difference.

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