Thoughts After Y Combinator Demo Day

There's lots of motion in the ocean in the early stage investing world.  TechCrunch has a write-up on the companies that presented at Y Combinator's demo day yesterday.  I had several of my own thoughts.

Quality

• The average company quality is up.  A much greater fraction of these companies will be singles or doubles compared to years prior.  I'm not sure if there will be more % homeruns or not.
• There are also more companies.  Xobni's class of 2006 had 15 companies; yesterday's graduating class had 36!
• So there's more early stage investing opportunity at YC than before.

The Index Fund Strategy

• Ron Conway and Keith Rabois invested in a number of these new YC startups.
• Some folks call this strategy the 'index fund' approach.  Let's define it as investing in more than five out of the thirty six companies.
• The 'index fund' approach might produce better returns (and/or risk-adjusted returns [1]) than cherry picking the best one or two companies from each Y Combinator batch.  I'm not sure.
• The index funds have three main advantages.  First, if you assume everyone's throwing darts then they are more likely to invest in the homeruns.  Second, they can collect returns from the longer tail of singles and doubles without breaking a sweat.  Third, they can make investment decisions faster.
• Interestingly, VC's still try to cherry pick.
• As are some of the new super angels.
• Anyone in the comments want to take a hack at the index fund versus cherry picking strategies, e.g. in environments with different levels of froth?

The World is Flat

• VentureHack's Angel List and YC's Demo Day have made the fundraising landscape more flat.  It's easier to see a wide variety of deals as an angel without doing heavy networking.
• This creates more competition.
• In particular is removes a competitive advantage for heavily networked angels like Ron Conway.
• Networks and experience still matter a shit ton for providing value to portfolio companies, though.
• For example, a new investor from Hollywood could come in and start making lots of investments very quickly.
• But when shit hits the fan or you need backchannels to an acquiring company the movie star won't be able to help.  (Unless the acquirer is Roc-A-Wear and your investor is Jay-Z, in which case I'm pretty jealous.)

Investor Credentials

• Looking at a VC's investment list is very useful.  Did they get into the hot deals?  Were their companies successful?  What do their founders say when you call for a reference check?
• Angels advertise their investment histories as well, but the informational value of those lists will go down as the world gets more and more flat, AND as the index fund strategy becomes more popular.
• Being an angel investor in Google back in the day meant you were connected.  It meant you were friends with the founders.  It meant you know some of the behind-the-scenes details of the company.
• But angels are investing in more companies, and companies are raising money from more investors.  So again the informational value goes down.
• What's the new credential?
• Probably references.  Founders of an angel's companies can tell you the real stories behind how an angel hurt, noop'ed, or helped their company.
• Do we need a TheFunded for angel investors?

Multiple Valuations: Early Bird Gets The Worm

• Another factor: different valuations for different angels.  As Paul Graham recently pointed out, a startup can issue convertible notes at different caps to different investors.
• This degree of freedom could be used in a number of ways.
• Some companies are trying to use this to give different valuations to different investors as a function of the order that they invest.
• The idea is that the first investor to commit is taking the most risk, so they should be rewarded for that.
• This can only go so far.
• If a company needs a minimum of $X to get to the next step, once a company has raised $X a valuation premium doesn't make sense.
• $X for a YC startup is probably around $200k.
• I'll stop there on this topic.  There are lots of dynamics at play, and it will vary company by company, but in summary I don't think early bird valuation discounts will become super prevalent.

Multiple Valuations: Value Add

• But as the angel investing world gets more flat the average investor will become more vanilla, and investors like Ron Conway will become more differentiated by their savvy, connections, and in some cases the time they can devote to helping the company.
• I predict that it will become more common to reward value added investors with valuation discounts.
• ESPECIALLY if these value add investors commit earlier.
• And often the big value add investors will commit earlier because they understand the space and get really excited about it.
• For example, one YC company yesterday had already raised money from a big time executive in their industry who can help them with intros/advising/etc.  Those situations can call for valuation boosts.
• Valuation boosts, while rare, were previously done by issuing extra common stock (sometimes specifically called "advisor shares") to the value-add investor.  But that approach was a little too heavyweight if the angel wasn't going to be heavily involved.
• So I think valuation cap differences will become more common for compensating value added investors, especially when they are the first money in.
• Secondary effect 1: non-value-add investors will be paying more for their equity, at least in theory, since entrepreneurs can now price discriminate.
• Secondary effect 2: more angel investors will try to be value add.  (?)  Especially super angels who have more resources and more companies to amortize fixed cost value adds across.

...good times.  : )

[1] thanks to Will Stockwell for reminding me that, of course, maximizing return/risk ratio is more important than maximizing returns.  More on this topic in the context of VC over at Fred Wilson's MBA Mondays.

Comments

[Rachnaspace]

Great post. I've been following YC program for a while, and I definitely see a lot more exposure now for the startups! It's like the model getting institutionalized, and in a good way. While I'm no expert on angel funding and the associated nitty-gritties - one of the changes I feel most happy about is the increasing angel investment activity, not just from funding perspective, but also from the advise/guidance perspective that is extremely helpful especially for first time entrepreneurs.
A friend who had not heard of YC, recently asked me what it is - the first sentence that came to me was, 'they're the best friends of first time entrepreneurs'. :)

[Ken Berger]

"more angel investors will try to be value add."

I think they will make an effort to *sound* value-add. But as they get stretched thinner by having to do ever more deals, and become less differentiated per your predictions, this will be harder for them to actually deliver. Much like it often has been w/ VC's who initially sounded like they could offer a lot, but a few years in the entrep wonders how they were much different than a bank.

[Abheek]

Great post. Another advantage of the "index funds" approach, and the big one in my mind - investor marketing.

There is very little information available at the seed stage for investors to choose from. One advantage of the spray-and-pray is there is a better chance they will end up investing in the next Google (well, maybe not Google, but you get the point =)). At that point, since this is a repeated game, they leverage their credentials as the prescient early-investors in a rock star company to get better quality deal flow in subsequent investments.

VCs don't do that because they want to be active investors, and their constraint is the individual partner's time. But if the investor is willing to be relatively passive (at least until the company takes off), and doesn't particularly care to optimize returns in this round of investing, index funds might be the way to go.

[Things to do in York]

Great! I also agree with your thoughts Abheek.

[David]

The comments about an "index fund" investing approach make me wonder how the tech startup investment market performs overall. There really isn't an index I'm aware of that tracks private companies, but maybe there should be. What's the average IRR and risk profile of social game companies, for example? It seems like getting this data together would be hard, but not impossible anymore.

[Qubrit]

great info, I am behind a startup - Qubrit (http://qubrit.com), which wasn't qualified for YC, although UK angels found Qubrit very attractive.

P.S. Qubrit is a virtual business cards and professional contacts network.

[twitter.com/Tedesign]

Cherry picking or Index-izing doesn't make sense when you're putting all your money in the same asset class. Hardly a way to diversify from risk.

The contrarian view is that specialized VCs seem to have better returns than multi-sector ones.

[Ddovgopoliy]

Adam, i want translate some of your post to Russian and publish it on my blog dennydov.blogspot.com with link to original posts and under your name. Is it ok with you?

DD

[Adam Smith]

Sure is! ThanksDdovgopoliy!

Adam

[Yegg]

I really don't see multiple valuations as a new thing. This already occurs quite a bit via doling out advisor shares to value-add investors.