Paul Graham’s Dilemma

I have to make sure I don’t take 4 months off from blogging again.  Having re-read this for editing, I had a lot to say, but more importantly, I enjoyed the mental exercise it put me through.

I am not sure that I am going to tread much new ground in simply covering the weekend news of Yuri Milner and Ron Conway basically blanket offering $6M to the Y!Combinator crop.  There’s been plenty of analysis and moaning about this being the beginning of the end for the tech market.

As a former founder, and venture capitalist (late stage, but investor in private companies nonetheless), I wanted to touch on a few points I hadn’t seen elsewhere.

Yuri is a genius.  Why?  Think about what you need to do when you are an angel investor.  You have a little bit of money (relative to the overall venture pie) that you want to get into deals.  There are quite a few more angels then there are venture funds.  Competition is fierce and getting into deals is really all about who you know.  As a venture investor, your primary concern is “proprietary deal flow.”  In English, that means having sources of deals that other guys don’t have.  That problem is somewhat exacerbated when there is fierce competition for deals.

Further compounding the problem of the angel investor is the high beta nature of the deals.  In short, you have WAY more company failures than wins.  You just hope to make the winners payout more than the losers.  You expect to be compensated for that risk.  So even if you have proprietary deal flow, you need to get into good deals to reduce your risk.  Investing is supposed to be about risk management after all.

Paul Graham acts as a (so far) pretty good filter function for deals.  By just writing a check to all the companies in the portfolio, Yuri solved two problems in one swipe – Paul did the work to get the a good portfolio of angel deals, and Yuri now has access to all of them.  Further, he has put money to work evenly in a portfolio of deals which are more or less not competitive.  He didn’t have to spend 2 years putting money to work in 40 deals.  He did it one shot, effectively enabling himself to have a nice angel mutual fund.  Genius.

This is all well and good for Yuri, but Paul has a couple of problems as far as I can see it.  He has done a great job of building his brand as the go-to place for the young entrepreneurs who might hatch the next big thing.  There’s been plenty of criticism about the features masquerading as companies in the Y!Combinator portfolio, but Paul’s business isn’t finding great companies.  Paul’s business is investing in great talent.  He has a recipe for how he identifies and invests in talent.  Over time, that recipe has proven out a bit, and the winners beget higher caliber talent looking to get in on it.  Better talent means better possibility for an exit, which means more VCs come to Paul to look at the deals at the end of the program.  It’s a very solid feedback loop.

Where does the talent pool end?  A casual viewing of American Idol these past 2 weeks would lead you to the same conclusion as you would have from would be “next Herokus” looking for funding.  You have quite a bad signal to noise ratio when you have too much success.  The proverbial ants coming out of the woodwork.  Can Paul scale his machine to work through the all but inevitable crushing deluge of applicants with increased success?  How can he keep his batting average high enough to continue his virtuous loop?  It just got a little bit harder with this new pile of money.

There was a comment on the TechCrunch article announcing 90% of the applicants had accepted the deal which caught my eye.  “Am I the only one who finds Y combinator predatory? It preys on 20 year old kids who think they’re building the next Google. Am I crazy?”  I’m not going to touch the comment other than to use it as a back drop to blow your mind a little bit.  Y!Combinator is great for the young’uns because they can afford to spend a summer hanging out, coding, etc, and get by on the $12K-$18K Paul gives them for a 2-3 person team.  With the $150K coming in from Yuri (or whomever comes next), the mortgage and kids become WAY less of an issue.  Two guys could put $84K in their pocket and enjoy a 6 month work holiday.  You’ll work hard, yes.  And you won’t put all that money in your pocket, since you will need to fund the business, but man, talk about risk reduction.  Carwoo notwithstanding (bunch of old men running that show <g>), my impression of the Y!Combinator set has been that they are quite young.  Did Y!Combinator just go from being MySpace to Facebook?  This Yuri deal could very well skew the demographic to the older set.

So imagine a world in which you have early to mid 30 somethings with solid work experience but perhaps just come from a different education background, socio-economic situation, whatever, and have never started their own thing.  You could potentially have a team that knows how to execute, could potentially have been working together for years, and they can now afford the risk associated with a Y!Combinator summer.  The more I think about it, the more that sounds like a slightly more risk averse Carwoo management team.  That management team is executing quite well.  Experience for entrepreneurs matters.  Kids have balls because they don’t know any better, but I bet on experience every time.  Sometimes the startup CEO inside of us just needs a little kick, and $150K extra is a hell of a kick.  Just because you haven’t been an entrepreneur CEO by the time you are 25 doesn’t mean you will never, or aren’t suited.

What of Yuri?  I doubt he gets the pole position on the next crop.  In fact, I’ll bet there is a dinner happening at some point this week at Bin38 to figure out how to kneecap this guy.  The terms on his deal were quite favorable.  In fact, I am scratching my head trying to come up with a way that someone could 1-up him on the next go round short of offering more cash.  He’s certainly upset the angel community with his uncapped Convert note.  That one left me speechless.  It’s entirely possible Paul has a similar meeting with the companies the next year, but it’s a bunch of angels looking to write checks, and the YC companies get to choose.  That drives up the check amounts, removes the incentives for the angels (uncapped converts…really?) and doesn’t really allow any one angel to take the mutual fund model, which means they would be investing with no due diligence.  Yikes. The only way this works is if one angel (or syndicate) can write all the checks.

There are some angels who have already spoken out on this.  I bring up Chris Yeh if for no other reason he and I went to grade school together (and I think he’s a pretty smart guy too).  He brings up a point that the concentration of talent decision making in too few hands is bad.  He’s right.  He moans a bit about some other things in the article, but this point isn’t the one that landed with me.  In fact, I think he missed the more important point.  Paul has singlehanded foisted the convertible note on the VC community through Y!Combinator.  Talent selection in the hands of too few is one sort of problem, but financial engineering concentrated in the hands of too few, especially those who think of themselves as smart, is really, really dangerous.  This has the potential to turn into a game of who can concoct the most esoteric and interesting funding investment.  In a world where Paul would rather things be easy than hard, he may win out.  Entrepreneurs appreciate simple.  I don’t know if I am more worried about how the angels will try to circumvent this, or what kind of behavior response this will get from the venture community.

So Paul has to decide how he is going to scale his sorting algorithm.  He has to tweak it to ensure that the all but certain increase in older applicants is in some way accounted.  He’s allowed a big money bag man a seat at the table, and has to decide what, if anything, he is going to do for the next batch of YC companies for this sort of investment process.  Paul also has to take responsibility for his actions as they pertain to the angel community.  It’s not enough to hide behind saying that any angel could have made this deal.  It’s done, and it’s good for his companies…now.  Paul, as a leader, has to now own up to what could potentially come next, and start planning for that future.  The ecosystem is important, but there needs to be diversity in that ecosystem.

UPDATE – one thing was bugging me when I posted.  I couldn’t quite sort it out until this morning.  Does Yuri have a provision in his funding documents that prices his money if there is a liquidation or change of control?  If not, wow.  If so, I would love to understand that better.  Anyone out there know?

  • Appreciate your well thought perspective.

    From a prefunding point of view, myself and several others see further differentiation between YCombinator and TechStars. Do other incubators offer 150k of follow on funding automatically (and on such favorable terms), if not they're going to attract a different type of entrepreneur.

    Of course there will be a handful of startups that bypass the heirarchy/club model of incubators altogether.

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  • Well-thought through, excellent comments.

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  • A lot of people are trying to grok the implications of this, and you have some interesting thoughts here. Thanks for writing this up.

    N.B. s/Y!Combinator/Y Combinator/g

  • Great article Brandon. I haven't read a better article on the Y combinator situation.

  • Also s/2009 Many Niches/2011 Many Niches/g

    I don't know why but whenever I see a web site where the (C) does not match the current year… it makes me feel anxious.

    I guess programmers just *love* details. 🙂

  • Mukund

    Good piece Brandon. The risks for Paul appear to be higher, but the risks for other non YC funded companies have gotten higher also in my perspective. Imagine the conversation a non YC funded company founder has with angels. “I would like the same terms as Yuri offered YC companies”. Angel “Huh? Okay, please get into YC then”.

  • read it via @om — and it is the most well thought out take on the angel mutual fund situation — i am not sure if entrepreneurs will like it or not – for hte YC ones, it is a mixed reaction thus far – the better ones know it will keep them from a better deal later and 150 isn't enough in some cases to make a difference.

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  • While I understand the wails of the VC community, what this has done is cut several gordian knots from an Entrepreneur's point of view. It's simple, you don't get put on a slow drip of money, so there is enough to do something really useful without continually scrabbling for cash.

  • Tom Alan

    If Microsoft wants to win the cell phone war, just do what you did back in 1993 to beat IBM-OS/2 and you will win…. So far you are NOT DOING IT!!!. There are a lot of people like me, with great ideas who are willing to work hard to help make Windows Phone successful, but you shouldn’t ignore us. If you want to win this war, you are going to have to start doing what you did in ’92-’93… when are you going to start?

  • TA

    PS… if you want to effectively compete with Android-Apple, you are going to have to ‘one-up’ them…. There are plenty of people who know how to do this, but apparently none of them work for Microsoft…… or Nokia…..

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