Crazily high valuations, investor FOMO, the ripple effects of Y Combinator’s new deal

On Monday, January 10, 2022, startup accelerator Y Combinator announced that it would be increasing its deal size for future investments from $125,000 to $500,000. For many, the news was great because founders would get more money from the accelerator. 

However, quite a few people have expressed concerns about what this could mean for founders and investors. Here, we look at the deal and what it means for African founders.

What is YC’s new deal?

According to the terms of the new deal, Y Combinator will invest $125,000 for 7% of a company as it has always done. However, it will also invest an additional $375,000 on “an uncapped safe with a Most Favored Nation (“MFN”) provision.” This second provision has some people worried, but first, what is an MFN?

NB: SAFE is short for simple agreement for future equity. It is an agreement that allows investors to invest in a company with a promise from the company to give stocks to the investor when they raise a priced round.

The most favoured nation status is not peculiar to the venture capital world and has been used for years in international trade and international politics. According to Investopedia, the MFN clause requires that a country provides the same concessions it does to one nation to all World Trade Organization (WTO) member countries.

Extrapolating to venture capital and YCs deal specifically means that when YC startups raise their next round, YCs $375k investment will be converted to shares in the company at the most favourable terms of any investor in the round. In other words, YC is giving startups an extra $375,000 at a future valuation that they (Y Combinator) don’t control.

What does this mean for African startups and founders?

On the surface, this sounds like a better deal for African startup founders – $500k upfront is a lot of money and could help stave off the pressure to raise immediately if the startup runs a lean operation. 

Kevin Simmons thinks this is a great deal for founders. “From the founder’s side, if you’re looking to raise $1 million, for instance, with YC offering you half of that, it’s a no-brainer to take the deal and get the balance from other investors. 

“It could also mean that founders increasingly go after YC. So if you’re the competition and your customers are going in one direction, you either have to offer them more money or better terms to compete because you don’t want to lose the best companies.”

One issue that has been raised is how difficult it is for startups in Africa to raise at high valuations. However, that is not entirely correct. Raising money at high valuations would always be tough because founders need to convince investors that their businesses are worth as much as they say 

But there has been such astronomical growth in the funding landscape that stakeholders now have conversations about extremely high startup valuations — an issue that was non-existent just a few years ago. In 2021, startups in Africa raised about $4.3 billion — 2.5x the amount raised in 2020. With more money flowing into the ecosystem, startups will find it easier to raise money at high valuations.

Most startups raise money to stay afloat before joining YC. However, YC acceptance has been seen as a sign of validation for startups, especially for African startups. This has made it easier for them to raise money from investors after YCs Demo Day as they receive increased visibility. 

According to Simmons, “There are two ways to look at Y Combinator’s deal. If you go into Y Combinator, you’re setting yourself up for high expectations anyway, and it’s because YC is believed to be thorough in their screening and selection of great startups. Those expectations come down to dollars and cents, which means they have to raise at higher valuations and build bigger businesses post-YC.”

With the new deal, YC gets a larger piece of the startup post-YC at the same value as subsequent investors. For the founders, it means giving up a larger part of their company before they have gotten to the Series A round.

Since the announcement, many investors, most of whom are from minority regions such as Latin America and Africa, have expressed concern that this could shut out local investors from the cap table — a vital move for startups that hope to tap into the local network these investors provide. However, not all investors in these regions agree.

Biola Alabi, an angel investor, believes that the benefits of going through YC will outweigh any perceived disadvantages of the deal. 

“I think that most early-stage investors will also benefit as long as they come in early. The benefit of going through YC will outweigh some of the initial trepidations around if this will affect smaller investors.  The most important thing is to believe and invest with conviction. Valuations will work themselves out. The market will also dictate these in the end.”

Despite the increase in investment going into African startups, there is still a need for super early investors who can come in either at the pre-seed or seed stages. For the most part, African startups at this stage have raised little amounts of capital, usually under $2 million. However, YCs move could exclude most angel investors and smaller VCs who invest at this round.

It remains to be seen how this change will affect other accelerators and investors, but Simmons believes that because of the growth witnessed in 2021, local investors will have an easier time raising capital from LPs which means they can invest higher amounts in startups.

He also points out that startups will probably think twice about joining YC just because of the brand. 

“If you went to YC before for the name thinking the 7% was not a big sacrifice to make, now you have to take $500k, and yes, it’s not all at 7%, but it gives them more influence.”

Consequently, the founders either have to raise smaller amounts before getting into YC or abandon the idea entirely, as raising future rounds at low valuations would mean giving up huge parts of the company. On the flip side, this could mean that local investors bet on these startups early enough without waiting for the validation that comes with a YC acceptance. 

Investors have typically shied away from using uncapped SAFEs, but YCs willingness to use them could be a game-changer. 

“With YC being such a big brand, will other investors be more willing to take on uncapped SAFEs? Just like the SAFE became standard practice, could we see the uncapped SAFE gain more acceptance?” Simmons queried. 

Modupe Odele, a lawyer and Founder of Vazi Legal, advises that startups that want YC onboard should ensure they get angel checks before signing YCs MFN SAFE. Furthermore, they need a lawyer to review the terms to ensure that the MFN clause is not retroactive. However, going by YCs announcement, it doesn’t appear that this is the case. 

There are no indications that YCs deal should keep founders up at night. Since it funded the first African startup in 2009, it has only funded 66 African startups. With over 800 deals done in Africa in 2021, that represents a tiny portion of deals that go on in Africa. Should other investors follow suit, that could become worrisome.

With Africa’s startup funding landscape not yet at the level of its American and European counterparts, it could get more challenging for African startups to raise money locally if they wish to go through Y Combinator. On the other hand, it could encourage more local investors to scout and invest in companies at really early stages.