Y-Combinator’s Growth Fund Will Create No Signaling Risk — But It’s Still a Big Deal

In case you lost Internet connection for the last few days, Y-Combinator has a $700M growth fund. And it’s a big deal.

Not because it creates signaling risk for founders and companies. It’s scary because it means all the firms that had previously gotten access to do the series B’s and series C’s of YC’s breakout companies (like Airbnb, Dropbox, Stripe, etc.) might not get in or may have to out-bid Y-Combinator.

As a reminder: Signaling risk is the risk created when an existing investor does not invest in the next round of a company, signaling to other would-be investors that something may be wrong with the company… otherwise why else would that existing investor not invest?

Why Will This Not Create Signaling Risk?

(1) Y-Combinator is taking its pro-rata in all companies raising capital at below a $300M valuation. I am POSITIVE this was not an arbitrary number and was backed by patterns seen in past YC companies that justify this number in some way.

(2) Y-Combinator will not be leading rounds unless they are Series B or series C. Signaling risk mostly occurs in Series A financings when there isn’t a ton of data to back up a company’s strenghs or weaknesses.

In the past, Y-Combinator avoided signaling risk by not having the money to participate in those follow on rounds. It also restricted YC partners from angel investing in particular companies (or at least put rules around it) to avoid signal.

But now YC is avoiding signal risk by participating in all rounds until companies reach a stage where investment decisions are made by a company’s numbers and tractions as opposed to qualitative metrics best assessed via founder and company interaction (the reason seed investors reserve as much $$ as possible for following on to companies as opposed to purposing that capital to make new investments).

Why is this Bad for Everyone Else?

I’ve recently seen bigger firms pro-actively ask portfolio companies if they can lead a follow on round even before the company plans on raising capital. The reason is that the firm would rather not face competition in making an offer and has best information on the company before anyone else could possibly make such an offer. Sometimes portfolio companies take those firms up on their offers because it allows them to extend runway without having to take their focus off of running their business in exchange for managing a capital raise.

I wouldn’t be surprised if Y-Combinator takes that approach with a number of companies that have gone through the program and the implication of this as follows:

· Other VC firms may never see the deal

· The VC firms that led the series A in each YC company will no longer be able to employ that tactic without at least one potential competitor who could bid up the Series B price.

· More broadly, all VC firms who look at Y-Combinator companies will know that in making their offer at least one other “growth stage” fund will know exactly what’s on the table.

Bottom Line

There won’t be much if any signaling risk because the stage YC would be investing is when diligence is based on numbers, not signal (seed and series A investing is much more signal driven).

But this fund will make it a lot harder for the Sequoia’s of the world who have done pretty damn awesome based on the accelerator’s graduates.

[5'9", ~170 lbs, male, New York, NY]. I blog about investing. And usually about things I’ve learned the hard way. Opinions are my own, not CoVenture’s

[5'9", ~170 lbs, male, New York, NY]. I blog about investing. And usually about things I’ve learned the hard way. Opinions are my own, not CoVenture’s