6% Can Be a Lot More Than You Think
Earlier this week, Paisano created quite a stir with his review of Y Combinator’s demo day. The reaction certainly shocked me, as I thought it was a pretty balanced piece. He gave Y Combinator credit for a lot of Web innovation while bringing up the fact that no big homeruns have come out of the incubator yet and mentioning they take a rather hefty cut of a startup for a comparatively small $5,000. (Semi-related, I enjoyed this post about the topic of incubator resentment.)
The biggest stir came from the 10% figure in the first draft (Y Combinator actually takes up to 10%; our apologies for the error!) But I think the debate it sparked was well worth having. Paul Graham—Y Combinator’s Grand Poobah—coincidentally had a piece on his blog the same day about the topic of giving up equity. (Apparently it was written last summer, although I just saw it that day.)
It’s a thought-provoking argument, and I’m not sure what I make of it. Perhaps I’ve been in the Valley too long, but at first blush it just reads like a VC trying to convince you to take his money. It’s a rational argument—but it certainly assumes that investors have a huge affect on a company’s outcome and when it comes to Web businesses, I’m not sure they do, especially at the early stages. Especially considering how much more equity you have to give up for every dollar you raise in those early days.
From Graham:
“For example, suppose Y Combinator offers to fund you in return for 6% of your company. In this case, n is .06 and 1/(1 - n) is 1.064. So you should take the deal if you believe we can improve your average outcome by more than 6.4%. If we improve your outcome by 10%, you're net ahead, because the remaining .94 you hold is worth .94 x 1.1 = 1.034.”
Yes, that makes sense, logically. But it ignores the plain fact that there’s no way to know if Y Combinator improves the company any more or less than on-the-fly learning would or—better yet—free mentorship from someone who has been there. In other words, maybe your startup is 10% better after going through an incubator. But maybe that would have been the case anyway, because you had a great idea that built an audience. In that case you’re not net ahead. It’d be like going to someone’s house for dinner then paying them for the meal they intended on giving you for free. Or, perhaps it's more like taking out an insurance policy, and most of the best entrepreneurs don't like insurance or safety nets. That's why they are entrepreneurs!
It reminds me of the risk-reward I hear potential grad school students weighing. In my case, I never considered getting a journalism degree because I didn’t have the money, and I didn’t want to take out a loan. Others argued it would increase my earning potential by x% so that investment would be worth it. The main argument was the connections you get from attending a well-heeled journalism school. So maybe, if I'd come out to a lucrative daily paper job, it could have seemed a good bet. But since those connections—and J School training--are primarily rooted in the daily newspaper world, I'd argue it could have actually cost me career value long term.
It’s a judgment call for any startup and there’s absolutely no right or wrong answer and no way to know if you made the absolute right move or not even in hindsight. I frequently argue that entrepreneurs should move to Silicon Valley because proximity to talent and smart advisers takes out certain inherent risk factors. There’s certainly a cost to that, so it’s not such different advice than Graham’s. I just think it's not as easy of a decision as he makes it out to be. 6% is a lot and no entrepreneur should be cavalier about giving it up, especially since there’s so much you can do for free or cheap on the Web.
I'm not trying to beat up on incubators, but most of the entrepreneurs I respect the most would argue they were better off putting off raising money for as long as possible. If you’re onto something, every user you grow will make your eventual windfall that much larger. 1% can be nothing. 1% of Facebook is also worth hundreds of millions (at least). You don’t have infinite slices of equity to pass around, and you don’t know how much you’ll have to give up later on. That 6% you don’t give up could wind up being a big chunk of your holdings-- maybe even the only thing you're left with.
I think Graham’s points do hold when it comes to hiring talent and the post is essential reading for anyone going through that decision. The right hires do frequently make and break a company, and especially in the Valley there is only so much top talent to go around.
I only really balked at this line:
“It would improve the average startup's prospects by more than 43% just to be able to say they were funded by Sequoia, even if they never actually got the money.”
Let's be clear: Sequoia has plenty of flops. There is nothing that easy in the world of building a company; no "magic touch." Sorry, but that is VC Kool-aid talking and no entrepreneur should believe that name cache is worth 30% of your company. There's a startup graveyard littered with desperate entrepreneurs who thought that way.
[For what it’s worth, I invited Paul via email to have dinner with me next time we’re in the same city as I’m dying to actually meet him. I’d love to get him on TechTicker sometime too.]
