Why does Y Combinator invest with a Most Favored Nation clause?

[clementinemoon]

Y Combinator invests $125,000 on a post-money safe in return for 7% of your company (the “$125k safe”. Then they invest $375,000 on an uncapped safe with a Most Favored Nation (“MFN”) provision (the “MFN safe”).

Why not just buy 10% equity for $500k, for example?

7% for $125K is a $1.8 million valuation. If you raise later at a valuation of, say, $12.5 million, that is 3% equity. Combined, it still equals 10%. They will own less than 10% overall if the valuation is higher.

 

[leaniemeanie]

@clementinemoon Well, let's look at the path of your typical non-YC company...

• A pre-seed round will usually range between $500K and $1.5M for 10%-15% of the company at a $5M-$10M valuation, and buys the company 12-18 months of runway. The lead investor is typically looking for at least half the round.
• A seed round usually ranges between $2.5M and $5M for 20% of the company at a $12.5M-$25M valuation, and buys the company 18-24 months of runway. The lead investor is typically looking for at least half the round.
• A Series A round usually ranges between $10 and $15M for 20% of the company at a $50M-$75M valuation and buys the company 18-24 months, and the lead investor is typically looking for at least half the round.

What does the typical YC fundraising path look like?

• A YC check is usually $125K for 7% of the company at a $1.78M valuation and really only lasts you until the end of the program
• This forced a lot of YC companies to go out and raise before they had any real signals of traction or market pull. While most VCs expect companies to get to Series A in 3-4 years, most YC companies typically don't raise Series A until year 5, which indicates that they are more patient and capital efficient than most of their peers.
• YC recognized that if they could offer founders an additional $500K, that would be enough runway for many to really figure things out before raising more money. However, they also had to set the terms in a way that would allow the founders to raise a proper seed round without screwing up their cap tables.
  
• MFN allows them to have meaningful participation in the next round without the burden of setting the terms of that round (prematurely), which is the job of the lead investor, who's typically in for a 10%-15% equity stake. All things considered, it keeps the cap tables, the fundraising and negotiations cycles pretty clean.
• YC effectively funds your entire pre-seed round, takes the 10% you would have given up anyway from pre-seed funds who deliver a fraction of the value.
• YC companies have runway/room to figure things out ahead of a proper seed round at better terms than most non-YC companies.
• The only people who really lose in this equation are pre-seed funds who get priced out of sub-$10M rounds.

 

[jaj]

@leaniemeanie Really good answer. Thanks for sharing

 

[delistuff]

@clementinemoon Because they can

 

[yvonnelizzy]

@delistuff Exactly this. YC switched from founder friendly pre-money SAFEs to incredibly investor-friendly post-money SAFEs with MFN clauses and spent months crowing about how much better this was for founders simply because it was more money.

They made their brand and are now milking it for everything it’s worth

 

[sammyclifnote]

@clementinemoon YC used to invest in most seed rounds already for the batch of startups — now they just committed to doing so out of the gate; the MFN clause almost always hits on the valuation of the seed round

 

[gracefulsongonfire]

@clementinemoon It’s an added incentive. YC targets Ivy and ex-FAANG 1st time founders, and those founders would all prefer $125k for 7% + $375k MFN over $500k for 10%.

They prefer this because they’re likely competitive and believe they can reduce the $375k hit by gunning for a $20m+ valuation (and many do get these on demo day).

More competitive accelerators like Neo give better terms because as a founder gains traction they’re less likely to want to do the YC deal in first place.

An even deeper example is Inception run by John Whaley. They do 0% equity with an optional uncapped SAFE (maybe it’s an MFN now, it’s been a while since I spoke about it with him).

There’s always going to be a market for early founders who would do the YC deal, but I would argue that they should make the terms more competitive + reduce their batch size.

 

[evegpt]

@gracefulsongonfire Thanks for the callout! Happy to answer any questions about Inception Studio. We have a very different model than YC and honestly attract a different type of founder than YC, so we don't have much overlap in founders who are interested in both programs. We tend to attract serial entrepreneurs (>70% are experienced founders) and people who don't need accelerator programs; e.g. exited founders, highly experienced founders who already have connections, or founders working in the hottest areas and who have no issues fundraising. Some people refer to Inception as "YC for experienced founders." The whole premise is to avoid the problem of adverse selection by making the program pure upside for the very best founders. There is inherent value in curating a group of exceptional founders and providing a high-value experience, and it is shortsighted to try to monetize or extract equity from them because it inevitably leads to an adverse selection problem.

 

[gracefulsongonfire]

@evegpt Np John. This is Orri btw

 

[leaniemeanie]

@gracefulsongonfire

More competitive accelerators like Neo give better terms because as a founder gains traction they’re less likely to want to do the YC deal in first place.

Damn, I've never heard of Neo... Have they accelerated 100ish unicorns as well?

 

[gracefulsongonfire]

@leaniemeanie lol they’re like 3 yrs old.

They’re more competitive because their terms are better and their cohorts are smaller.

 

[leaniemeanie]

@gracefulsongonfire So they're just cheaper... Not more competitive.

 

[gracefulsongonfire]

@leaniemeanie 12 spots vs 150+ and higher quality founders on average = more competitive.

They’re also just one example. Same goes with Sequoia Arc, a16z’s program, HF0…

Competition is a good thing. It’s now on YC to up their value (or not).

 

[leaniemeanie]

@gracefulsongonfire This is a results-driven industry, and Neo has no outcomes to speak of yet. Therefore they are not competitive with anyone, especially not the most successful accelerator of all time. The only other accelerators with any real outcomes to speak of are Techstars and 500, and most tier-1 VCs don't even bother to track their cohorts anymore.

In the grand scheme of things, what you're selling is a smaller, cheaper community college as a more competitive alternative to Harvard or Stanford. Strictly by the numbers, community college is a better deal... cheaper tuition, smaller class sizes, comparable course catalogs, but they have no brand value and just a small fraction of the network in industry, which is why have poor matriculation rates.

What I'm saying is show some real outcomes before you talk about being competitive. Unless Neo has a 70% graduation rate to Series A, Neo and YC should never be grouped in the same sentence again.

 

[jesuspleasesaveme]

@gracefulsongonfire Neo does not get anywhere near 25k applications per cycle lol. Sequoia Arc, a16z is just a different name for their usual investment strategy of 10-15 seed deals a year - they just call it an accelerator but it’s just the usual seed investment process.