On Monday, January 10, 2022 startup accelerator Y Combinator declared it would increase its deal size for future investment from $125,000 to $500,000. Many people found the announcement exciting because it meant that founders would receive more money from the accelerator.
However, many people are concerned about the implications for investors and founders. We will examine the deal and its implications for African founders.
What’s the new deal from YC?
The new agreement stipulates that Y Combinator will continue to invest $125,000 in 7% of a company, as it has done previously. It will invest $375,000 more on an “uncapped safe with an Most Favored Nation (“MFN”) provision.” Some people are concerned about this second provision. But first, what exactly is an MFN?
SAFE stands for simple agreement for future equity. This agreement allows investors to invest in companies with the promise that the company will give stock to them if they raise a price round.
The most favoured country status is not exclusive to venture capital. It has been used for many years in international trade as well as international politics. According to Investopedia the MFN clause states that a country must grant the same concessions to one nation as it does to all other members of the World Trade Organization (WTO).
Extrapolating to venture capital, YCs deal means that when YC startups raise the next round of funding, YCs $375k investment in them will be converted into shares in the company at all the most favorable terms for any investor. YC gives startups an additional $375,000 for a future valuation they (Y Combinator don’t control).
What does this mean to African founders and startups?
This seems like a better deal to African startup founders. $500k upfront is a large sum and could be used to offset the need for immediate funding if the startup has a lean operation.
Kevin Simmons believes this is a great deal to founders. For founders looking to raise $1,000,000, YC offers half the amount. It’s a simple decision to accept the deal and then get the balance from other investors.
It could also indicate that founders are increasingly looking after YC. If you are the competition and your customers are moving in the opposite direction, then you must offer them more money or better terms. You don’t want the best companies to go under your nose.
One problem that has been brought up is the difficulty for African startups to raise high valuations. This is incorrect. It would be difficult to raise money at high valuations because founders must convince investors that they are as valuable as their businesses.
However, there has been an astronomical increase in funding that many stakeholders are now having conversations about startup valuations. This is a problem that was not present just a few short years ago. Africa startups raised $4.3 billion in 2021 — 2.5x more than the amount raised in 2020. Startups will be able to raise capital at higher valuations if there is more money in the ecosystem.
Before joining YC, most startups raise capital to keep their business afloat. Acceptance by YC has been seen as a validation for startups, particularly African ones. As they are more visible, it has been easier for them raise money from investors.
Simmons says there are two ways to view Y Combinator’s deal. You can expect high expectations if you enter Y Combinator. This is because YC is known to have rigorous screening and selection process for great startups. Those expectations are based on dollars and cents. This means that they must raise higher valuations and build larger businesses after YC.
YC will receive a greater share of the startup after the deal. This is the same amount as the subsequent investors. It means that the founders will have to give up more of their company in order to reach the Series A round.
Many investors, most of them from Latin America and Africa, expressed concern about the exclusion of local investors from the captable. This is a crucial move for startups looking to tap into the local network provided by these investors. These investors are not all in agreement.
Biola Alabi is an angel investor who believes the benefits of going through YC outweigh any potential disadvantages.
“I believe that early-stage investors can also reap the benefits if they arrive early. Even if smaller investors are apprehensive, the benefits of YC outweigh any initial trepidations. It is important to believe in yourself and to invest with conviction. The market will decide the value. These will be determined by the market in the end.”
Despite increased investment in African startups, there are still super early investors who are available at either the pre-seed and seed stages. Most African startups at this stage have raised very little capital, typically less than $2 million. However, YCs move may exclude many angel investors and smaller VCs that invest in this round.
While it is unclear how this change will impact other accelerators or investors, Simmons believes that local investors will be able to raise capital more easily from LPs, which will allow them to invest in startups at higher levels.
He also pointed out that startups may be hesitant to join YC because of the brand.
“If you thought that the 7% was not a significant sacrifice, you will now need to pay $500k.
The founders will have to either raise less money before they can get into YC, or give up on the idea altogether. Raising future rounds at low valuations would require giving up large parts of the company. This could also mean that local investors are able to invest in these startups before they receive YC approval.
Investors are used to avoiding uncapped SAFEs. However, YCs willingness and ability to use them could make a difference.
“YC is such a well-known brand that other investors might be more inclined to invest in uncapped SAFEs. Simmons asked if the uncapped SAFE could gain acceptance, just as the SAFE was accepted as a standard practice.
Modupe Odele is a lawyer and founder of Vazi Legal, . He advises startups who want YC should get angel checks before signing YCs FN SAFE. They should also consult a lawyer to make sure that the MFN clause does not go backwards. It doesn’t seem that this is true, judging by YCs announcement.
There is no evidence that YCs deal will keep founders awake at night. It has funded 66 African startups since 2009, when it first funded an African startup. This is a small percentage of the deals in Africa that will be done 800 in 2021. This could be worrisome if other investors follow their lead.
It could be more difficult for African startups to raise funds locally, as the continent’s startup funding landscape is not at the same level as that of Europe and America. It could also encourage local investors to invest in early stage companies.