Y Combinator’s Paul Graham Warns Start-Ups to Lower Funding Expectations
Given the risk of the Facebook IPO’s poor performance potentially depressing the start-up market, Y Combinator leader Paul Graham is now warning his companies to lower their funding expectations and to conserve current funding.
The risk, as Graham lays it out, is that companies who have been valued highly may have to raise “down rounds” the next time they need money, which look bad for companies and dilute founders.
It’s an interesting move for Graham to cry wolf now, as Y Combinator has in recent years set the tone for Silicon Valley start-ups, and lately has been known for the funding frenzy around its companies.
Graham’s message is mainly about fiscal responsibility, but the fact that he said anything at all is a negative indicator in and of itself.
A somewhat similar warning from Sequoia Capital to its portfolio companies back in 2008 has become emblematic of that particular downturn. In a presentation called “RIP Good Times,” Sequoia told start-ups to cut costs.
Graham does hedge his warning, saying he’s not sure how much the Facebook IPO’s performance will affect the early-stage market.
He writes:
The startups that really get hosed are going to be the ones that have easy money built into the structure of their company: the ones that raise a lot on easy terms, and are then led thereby to spend a lot, and to pay little attention to profitability. That kind of startup gets destroyed when markets tighten up. So don’t be that startup.
The warning came in the form of a private letter that was published by a user on Hacker News, a widely read aggregation site managed by Y Combinator. It also appeared on Business Insider. Graham confirmed the letter’s validity via email to AllThingsD.
Asked whether he assumed his letter would become public, Graham replied, “No. I never thought anyone would care enough to treat this as news. The email is mostly fairly technical stuff about what to do if the funding market turns bad.”
Here’s the full text:
Jessica and I had dinner recently with a prominent investor. He seemed sure the bad performance of the Facebook IPO will hurt the funding market for earlier stage startups. But no one knows yet how much. Possibly only a little. Possibly a lot, if it becomes a vicious circle.
What does this mean for you? If it means new startups raise their first money on worse terms than they would have a few months ago, that’s not the end of the world, because by historical standards valuations had been high. Airbnb and Dropbox prove you can raise money at a fraction of recent valuations and do just fine. What I do worry about is (a) it may be harder to raise money at all, regardless of price and (b) that companies that previously raised money at high valuations will now face “down rounds,” which can be damaging.
What to do?
If you haven’t raised money yet, lower your expectations for fundraising. How much should you lower them? We don’t know yet how hard it will be to raise money or what will happen to valuations for those who do. Which means it’s more important than ever to be flexible about the valuation you expect and the amount you want to raise (which, odd as it may seem, are connected). First talk to investors about whether they want to invest at all, then negotiate price.
If you raised money on a convertible note with a high cap, you may be about to get an illustration of the difference between a valuation cap on a note and an actual valuation. I.e. when you do raise an equity round, the valuation may be below the cap. I don’t think this is a problem, except for the possibility that your previous high cap will cause the round to seem to potential investors like a down one. If that’s a problem, the solution is not to emphasize that number in conversations with potential investors in an equity round.
If you raised money in an equity round at a high valuation, you may find that if you need money you can only get it at a lower one. Which is bad, because “down rounds” not only dilute you horribly, but make you seem and perhaps even feel like damaged goods.
The best solution is not to need money. The less you need investor money, (a) the more investors like you, in all markets, and (b) the less you’re harmed by bad markets.
I often tell startups after raising money that they should act as if it’s the last they’re ever going to get. In the past that has been a useful heuristic, because doing that is the best way to ensure it’s easy to raise more. But if the funding market tanks, it’s going to be more than a heuristic.
The startups that really get hosed are going to be the ones that have easy money built into the structure of their company: the ones that raise a lot on easy terms, and are then led thereby to spend a lot, and to pay little attention to profitability. That kind of startup gets destroyed when markets tighten up. So don’t be that startup. If you’ve raised a lot, don’t spend it; not merely for the obvious reason that you’ll run out faster, but because it will turn you into the wrong sort of company to thrive in bad times.
–pg
