June 2013(This talk was written for an audience of investors.)Y Combinator has now funded 564 startups including the currentbatch, which has 53. The total valuation of the 287 that havevaluations (either by raising an equity round, getting acquired,or dying) is about $11.7 billion, and the 511 prior to the currentbatch have collectively raised about $1.7 billion.[1]As usual those numbers are dominated by a few big winners. The top10 startups account for 8.6 of that 11.7 billion. But there is apeloton of younger startups behind them. There are about 40 morethat have a shot at being really big.Things got a little out of hand last summer when we had 84 companiesin the batch, so we tightened up our filter to decrease the batchsize. [2]Several journalists have tried to interpret that asevidence for some macro story they were telling, but the reason hadnothing to do with any external trend. The reason was that wediscovered we were using an n² algorithm, and we needed to buytime to fix it. Fortunately we've come up with several techniquesfor sharding YC, and the problem now seems to be fixed. With a newmore scaleable model and only 53 companies, the current batch feelslike a walk in the park. I'd guess we can grow another 2 or 3xbefore hitting the next bottleneck. [3]One consequence of funding such a large number of startups is thatwe see trends early. And since fundraising is one of the mainthings we help startups with, we're in a good position to noticetrends in investing.I'm going to take a shot at describing where these trends areleading. Let's start with the most basic question: will the futurebe better or worse than the past? Will investors, in the aggregate,make more money or less?I think more. There are multiple forces at work, some of whichwill decrease returns, and some of which will increase them. Ican't predict for sure which forces will prevail, but I'll describethem and you can decide for yourself.There are two big forces driving change in startup funding: it'sbecoming cheaper to start a startup, and startups are becoming amore normal thing to do.When I graduated from college in 1986, there were essentially twooptions: get a job or go to grad school. Now there's a third: startyour own company.That's a big change. In principle it was possible to start yourown company in 1986 too, but it didn't seem like a real possibility.It seemed possible to start a consulting company, or a niche productcompany, but it didn't seem possible to start a company that wouldbecome big.[4]That kind of change, from 2 paths to 3, is the sort of big socialshift that only happens once every few generations. I think we'restill at the beginning of this one. It's hard to predict how biga deal it will be. As big a deal as the Industrial Revolution?Maybe. Probably not. But it will be a big enough deal that ittakes almost everyone by surprise, because those big social shiftsalways do.One thing we can say for sure is that there will be a lot morestartups. The monolithic, hierarchical companies of the mid 20thcentury are being replaced by networksof smaller companies. This process is not just something happeningnow in Silicon Valley. It started decades ago, and it's happeningas far afield as the car industry. It has a long way to run. [5]The other big driver of change is that startups are becoming cheaperto start. And in fact the two forces are related: the decreasingcost of starting a startup is one of the reasons startups arebecoming a more normal thing to do.The fact that startups need less money means founders will increasinglyhave the upper hand over investors. You still need just as muchof their energy and imagination, but they don't need as much ofyour money. Because founders have the upper hand, they'll retainan increasingly large share of the stock in, and control of, theircompanies. Which means investors will get less stock and lesscontrol.Does that mean investors will make less money? Not necessarily,because there will be more good startups. The total amount ofdesirable startup stock available to investors will probably increase,because the number of desirable startups will probably grow fasterthan the percentage they sell to investors shrinks.There's a rule of thumb in the VC business that there are about 15companies a year that will be really successful. Although a lotof investors unconsciously treat this number as if it were somesort of cosmological constant, I'm certain it isn't. There areprobably limits on the rate at which technology can develop, butthat's not the limiting factor now. If it were, each successfulstartup would be founded the month it became possible, and that isnot the case. Right now the limiting factor on the number of bighits is the number of sufficiently good founders starting companies,and that number can and will increase. There are still a lot ofpeople who'd make great founders who never end up starting a company.You can see that from how randomly some of the most successfulstartups got started. So many of the biggest startups almost didn'thappen that there must be a lot of equally good startups thatactually didn't happen.There might be 10x or even 50x more good founders out there. Asmore of them go ahead and start startups, those 15 big hits a yearcould easily become 50 or even 100.[6]What about returns, though? Are we heading for a world in whichreturns will be pinched by increasingly high valuations? I thinkthe top firms will actually make more money than they have in thepast. High returns don't come from investing at low valuations.They come from investing in the companies that do really well. Soif there are more of those to be had each year, the best pickersshould have more hits.This means there should be more variability in the VC business.The firms that can recognize and attract the best startups will doeven better, because there will be more of them to recognize andattract. Whereas the bad firms will get the leftovers, as they donow, and yet pay a higher price for them.Nor do I think it will be a problem that founders keep control oftheir companies for longer. The empirical evidence on that isalready clear: investors make more money as founders' bitches thantheir bosses. Though somewhat humiliating, this is actually goodnews for investors, because it takes less time to serve foundersthan to micromanage them.What about angels? I think there is a lot of opportunity there.It used to suck to be an angel investor. You couldn't get accessto the best deals, unless you got lucky like Andy Bechtolsheim, andwhen you did invest in a startup, VCs might try to strip you ofyour stock when they arrived later. Now an angel can go to somethinglike Demo Day or AngelList and have access to the same deals VCsdo. And the days when VCs could wash angels out of the cap tableare long gone.I think one of the biggest unexploited opportunities in startupinvesting right now is angel-sized investments made quickly. Fewinvestors understand the cost that raising money from them imposeson startups. When the company consists only of the founders,everything grinds to a halt during fundraising, which can easilytake 6 weeks. The current high cost of fundraising means there isroom for low-cost investors to undercut the rest. And in thiscontext, low-cost means deciding quickly. If there were a reputableinvestor who invested $100k on good terms and promised to decideyes or no within 24 hours, they'd get access to almost all the bestdeals, because every good startup would approach them first. Itwould be up to them to pick, because every bad startup would approachthem first too, but at least they'd see everything. Whereas if aninvestor is notorious for taking a long time to make up their mindor negotiating a lot about valuation, founders will save them forlast. And in the case of the most promising startups, which tendto have an easy time raising money, last can easily become never.Will the number of big hits grow linearly with the total number ofnew startups? Probably not, for two reasons. One is that thescariness of starting a startup in the old days was a pretty effectivefilter. Now that the cost of failing is becoming lower, we shouldexpect founders to do it more. That's not a bad thing. It's commonin technology for an innovation that decreases the cost of failureto increase the number of failures and yet leave you net ahead.The other reason the number of big hits won't grow proportionatelyto the number of startups is that there will start to be an increasingnumber of idea clashes. Although the finiteness of the number ofgood ideas is not the reason there are only 15 big hits a year, thenumber has to be finite, and the more startups there are, the morewe'll see multiple companies doing the same thing at the same time.It will be interesting, in a bad way, if idea clashes become a lotmore common. [7]Mostly because of the increasing number of early failures, the startupbusiness of the future won't simply be the same shape, scaled up.What used to be an obelisk will become a pyramid. It will be alittle wider at the top, but a lot wider at the bottom.What does that mean for investors? One thing it means is that therewill be more opportunities for investors at the earliest stage,because that's where the volume of our imaginary solid is growingfastest. Imagine the obelisk of investors that corresponds tothe obelisk of startups. As it widens out into a pyramid to matchthe startup pyramid, all the contents are adhering to the top,leaving a vacuum at the bottom.That opportunity for investors mostly means an opportunity for newinvestors, because the degree of risk an existing investor or firmis comfortable taking is one of the hardest things for them tochange. Different types of investors are adapted to differentdegrees of risk, but each has its specific degree of risk deeplyimprinted on it, not just in the procedures they follow but in thepersonalities of the people who work there.I think the biggest danger for VCs, and also the biggest opportunity,is at the series A stage. Or rather, what used to be the series Astage before series As turned into de facto series B rounds.Right now, VCs often knowingly invest too much money at the seriesA stage. They do it because they feel they need to get a big chunkof each series A company to compensate for the opportunity cost ofthe board seat it consumes. Which means when there is a lot ofcompetition for a deal, the number that moves is the valuation (andthus amount invested) rather than the percentage of the companybeing sold. Which means, especially in the case of more promisingstartups, that series A investors often make companies take moremoney than they want.Some VCs lie and claim the company really needs that much. Othersare more candid, and admit their financial models require them toown a certain percentage of each company. But we all know theamounts being raised in series A rounds are not determined by askingwhat would be best for the companies. They're determined by VCsstarting from the amount of the company they want to own, and themarket setting the valuation and thus the amount invested.Like a lot of bad things, this didn't happen intentionally. TheVC business backed into it as their initial assumptions graduallybecame obsolete. The traditions and financial models of the VCbusiness were established when founders needed investors more. Inthose days it was natural for founders to sell VCs a big chunk oftheir company in the series A round. Now founders would prefer tosell less, and VCs are digging in their heels because they're notsure if they can make money buying less than 20% of each series Acompany.The reason I describe this as a danger is that series A investorsare increasingly at odds with the startups they supposedly serve,and that tends to come back to bite you eventually. The reason Idescribe it as an opportunity is that there is now a lot of potentialenergy built up, as the market has moved away from VCs' traditionalbusiness model. Which means the first VC to break ranks and startto do series A rounds for as much equity as founders want to sell(and with no "option pool" that comes only from the founders' shares)stands to reap huge benefits.What will happen to the VC business when that happens? Hell if Iknow. But I bet that particular firm will end up ahead. If onetop-tier VC firm started to do series A rounds that started fromthe amount the company needed to raise and let the percentageacquired vary with the market, instead of the other way around,they'd instantly get almost all the best startups. And that's wherethe money is.You can't fight market forces forever. Over the last decade we'veseen the percentage of the company sold in series A rounds creepinexorably downward. 40% used to be common. Now VCs are fightingto hold the line at 20%. But I am daily waiting for the line tocollapse. It's going to happen. You may as well anticipate it,and look bold.Who knows, maybe VCs will make more money by doing the right thing.It wouldn't be the first time that happened. Venture capital is abusiness where occasional big successes generate hundredfold returns.How much confidence can you really have in financial models forsomething like that anyway? Thebig successes only have to get a tiny bit less occasional tocompensate for a 2x decrease in the stock sold in series A rounds.If you want to find new opportunities for investing, look for thingsfounders complain about. Founders are your customers, and thethings they complain about are unsatisfied demand. I've given twoexamples of things founders complain about most—investors whotake too long to make up their minds, and excessive dilution inseries A rounds—so those are good places to look now. Butthe more general recipe is: do something founders want.Notes[1]I realize revenue and not fundraising is the proper test ofsuccess for a startup. The reason we quote statistics aboutfundraising is because those are the numbers we have. We couldn'ttalk meaningfully about revenues without including the numbers fromthe most successful startups, and we don't have those. We oftendiscuss revenue growth with the earlier stage startups, becausethat's how we gauge their progress, but when companies reach acertain size it gets presumptuous for a seed investor to do that.In any case, companies' market caps do eventually become a functionof revenues, and post-money valuations of funding rounds are atleast guesses by pros about where those market caps will end up.The reason only 287 have valuations is that the rest have mostlyraised money on convertible notes, and although convertible notesoften have valuation caps, a valuation cap is merely an upper boundon a valuation.[2]We didn't try to accept a particular number. We have no wayof doing that even if we wanted to. We just tried to be significantlypickier.[3]Though you never know with bottlenecks, I'm guessing the nextone will be coordinating efforts among partners.[4]I realize starting a company doesn't have to mean starting astartup. There will be lots of people starting normal companiestoo. But that's not relevant to an audience of investors.Geoff Ralston reports that in Silicon Valley it seemed thinkableto start a startup in the mid 1980s. It would have started there.But I know it didn't to undergraduates on the East Coast.[5]This trend is one of the main causes of the increase ineconomic inequality in the US since the mid twentieth century. Theperson who would in 1950 have been the general manager of the xdivision of Megacorp is now the founder of the x company, and ownssignificant equity in it.[6]If Congress passes the foundervisa in a non-broken form, that alone could in principle getus up to 20x, since 95% of the world's population lives outside theUS.[7]If idea clashes got bad enough, it could change what it meansto be a startup. We currently advise startups mostly to ignorecompetitors. We tell them startups are competitive like running,not like soccer; you don't have to go and steal the ball away fromthe other team. But if idea clashes became common enough, maybeyou'd start to have to. That would be unfortunate.Thanks to Sam Altman, Paul Buchheit, Dalton Caldwell,Patrick Collison, JessicaLivingston, Andrew Mason, Geoff Ralston, and Garry Tan for readingdrafts of this.
