Decoding PG’s Latest “Startup Investing Trends” Essay

Over the weekend, YC co-founder Paul Graham penned this very important essay on his observation on investing trends. It is a very important post. I’m not one to fawn over PG’s recent posts and tweets, but if you’re at all interested in investing in and around startups, it is critical to understand this piece and read it over and over again. I’ve reproduced PG’s essay below (it should be read, not summarized) and have inserted my commentary in bold text within. If you find this interesting and/or disagree with something, please leave a comment.

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[Full text of Paul Graham’s latest essay, “Startup Investing Trends” reproduced here ]

Y Combinator has now funded 564 startups including the current batch, which has 53. The total valuation of the 287 that have valuations (either by raising an equity round, getting acquired, or dying) is about $11.7 billion, and the 511 prior to the current batch have collectively raised about $1.7 billion. As usual those numbers are dominated by a few big winners. The top 10 startups account for 8.6 of that 11.7 billion. But there is a peloton of younger startups behind them. There are about 40 more that have a shot at being really big.

Things got a little out of hand last summer when we had 84 companies in the batch, so we tightened up our filter to decrease the batch size. Several journalists have tried to interpret that as evidence for some macro story they were telling, but the reason had nothing to do with any external trend. The reason was that we discovered we were using an n² algorithm, and we needed to buy time to fix it. Fortunately we’ve come up with several techniques for sharding YC, and the problem now seems to be fixed. With a new more scaleable model and only 53 companies, the current batch feels like a walk in the park. I’d guess we can grow another 2 or 3x before hitting the next bottleneck. [The common comment here is “YC can’t scale,” and then “when they tried to, it was bloated.” While that seems logical based on recent events, I would bet YC specifically will scale, mostly because knowledge within the organization is continuously collected and decentralized. Second, there are so many great, loyal, successful alumni of YC who could assume more leadership capabilities or physically expand the franchise — it’s not hard to imagine a YC based in NYC, and in fact, I expect that to happen eventually.]

One consequence of funding such a large number of startups is that we see trends early. And since fundraising is one of the main things we help startups with, we’re in a good position to notice trends in investing. [YC is in the BEST position, not just a good position, to notice these trends.]

I’m going to take a shot at describing where these trends are leading. Let’s start with the most basic question: will the future be better or worse than the past? Will investors, in the aggregate, make more money or less?  think more. There are multiple forces at work, some of which will decrease returns, and some of which will increase them. I can’t predict for sure which forces will prevail, but I’ll describe them and you can decide for yourself.

There are two big forces driving change in startup funding: it’s becoming cheaper to start a startup, and startups are becoming a more normal thing to do.

When I graduated from college in 1986, there were essentially two options: get a job or go to grad school. Now there’s a third: start your own company. That’s a big change. In principle it was possible to start your own company in 1986 too, but it didn’t seem like a real possibility. It seemed possible to start a consulting company, or a niche product company, but it didn’t seem possible to start a company that would become big.

That kind of change, from 2 paths to 3, is the sort of big social shift that only happens once every few generations. I think we’re still at the beginning of this one. It’s hard to predict how big a deal it will be. As big a deal as the Industrial Revolution? Maybe. Probably not. But it will be a big enough deal that it takes almost everyone by surprise, because those big social shifts always do.

 One thing we can say for sure is that there will be a lot more startups. The monolithic, hierarchical companies of the mid 20th century are being replaced by networks of smaller companies. This process is not just something happening now in Silicon Valley. It started decades ago, and it’s happening as far afield as the car industry. It has a long way to run. [This is important to understand because one could divide LPs and GPs into two groups — those who believe our economy is going through a cyclical change, and those who believe we are witnessing a structural change. The distinction is important, and I’ve written more about it here. PG’s argument, which I agree with, is that startups are the new normal and will continue to increase in number.]

The other big driver of change is that startups are becoming cheaper to start. And in fact the two forces are related: the decreasing cost of starting a startup is one of the reasons startups are becoming a more normal thing to do.

The fact that startups need less money means founders will increasingly have the upper hand over investors. You still need just as much of their energy and imagination, but they don’t need as much of your money. Because founders have the upper hand, they’ll retain an increasingly large share of the stock in, and control of, their companies. Which means investors will get less stock and less control. [Relatively speaking, this is absolutely true. The question is, “How much?” I’ll offer an idea below.]

Does that mean investors will make less money? Not necessarily, because there will be more good startups. The total amount of desirable startup stock available to investors will probably increase, because the number of desirable startups will probably grow faster than the percentage they sell to investors shrinks.

There’s a rule of thumb in the VC business that there are about 15 companies a year that will be really successful. Although a lot of investors unconsciously treat this number as if it were some sort of cosmological constant, I’m certain it isn’t. There are probably limits on the rate at which technology can develop, but that’s not the limiting factor now. If it were, each successful startup would be founded the month it became possible, and that is not the case. Right now the limiting factor on the number of big hits is the number of sufficiently good founders starting companies, and that number can and will increase. There are still a lot of people who’d make great founders who never end up starting a company. You can see that from how randomly some of the most successful startups got started. So many of the biggest startups almost didn’t happen that there must be a lot of equally good startups that actually didn’t happen.

There might be 10x or even 50x more good founders out there. As more of them go ahead and start startups, those 15 big hits a year could easily become 50 or even 100.

What about returns, though? Are we heading for a world in which returns will be pinched by increasingly high valuations? I think the top firms will actually make more money than they have in the past. High returns don’t come from investing at low valuations. They come from investing in the companies that do really well. So if there are more of those to be had each year, the best pickers should have more hits. [I’m not sure I agree with this paragraph entirely. I do believe the top firms will generate even more returns as they grow in size and cut bigger checks at the later stages, but more modest funds can most definitely generate outsized returns by investing earlier, at lower valuations. USV is the obvious example, so look at this back-of-the-envelope estimation I made of one of their best vintages.]

This means there should be more variability in the VC business. The firms that can recognize and attract the best startups will do even better, because there will be more of them to recognize and attract. Whereas the bad firms will get the leftovers, as they do now, and yet pay a higher price for them.

Nor do I think it will be a problem that founders keep control of their companies for longer. The empirical evidence on that is already clear: investors make more money as founders’ bitches than their bosses. Though somewhat humiliating, this is actually good news for investors, because it takes less time to serve founders than to micromanage them. [I guess this style of demonizing will always continue. Ha! From my vantage point, all the great investors and up-and-coming ones never act as “bosses” nor “bitches.” They’re partners. Of course, without founders, investors couldn’t do their work, but if you ask the founders, most of them value having those good investors around the table for a variety of reasons and do not think of them as servants — they want to leverage them and their networks.]

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 access to the best deals, unless you got lucky like Andy Bechtolsheim, and when you did invest in a startup, VCs might try to strip you of your stock when they arrived later. Now an angel can go to something like Demo Day or AngelList and have access to the same deals VCs do. And the days when VCs could wash angels out of the cap table are long gone. [I hope this is true. It would be great. My concern is that I know a bunch of very successful but quieter former-angels who have stopped. They’d disagree with PG’s assessment. Specifically, they’d say valuations for individual angels are too high, and since most companies end up in some kind of modest M&A, the path to any return for an angel is even tougher.]

I think one of the biggest unexploited opportunities in startup investing right now is angel-sized investments made quickly. Few investors understand the cost that raising money from them imposes on startups. When the company consists only of the founders, everything grinds to a halt during fundraising, which can easily take 6 weeks. The current high cost of fundraising means there is room for low-cost investors to undercut the rest. And in this context, low-cost means deciding quickly. If there were a reputable investor who invested $100k on good terms and promised to decide yes or no within 24 hours, they’d get access to almost all the best deals, because every good startup would approach them first. It would be up to them to pick, because every bad startup would approach them first too, but at least they’d see everything. Whereas if an investor is notorious for taking a long time to make up their mind or negotiating a lot about valuation, founders will save them for last. And in the case of the most promising startups, which tend to have an easy time raising money, last can easily become never. [This is absolutely true. I have seen it. In fact, there’s a new fund which sort of operates this way, perhaps based on this realization. It’s called Bloomberg BETA and it’s run by Roy Bahat, and my friend James Cham, and a few others. While I think deciding in 24 hours is probably too fast for a variety of reasons, it’s also not rocket science and small checks should be decided on very quickly. The problem in practice is that most smaller investors will still tell founders that they’re “in” so long as they find a lead because they don’t want to wire $100k while the founders grind out three months to collect the remaining $900k, if they can at all.]

Will the number of big hits grow linearly with the total number of new startups? Probably not, for two reasons. One is that the scariness of starting a startup in the old days was a pretty effective filter. Now that the cost of failing is becoming lower, we should expect founders to do it more. That’s not a bad thing. It’s common in technology for an innovation that decreases the cost of failure to increase the number of failures and yet leave you net ahead.

The other reason the number of big hits won’t grow proportionately to the number of startups is that there will start to be an increasing number of idea clashes. Although the finiteness of the number of good ideas is not the reason there are only 15 big hits a year, the number has to be finite, and the more startups there are, the more we’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 lot more common.

Mostly because of the increasing number of early failures, the startup business 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 a little wider at the top, but a lot wider at the bottom.

What does that mean for investors? One thing it means is that there will be more opportunities for investors at the earliest stage, because that’s where the volume of our imaginary solid is growing fastest. Imagine the obelisk of investors that corresponds to the obelisk of startups. As it widens out into a pyramid to match the 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 new investors, because the degree of risk an existing investor or firm is comfortable taking is one of the hardest things for them to change. Different types of investors are adapted to different degrees of risk, but each has its specific degree of risk deeply imprinted on it, not just in the procedures they follow but in the personalities of the people who work there. [Boy, I could write a whole post just on this. Very, very true. Change in a VC firm on any dimension is hard because VC partnerships combine two of the least-efficient ingredients found on Earth: partnership structures and VCs themselves. I’m partially joking, but partnerships are, in my mind, the tragedy of the commons in corporate life. This is why the top firms mostly have either flat structures or have a top-dog in charge who makes sure the partnership doesn’t devolve into a tragedy. Therefore, changing dynamics inside a firm is really, really hard. Even for the easy, small stuff — but if you consider an input as big as risk, well, that’s nearly impossible unless the partnership changes in composition drastically.]

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 A stage before series As turned into de facto series B rounds.

Right now, VCs often knowingly invest too much money at the series A stage. They do it because they feel they need to get a big chunk of each series A company to compensate for the opportunity cost of the board seat it consumes. Which means when there is a lot of competition for a deal, the number that moves is the valuation (and thus amount invested) rather than the percentage of the company being sold. Which means, especially in the case of more promising startups, that series A investors often make companies take more money than they want.

Some VCs lie and claim the company really needs that much. Others are more candid, and admit their financial models require them to own a certain percentage of each company. But we all know the amounts being raised in series A rounds are not determined by asking what would be best for the companies. They’re determined by VCs starting from the amount of the company they want to own, and the market setting the valuation and thus the amount invested.

Like a lot of bad things, this didn’t happen intentionally. The VC business backed into it as their initial assumptions gradually became obsolete. The traditions and financial models of the VC business were established when founders needed investors more. In those days it was natural for founders to sell VCs a big chunk of their company in the series A round. Now founders would prefer to sell less, and VCs are digging in their heels because they’re not sure if they can make money buying less than 20% of each series A company.

The reason I describe this as a danger is that series A investors are increasingly at odds with the startups they supposedly serve, and that tends to come back to bite you eventually. The reason I describe it as an opportunity is that there is now a lot of potential energy built up, as the market has moved away from VCs’s traditional business model. Which means the first VC to break ranks and start to 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. [Again, this is absolutely right. The market has moved away from VC’s traditional business model around what constitutes required ownership levels. Fred Wilson wrote about this last week, as well. The problem here, in practice, is that only firms as small and modest in size like USV can adapt to these changes. If you are managing $800M or over a billion dollars, those 20% ownership floors are critically important for the investors’ model. Smaller funds, by contrast, are on the hook to return less dollars overall, so they are in a position to do what PG says. The problem, however, is that generally-speaking, founders are still motivated by the size of the round they can pull down, as well as the valuation. This is where deals fall apart in real life: A smaller fund wants to invest in a hot Series A deal, and they want to invest around $5m at a more modest valuation, but a larger firm will literally double the cash in, and then all sorts of irrational behaviors kick in, as well as endorphins. Again, I agree with PG, but haven’t seen this yet, though I hope to. In fact, I view it as a sign of sophistication of a founder to take on more modest valuations in order to maximize their exit options down the road.]

What will happen to the VC business when that happens? Hell if I know. But I bet that particular firm will end up ahead. If one top-tier VC firm started to do series A rounds that started from the amount the company needed to raise and let the percentage acquired vary with the market, instead of the other way around, they’d instantly get almost all the best startups. And that’s where the money is.

You can’t fight market forces forever. Over the last decade we’ve seen the percentage of the company sold in series A rounds creep inexorably downward. 40% used to be common. Now VCs are fighting to hold the line at 20%. But I am daily waiting for the line to collapse. It’s going to happen. You may as well anticipate it, and look bold. [Definitely true. Smaller firms are going down to 13%, even 8-9% for smaller Series A. However, so much of this is inside-baseball. Sometimes founders do want to work with specific investors and will take more dilution in order to. Sometimes they want to reward the firm that made the first offer, even if the terms aren’t “the best.” I’ve seen this happen a few times already this year.]

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 a business where occasional big successes generate hundredfold returns. How much confidence can you really have in financial models for something like that anyway? The big successes only have to get a tiny bit less occasional to compensate for a 2x decrease in the stock sold in series A rounds.

If you want to find new opportunities for investing, look for things founders complain about. Founders are your customers, and the things they complain about are unsatisfied demand. I’ve given two examples of things founders complain about most—investors who take too long to make up their minds, and excessive dilution in series A rounds—so those are good places to look now. But the more general recipe is: do something founders want.

Haystack is written by Semil Shah, and is published under a Creative Commons BY-NC-SA license. Copyright © 2018 Semil Shah.

“I write this not for the many, but for you; each of us is enough of an audience for the other.”— Epicurus