Is There a YCombinator Valuation Bubble or Not?

At the end of Friday's piece, I asked you guys to vote on SurveyMonkey what I should write about this weekend. Over 50% of you said you wanted me to discuss the buzz around the bubble in valuations for Y Combinator companies. ( Full results: http://jc.is/HE3AV5 )

I speak with six to 12 investors a week, both angels and VCs, as well as a half-dozen founders. Almost every discussion for the past couple of weeks has shifted to the valuations of the latest YC crop.

[ Note: In this piece I will not reference any specific knowledge I have as an angel investor. Everything here is based on public discussion of these issues. ]

For background, the valuation of a startup is the number investors and founders come up with as the full monetary value of a business during a financing event.

Valuations are always a hot topic, but they are delicate for two specific reasons:

1. They are a manifestation of how much investors, and by extension the entire world, love a founder and their idea.

2. Valuation at time of investment is a key variable -- along with growth -- in determining investor results. (That whole "buy low, sell high" thing.)
 
Clearly, this is the issue of the moment.

There has been a lot of very public talk about the "valuation caps" on the "convertible notes" of YC startups in the Winter 2012 class.

[ Quick background for those who are not familiar with these terms:

(a) Convertible note: The financial documentation of choice today for financing early-stage startups. It's essentially a loan that converts into equity at a discount to the next "priced round" of financing. Typically with a discount to the "priced round." These are popular because they cost $5k in legal fees, while a priced round costs $20k to $35k in legal fees.

(b) Valuation caps: A convertible note "converts" in two different ways (typically). First, the loan can come due and the investors can get their money money back, typically with interest, or convert to an agreed upon valuation (guess who has the power in that situation!). That doesn't happen often; the company will typically shut down by that point. Second, another investor (typically a VC) can price the next round at a specific value. The investors who made the loan in the convertible note are forced to accept that new valuation up to, you guessed it, the valuation cap. There is typically a 20% discount given to note-holders for taking the risk. For example, a capped note at $10M would yield a $10M valuation for the angels if the valuation of the next round was > $12.5M. Search blogs like www.venturehacks.com, www.avc.com or www.bothsidesofthetable.com for more details on these issues. ]

These caps have reached $10M to $15M according to public discussions. I won't confirm this, as the discussions I have with startups are always confidential unless they tell me they're not.

I can confirm that last year, in aggregate, valuation caps were typically $4M to $8M, and two years ago they were $2M to $6M.

So here are the questions on everyone's mind:
 

I. Is There a Bubble?
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Before you ask, “Is there a YC bubble?” you have to address "Is the internet industry experiencing a bubble?"

Yes there are bubbles, but those bubbles make up the froth on top of the massive rising tide of value being startups are creating today.

The $210M sale of OMGPOP and the $1B Instagram purchase feel like a bubble, but you have to step back for a moment and realize that OMGPOP was purchased for 2% of the value of Zynga and Instagram for 1% of the value of Facebook.

Now, are Zynga and Facebook overvalued? Well, that's a separate email of 2k words. The short version is they are aggressively valued based on their massive growth. I've heard folks say that $10B for Zynga and $100B for Facebook are anywhere from 0 to 30% rich. Most folks believe we are seeing a premium for growth -- not a bubble -- in these stocks. I'm inclined to agree.  

Instagram has 5%+ of Facebook's user base and OMGPOP has well over 10% of Zynga's monthly and daily user base.

The delta between the user bases of the acquisitions and the price paid is 5x+ in both cases, I'm guessing. That means shareholders of Facebook and Zynga probably got EXCELLENT value in both these "bubbly" valuations.
 

II. Is There a YC Bubble?
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If these were priced rounds -- in other words the valuation was set as opposed to capped -- you could say there is a bubble in not only YC but all startup valuations.

We've seen all angel rounds--including YC--go from priced rounds at $2 to $4M 30 months ago to $10-15M caps (as well as uncapped notes) today. Feels "bubbly," sure.

The truth is, we're seeing A-Round economics shifting down to what's being called “angel rounds.” It's an angel round because a bunch of angels invest -- as many as two dozen on occasion (again, public info) -- as opposed to just one VC taking the whole round.

Same exact thing happened in the dotcom bubble. Angel rounds started looking like A rounds, A rounds started looking like B rounds (e.g., $30M A rounds) and late-stage rounds (C and D rounds) were the same as IPOing. Yammer's $85M round and Twitter's nine-figure rounds are more than what many companies raise when they go public.

In a hot market, everyone moves one chair down; in a down market, everything moves back.  

However, the startups in question from YC are offering convertible notes -- not priced rounds. For these "eye-popping" (as one VC called them) valuations to manifest themselves into reality, a VC has to price a round at that number (or higher).

Will that happen?

Sadly, most angel-funded startups fail to raise an A round, so statistically no.

I'm guessing, due to Paul G's awesome track record, that 50% of YC startups will get A rounds  (I pulled that number out of the air, someone fact check me). Of those that do, maybe 50% will be below the cap and 50% at the cap (again, pulled from the air. Please debate/do some stats, someone).

So, it's only material in the case of a startup that has already proven themselves with exceptional performance, like say Zynga, Twitter, Dropbox, Airbnb, Uber, Facebook, Yammer and others.

If you could get into those A rounds, even at higher valuations, you would.

What we’re seeing now is founders doing their jobs: getting the best price for their teams.

Angels are willing to pay under these terms, so they are essentially saying they'll give up the first 2x to 3x of a deal's return in the hopes of getting YC’s next Airbnb or Dropbox. (Those two investments are up 50x to 300x since their YC days.)

Most angel investors have their activity covered by one big hit (that's been my experience -- go Uber!).

Bottom line: It feels like a bubble, but it's really just a hot market.
 

III. Are You Better off Investing in Two Non-YC Startups at 1/2 the Price?
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Now that's a really interesting question.

It assumes that you can a) get into the YC rounds (which 95% of angels can not) and b) there are other deals out there as good as the YC deals (80% of angel deals I see are not as refined as YC startups).

Again, the YC "2x to 3x market valuations" only come to fruition if a VC makes them real with additional funding. So, it's probably well worth it for angels to just bite their lips with the emotional issue around investing in "eye-popping" rounds and be thankful they got it.

Note: VCs considering "buying low" their key skill, so by forcing them to pay a premium foudners are--essentially--kicking them in the nuts and saying, "Gotcha!" Many of them take it personal. It's an emotional not logical thing. Me? I don't feel that way. I think foudners should get their best price, make a decision on who can help them the most and then correct the price to the level of quality they want in their investors. That's what I've done (i.e. taken a smaller valuation but having Sequoia do Mahalo's A Round, not a B-level VC).

That being said, AngelList and TechStars are filled with startups that are just as good as those coming out of YC. Heck, you might find some diamonds in the rough coming out of Founders Institute at a quarter the price (Adeo has been making some nice progress with FI, which accepts founders who don't have an idea year typically).

Despite the tight filtering process for YC, and their powerful support network, everyone knows there is no guarantee of success when it comes to startups. The world owes you nothing, and the world is particularly cruel to "the new" (hat tip: Anton Ego).

If you can find and invest in three startups with $5M caps that are as good as YC startups -- not an easy task, but not impossible -- you should clearly do that. The YC startups understand this, I think, and that's why they are not doing uncapped notes or pushing the rounds to $20M or $30M -- which they could!

I'm absolutely certain that the top 1/3rd of YC startups could have raised their rounds with uncapped notes or $25M rounds. YC is that hot and many rich angels on AngelList are looking to gamble.

In a way, the YC startups are showing restraint -- which I think is wise.

Bottom line:

(a) We're not in a bubble. We're in a revenue tsunami like nothing any of us have ever seen in our lifetimes.

(b) In a market like this, founders shouldn't optimize for valuation. They should optimize for getting the involvement and attention of the best investors who provide the best long-term value.

(c) We could go into a complete nuclear winter for funding if one insane dictator, terrorist or Goldman Sachs trader decides to blow something up again (and they seem to do that every 40 months or so).*

Vote now in my SurveyMonkey: http://www.surveymonkey.com/s/isthereabubble: 1. Is there a bubble, 2. Is there a YC bubble, 3. Are you better off investing in two non-YC startups at half the price? 4.What should I write about next?

Be excellent to each other, @jason

* Apologies to terrorists and dictators everywhere for putting them in the same company as Goldman Sachs traders/traitors.

PS - 250 educators, VCs, angels, founders and journalists are getting together on June 12 & 13 to discuss innovations in learning at LAUNCH Education & Kids. Details here: http://www.launch.co/blog/disrupting-education.html