June 2013

(This talk was written for an audience of investors.)

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. [1]

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. [2] 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. [3]

YC has funded 564 startups, and the 287 with valuations are worth about $11.7 billion. A few winners dominate—the top 10 are 8.6 of that—but behind them is a peloton, about 40 with a shot at being really big.

We shrank the batch last summer by tightening our filter, and journalists read it as a macro trend. The duller truth: we'd found an n² algorithm and needed time to fix it. With sharding, I'd guess we can still grow 2 or 3x.

YC has funded 564 startups worth about $11.7 billion, dominated by a few winners with a peloton behind. We shrank the batch last summer for a boring reason: an n² algorithm we had to fix.

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.

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?

I 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.

Funding so many startups, and helping them fundraise, lets us see investing trends early. The basic question: will investors, in the aggregate, make more money or less?

I think more. Multiple forces are at work, some lowering returns and some raising them; I can't predict which prevails, but I'll describe them and you can decide.

Funding so many startups, and helping them fundraise, lets us see investing trends early. The basic question: will investors make more money or less?

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. [4]

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 [blocked] 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. [5]

Two forces drive change: it's getting cheaper to start a startup, and startups are becoming a normal thing to do. When I graduated in 1986, there were two options: a job or grad school. Now there's a third: start your own company. It was possible then too, but didn't seem real—not a company that would become big.

That change, from 2 paths to 3, is a social shift that happens once every few generations, and we're still at the beginning. As big a deal as the Industrial Revolution? Probably not. But big enough to take almost everyone by surprise, because those shifts always do.

One thing is sure: a lot more startups. The monolithic companies of the mid 20th century are being replaced [blocked] by networks of smaller ones—a process that started decades ago and has a long way to run.

Two forces drive the change: startups are getting cheaper, and starting one has become a normal path. When I graduated in 1986 there were two options; now there's a third, a social shift that happens once in generations.

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 [blocked], their companies.

Which means investors will get less stock and less control.

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.

The other driver is that startups are cheaper to start. Needing less money gives founders the upper hand—you still need their energy and imagination, not as much of your money—so they keep more stock and control of [blocked] their companies, and investors get less of both.

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

As startups need less money, founders gain the upper hand and keep more stock and control, so investors get less of each. But returns needn't fall, because the number of good startups will grow faster than the share investors lose.

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. [6]

There's a rule of thumb that about 15 companies a year will be really successful. Investors treat it like a cosmological constant, but I'm certain it isn't. Technology's pace has limits, but that's not the binding one now.

The real limit is the number of sufficiently good founders starting companies, and that will increase. Plenty who'd make great founders never start one—you can see it in how randomly the biggest startups got going; so many almost didn't happen that many equally good ones must not have. With 10x or 50x more out there, 15 big hits a year could become 50 or 100.

The VC rule that ~15 companies a year will be really successful isn't a cosmological constant. The real limit is the number of good founders starting companies, and that can rise 10x or more, turning 15 hits into 50 or 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.

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.

Will returns be pinched by high valuations? I think the top firms will make more. High returns don't come from low valuations; they come from the companies that do really well—so with more of those each year, the best pickers have more hits.

This means more variability. Firms that pick the best startups do even better, while the bad firms get the leftovers, as they do now, and pay more for them.

Nor is it a problem that founders keep control longer. The evidence is clear: investors make more money as founders' bitches than their bosses. Humiliating, maybe, but it takes less time to serve founders than to micromanage them.

High returns come from backing the companies that do well, not from low valuations, so with more big hits the best pickers win bigger. Variability rises; the good firms pull ahead, the bad ones overpay for leftovers.

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 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.

What about angels? Lots of opportunity there. It used to suck—you couldn't reach the best deals unless you got lucky like Andy Bechtolsheim, and VCs might strip your stock later. Now an angel can use Demo Day or AngelList for the same deals VCs get, and the days of washing angels out of the cap table are gone.

The biggest unexploited opportunity is angel-sized investments made quickly. When a company is just its founders, everything halts during a fundraise that easily takes 6 weeks. That high cost leaves room for low-cost investors—and low-cost means deciding quickly.

An investor who put in $100k on good terms and promised yes or no within 24 hours would get almost all the best deals, because every startup, good and bad, would come first—they'd have to pick, but they'd see everything. An investor known for dithering or haggling gets saved for last, and with the most promising startups, last easily becomes never.

Angels now have VC-level access through Demo Day and AngelList, and can't be washed out of the cap table. The biggest unexploited opportunity is fast angel-sized checks: an investor who said yes or no within 24 hours would see every good deal first.

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. [7]

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.

Will big hits grow linearly with the number of startups? Probably not. One reason: the old scariness was an effective filter, and as the cost of failing drops, founders will do it more. That's fine—lowering the cost of failure raises the number of failures and still leaves you net ahead.

The other reason is idea clashes. Good ideas are finite, and the more startups there are, the more we'll see multiple companies doing the same thing at once. It will be interesting, in a bad way, if clashes become common.

Mostly because of the early failures, the startup business won't be the same shape scaled up. What used to be an obelisk will become a pyramid: a little wider at the top, but a lot wider at the bottom.

Big hits won't grow linearly with startups: cheaper failure means more failures, and a finite stock of ideas means more clashes. The startup business will go from obelisk to pyramid—a little wider at the top, 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.

What does that mean for investors? More opportunity at the earliest stage, where the volume grows fastest. As the obelisk of investors widens into a pyramid, the contents adhere to the top, leaving a vacuum at the bottom.

That mostly means an opening for new investors, because the risk an existing firm will take is one of the hardest things to change—imprinted in its procedures and in the personalities of its people.

As the startup pyramid widens, the volume grows fastest at the earliest stage, leaving a vacuum there for investors. It's mostly an opening for new investors, since each existing firm's tolerance for risk is deeply imprinted and hard to change.

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' 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.

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.

The biggest danger and opportunity for VCs is the series A stage—or what used to be it, before series As became de facto series B rounds. VCs knowingly invest too much there, needing a big chunk to justify the board seat. So in a competitive deal the valuation moves, not the percentage sold, and they make companies take more than they want.

Some VCs lie and say the company needs it; others admit their models require owning a certain percentage. But series A amounts aren't set by what's best for the company: VCs start from the share they want, and the market sets the amount.

This wasn't intentional. The VC business backed into it as its assumptions went obsolete. The traditions were set when founders needed investors more, when it was natural to sell a big chunk in the series A. Now founders would rather sell less, and VCs dig in, unsure they can make money under 20% of each company.

It's a danger because series A investors are increasingly at odds with the startups they serve, and that bites you. It's an opportunity because so much potential energy has built up. The first VC to break ranks—doing series A rounds for as much equity as founders want to sell, with no option pool from founders' shares alone—stands to reap huge benefits.

What happens to the VC business then? Hell if I know. But I bet that firm ends up ahead. If one top-tier firm started from the amount a company needed and let the percentage float with the market, they'd instantly get almost all the best startups. And that's where the money is.

VCs knowingly overfund series A rounds because their models require owning a fixed percentage, forcing money on companies. The first top firm to start from what the company needs, and let the percentage float, would grab almost all the best startups.

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.

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.

You can't fight market forces forever. The percentage sold in series A rounds has crept inexorably down—40% used to be common, now VCs fight to hold the line at 20%. I'm daily waiting for it to collapse. It's going to happen; you may as well anticipate it, and look bold.

Maybe VCs will make more by doing the right thing—it wouldn't be the first time. Venture capital is a business where occasional big successes generate hundredfold returns; how much confidence can you have in financial models for that? The successes only have to get slightly less occasional to cover a 2x cut in stock sold.

The share sold in series A rounds has crept from 40% toward 20% and the line will collapse; you may as well anticipate it. The occasional big successes only have to get slightly less occasional to cover a 2x cut in stock sold.

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.

To find new opportunities, look for what founders complain about: they're your customers, and their complaints are unsatisfied demand. The two I've given—slow investors and excessive series A dilution—are good places to start. But the general recipe is: do something founders want.

To find new opportunities, look for what founders complain about—slow investors and series A dilution are two—because founders are your customers and their complaints are unsatisfied demand.

Notes

[1] I realize revenue and not fundraising is the proper test of success for a startup. The reason we quote statistics about fundraising is because those are the numbers we have. We couldn't talk meaningfully about revenues without including the numbers from the most successful startups, and we don't have those. We often discuss revenue growth with the earlier stage startups, because that's how we gauge their progress, but when companies reach a certain size it gets presumptuous for a seed investor to do that.

In any case, companies' market caps do eventually become a function of revenues, and post-money valuations of funding rounds are at least guesses by pros about where those market caps will end up.

The reason only 287 have valuations is that the rest have mostly raised money on convertible notes, and although convertible notes often have valuation caps, a valuation cap is merely an upper bound on a valuation.

[2] We didn't try to accept a particular number. We have no way of doing that even if we wanted to. We just tried to be significantly pickier.

[3] Though you never know with bottlenecks, I'm guessing the next one will be coordinating efforts among partners.

[4] I realize starting a company doesn't have to mean starting a startup [blocked]. There will be lots of people starting normal companies too. But that's not relevant to an audience of investors.

Geoff Ralston reports that in Silicon Valley it seemed thinkable to 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 in economic inequality in the US since the mid twentieth century. The person who would in 1950 have been the general manager of the x division of Megacorp is now the founder of the x company, and owns significant equity in it.

[6] If Congress passes the founder visa [blocked] in a non-broken form, that alone could in principle get us up to 20x, since 95% of the world's population lives outside the US.

[7] If idea clashes got bad enough, it could change what it means to be a startup. We currently advise startups mostly to ignore competitors. We tell them startups are competitive like running, not like soccer; you don't have to go and steal the ball away from the other team. But if idea clashes became common enough, maybe you'd start to have to. That would be unfortunate.

Thanks to Sam Altman, Paul Buchheit, Dalton Caldwell, Patrick Collison, Jessica Livingston, Andrew Mason, Geoff Ralston, and Garry Tan for reading drafts of this.

Revenue, not fundraising, is the proper test of success, but fundraising numbers are the ones we have. Only 287 have valuations because the rest raised on convertible notes, whose caps are merely upper bounds.

Geoff Ralston reports that starting a startup seemed thinkable in Silicon Valley in the mid 1980s, though not to East Coast undergraduates. This shift toward networked companies drives rising US inequality: the man who'd have run a division of Megacorp now founds the company and owns equity. A non-broken founder visa [blocked] could alone get us to 20x.

If idea clashes got bad enough, they could change what it means to be a startup. We tell startups to ignore competitors—competitive like running, not soccer—but if clashes became common, maybe you'd have to steal the ball.

Notes: fundraising stats stand in for unavailable revenue numbers; the batch was cut by being pickier, not to a target; this networked-company shift drives US inequality; a founder visa could push founder growth to 20x.