To Counter Investor Signaling, YC Partners Can No Longer Be The First Money Into The Incubator’s Startups

Y Combinator has long allowed its partners to invest their own personal money in the incubator’s startups — often times partners put money into these startups before institutional investors and angels have a look. Unfortunately, whether a partner (or partners) put money into a YC company started to become a signal to outside investors of the good bets in the incubator.

It makes sense. These partners are often integrally involved in helping build these companies inside of Y Combinator. So they would know which startups have the legs to be successful, and potentially have insider knowledge into which startups have the potential for going the distance. To mitigate this signaling effect, Y Combinator is implementing a new policy whereby YC partners can’t be the first money into a startup from the incubator.

Specifically, YC partners can’t be in the first $500,000 a company raises unless it’s three weeks past Demo Day.

As YC co-founder Paul Graham explains to us, the danger of letting the partners at an incubator invest in the startups is that it makes it harder for the ones the partners don’t invest in to raise money. In the early years of YC, this wasn’t as much of an issue because Graham was the only one investing, and he wasn’t systematic about it. But in the last few batches, investors started treating the companies that had investments by YC partners as an indication of what YC thought of the startups.

Currently YC has about a dozen partners involved, including Paul Buchheit, Garry Tan, and Geoff Ralston. What’s also of interest is that any funds that YC partners operate will also fall into this rule as well. So the new fund started by Tan, now part-time partner Harj Taggar, and Reddit co-founder Alexis Ohanian, will not be able to be the first money into a startup.

This is clearly a founder-friendly move, and evens the playing field in some ways for startups to raise money from outside investors. It’s no secret that Y Combinator’s class sizes have steadily risen, and in the effort to save time and optimize their money, investors look for signals on which startups to invest in. Of course, YC partners investing in a startup is just one of many signals investors are looking at when evaluating a startup at the seed stage.

YC also recently debuted a new, easier convertible equity model for founders.

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Investor Reaction To Microsoft’s Rumored CEO Choice: We’re Fine With That

Yesterday in after-hours trading, Microsoft picked up a minor gain. The trading period was interesting as news that Microsoft’s board was tipped to select its own Satya Nadella as its next CEO had broken.

This morning, the company’s stock has risen more than 2 percent in a generally down market day. Investors appear at least blasé with the CEO choice.

If Microsoft had fallen sharply, or risen dramatically directly following the news, that would have been a different sort of signal.

Is it negative that Microsoft’s stock didn’t spike following the Nadella news, perhaps indicating that the company could have done better in its choice? You could read it that way, but I think two things can force us — for now — to not be too negative. Primarily, Microsoft has not announced the news itself, so we’re still discussing probabilities and potentialities, no matter how strong the sourcing is.

And secondly, I doubt that the street is too familiar with Nadella. Uncertainty is usually a sell, sure, but Nadella’s coverage has generally mentioned his strengths, perhaps providing some mental insurance to the trading classes.

The caveat, naturally, is Nadella’s weaknesses — such as they are. I’ll be digging into this later today, but the simple summation is while he is tops at technical work and enterprise-facing efforts, he lacks commensurate experience with consumer products and hardware, and could therefore lack the leadership and vision he needs to drive Microsoft forward in those key areas.

For now, however, the market is telling Microsoft it is fine with its supposed choice.

Top Image Credit:  Dan Taylor/Heisenberg Media 

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The Rise Of The Hedge Fund Startup Investor (Again)

The first question I thought of when I read that San Francisco hedge fund Coatue Management was the backer behind Snapchat’s $50 million round of funding was which VC firm lost the deal. My second question was why take money from a hedge fund?

In the past two years or so, you have seen more hedge funds dabbling in tech investing. As one venture investor put it in 2011, “They are the antichrist of patient, supportive early-stage investing. But increasingly, hedge funds are scoring some of the deals you would expect traditional VCs to get. Case in point — Snapchat. Over the past few weeks, I spoke to a dozen or so public and private market investors around this trend, why it is taking place, and what it means for founders.

Coatue isn’t the first “cross-over” fund (an investment fund that crosses over to the private from the public markets) to emerge in technology investing. Integral Capital Partners, co-founded by Roger McNamee and John Powell, was one of the first to start doing this in the nineties. Hedge fund Tiger Global has been doing it more recently, with a venture arm that has backed Warby Parker, Nextdoor, Redfin, Eventbrite and Pure Storage, among many others.

This wasn’t Coatue’s first mid-stage private tech backing. Last year, the firm established a $300 million growth fund for this purpose, as reported by Pando’s Sarah Lacy. The fund recently led mobile travel startup Hotel Tonight’s $45 million round in September. Coatue also participated in Box’s funding round in 2012.

And Coatue and Tiger Global aren’t the only hedge funds to jump into the private markets tech-investing game of late. Altimeter has been backing private tech companies for the past few years. Valiant Capital Partners has backed Dropbox, Evernote, and Pinterest in the past two years. Maverick Capital has participated in a few seed deals, including Zenefits in 2013. And the fund isn’t just going after growth-stage funding. In December, the firm participated in a seed round in Estimote, which develops beacons.

As one investor explained to me, hedge funds are once again seeing the potential for greater returns by dabbling in the private markets. Much of this is due to the fact that tech companies are waiting longer to go public. It used to be that the benchmark to go public was a $100 million revenue run rate, and the strategy would be to go public and then use that money to expand to international markets.

Now companies are hitting this revenue and seeing international growth happening in the private markets. Twitter and Facebook both had this type of growth before their respective IPOs. Employee liquidity, which is another benefit to going public, is also an event that can be accomplished by private offerings. You’ve seen Twitter and other companies allow for this pre-IPO.

By the time hedge funds start investing in these companies when they are public, there is not much upside in a two-to-three-year time frame. So to achieve some of the upside that VCs are seeing with hits like Twitter, Facebook and others, hedge funds are starting to go upstream in the investment stage.

It’s important to note that we’re seeing this happen mostly among hedge funds that focus on tech. By engaging in crossover investing, hedge funds can use the expertise they’ve gained from the private markets (e.g. more knowledge on mobile advertising) and apply it to their public market investments, and vice versa. For example, Altimeter Capital has been investing in the travel industries across both public and private companies.

As I heard from a few investors, the Goldman Sachs Private Internet Company conferences (as well as the other investment-backed private tech gatherings) over the past two years have been packed with hedge fund investors who want to see if they could gain access to the hottest, fastest-growing early and mid-stage companies in tech. “In 2008 and 2009, no one was showing up,” one investor told me. But in the past two years, these conferences have been oversubscribed and packed with hedge fund managers.

For early-stage entrepreneurs, especially those looking for Series B/C and growth funding, more capital is always a good thing. Hedge funds can afford to be flexible on pricing, and tend to give founders higher valuations. Many hedge funds are willing to give founders valuations that VCs would balk at, one investor told me. This is where the negative effect could take place.

Because hedge funds are often flexible in their mandates, they have the capacity and permission from their LPs to fund private deals. Also, hedge funds aren’t beholden to returning money in the same way VCs are. They can be flexible on pricing and valuations, because a 10 or 20 percent return is stellar. Last year, hedge funds returned an average of 7.4 percent. VCs aim toward a much higher percent return — and need to price and value startups to optimize for that. And because of this flexible structure, hedge funds can give founders cash more quickly than a VC. Hedge funds have their cash on hand and can liquidate faster. VCs operate on a commitment basis and don’t collect their entire funds at once. One investor referred to hedge funds as ideal for “easy, quick cash.”

But some in the industry caution against going the Snapchat route and taking entire rounds from hedge funds. Because hedge fund managers tend to be passive investors, they probably aren’t going to get as actively involved in operations or board-level decisions as a seasoned VC might. In the case of Snapchat, CEO and co-founder Evan Spiegel had already taken money from a number of well-known VCs, including Lightspeed, General Catalyst and Benchmark Capital. If a founder is considering taking money from a hedge fund, expect a hands-off approach for the most part, we hear.

The downside to this lack of accountability, some investors say, is that they are not long-term holders of stock. These funds, say investors, will have little problem selling the stock after a company goes public. Or, as one investor warns, he’s seen funds that have tried to unload private stock when a company encounters strife of some sort, or if user numbers plummet. ” Most VCs are in it for the good and the bad, and that may not be the case for hedge funds, advised one source.

As one investor tells me, hedge funds getting into private-company investing at the early stage is part of a greater trend of the unbundling of company building, which VCs tend to be good at, from actual capital. This year will bring more money to startups, but likely in the form of the non-traditional funds, whether that be hedge funds, family funds, and other alternative assets.

It’s hard not to also acknowledge the effect of outside investors on the whole bubble perception issue. VCs caution that more hedge funds could drive up valuations, which in turn creates more of a bubble around these valuations. But unlike the craziness of the bubble, hedge funds don’t necessarily represent “dumb money” any more. The hedge funds investing in tech startups these days seem to be doing their due diligence, for the most part, and convincing entrepreneurs that they add some value.

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