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If Paul Graham likes your company enough to take you into Y Combinator, his prestigious startup incubator, your company might be worth as little as $200,000 on your first term sheet. Or it might be worth as much as $400,000 — and that’s if you’ve got a team of five and previous experience building a company.

Yet Graham this week called out other investors for “lowball” funding deals.

In a leaked memo, Graham cautioned Y Combinator companies not to accept deals from Google Ventures, calling that firm’s funding term sheets lowball offers.

“If you’re talking to Google Ventures you may be part of a pattern. … You’ve already raised some money at a cap of $x. Then GV says they’re interested and wants to invest at a cap of $x/2. … For some bizarre reason this is just their standard m.o. … Just focus on other investors instead. Maybe you’ll find enough from other sources that you can blow off GV. Or maybe you won’t, and you’ll need that offer to fall back upon.”
Paul Graham

But in talking with a slew of Y Combinator alumni from the past three years of YC batches, we found that Graham himself takes between 5 percent and 7 percent of companies for amounts ranging between $12,000 and $20,000. Those amounts aren’t any great secret; YC publishes approximations on its own site. But while the founders said YC insisted that these terms had nothing to do with their companies’ actual valuations, on paper, it made the startups worth between $228,000 and $287,000 on the high end.

“We’d had our first product on the market for four or five months; we’d been incorporated for a year and had already taken angel money,” said one YC alum we spoke to. “So the valuation, did that make sense? Absolutely not.”

This founder, whom we’ll call Tom Green, said that while exact dollar amounts and percentages fluctuated slightly based on how many founders a company had and how experienced those founders were (younger founders lost 1 percent or 2 percent more in equity for the same amounts of money), most of the deals were structured to favor Y Combinator with the assumption that most of the teams were just starting out and were likely to fail.

Unlike full-fledged investment firms, Y Combinator doesn’t do research or due diligence — not in the traditional sense, at least. Graham has seen thousands of products and teams in his time in the Valley, and YC alums tell us he’s got a strong sense for pattern-matching. He’ll make a one-meeting deal based on his gut, but he likes to bet on teams, not business plans. For YC’s mammoth classes of startups, which are sometimes 60 or 80 teams strong, this approach is the only one that scales. And granted, many of its companies are very early-stage startups that aren’t likely to command particularly big valuations anywhere. Still, its one-size-fits-all approach does lead Y Combinator to undervalue some of its companies.

“I would have loved for YC to sit down with us for three days and evaluate our product … and say, ‘We should really cut down our take or give you a lot more money,'” said Green. “But I don’t think that would scale for them.”

Why the lowballing is OK

YC offers the same funding, more or less, to every startup. It’s pretty upfront about the deals, and all incoming founders know what they’re getting into: a package deal based on a one-time gut reaction to the product and/or the team. There are enough repeat YC founders that we can safely assume most alums don’t feel they’re getting screwed in the process.

We can’t fault Graham and Co. for structuring YC’s deals this way. The incubator puts around $2 million into its teams each year, and the vast majority of them fizzle out quickly. Relatively few are acquired or go on to make significant profits, and because the teams are in such nascent stages during their YC months, getting to an exit or profitability can take years.

If YC’s deals were anything other than lowball deals, Graham and the other partners wouldn’t be able to continue doing business.

Besides, as every YC alum we spoke to attested, Graham gives a lot more than a few thousand dollars in exchange for equity. YC alumni have a huge network of peers and mentors, access to influential VCs, and a large megaphone to talk to press and the public.

In many ways, in fact, the YC network and opportunities mirrors what we’ve seen happen at Google Ventures.

In a recent in-depth investigation of the firm, we found that while its deal amounts were relatively small (also being rather early-stage deals, though not as early as Graham’s), what the firm really brings is its network of engineers, designers, product experts, PR professionals, recruiters, and co-investing VCs. Arguably, the Google Ventures team’s nonfinancial assets far outweigh those of Y Combinator’s.

When we spoke to Google Ventures about the leaked memo, the team was taken aback. Graham’s words caught the partners totally by surprise. But it didn’t upset them much, either.

“I’m fine with that headline, that Google Ventures doesn’t write blank checks to YC companies … that Google Ventures negotiates and invests wisely,” said Google Ventures partner Bill Maris in a phone call.

In our talk, Maris noted the obvious: Investors outside of the mass-incubator scenario are obliged to do due diligence, research, and analysis on their companies, and they’re entitled to offer whatever terms they feel are fair. And startup founders are likewise entitled to turn down an offer if they think it’s not adequate.

Also, Google Ventures has invested in multiple YC companies, some as recently as a few weeks ago. Moreover, Google itself has acquired YC companies.

YC alums who go to Google Ventures

Tikhon Bernstam might know better than anyone else exactly what both entities have to offer. A two-time YC alum, he took Scribd through the program in 2006 as one of 11 startups in the batch. He returned for another round with Parse in 2011 as part of a 63-company class. Then, Parse took a round of funding from Google Ventures.

When we talked to Bernstam last year, he, like every other YC alum, was positive about the incubator.

“The number one complaint people have about Y Combinator is that … the valuations are relatively low,” he said during our interview. “But the value-add is so high. … It’s well worth the five, six, seven points you give.”

In a phone conversation yesterday, Bernstam reiterated his belief that the YC experience and network were worth the equity — and he said the same about the Google Ventures deal. “There are a lot of investors out there who are just a check, but that is not the case for either YC or Google Ventures,” he said. [Disclosure: Bernstam has invested in YC and non-YC companies.]

And as far as valuations are concerned, Bernstam echoed the sentiments we heard from Google Ventures partners, saying, “The companies that are the hottest in the YC batch can often raise on those [high valuation] terms — Parse did actually. … When the best of the best come out of the batch … a lot of investors will not invest on those terms, but a lot will.” He felt that both YC and Google Ventures were fair in their dealings with his company.

As far as Bernstam knows, all the YC alums who later took money from Google Ventures have been happy with their deals; he was quite surprised to read about the “lowball” news, especially since YC advises a lot of first-time fundraisers.

Big picture: Graham has a problem with Google Ventures

Stepping back for a moment, we have to acknowledge the obvious: Both entities are here to make money from the labor and success of entrepreneurs, essentially operating in a predatory role. Both entities gamble, although YC takes more risk and gives less money, because of its earlier-stage deals. But both investment firms are essentially the same, especially since they both put more influence on the table than money.

The two entities are exactly alike in their core philosophy: They feel that successful investing has less to do with picking the right company than with nurturing the right people. That’s why both place such emphasis on their capabilities to nurture companies, not just fund them.

So what makes Google Ventures a “lowball” firm, in Graham’s opinion?

In an email exchange I had with Graham last night, and in a public thread on YC-controlled news aggregator Hacker News, he said his original memo only applied to capped debt financing with subsequent decreasing caps (keep in mind, caps have no impact on valuation, and debt financing is quite popular for very early rounds at very young startups*).

Graham’s contention is that YC startups are taking a higher cap in a first round of debt financing, and then Google Ventures is offering a lower cap in a second round of debt financing.

From VCs and YC alumni, we’ve heard YC partners recommend setting debt financing caps at $10 million. Apparently, some investors, including Google Ventures partners, are signing up for those deals. Other investors, including Google Ventures partners, are trying to negotiate for what they consider a more fair cap.

“The problem is not that the valuation caps GV asked for were low in themselves,” Graham said via email. “The problem is simply that they were lower than the caps at which the startups had already raised money, which can cause complications.”

In debt financing, most rounds have multiple caps (this fact, in addition to being common knowledge, is one we’ve heard from both founders and VCs who’ve spoken on background about this specific case). The caps will range depending on the founder’s relationship with the VC and what he thinks the VC can offer in addition to cash.

This “lowballing” accusation has everything to do with business, but not the business of how either Graham or Google are structuring their deals.

We asked Graham to clarify the basic question of valuations and whether both YC and Google Ventures give startup teams a fair idea of what their companies are actually worth. Graham responded, “I don’t think valuations matter that much,” and that in general, he doesn’t have a problem with Google Ventures’ valuations.

“The most important thing to remember about fundraising is to get it over with and get back to working on the company.”

Considering this comes from a man who just asked his portfolio to blacklist an entire venture firm, this might read as a rather contradictory statement.

On the other hand, with two new deals per week, a focus on seed deals under $250,000, and a new startup lab focused on incubating the best teams, Google Ventures has perhaps become more of a competitor to Y Combinator than an asset. Under those conditions, Graham’s original accusation makes perfect sense; he’s trying to keep his money-makers from defecting to a competitor.

The kicker, and the truly poetic part of all this, is, as Graham hints, that all these valuations are made up, anyhow. They’re all high-powered guesswork. With no users, shells of products, and no employees beyond a founding team, these companies’ valuations are entirely hypothetical.

It’s a lot of sound and fury to start an investor battle over, but in this valley of braggadocio and egos, wars have been fought over much less.

Top image courtesy of Jolie O’Dell

*Here’s a primer on debt rounds and why convertible notes with caps have become so important.

The industry calls them debt rounds because they’re actually loans. The loan amount is later converted into equity when the company goes on to raise its Series A round (equity funding) from venture capitalists.

The advantage of this debt financing is huge for the entrepreneur. It avoids a lot of paperwork and haggling with investors over setting a valuation, a requirement of taking an equity round. By agreeing to a loan round, the entrepreneur and investors are agreeing to let the valuation be determined in the next round. If a company is successful, it’s great for them. They can command a higher valuation and give away less of their company per dollar invested.

But many investors don’t like debt rounds. If company goes on to raise the next round at a high valuation, the investor doesn’t get any increase in that value. That’s why they sometimes ask for a cap, which sets a ceiling on the value of the price they pay for their share of the company in the next round.

Still confused or need more detail? Here’s more on valuation caps and how they work. Fred Wilson also has a good explanation of convertible debt.

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