An Innovation in Angel Investing?

The biggest news in the world of start-ups recently is the announcement that investor Yuri Milner of DST is partnering with famed angel investor Ron Conway on a new innovative start-up investment vehicle called Start Fund. The Start Fund is offering $150,000 loans to every one of the 43 start-ups in the Y Combinator class.

Some background here. Yuri Milner runs the Russian investment firm DST, which has already been a force of disruption in the venture capital world by making very large investments in Facebook, Zynga, and Groupon at valuations that, at the time were considered absurdly high, but are now all looking like shrewd investments. Y Combinator is the most prestigious and well-known start-up “accelerator”, investing a small amount of money in a large number of start-ups who move to Silicon Valley for 3 months to build their businesses with Y Combinator’s help.

So what is so innovative about the Start Fund?

First, these $150,000 loans are being offered to every current Y Combinator start-up. Regardless of their business, and without any due diligence. Y Combinator’s acceptance of a start-up into their program is being relied on as a proxy for the quality of the start-up.

Second, the loans are convertible into equity at the start-up’s future funding round, at no discount and with no cap on valuation. Those terms are just unheard of. Most convertible notes convert to equity at some discount – say 25% – to the next round of investors, to compensate them for the increased risk of making earlier investments. And most convertible notes also include a cap on the valuation that they convert at – again to compensate investors for investing early. Without discounts and caps, an investor is getting no direct financial incentive for being an early investor: the $150,000 loan could convert to equity two years later at the exact same terms as a new investor coming in on that date.

If there is no financial incentive, then why are they doing it? While there is no direct financial incentive, there is an indirect one – they have the chance to get into every Y Combinator company, and effectively have an option on investing more money in future rounds of the more successful companies by already being a seed investor in them.

The blogosphere has caught fire with this news.

• Scobelizer: I will miss the old Y Combinator
• VentureBeat: Yuri Milner and Ron Conway aim to disrupt angel investing with latest proposal
• TechCrunch: Is Yuri Milner a threat to Silicon Valley?
• Information Arbitrage: Start Fund: No big Deal. Business as usual

Here is my take on the winners and losers.

• Y Combinator start-ups are the biggest winners. These $150,000 loans could very well be enough money to get their products to market. They don’t have to waste any time attracting investors, and their first investment round will likely be at higher valuations because they will be further along in their life cycle. Indeed, TechCrunch reported that less than 24 hours after the announcement, 90% of the 43 start-ups had already accepted the loan.
• Y Combinator is a winner, though because they are already at the top of their industry they can’t really rise much higher. They already have a sizable applicant pool, but this should certainly lead to even more start-up applications than before.
• Yuri and Ron are winners. The combined investment of $6 million is spread over 40+ start-ups. It only takes one big hit out of the 40 to make the investment pay off.
• Angels and venture funds are losers here, though the effect will vary greatly. Most Y Combinator start-ups will delay their own fundraising, and when they do raise funds it will be at higher valuations. You can argue that the effect should be trivial because we’re only talking about a sliver of the investment community – just $6 million and 43 start-ups. The effect will obviously be the most pronounced with investors that would traditionally target Y Combinator companies.

Lastly, what is the effect on start-ups that aren’t part of Y Combinator? Probably trivial, but still a mixed bag. On the one hand, many people believe there is an investment bubble at work, and having 43 high profile start-ups delay their own fundraising could mean that there is less competition for the investment dollars from angels and VCs. Plus, there will be increasing pressure over the long-term to continue to make deal terms more favorable to entrepreneurs (not that anyone should expect a no-cap, no discount convertible note from any investor with a pulse).

On the other hand, those Y Combinator start-ups have now all increased their likelihoods for success. Just hope they aren’t in the same space as your start-up.

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Rocco Tarasi was an accountant, investment banker, and CFO before becoming a technology entrepreneur.