Dave McClure & Jordan Stein on YC, "Spray and Pray", and Games VCs Play | E1923 TWiST

David Weisburd intros Dave McClure, Jordan Stein, and Jason Calacanis (00:00:00)

• The last investment made out of the fund was 776 Alexis Ohanian.
• Alexis Ohanian was the co-founder of Reddit.
• Dave McClure and Jordan Stein discuss their experiences with YC and the "spray and pray" investment strategy.
• They talk about the importance of finding the right balance between investing in too many startups and not investing in enough.
• They also discuss the games that VCs play and how to avoid getting caught up in them.

Reddit's IPO adds to YC's track record of successful public listings (00:00:28)

• Dave McClure, co-founder of 500 Startups, clarifies that the "spray and pray" investment strategy was popularized by SV Angel and others, not invented by 500 Startups.
• The current startup ecosystem has evolved significantly, with the emergence of angel investors, accelerators, and pre-accelerators, providing a more comprehensive support system for startups.
• Accelerators like Y Combinator invest at $2 million valuations, while seed funds invest at $8-10 million valuations.
• Accelerators can take more risks and make more investments than seed funds due to their lower hit rates.
• The hit rate for accelerator portfolios is generally low, with 65-70% failing completely, 20-25% yielding small wins, 8-10% yielding large wins, and 2-3% yielding unicorn-sized outcomes.
• Accelerators like Y Combinator likely get most of their ownership at sub $1-2 million valuations, making it easier for them to achieve high multiples.
• Dave McClure and Jordan Stein discussed the venture capital (VC) industry, particularly in relation to Y Combinator (YC) and the "spray and pray" investment strategy.
• McClure shared his experience with YC and how it operates, highlighting the importance of founders having a clear vision and being able to articulate their ideas effectively.
• Both McClure and Stein emphasized the importance of founders doing their research and understanding the VC landscape before seeking funding.
• Dave McClure and Jordan Stein, former partners at 500 Startups, discuss their experiences in the venture capital industry.
• YC (Y Combinator) is a startup accelerator that provides seed funding and mentorship to early-stage startups.
• YC has a "spray and pray" approach to investing, where they invest in a large number of startups and hope that a few of them will become successful.
• This approach has been criticized by some for being inefficient and wasteful.
• However, McClure and Stein argue that it is the best way to find the most promising startups.
• VCs often play games with entrepreneurs, such as lowballing them on their valuations or making them compete against each other for funding.
• McClure and Stein advise entrepreneurs to be aware of these games and to not let VCs take advantage of them.
• Entrepreneurs should be confident in their own businesses and should not be afraid to walk away from a deal if the terms are not favorable.

Strategy of investing in YC ecosystem and the importance of entry point evaluation (00:11:39)

• YC has built a strong community over 20 years and generates significant value through its network and signal, making it the top accelerator.
• While other accelerators may have advantages in specific verticals, it is unlikely anyone will catch up to YC's established lead.
• There is no one-size-fits-all approach to investing in YC-backed companies, with both index-style and stock-picking strategies being viable depending on the broader portfolio construction and potential overlap between strategies.
• Investing heavily in YC companies and bringing them in directly can be a compelling strategy, indicating the GP's ability to consistently find such opportunities.
• Investing at YC demo day prices may mean entering at high valuations, and the best companies may already have funding.
• Entry point valuation matters, and it is important to be aware of the actual investment stage rather than relying solely on an accelerator's brand association with successful companies.
• YC's early-stage track record is considered one of the best, with notable successes like Airbnb, Coinbase, and Stripe.
• To compete with YC, other venture capital firms have adopted strategies such as large-scale investing, international expansion, and focusing on underrepresented founders.
• YC recognized the value of large portfolios and began scaling batch sizes, expanding internationally, and investing in more diverse founders.

YC's demo day and opportunities for other accelerators (00:18:40)

• YC's top companies often skip demo day, raising concerns about fairness and potential conflicts of interest.
• Demo day can be overpriced compared to a company's actual traction, leading to inflated valuations.
• YC uses high-pressure tactics to create a sense of urgency and FOMO among investors, which can result in suboptimal outcomes for founders.
• Patience is key when investing in YC companies, as some of the most successful ones may not be immediately apparent.
• YC's broad-based global accelerator model may face competition from accelerators that focus on specific categories, geographies, or specialties.
• Running an accelerator requires a significant amount of effort, including meeting with thousands of companies and supporting hundreds of founders.
• YC's batch sizes have ranged from 30 to 50 companies, with four batches per year in two locations, resulting in a total of 200 to 300 companies per year.
• Dave McClure and Jordan Stein, former partners at 500 Startups, discuss their experiences in venture capital and the startup ecosystem.
• They talk about the "spray and pray" approach to investing, where VCs invest in a large number of startups in the hopes that a few will succeed.
• They also discuss the games that VCs play, such as creating artificial scarcity and using FOMO (fear of missing out) to drive up valuations.
• Y Combinator (YC) is a startup accelerator that has helped launch successful companies like Airbnb, Dropbox, and Stripe.
• YC provides seed funding, mentorship, and networking opportunities to startups.
• The YC application process is highly competitive, and only a small percentage of applicants are accepted.
• YC has a strong track record of success, and its alumni have gone on to raise billions of dollars in funding.

YC's demo day and opportunities for other accelerators cont. (00:27:18)

• Y Combinator (YC) is a prestigious accelerator program, but many applicants who are not accepted go on to other accelerators.
• YC's strong brand and reputation make it a top choice for founders, but there is room for competition, particularly by offering more favorable equity terms.
• Founders University's experiment of offering a smaller check with a lower equity percentage saw a 60% acceptance rate.
• To compete with YC, accelerators need a differentiated value proposition, such as a focus on a specific vertical or geographic area, and the ability to deliver real value to founders.

Carta’s report on the rise of capital call requests (00:32:24)

• Capital call requests surged in January 2023, indicating renewed optimism in the venture capital industry driven by factors such as AI hype, reduced market uncertainty, and companies seeking additional funding.
• The secondary market is gaining traction as an alternative liquidity option for funds, founders, and investors, particularly in the current economic climate.
• Secondary funds focusing on smaller ticket sizes below $5 million are emerging to cater to non-institutional investors and emerging managers, addressing the lack of liquidity in the market.
• Building relationships with general partners (GPs) is essential for successful secondary investments, as smaller investors often lack the connections to access behind-the-scenes information and opportunities in the VC ecosystem.
• Direct or company secondary involves investing in individual companies, while strip sales or portfolio secondary involves investing in a basket of assets from a VC portfolio.
• Portfolio secondary requires consent from the fund's GP, evaluation of multiple companies, and consideration of the exit trajectory for the entire portfolio, but it can offer attractive pricing and arbitrage opportunities due to limited competition.
• Dave McClure and Jordan Stein, former partners at 500 Startups, discuss their experiences in the venture capital industry.
• McClure and Stein talk about the "spray and pray" approach to venture capital, which involves investing in a large number of startups in the hopes that a few will succeed.
• They also discuss the games that venture capitalists play, such as creating artificial scarcity and using FOMO (fear of missing out) to drive up valuations.
• McClure and Stein discuss their experiences with Y Combinator, a startup accelerator program.
• They talk about the benefits of Y Combinator, such as the access to mentorship and funding that it provides.
• They also discuss the challenges of Y Combinator, such as the intense competition and the pressure to succeed.

The role of secondary funds in the current macroeconomic conditions and the potential for more company shutdowns (00:40:26)

• Despite a slight slowdown, capital calls for venture capital funds remain consistent.
• Many venture-backed companies underwent significant layoffs and restructuring to reduce costs and align their workforce with revenue.
• Public biotech companies with failed drugs are facing hostile takeovers and negotiations due to overvalued valuations.
• Venture capitalists are generally holding their portfolios at valuations set in 2020 and 2021, leading to overvalued portfolios.
• Secondary market activity can indicate fair market valuation and force repricing.
• Some founders are taking profitability seriously and aiming for infinite runway, but VCs may push for faster growth and higher burn rates to achieve more aggressive growth targets.
• Moderate success can be a blocker to breakout success, as it can lead to companies getting stuck in a "tweener" phase with limited growth potential.
• Buying out investors may be necessary to allow them to take a loss or wind down a fund, especially after 15 years.
• Secondary sales and strip sales are becoming more common as a way for fund managers to generate DPI and raise their next fund.
• Many venture funds shut down after one or two funds, leaving the question of who will manage the remaining assets for the next 10-12 years.
• Venture capitalists typically check out of the industry between years four and eight, after the investment period and the front-loaded management fees.
• Key factors in evaluating a fund manager include their ability to identify and win investments in the best opportunities and Founders.
• A proportional progression of the portfolio is important, with consistent percentages of bets progressing from pre-seed to seed, seed to Series A, and Series A to Series B.

Betting on outliers and the decision-making process for doubling down (01:00:49)

• Accelerators should focus on finding unique and innovative ideas rather than replicating existing products.
• Despite a high attrition rate of 80-90% at the early stages, accelerators can achieve a significant step-up in valuation, sometimes 4X or more.
• Accelerators should aim to maximize their returns on their initial investment, especially in competitive environments.
• Researchers and analysts can play a crucial role in advocating for companies and aiding investment decisions based on their expertise.
• When considering follow-on investments, accelerators must balance the potential for increased ownership against the opportunity to make more investments at lower valuations.
• Dave McClure and Jordan Stein discuss strategies for venture capitalists (VCs), emphasizing the importance of a limited number of bets, focusing on relative ownership, and identifying breakout companies.
• Clint Corver's analysis suggests that the default approach should be not to follow on investments unless there is strong growth and significant marginal ownership.
• From the limited partner's perspective, there is a desire to capture high outperformance, leading to a bias towards follow-on investments.
• McClure cautions that follow-on bets can be risky for VCs, potentially resulting in marginal gains or significant losses that could impact their ability to raise future funds.
• McClure and Stein discuss the VC industry, including strategies and challenges, highlighting the concept of "spray and pray" investing and the importance of having a portfolio strategy and learning from mistakes.
• Both McClure and Stein emphasize the significance of a growth mindset and humility in the VC industry.

Lightning round: Top 3 investments from each guest (01:14:16)

• Initialized Capital, co-founded by Alexis Ohanian and Gary Tan, shared notable investments from their fund, including Mercury, a startup banking platform; Gropius, specializing in factory automation for prefab housing; and RicaricaPay, a Brazilian payments platform.
• Jordan Stein highlighted Motive, a website builder for car dealerships; Superhuman, an email client focused on productivity; and Deel, a global payroll platform for hiring international employees.
• Raising prices can be a beneficial strategy for companies, potentially increasing revenue while losing only a small percentage of customers.
• Selling to developers can be challenging due to their prioritization of low prices and high margins, often neglecting maintenance and efficiency.
• Sustainable living and modular housing were discussed, emphasizing the potential of modular housing despite challenges faced by companies in the sector.
• Recent fund investments mentioned include Andreessen Horowitz, Founders Fund, and 776, with positive remarks about each firm.
• Alexis Ohanian's exclusion from a tweet about Initialized Capital's co-founders generated controversy.
• Dave McClure praised Alexis Ohanian for his humility, graciousness, and overall positive qualities.

Discussing the upcoming (01:25:20)

• The Liquidity Summit, organized by Dave McClure and Jordan Stein, aims to connect limited partners (LPs) and general partners (GPs) in a constructive environment for networking and deal-making.
• The summit will be held in Napa with a limited capacity of 125 attendees, including 70 GPs, 50 LPs, and a select number of founders and service providers.
• Service providers can attend by sponsoring the event, such as providing meals for attendees.
• To enhance networking efficiency, GPs may provide one-pagers or short videos about their funds in advance, allowing LPs to prioritize and select meetings.
• Casual activities like wine tasting, cooking classes, poker nights, or board game meetups will be organized to facilitate organic conversations and connections.
• The summit will feature a "fun to fun" panel, where three panelists share their perspectives followed by a roundtable discussion with the audience, encouraging open discussions and audience participation.