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Tech Incubator Y Combinator Raises $700 million to Get Into late-stage investment

... Douglas MacMillan/WSJ:

Over the past decade, tech-startup incubator Y Combinator has invested in and cultivated hundreds of fledgling companies, including highfliers like Airbnb Inc. and Dropbox Inc.

Now, with money rushing into Silicon Valley, the seed investor known as YC is aiming to cash in on its influential name and investor network by doubling down on its hottest startups. It raised a $700 million venture-capital fund in late September aimed at expanding ownership stakes in its most successful companies and helping cash-intensive businesses that might have trouble raising funds elsewhere.

The new vehicle’s backers are betting YC can turn one of tech’s most recognized startup factories into a profitable late-stage investor. The fund’s investors include Stanford University and Willett Advisors LLC, the firm managing Michael Bloomberg’s investments, according to people familiar with the matter.

But the new fund also risks accelerating the demise of dozens of YC companies. With the creation of the VC fund, the Mountain View, Calif., firm has taken on a fiduciary duty to the investors in its fund to pick the winners and steer clear of less-promising companies. This conflicts with its long-standing tradition of giving startup founders equal weight.

“It may change founders’ willingness to tell us really bad things because they’re treating us as a potential investor,” said Sam Altman, YC’s president, in his first interview about the fund.

Mr. Altman said the new “continuity fund” will put money into each funding round raised by every YC company valued at up to $300 million, and then make discretionary bets on companies worth more than that amount.

That should come as welcome news to the most promising startups that complete YC’s three-month boot camp, and then present to investors in what is known as demo day. This past summer’s pitch event drew more than 500 investors, from billionaire hedge-fund manager Steven Cohen to former San Francisco 49ers quarterback Joe Montana.

YC is an investor in at least six private companies valued at $1 billion or more that went through its program, including payments company Stripe Inc. and human-resources software maker Zenefits Inc.

Those early investments may eventually pay off, but none of the roughly 900 companies has held an IPO. Of the companies backed by YC in the first five years of its program, some 48% have failed. Nearly half of all U.S. companies backed by venture capital fail outright, and another 25% don’t return investors’ money, according to research firm Sand Hill Econometrics.

Serial entrepreneur Paul Graham founded YC in 2005 with $100,000 and the idea that giving money and close supervision to batches of startups would improve their odds. During weekly dinners at a warehouse in Mountain View, Mr. Graham served homemade chili from Crock-Pots and coached startups on how to stay afloat on modest means.

A fund managed by Mr. Graham and his partners took up to 10% equity in each startup. Founders received small, roughly equal amounts of money; three months of training; and membership in a fraternity of entrepreneurs who help each other with recruiting, fundraising and advice.

Mr. Altman, a YC alumnus, took over YC in early 2014. He expanded the program’s size to more than 100 companies a year and added more than a dozen full- and part-time advisers. Among them is Ali Rowghani, a former top executive at Twitter Inc. who manages YC’s new fund.

Along the way, YC’s partners rankled some entrepreneurs by personally investing in startups before they emerged from the program. This practice signaled to investors which startups the partners believed were the most promising, prompting Messrs. Graham and Altman to restrict when partners are allowed to invest.

Mr. Altman, whose personal fund invested in several YC companies before he took over the incubator, said the policy changes helped, and that YC partners tend not to cluster their investments in only a few startups.

Some YC graduates said they felt as if the partners played favorites when companies competed in the same market.

Balanced, a payments service for businesses created in YC’s winter 2011 class, faced pressure when another graduate, Stripe, switched from focusing on consumers to businesses. YC partners, including Mr. Graham, advised and publicly praised Stripe.

The founders of Balanced then found it difficult to interact with YC partners, according to people familiar with the matter. The startup decided to stop providing financial updates to the incubator, out of fear they would be shared with Stripe, the people said.

Stripe was most recently valued at nearly $5 billion. Balanced, struggling to grow, shut its doors in August and referred its customers to Stripe.

Mr. Altman declined to comment specifically about Balanced, but said it isn’t unusual for companies seeded by YC to end up competing with one another. “We tell the companies not to update us with anything they are uncomfortable with and promise to keep their information secret from their competitive companies,” he said.

A wiry, fast-talking 30-year-old, Mr. Altman—widely known as “Sama”—has become an exuberant evangelist for YC. Although he has founded just one company, mobile location-sharing app Loopt, which sold in 2012 for close to the same amount investors put in, he speaks and tweets as an authority on startup success.

Mr. Altman spends most of his week shuttling in an Uber car between San Francisco and office parks in Silicon Valley, meeting with YC founders. On a recent trip to visit the founder of biotech-laboratory startup Transcriptic Inc., Mr. Altman toured the company’s 10,000-square-foot facility in Menlo Park, where a robotic arm glided back and forth over petri dishes.

After hopping into another Uber car, Mr. Altman opened his laptop to record his impressions of the meeting. Since 2009, a password-protected site has been used to collect notes from every meeting a YC partner has held with portfolio companies.

“They are picking the six, eight, 10 or 12 companies that they think could really drive the returns,” said Edwin Poston, general partner of TrueBridge Capital Partners, an investor in the YC fund. “We think it’s going to be very good returns.”