On investing in “hot” Y Combinator startups
I was having a debate recently with a fellow Y Combinator startup investor on whether or not companies that get “hot” at Demo Day make for good seed investments. These are the companies that, for whatever reason, get very popular with investors and find their seed rounds heavily oversubscribed. The founders of these companies become rationally quite selective of their investors, and irrationally confident in their startup’s future despite its nascent stage.
Anecdotally, several YC partners have told me they haven’t noticed a strong relationship between companies that get “hot” at Demo Day and those that ultimately have good outcomes. There are plenty of examples of companies that were hot during their YC batch and did quite well (Stripe, Gusto, etc), many examples of companies that were not popular with investors and did quite well (Segment, Deel, etc), and of course, many companies that were hot at Demo Day and did very poorly (I won’t name names)
Since Rebel Fund has developed the largest and most comprehensive dataset that exists of Y Combinator startups, founders, and outcomes outside of YC itself, it only seemed fitting that we should answer this question statistically, and this blog post will explain what we found.
To start, we randomly sampled a couple hundred YC startups from the 2015–2018 batch years, roughly evenly divided across each of the following categories based on their latest valuations:
Unicorns — $1B+ valuations
Top companies — $100M+ valuations
Regular startups — <$100M valuations or inactive
We choose the 2015–2018 batch years since these companies are old enough to have matured, yet young enough to reflect relatively recent YC history. We chose companies spread across these valuation categories so we’d have a good dispersement of outcomes within our sample.
Since we can’t measure a company’s “hotness” at Demo Day directly, we used as a proxy the total amount of capital each company raised in their batch year — one of the hundreds of metrics Rebel tracks on each YC startup. Our rationale is the hotter a company was at Demo Day, the more capital they probably raised.
The first thing we found is there is indeed a decent positive correlation between the total amount of capital a company raised in their batch year and their latest valuation (0.23):
The correlation wasn’t nearly as strong as that between their total funding raised and latest valuation (0.64) but it’s still decent. So, at first blush, hotter companies do indeed perform a bit better.
We then dug in a bit deeper, looking at the relationship on a logarithmic scale (since YC startup outcomes tend to follow a power law) and while you can still see the positive relationship between total capital raised in batch year vs latest company valuation, the slope elasticity is only 1.19, meaning that for every 1% increase in batch-year capital raised, there is only a 1.19% increase latest company valuation:
YC startups tend to increase their valuations when investor demand is high, targeting a specific percentage of seed round dilution, so companies that raised more in their batch year were likely proportionately more expensive to investors. So, after taking into account their higher entry valuations, an investor would only expect a ~19% bump in ROI with a “hot” company.
Also, the R² is only 0.090, which means only ~9% of the variation in a company’s latest valuation is explained by their batch-year funding, so the other ~91% is explained by other factors.
The bottom line is that a company being “hot” with investors at Demo Day is generally a positive signal, but a relatively weak one, especially once you take into account their higher entry valuation. So, the implication for investors is don’t be afraid to invest in hot companies when you like them, since they do perform slightly better than their peers, but don’t assume they’ll do well just because they’re hot, since >90% of a company’s success is driven by other factors.
This is why at Rebel, we mostly ignore deal heat and instead focus on the fundamentals of each company, like its team, product, market, defensibility, etc that predict the other >90% of a company’s success. As I explained my last post On why AI is coming for my job next, we’d rather use our vast database, cutting-edge Rebel Theorem algorithm, and experienced partners to select tomorrow’s YC unicorns — not just follow the herd.
