Funding rounds dilute preexisting investors. One of the possible terms in an investment contract are pro-rata rights for investors, giving them the right during future financing rounds to invest more money to maintain their percentage ownership. Thus an early seed investor who gets 5% of the company for 500k can ensure they retain 5% of the company in the A and B rounds, so long as they're willing to fork over the cash for the top-up shares at the A and B round valuations.
This is an important part of VC strategy. VCs invest in, say, 10 companies, expecting 8 to fail outright. The 2 winners need to make up for the 8 losers. But the investor can't see into the future to figure out which are the 2 winners. Pro-rata rights give them some optionality: by the time the A round happens, it'll be clearer to the investor whether they should have plowed more money into that company, and pro-rata lets them do that.
The problem for YC is that each YC batch has 30-50 companies in it, most of which will fail. When those companies go to raise later rounds, new investors want to know whether YC believes in them. If YC exercises pro-rata rights on just some of their companies, the ones that don't see the exercise are damaged goods. So instead, YC is committing themselves to pro-rata all their companies (this is a lot of companies) so long as they can afford it.
> The problem for YC is that each YC batch has 30-50 companies in it, most of which will fail. When those companies go to raise later rounds, new investors want to know whether YC believes in them. If YC exercises pro-rata rights on just some of their companies, the ones that don't see the exercise are damaged goods. So instead, YC is committing themselves to pro-rata all their companies (this is a lot of companies) so long as they can afford it.
Does this mean a bunch of money is being thrown away on signaling?
Thrown away? YC will save time and energy required to analyzing the deeper aspects of each startup they might want to invest in. If a YC company raises then someone believed in them enough, so in a way for YC it is more of a positive where they can piggyback on someone elses' due diligence (hopefully).
Buying in later rounds if you think it is worth the investment, and spending money on 'signalling' - i.e. money spent to not reveal what you are really thinking.
(This is just an observation. I am not implying that this strategy is like gambling or anything like that)
How / why? I tried Googling this and it's left me more confused. If I purchase 5% of a company, and that company later gets other investors, assuming I do nothing, how can I end up with less than 5% of the company? One of the answers[1] I found says,
> The company creates new shares to sell when the financing event is imminent. Thus every existing holder gets an equal amount of dilution, and the number of conceivable rounds is infinite.
By doing this, how is the company not effectively selling something that isn't theirs? (the portion of the company that I thought I owned, that is now "diluted"?)
The company is not actually selling "five percent of itself". It's selling shares, and the number of shares in the whole company is a board decision.
In serious financing rounds, the company sells preferred shares which have shareholders agreements attached that might protect investors against dilution, for instance by allowing those shares to convert into common shares at a rate that accounts for any dilution.
In practice, dilution as a simple function of outstanding shares is a fact of life, expected by everyone who invests.
It's done with the permission of a majority of shareholders (and any the remaining shareholders had agreed that this is a sufficient condition when they bought shares).
Your dollar value should actually increase (assuming we're not talking down rounds). You still have the same amount of shares, but an "up round" means that each share is now theoretically worth more than it was when you bought in. Practically, however, it's hard to put a true "value" on the shares until an actual sale of the Company or IPO.
This is an important part of VC strategy. VCs invest in, say, 10 companies, expecting 8 to fail outright. The 2 winners need to make up for the 8 losers. But the investor can't see into the future to figure out which are the 2 winners. Pro-rata rights give them some optionality: by the time the A round happens, it'll be clearer to the investor whether they should have plowed more money into that company, and pro-rata lets them do that.
The problem for YC is that each YC batch has 30-50 companies in it, most of which will fail. When those companies go to raise later rounds, new investors want to know whether YC believes in them. If YC exercises pro-rata rights on just some of their companies, the ones that don't see the exercise are damaged goods. So instead, YC is committing themselves to pro-rata all their companies (this is a lot of companies) so long as they can afford it.