With each cohort that graduates from Y Combinator, the same debate emerges: How can such early-stage startups justify such high valuations?

According to YC President Garry Tan, 75% of the current summer cohort is pre-revenue and 81% are looking at raising their first external capital. Many of the founders will have entered the accelerator without much more than an idea.

Despite this, YC has developed a reputation for launching startups into the investment market at eye-watering prices. This is particularly striking in H2 2023, coming off a real downturn for startup fundraising. Investor Erik Bruckner has reported $15 million post-money caps as the most common terms among the sample of startups he’s met from this batch, at a time when the median U.S. pre-seed valuation is closer to $8.7 million.

How can YC justify promoting these terms to a more conservative venture market?

YC is not setting any valuations

While the partners at YC can make recommendations on terms, the terms of any subsequent raise are up to the founding team. Founders will attempt to raise at a price they think reflects the opportunity they offer, and — for YC startups — the market is on their side.

Secondly, startups raising out of YC are typically doing so with a capped SAFE (simple agreement for future equity) agreement, which determines the maximum price at which capital converts to equity in a future priced round.

Conflating caps and valuations is an easy mistake to make. They share many of the same characteristics, and if it is set reasonably, a cap may well end up reflecting the valuation of a startup. But they aren’t the same. Fundamentally, a valuation is a determination of value while a cap is a ceiling on price.

While it has implications on value, a cap is effectively meaningless up until a startup actually goes through a proper valuation for a priced round — and not all YC startups will manage to raise at or above that cap.

Venture is a power law game

A well understood concept in venture is that the majority of any fund’s returns will be driven by a handful of companies. Maybe 1% of investments will be a 100x return, 5% will be 10x returns, and 50% will lose money. Identifying those outliers is the whole ballgame, so even a marginal improvement to selection can have a huge influence on fund performance. This factor has driven significant investment into VC “platform teams” since 2010.

With that in mind, consider that roughly 4.5% of Y Combinator startups have achieved “unicorn” status since 2010, according to analysis by Inside. That’s head and shoulders above similar accelerators, which makes it such an appealing target for investors.

The increase in price is worth every penny if it can increase your hit rate.

The end justifies the means

Ultimately, if YC didn’t deliver high-quality opportunities for investors, they wouldn’t be able to secure investment at above-market rates.

In fact, YC’s performance even stands up outside of power law shenanigans. Analysis by Jared Heyman of Rebel Fund, a VC that exclusively targets the top 5%-10% of YC startups each year, shows that an index of all YC startups would yield an impressive annual return of 176%, net of dilution.

There has been speculation over the years that YC has lost its way, that it has grown beyond some optimal size. That criticism doesn’t yet appear to be supported by any data, and comes largely from the group which would benefit from lower entry prices: the VCs who will inevitably be queuing up to invest in the next cohort.