Y Combinator: Accelerating Innovation

Merits of the Startup Accelerator Model

What do Airbnb, Dropbox, Zenefits, Stripe, and Instacart all have in common? Besides their astronomical valuations, they all got early funding from Y Combinator. YC is the most prominent startup accelerator in the world. Founded in 2005 and based in Mountain View, CA, YC invests in startups at the earliest stage and provides special resources to help entrepreneurs get off the ground. To date, Y Combinator has funded roughly 900 startups (typically investing $120k for a 7% stake). The value of YC’s investments, led by six $1 billion+ “unicorns,” is now likely in the billions, delivering a phenomenal return that has yet to be fully cashed in (there have been some prominent YC exits including Twitch and Reddit). Recently, YC raised a fund to enter late-stage investing as well, complementing its early-stage business.

Fundamentally, YC’s business model is to invest low amounts of capital into a large volume of high-risk startups (that may not even have a functioning prototype), with the hopes striking gold among a few investments. So far, this strategy has proven successful. But the “cast a wide net” business model in itself is not differentiated from that of the broader venture capital community. What separates Y Combinator, as well as Techstars and other accelerators, is the value-added resources and structure that the accelerator program provides to startups. Here is where YC’s operating model is key to its success.

Traditional angel and venture capital investors sometimes provide value-added resources (e.g., legal advice) to startup founders that are stretched beyond their core competencies. YC provides these resources in a high-impact, systematic way at scale. When YC invests in a startup, it requires its founders to relocate to the Bay Area and participate in a three-month program (referred to by some as a “boot camp”) During this time, the startup must work on building its product and acquiring users. The founders have access to YC expert counselors (YC’s partners) who can help with solving legal issues such incorporation, patent filing, and dispute mediation, but also with building business competencies such as salesmanship and finding talent. YC strives to relieve founders of inevitable distractions so they can remained focused on building a viable product, which will enable them to achieve credibility sooner, and consequently, raise more funds, more quickly.

YC also provides startup founders with an immediate network of other founders as well as weekly speaker events with high-profile guests such as Mark Zuckerberg and other industry veterans. The convergence of people, ideas, and resources in one place provides an ideal environment for startups, with benefits seen during the program and after. At the end of the program, startups pitch their products at Demo Day, attended by high-profile investors and journalists. In some cases, startups can receive significant funding from investors they meet at Demo Day. Given the prime opportunity to access investors, startups entering the accelerator are highly incentivized to deliver something tangible and compelling at the end of their three months.

In requiring startups to participate in a program on-site, efficiently connecting them with resources, and putting in place structure, timeline, and incentive around a single goal (building a great product), YC has developed an operating model that increases the likelihood that startups make quick progress and build momentum.

Beyond program execution, YC’s overall management of its funding cycles also gives them an edge. YC runs two funding cycles per year (3 months each) and utilizes a relatively straightforward application and interview process that systematically collects inbound interest. This generates a high-volume and stable investment pipeline. Furthermore, YC’s standardization of its program and investment terms increases its marketability to startups and investors by simplifying the discussion of what YC is and can do, while enabling scale that generates buzz and excitement. In recent cycles, YC has received 2,500+ applications and has selected ~50 inductees per cycle.

On its website, YC states as some of its goals: to “be the preferred source of seed funding,” to “get [startups] through the first phase… to the point where [they’ve] built something impressive enough to raise money on a large scale,” and ultimately, “to help startups really take off.” Of course, most startups will not be home runs, but all YC needs is a higher batting average and/or slugging percentage to meet and exceed its investment objectives. YC’s operating model is designed to that end and Silicon Valley has been taking note.

 

Sources:

https://www.ycombinator.com

http://www.wsj.com/articles/tech-incubator-y-combinator-takes-new-tack-with-venture-capital-fund-1444938590

http://www.nytimes.com/2013/05/05/magazine/y-combinator-silicon-valleys-start-up-machine.html?pagewanted=all&_r=0

http://www.wired.com/2011/05/ff_ycombinator/

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4 thoughts on “Y Combinator: Accelerating Innovation

  1. Hey Avi,

    Super interesting post. I’ve loosely followed YC, so it was interesting to hear more. You note that “all YC needs is a higher batting average and/or slugging percentage to meet and exceed its investment objectives.” How does YC compare to other seed stage investment funds? Are there any stats out there?

    One thing I have always wondered is what portion of YC’s success (or batting average as you put it) is a function of their input (which does seem substantial, per your post) or just their aggressive selection criteria (~2% according to your stats). Are they just very good at selecting the best 2% of start ups? Or do they really add value? It’s almost certainly a combination of the two–but I wonder to what extent. I am not sure how you would get a handle on this, but it would be interesting to test if possible.

    Brian

  2. Avi, this is a great post and makes for a fascinating read. I have been a skeptic of the YC model, despite its notable successes, but thought you may be well-positioned to answer a couple of my questions:

    1) They are one of the prime catalysts behind fuelling crazy valuations right from the angel/seed stage. “Paper napkin” valuations of $1 Million to seed valuation of $5 Mn to Series A valuation of $50-100 Mn seems to be their default success path. However, the way I read it, it is predicated heavily on the “greater fool theory” (i.e. I will buy a pig for 100, apply lipstick on it and sell it for 500 asap, and some greater fool will be willing to do the same going forward, so he will come and buy it). So YC and the first 1-2 angels exit as soon as possible to achieve “liquidity”. What would give me confidence that this is not the case, if they hold on to their investments until say Series C or D when the model is actually proven out and the company achieves some degree of profitability (or atleast a path towards profitability). So my question is — do you think they are good investors or just that they appear to be in the right place at the right time, and have been significant beneficiaries of the macro around (i.e. Tech Bubble in Silicon Valley)?

    2) Many of the ideas they seem to fund appear to be of the “mobile app — x for y” variety (i.e. AirBnb for pets), and not ideas that propel the society towards genuine innovation (e.g., Tesla batteries, pharma/healthcare R&D etc.). How do you think about that?

    Once again, this is a great overview of their model and appears to be working super well for them.

  3. The first YC batch had only 8 companies. The “companies” were incredibly early stage, mostly without any users. In the first batch, there was Reddit. AirBnB and other mainstream success stories followed. These days YC accepts more like 100 companies and at much later stages. Many have had institutional investment already (at a much higher valuation) and just look for the YC reputation. Few have become success stories similar to AirBnB and Reddit.

    This makes me wonder, has YC lost its mojo? Has the batting average decreased? Has YC increased its batch size so drastically because it doesn’t believe in its own ability to grow great companies but now subscribes to a “spray and pray” strategy?
    YC should focus on how it adds value beyond the obvious monetary and network incentives. With a little bit more substance behind the fancy talk, maybe there is another AirBnB waiting around the corner.

  4. Avi, really interesting post — thanks for sharing your knowledge of YC. I had a similar question as BP’s reply — to what extent is YC’s success driven by its ability to select high-potential opportunities versus its proprietary resources and network? I wonder if, as YC becomes more successful, it will change its selection behavior. Namely, do you think YC will become more risk adverse as it selects opportunities to back, focusing on the “safe” bets versus the risky-but-high-upside bets?

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