YC: organizing the seed-funding ecosystem
Y Combinator (YC) started in early 2005 to create a better seed funding ecosystem. Since then, it has spurred a new category of incubators and accelerators such as TechStars, AngelPad. These accelerators provide short-term intensive coaching and mentorship. Before this wave of accelerators, seeding funding was very haphazard: founders relied on their personal networks to find investors and received incredibly varied terms. YC takes in “classes” of entrepreneurs for a period of three months and provides them with a cash infusion in exchange for an equity stake (typically $10-15K for 6-7% equity). Founders also receive a wide-range of advice from incubator partners in areas such as legal, marketing, business model, technology matters. At the end of the incubator period, the class presents in two to five minute pitches to a large group of angel and venture capital investors on “Demo Day” with the goal of soliciting funding.
YC’s core value-adds for founders include:
- The liberty to focus exclusively on the idea at hand, by providing a stipend/salary substitute—founders are often otherwise forced to work on an idea in addition to a day-job;
- Intense support for developing the founders’ idea through daily interactions with experts with relevant legal, technical and business/managerial expertise;
- A time-pressured, fixed deadline (“demo day”) environment to target and maximize the pace of development;
- A localized network in the form of the YC “batch”—YC requires admitted founders to move to the Bay Area for the program duration—as well as a large YC-alumni network
- Providing visibility to and network of seed and VC investors for the opportunity to obtain substantial funding through “demo day”
For investors, the key value proposition includes:
- Outsourcing the substantial work involved with identifying and mentoring high-potential early stage start-ups;
- Structured development of the core idea as well as a business goal/strategy by experts/previous founders who understand the needs of new start-ups;
- Providing multiple credible investment options on “demo day” in a similar format
- Being presented companies which founders still own almost all the equity (no bad angel / seed terms)
YC captures value in a similar way to an early-stage investment fund. YC invests in a portfolio of founders and aims to make an outsized return on them down the road. The YC process aims to increase the chances of success of the startups in their accelerator. YC started off with accepting just a few student founders over the summer holidays and has now grown to two classes annually of over 100 each. YC is also a start-up, with their own investor base. For the company, and these investors, YC provides a diversified portfolio of early, seed-stage investments which are given more tools, advice and better network to outperform.
For YC’s success, building a program that will help give founders a boost and building a brand to attract both founders and investors is critical. YC’s platform has both indirect and direct network effects, but these also rely on successful outcome. The more successful founder ideas there are, the more investors will be part of the ecosystem (indirect effects). The more successful founders there are who have gone through YC’s program the more prestigious the program becomes, and likewise for the investor side. The challenge for a platform like YC in the early days is that it requires both sides of the platform (founders and investors) to be recruited in order to set the platform up for success.
In scaling the platform, a huge challenge is the funding required and the long cash flow cycle of the business. Although YC has invested early in many successful startups, as an equity investor, they cannot realize the value and cash out early – the successes take many years to provide returns to YC. As it grows, YC has to maintain a balance between the number of founders it accepts (selectivity) and the number of investors that show up (funding). Even though the investors in this market can multi-home across different accelerators, the start-ups cannot multi-home (founders are not likely to either). This implies that on the founder-side, it is more of a winner-take-all marketplace where YC has emerged as is a strong winner. YC has been able to successfully grow due to its strong brand and portfolio of successful companies.
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Thank you, this is a very interesting post. My question is what will the competition end up looking like in this industry as I’m not sure if it will end up being winner-takes-all. As you mentioned, there have been a wave of new incubators and accelerators that have emerged to compete with Y Combinator. And while entrepreneurs cannot multi-home, investors can easily multi-home in this space. To me, this puts incubators in the top right corner of our 2×2 matrix, in which players are compete on differentiating characteristics. For example in Entrepreneurial Finance last semester we did a case on Bolt, an incubator that specializes in connected hardware.
Very interesting post! Y combinator actually uses a standard deal now of investing $120k in return for 7% of the company’s equity (unless there are exceptional cases). What’s interesting about Y combinator vs. other platforms we’ve covered is that their long-term success is directly linked to the long-term success of both their founders and, given that returns are driven by the long-term company valuation, the success of the company’s investors. As with other VCs, y combinator is making bets that a handful of companies out of hundreds will become “home-runs” with multi-million or billion $ valuations. (They’ve had several already – airbnb, dropbox, reddit, and others) Unlike most VCs, y combinator has been able to achieve a highly efficient process of seeing hundreds of startups each year, investing relatively small amounts of money up front, and setting the companies up for maximum growth (and thus the fund for maximum returns). It’s a great model because the winners win so big.
Great example of a platform business. It seems with the growing popularity of this platform, YC’s been able to attract a higher volume of quality startups – I think this raises a couple of interesting challenges for its future. Firstly, the quality of its chosen startups becomes critical to maintain the brand and to continue to attract new startups in future. Secondly, investors could use their time participating on the platform to learn how to identify successful startups and go approach startups directly, dis-intermediating YC in the process. Do you have any thoughts on how YC can overcome these challenges?