Paul Graham's intensive workshop permits investors and startups to check each other out with a minimum of risk and a maximum of potential
Paul Graham knows that most startups will eventually fail. But at Y Combinator, the hacker guru's seed fund for young techies, they're encouraged to fail fast and fail cheap—and then to reboot and start again. Designed with the new economics of Web-based entrepreneurship in mind, Y Combinator is a new type of venture fund—dispensing tiny amounts of cash but lots of hands-on mentoring.
Since its founding in 2005, Y Combinator has funded 58 startups—nearly all in software or Web services—bringing in a new crop twice a year (in Cambridge, Mass., in the summer; in the San Francisco Bay Area in the winter) for a three-month crash course in the Graham-ian philosophy of entrepreneurship (BusinessWeek, 9/26/07). Each team gets a small sum to cover basic expenses ($5,000, plus $5,000 per founder) and the chance to pitch their idea to a roomful of top angel investors and venture capitalists. The insider status of Graham himself—a Web software pioneer who sold his startup to Yahoo! (YHOO) in 1999 for $49 million—lends additional cachet.
In return, Graham and his four partners get a stake in the company, usually about 6%. So far, Y Combinator investments like the social news site Reddit, acquired by Condé Nast in 2006, and slide show app-maker Zenter, acquired by Google (GOOG) earlier this summer, both for undisclosed amounts, are positive signs that the formula works. Because the sums Y Combinator invests are so small, even early-stage acquisitions can translate into relatively big paydays.
After two years, Y Combinator's portfolio is still too young to fully evaluate the success of Graham's strategy—but that hasn't discouraged a growing number of investors around the globe from launching their own copycat programs.
One main reason? "It's cheaper equity," says David Cohen, the executive director of the most established Y Combinator counterpart, a Boulder (Colo.) program called TechStars, which ran its first three-month session in May, 2007. "If you look at the companies that are getting to an A-round, the model that we've created gives a significant discount to those valuations." Critics say that makes the arrangement exploitative for the startups involved, but Cohen disagrees: "I think for a first-time entrepreneur, it's actually an incredible deal."
Both Cohen and Graham say money is actually among the least important things they offer to entrepreneurs, since drastically cheaper hardware, software, and bandwidth—among other factors—have made it much easier to start a company than it was a decade ago (BusinessWeek, 5/31/07).
Dating Before Marriage
But disappearing barriers to entry also make it harder for any one startup to stand out in the crowd—a challenge that's as tricky for investors as it is for entrepreneurs themselves. Without a track record to go on, after all, how do you discern a future Mark Zuckerberg (Facebook) or Kevin Rose (Digg) from a sea of equally fresh-faced, Red Bull-swilling computer whizzes? With a program like Y Combinator, investors get three months of hands-on experience with talented entrepreneurs—and an early look at their work—before reaching for their checkbooks.
Cohen says he's already fielded inquiries from angel investors in 20-odd cities, all interested in starting similar programs of their own. "You're going to see a massive proliferation of this model," he predicts.
Graham, a widely read essayist who has written prolifically on topics like "What Business Can Learn From Open Source," isn't flattered by the unauthorized open-sourcing of his own model—including one clone in Vienna shamelessly named YEurope. (His opinion about such copycats is made clear on Y Combinator's FAQ. Question: "Will you help us set up something like Y Combinator in our town?" The answer: "There already is a Y Combinator in your town: Y Combinator.")
Why Reinvent the Wheel?
Many of Graham's admirers, however, say they respectfully disagree. Among them is Web industry veteran Saul Klein (BusinessWeek, 6/7/07), a partner at London venture capital firm Index Ventures and a former executive at Skype (EBAY). Klein helms the most prominent Y Combinator lookalike in Europe thus far: the London-based Seedcamp, which launched in September. In a slightly novel twist, Seedcamp began its competition by bringing 20 startups—plucked from an application pool of 268—for an "unconference" (BusinessWeek, 5/14/07) before selecting six companies to participate in the three-month program. Each of the six companies received €50,000 (about $70,614) in seed money—a considerably heftier sum than other Y Combinator-like programs—with Seedcamp taking a larger, 10%, stake in each.
And bona fide venture hubs like London aren't the only place the Y Combinator model is attracting interest. Cities such as Lexington, Ky., and Milwaukee are taking note, too. In Atlanta, a small group of angel investors hopes to replicate the Y Combinator model with a program called BoostPhase. Co-founder Wayt King says he envisions BoostPhase, set to launch this fall, as "a Y Combinator for the Southeast."
"We have huge respect for Paul Graham and what he's done, and we figured there's not much sense in reinventing the wheel," King says—adding that he doesn't see BoostPhase as competition for Graham's original. "There are a lot of entrepreneurs who don't want to or simply can't move to Silicon Valley or Boston."
Standing Out from the Crowd
TechStars' Cohen says he's not worried about the competition. "There's a pretty clear demand for this," Cohen says, noting that the 10 startups TechStars funded represented only 26 of 302 applicants. Y Combinator accepted an even smaller number for its summer 2007 round—19 of 435 applicants—making an applicant's chances of getting tapped for Y Combinator (4.4%) only slightly higher than those of the brainiacs vying for a Rhodes scholarship (last year's acceptance rate: 3.6%).
For participants, the real draw of a program like Y Combinator isn't the money, it's credibility—and not just with investors. The traffic bump from an early mention about getting funded on an influential blog like TechCrunch can be just as crucial as a Series-A round in helping a Web startup gain traction over its rivals. And by adding structure to an otherwise nebulous pursuit, Y Combinator also makes a startup a less risky endeavor for entrepreneurs themselves—both practically and psychologically. "Y Combinator provided a socially acceptable way to drop out or postpone my college education and focus on the company full-time," says Kevin Fischer, a 21-year-old industrial engineering student at the University of Pittsburgh who applied to both Y Combinator and TechStars. Plus, he adds, "It seems like even the people that fail still go on to jobs at Google—no one does too badly."