Picking Winners: Are Start-Up Accelerators Like Y Combinator Taking Over the Venture Business?

Disruptive innovation is an awesome concept - that is until your business is the one being disrupted. 

Then, well, it's deficiencies tend to get rather definitively highlighted, at least by those who find themselves on the receiving end of its effects.

It is undoubtedly ironic that the venture capital industry, that which spawned the revolution that now defines much of the way we live, is finding itself being nudged rather more than it likes - or believes its august record deserves.

But this is not to say that the warning signs have not been there for a very long time. There are good reasons why inbreeding is considered a biological misstep and the VC biz has become about as inbred as any rare breed of dog. The VC firms tended to be a small crowd to begin with and they have displayed a preference to bringing in those who have generated success on their behalf. Selection bias can affect results rather dramatically over time.

So the fact that accelerators, which share some of the same educational and social roots as VCs, but appear to be somewhat broader in their demo, psycho and socio-graphic reach are beginning to vie for and win the best of the new prospects. To some degree this is because the VCs have earned a reportedly deserved reputation for greed and control-freakish tendencies.

Ultimately, this new option is just the capitalist system at work: opportunity attracts money - and employs innovation to gain advantage. JL

Eric Newcomer reports in Tech Genius:

Brand has always been  important in the venture capital business, where the key to success is persuading the most desirable entrepreneurs to take your firms money rather than someone else’s. Reputation—largely determined by big exits and a dash of charisma—is essential.
For even the most distinguished of
venture capital firms, it’s now obvious that Y Combinator and other startup “accelerators” pose an existential threat. And recent moves by Y Combinator and its new boss, Sam Altman, are bound to further aggravate tensions with VCs even if the red-hot accelerate chooses not to become a direct competitor in the venture funding business.

Since it was launched nine years ago, Y Combinator has chipped away at one of top-tier venture firms’ most valuable functions: using their august brands and network of elite connections to effectively anoint certain companies as likely winners. The YC brand has exploded as alumni such as Airbnb, Dropbox and Twitch soar, and there is today no better calling card for a Silicon Valley startup than to be “a YC company.”

Now, following Y Combinator founder Paul Graham’s February decision to step aside and hand the reins to youthful Loopt founder Mr. Altman, Y Combinator is starting to throw its weight around. The startup accelerator recently froze venture capital firms out of investing automatically in YC-backed companies— keeping them out of a pool money known YC VC (previously the Start Fund). The fund previously allowed a select group of investors, including Andreessen Horowitz, General Catalyst, and Maverick Capital, to automatically invest in YC companies.

Making matters worse for more connected venture firms, Mr. Altman wrote late last week that he’s creating a shared email list for all VCs and YC companies, instead of sending out individual introductions—a move that puts all venture firms on a more even playing field. Up until 2010, some venture firms had functioned as limited partners for Y Combinator, providing capital for YC to put into its startups. But YC severed those ties as well.

Y Combinator has always struggled with how much money to allocate to startups accepted into the program, which mentors a batch of about 80 companies twice a year. Those companies move to Silicon Valley and attend regular office hours with YC partners who help guide their companies. Under Mr. Altman, YC has raised the amount of money it automatically invests in companies to $120,000, and its takes a 7 percent stake in return.

YC’s new moves come even as established venture investors gripe that YC companies are over-valued. At the same time, an explosion of startup accelerators around the country, combined with new tools and looser rules for angel investing, promise to continue making life more complicated for traditional venture investors.

Branded Investors

Brand has always been extremely important in the venture capital business, where the key to success is persuading the most desirable companies and entrepreneurs to take your firms money rather than someone else’s. That means that reputation—largely determined by big exits, exclusive networks of supporters and a dash of charisma—is essential.

So it shouldn’t be surprising that venture capital firms are starting to worry that YC might start elbowing into the capital allocation part of the businesses. Mr. Altman insists that YC doesn’t plan to do that, and is much more likely to expand by accepting more companies than by moving more heavily into company financing.

He allows that YC might one day ask for “pro rata” rights to invest more money in firms in which it already has a stake, or even participate in a late-stage round for a YC company. Investing in early rounds, however, is problematic because of the “signaling” problem it would create for a YC companies didn’t receive such investment, Mr. Altman says.

But even if Y Combinator doesn’t compete with VCs more directly, it’s helped create a big opening for wealthy individuals and others to play alongside VCs. With the boom in angel investing and the growth of resources like Angel List and crowdfunding platforms, non-traditional investors can get into the startup funding game with almost as much good information as the pros. After all, anyone can see that a certain company graduated from Y Combinator.

“One of the benefits of YC is that you get your credentials early. You don’t necessarily need to pay up for a VC later. You’ve basically been branded as smart,” says Naval Ravikant, co-founder of the online fundraising site AngelList.

Replacing Business School?

The words incubator and accelerator are often used interchangeably. Many traditional incubators generate the idea and then bring in a team to create the business, while accelerators help founders build a business out of their idea. Of course, YC has helped plenty of founders rejigger their original idea or come up with a new one altogether; that’s one of the things Mr. Graham is famous for.

An explosion of incubators and accelerators has accompanied the current tech boom, but there are only a few that matter. Y Combinator is often referred to as either the Harvard, Stanford or MIT of accelerators, or all three rolled up into one. Maybe Lemnos Labs, a young hardware focused accelerator, is the Carnegie Melon or Caltech.

TechStars, a multi-campused accelerator, might best be compared to the University of California system—if the regents offered a money back guarantee. (TechStars recently promised to give its equity stake back if founders weren’t satisfied with their experience.) And 500 Startups, Dave McClure’s quarterly startup bootcamp, would be the Purdue or Rice. AngelPad is another contender that entered the fray in 2010.

The metaphor has some legs—accelerators offer a business education, connections and credentials, just like business school. “Disrupting business school, that’s what’s happening and they don’t even know it yet, they’re just fucking clueless,” says Mr. McClure. “We’re stealing market share from business schools. Why are you going to pay $100,000 a year for two years? Instead we’ll give you $100,000.”

But investors also see accelerators in a very different way—as one of them.

The question then is what direction accelerators are going to move. Will they truly become the new business schools, perhaps with hundreds or even thousands of graduates a year? Or will they become more enmeshed in the capital allocation game?

“YC is in some ways the best venture capital firm on the planet, right? They get to be the index of all innovation. All the great founders want to go there. They give them 7 percent for $100,000 grand,” says one venture capitalists from an elite Silicon Valley venture firm. “Where do I sign up for that deal? In that sense they are phenomenal and formidable.”

The question then is what direction accelerators are going to move. Will they truly become the new business schools, perhaps with hundreds or even thousands of graduates a year? Or will they become more enmeshed in the capital allocation game?
The answer could be both. Some accelerators like TechStars and 500 Startups are already more willing to participate in later rounds than Y Combinator.

David Brown, managing partner at TechStars says, “We do operate a fund, we do invest in the companies as they go into Series A we’ve made a couple out of our two fund, that is absolutely part of our approach to help the best companies continue on their journey.”

500 Startups typically invests $100,000 but will sometimes put $200,000 into a company, Mr. McClure says. And Lemnos Labs, which birthed the now Andreessen Horowitz-backed drone company Airware, invests will invest $200,000. (Airware also participated in YC.) Like many other accelerators, Lemnos Labs get the money to invest in startups from limited partners just like VCs do. It’s easy to imagine those ties deepening over time and limited partners putting more money into accelerators instead of traditional venture firms.

Mr. Altman says that he thinks the strategy of picking and choosing winners out of an accelerator’s own batch is flawed. Y Combinator recently tightened its restrictions on when partners can personally invest in YC companies to avoid inadvertently torpedoing startups who don’t get a YC-partner’s financial imprimatur.

“We get offers all the time to raise a venture fund, but we don't want to. If you ask the founders that go through these combination accelerator/A round shops, they hate it. It's a huge signaling problem,” he says. “I don’t make any comments about what we’re going to do in the future because things evolve but I”ll just say—we have no desire to compete with VCs in their venture business. That's not what we want to do or think we'd be good at. Similarly, we don't lose too much sleep when they try to start accelerators.”

Soaring Valuations

But even if Y Combinator doesn’t step into the fray other forms of capital are already putting traditional venture firms—accustomed to have a good deal of leverage at the negotiating table—at risk. Just look at the valuations.

One of the main reasons that investors have grown more fearful about YC’s dominance is the increasingly stratospheric valuations of YC companies. As YC carriers more and more weight behind its brand, the more an investment in a YC company can seem like a surer bet, driving up valuations.

Judging by AngelList’s decidedly imperfect tally, the average YC startup already has a disproportionately high valuation. The average YC company has a $6.3 million valuation. Compare that to 500 Startups $4.8 million, TechStar’s $4.2 million, Stanford graduates’ $4.5 million or Harvard graduates’ $4.4 million.

Mr. Altman says the average valuation of all the YC-backed companies through their winter 2014 batch is more than $50 million.
Those high valuations puts institutional investors—who have to make calculated bets—and cost-cautious angel investors in a pinch.
But many others are waiting in the wings. Already crowdfunding sites like WeFunder and FundersClub (both are YC companies) raise money for cohorts of the YC class. WeFunder co-founder Mike Norman and FundersClub co-founder Alex Mittal both attended the most recent Demo Day. AngelList makes it easy for investors to connect with YC startups. And angels are more able to pool their money and jump into a company. All these forces help drive up valuations.

“If you're new to angel investing and have low deal flow then I don't think there is any harm in paying 2- 15x the premium that YC startups have,” angel investor Jason Calacanis wrote in an email. “However, I see almost all the deals in the market so it simply doesn't make sense to deploy $250k to own 2.5% of a YC company when I can deploy that same $250k and own 2.5% of two or three startups that are further along than the YC startups.”

He continued, “At YC you know you are not getting a lemon so paying 3x on average (pulling that number from the air) makes total sense as an insurance policy. However, if I can get 1/3rd the valuation i can make 3x the bets and increase my odds. The valuations I see from YC startups right now is 7-12m compared to 3- 8m for Apples-to-Apples.”

Of course, some YC-backed startups are turning away higher valuations in exchange for top tier venture brands.

“Bad earlier stage investors are getting totally crowded out—proprietary deal flow and proprietary networks are mostly over,” Mr. Altman says. “You—and your references—have to be able to explain to a founder how you're going to help them.”