11 Notes on Y Combinator

European Straits #170

Nicolas Colin

Hi, it’s Nicolas from The Family. Today, I’m discussing Y Combinator, how it evolved from a small summer program in Boston to a Silicon Valley powerhouse, and what we Europeans can learn from it.

⚠️ The paid version of European Straits launched some time ago. If you’re not one of my paying subscribers, here’s what you’ve missed lately 😉

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As for today, I’d like to continue my “11 Notes” series dedicated to interesting businesses, following instalments on Amazon, Berkshire Hathaway (with my cofounder Oussama Ammar), Goldman Sachs, and Lego. Since Y Combinator has been in the news recently, they’re next on the list 👇

1/ Like many prominent players in today’s tech world, Y Combinator was founded by entrepreneurs who initially got successful at the time of the dotcom bubble—and then doubled down. Some time after having sold Viaweb to Yahoo, veteran tech entrepreneurs and programmers Paul Graham, Trevor Blackwell and Robert Morris dedicated an entire summer to helping young startup founders from Boston and the surrounding area. All three had both time on their hands and money to invest. Only Jessica Livingston, who joined as the fourth partner, was still working a different job at the time (at an investment bank), a job she left as soon as the group decided to turn their project into a full-time business that they together called Y Combinator (in reference to a computer science concept).

2/ Y Combinator was meant to do angel investing in a different way. Paul Graham wanted to be an angel but didn’t want the hassle that usually comes with it, notably on the legal side (he’d probably tell you he’s a lazy man and easily bored, like so many nerds 😉). Overall, his interest was in spending time with founders. Hence the idea was to find a processed, professional way to maximize both the probability of success at the earlier stage and the pleasure that Y Combinator partners would have in conducting their day-to-day business—both of which required as much focus as possible on the founders and their products.

Within the founding team, some took charge over certain sides of the business—for instance, Jessica Livingston would help founders with the legal aspects of setting up their companies while other partners focused on the product side. This had a virtuous effect: specialization inspired the team to find new ways of executing the various tasks and eventually helped Y Combinator discover its business model.

With young founders, something clicked from the beginning. Paul Graham was well known in the tech world thanks to his renowned essays covering computer programming (especially LISP), startups, and venture capital. Native traffic on his personal website, where Y Combinator was advertised for the first time, helped attract the first batch of startups. Feedback from the first founders was extremely positive. Many other entrepreneurs heard about the initiative and wanted to be part of the next batch. At that point, the partners knew they had a promising business on their hands. Key decisions were made, namely moving from Boston to Silicon Valley and crafting what was to become the core value proposition.

3/ Y Combinator’s value proposition of being a hands-on investor was a key differentiator during their early years. Unlike today, the idea of an investment firm adding value by providing advice and operational support was not particularly widespread in the venture capital industry then:

  • Originally, Y Combinator helped startups with their legal setup and then worked closely with them on their products, thus sparing them many mistakes along the way. Nowadays, it’s more about connecting founders to the right people, providing them with as much education and inspiration as possible, and paving the way for future success in raising money.

  • The whole process lasts three months, a period during which founders have access to so-called “office hours” with Y Combinator partners and attend a weekly founder dinner where a special guest tells behind-the-scenes stories and there are many interesting people to network with.

  • At the end of a batch’s three-month period, startups are introduced to other investors. During the so-called “Demo Day”, founders have the opportunity to pitch their startup to qualified investors hand-screened by Y Combinator.

Repeatedly asked to describe Y Combinator’s business in one word, Paul Graham coined the term “accelerator”, with the following reasoning: a startup is all about growth (as explained in one of his most renowned essays); there is no point in raising too much capital before growth has been ignited; and so Y Combinator’s purpose is to accelerate the product development phase until growth kicks in so that post-Demo Day an investor’s money is dedicated to financing that growth.

Meanwhile, the money invested by Y Combinator is leveraged by the whole experience that it provides to founders. Y Combinator increases its return on invested capital through the value added by non-financial resources (office hours, education, emulation) and its selection process both at the beginning (sourcing the best founders) and at the end of the process (attracting the right investors).

4/ My cofounder Alice Zagury’s first professional experience was being charged with setting up an accelerator program in Paris. As she discovered, even back in 2010-12 Y Combinator was already the standard for designing such programs, and so she set out to get some inspiration from it. However, later on she realized that many (most?) people around the world assume things about Y Combinator’s model that are either fortuitous (in that they aren’t a key feature of the model) or outright wrong. (Needless to say, the lessons she eventually drew contributed to shaping The Family.)

Here are several examples:

  • The program’s 3-month duration has nothing to do with how long a startup should dedicate to product development. Instead, it was simply the duration of Harvard’s summer break. Because they started experimenting with that period as a constraint, Y Combinator’s founders discovered that you could build amazing products in a short time. And so even though they stuck to the 3-month batch, that doesn’t mean three months is the time it will take any founding team anywhere in the world to hit the market. In truth, it all depends on the industry, the market, and the surrounding ecosystem. (Also, three months is the duration of a tourist visa in the US, which means that it’s easy for a foreign founder to spend the necessary time in Silicon Valley before going back home as their startup enters the growth phase.)

  • Y Combinator does NOT host its portfolio startups in a physical space. Former president of the firm Sam Altman even had to remind the public about that fact in a tweet back in 2015, triggering a heated discussion about the adverse effects of gathering a bunch of startups in the same co-working space. As mentioned by Keith Rabois at the time, the idea is that great startups are (for better or worse) like cults, and “cults don't share space”. During the 3 months they spend in Silicon Valley, Y Combinator founders work from either home or any office they can find in the neighborhood. In practice, finding a home where all the co-founders both live and work is the preferred option: it maximizes the sharing of information and minimizes the time dedicated to going from home to the office. (And now, because of COVID-19, Y Combinator has announced that it will be switching to remote, maybe on a permanent basis? We’ll see!)

  • Content plays a key (and underestimated?) role in Y Combinator’s strategy. Graham’s essays were instrumental in generating the traffic that made it possible both to attract the first batch and to provide the founders with a basic education about what startups and web-based applications are all about. Later, Hacker News, a media operated by Y Combinator and of which Paul Graham was the editor for a long time, contributed a great deal to the firm’s influence in the startup world. Today, Hacker News is still one of the hottest and most visited tech sites in Silicon Valley and the world, and having your tech-related content featured there is kind of the Holy Grail. (One day my colleague Mathias Pastor saw a huge jump in traffic on his article, Avoiding Zombie Startups; sure enough, it had been posted on Hacker News and was generating a big debate.)

5/ Y Combinator’s early success was marked by the impressive performances of highly successful tech companies such as Reddit (bought by Condé Nast in 2006, just one year after launch, at the then-staggering value of $20M) and Dropbox (now a listed company valued at $8.5B+). Amazed by the results in their first batches, Y Combinator’s partners decided to expand operations and increase the number of startups in a batch. From 8 startups in the first batch (Summer 2005), Y Combinator grew to having 99 startups in the Summer 2015 batch and has been expanding even further in recent years.

This all led to a radical transformation of how Y Combinator operates:

  • The number of partners has increased. It should be noted that partners are not compensated other than via capital gains.

  • A software infrastructure had to be deployed, if only to share information among partners from one office hour to another. It helped that the firm was founded by programmers rather than financiers: they coded their infrastructure themselves!

  • As batches multiplied and grew in size, startup founders who went through Y Combinator began to form a powerful network of alumni. Not only do they entertain long-term relationships with the partners, they also become a valuable resource for new founders.

  • You can apply again and join another batch if your initial startup fails, which only reinforces long-term, trusted relationships.

  • Most of the education provided by Y Combinator has been made accessible for entrepreneurs on the outside, notably through Startup School. If you need to be convinced that important lessons are shared with founders participating in Startup School, check out Balaji S. Srinivasan’s Silicon Valley’s Ultimate Exit.

6/ Today, Y Combinator is growing even faster in terms of both geography and scope:

7/ Despite the high level of operational support, Y Combinator has always deployed financial capital in the startups that it selects. Indeed, being located in cash-rich Silicon Valley means it would be impossible for Y Combinator to attract the best early stage founders without providing a certain amount of cash, however little. Providing cash also makes it possible for many founders from outside Silicon Valley to benefit from the program, as otherwise they wouldn’t have the means to settle there for three months and pay the rent.

Yet the financial dimension certainly doesn’t make Y Combinator just another seed investor. First of all, seed investment didn’t exist back when Y Combinator launched (it became a thing a bit later, as Bryce Roberts of O’Reilly AlphaTech Ventures explains here). And the way Y Combinator deploys capital is rather different from the methods of a traditional VC firm:

  • The Y Combinator term sheet aligns the firm’s interests with those of the founders. They own common stocks (and convertible instruments—see below), and their shield against dilution relies mostly on the founders’ leverage in their future negotiations with later-stage investors (and pro-rata rights, obviously). This contributes to minimizing conflicting interests with founders.

  • From 2005 to 2009, Y Combinator only invested money brought forward by its partners. But then it decided to try and attract outside capital, which was needed both to keep up with a fast-growing portfolio and to make sure that the 2008 financial crisis wouldn’t slow down the pace of investing or lower the willingness to take risks. Indeed, a key feature of Y Combinator’s model is that investment decisions should not depend on economic and financial cycles, rather being based on the long-term vision of Y Combinator’s partners.

  • Thanks to the early performance of their portfolio and the clout of its partners, it didn’t prove hard for Y Combinator to attract outside investors. At first, money was raised from Sequoia and some angel investors (Ron Conway, Paul Buchheit and Aydin Senkut), and stored in a fund that was managed by Y Combinator. Those investors were chosen based on the fact that they were the ones who had invested the most in YC’s startups in the past. To prevent any signaling issues, they were denied any special rights in exchange for their investment.

8/ Then even more money was poured into the Y Combinator ecosystem:

  • The initial model was to buy a 7% equity stake in exchange for a sum that depended on the number of founders—$17,000 per founder on average.

  • The next iteration was the setup known as YCVC. In 2011, Yuri Milner and SV Angel began to offer $150,000 to every startup YC selected using an uncapped convertible note. After a few different versions of this original deal, it was brought down to $80,000 (in addition to the equity investment by Y Combinator), as the original $150,000 was so large as to cause problems in some of the startups. The participating investors in YCVC have changed over time, including Andreessen Horowitz, General Catalyst Partners, Maverick Capital, and Khosla Ventures. (And later, after YCVC was shut down, there would also be Stanford’s endowment fund as well as Michael Bloomberg as LPs.)

  • Over time, Y Combinator has invested in several ways. They used to buy stock in the company while providing additional money by way of convertible stock—which enables founders to wait for later rounds before anchoring their company’s valuation. From 2013 onward, convertible notes were refined under the form of a SAFE (simple agreement for future equity, a contract designed to address many of the problems with convertible notes while preserving their liquidity). Today, Y Combinator invests “"$150k on a “post-money” SAFE”, and enters “an agreement with the company and founders that sets out some YC-specific guidelines and rights, including a participation right to invest in the company’s future financing rounds (the “YC Agreement”).”

  • Having more money and following up at later stages hasn’t come without difficulties. Y Combinator deciding whether they’ll exert their pro-rata or not has had a significant impact on the ability of a given company to raise additional capital. To handle such signaling risks, the firm had to tweak its approach. They first decided not to communicate regarding which startups raised money on Demo Day and how much; now they only communicate regarding the whole batch. Likewise, in 2014, they had to decide that partners would no longer be allowed to invest their own money in the first $500,000 raised by a startup until three weeks after their batch’s demo day, citing “messy, inaccurate, and even potentially unfair signaling as its reason for the change”.

More recently, Y Combinator announced a further change to their model, potentially opening the gate to more signaling turmoil again. Here’s TechCrunch’s Jonathan Shieber last week:

The number of companies in [Y Combinator’s] portfolio has gotten too large for it to invest and some of the limited partners who back the accelerator’s operations are balking at making commitments to the pro rata investment program.

“We have significantly exceeded the funds we raised for pro ratas, and the investors who support YC do not have the appetite to fund the pro rata program at the same scale,” the accelerator wrote in a post seen by TechCrunch. “In addition, processing hundreds of follow-on rounds per year has created significant operational complexities for YC that we did not anticipate. Said simply, investing in every round for every YC company requires more capital than we want to raise and manage. We always tell startups to stay small and manage their budgets carefully. In this instance, we failed to follow our own advice.”

9/ All in all, Y Combinator matters a lot to all of us in the startup world, including in Europe, because it has contributed so much to revolutionizing startup investing in general and Silicon Valley in particular.

First of all, it has democratized entrepreneurship. Thanks to Y Combinator, secret codes have been made visible for everyone to see. In the past, few young entrepreneurs had access to the necessary know-how and resources to start their business. If you didn’t have the right network or the right background, it was difficult to settle in Silicon Valley and launch a successful startup. After Y Combinator entered the stage, it became easier for the best entrepreneurs, provided they managed to be selected in a Y Combinator batch, to minimize the probability of missteps during their first years. And even those who haven’t gone through Y Combinator have benefited from the spillover of their in-house education, the accelerating pace of online publications by prominent Y Combinator partners, and the widespread influence of their alumni network within the tech industry, as exemplified by the likes of Stripe’s Patrick Collison and John Collison and Initialized’s Garry Tan and Alexis Ohanian.

It has also made a key difference in leveling up the Silicon Valley ecosystem, because turning early-stage investment into an industry is the finishing touch in polishing an ecosystem that works—and Y Combinator provided that finishing touch to Silicon Valley. As I once wrote to a friend,

Early-stage investment firms, especially self-styled “accelerators”, are misleading for outside observers. We think they are the first brick to be laid out because those firms intervene at the start of business life. But in reality, it is exactly the opposite. Firms such as Y Combinator are rather the finishing touch to an already large and healthy ecosystem (in this case, Silicon Valley), in which we seek to optimize the first steps of the new generations who are following known steps.

In other words, “accelerators” only work well if they have something to pass on. At The Family we have our own doctrine to share, but nothing more. It's ours, not everyone adheres to it, the only thing is that we have worked hard on it, we believe in it, and we keep on refining it day after day. A healthy ecosystem like Silicon Valley has something to convey. But Paris, as an ecosystem, has nothing to transmit that is stable, unequivocal and proven, because it lacks earlier generations of widely successful tech companies.

Therefore it’s impossible to reverse engineer what maximizes the probability of success at the later stages if you don’t have previous generations of companies that have been widely successful. Y Combinator could reverse engineer startup success in Silicon Valley. We in Europe can only guess what could eventually work and try and make it happen.

In short, all of these accelerators that you can find in every city in the world, often modelled after Y Combinator (even with misinterpretations), are like painting the inside of the house before you put the roof on. It's time to learn how to do it right and to realize that Y Combinator wouldn’t exist without the healthy ecosystem that is Silicon Valley—and that it’s useless, even counter-productive, to try and emulate it in the absence of such an ecosystem!

10/ Ultimately, I think that one of Y Combinator’s most important contributions has been in revealing the hidden value of  angel investing as an asset class. As once written by David Teten, “angel investors earn higher returns than small VCs, who in turn earn higher returns than large VCs, let alone most other asset classes.” Yet the same angel investing has been overlooked by the asset management industry for a reason that’s almost unspeakable (or rather laughable): you can’t make fees on angel investing.

Y Combinator has proven that you can scale up angel investing and generate spectacular returns, provided that 1/ you belong to an ecosystem that’s already healthy and 2/ you’re willing to remain entrepreneurial and try many things along the way—some of which will work, some of which won’t.

11/ My finding is that this is a most important contribution to the current paradigm shift. Thanks to pioneers such as Y Combinator, the fact that it’s easier for a larger number of individuals to do angel investing doesn’t necessarily turn into lower returns. All of us can still hope that at some point angel investing as an asset class will be made more widely accessible to all while still remaining as rewarding as it has been in the past few decades. And so let’s climb on the shoulders of those giants and adapt their playbook to our lagging ecosystem in Europe. What do you think? 🤔

⚠️ As I said last week, my wife Laetitia Vitaud and I launched a new media in French called Nouveau Départ to cover the COVID-19 crisis and its aftermath from an entrepreneur’s perspective. We’ve gathered quite an audience and we’re now accelerating the pace on releasing content for paying subscribers. Here’s what you should expect to find if you subscribe to Nouveau Départ:

  • Twice a week: Interviews of practitioners and experts who have strong opinions and inspiring ideas to contribute (videos).

  • Once a week: An in-depth discussion, by either Laetitia or me, of what the COVID-19’s impact will be on a given industry (also videos).

  • Overtime: Access to a wide knowledge base that we’ll develop around our videos, as well as opportunities to come together as a community through live events.

🦊 In terms of other events, my cofounder Alice Zagury is continuing Good Vibes, her interview series with entrepreneurs focusing on how they’re confronting the crisis while maintaining a positive outlook. They’re free to join every weekday at 12:19, and you can find the lineup and past episodes here.

👭 And finally we have the next installment of Be My Cofounder happening this Friday. Since one of the key benefits of events at The Family is serendipity (you never know who you’ll meet!), we wanted to find a way to do the same thing online for budding entrepreneurs looking for the right person to join them on the adventure. Tickets are available though Hopin here.

The comprehensive reading list attached to the European Straits weekly essay is part of the Friday Reads paid edition. Subscribe if you want to receive my list of revealing articles on Y Combinator!

From Normandy, France 🇫🇷

Nicolas