OnStartups

Let me introduce this article by making clear some important facts:

1. I have read most of what Paul Graham has said and agree with 95% of his thoughts and insights (which is rare).
2. I think YCombinator is doing some very creative things with respect to funding very early stage companies
3. From outwardly visible data (I’ve never met him), I don’t think Paul Graham has malicious intent or is intrinsically evil.  In fact, he seems to be a really nice guy.

Disclaimer:  Since I am in some sense a private/angel investor myself, there is the risk that some of my thoughts can be taken as “competitive criticism”.  (i.e. I’m competing with YCombinator).  Though this has an element of truth (i.e. I have a biased opinion), it doesn’t necessarily make me wrong.  Will let you judge for yourself.

Having said that, I think its important to try and analyze the YCombinator “path” for startup founders and how this compares to other possible alternatives (one of which is to do nothing at all).  If you don’t know anything about YCombinator, I encourage you to read up on them (a Google search is sufficient, and will give you the most current stuff) so I’m not going to post direct links here.  If you already know about YCombinator, Paul Graham and the Summer Founders Program, read-on.

Here are things I like about Paul Graham and YCombinator and what they are doing:

1. They seem focused on very early stage companies (which is a good thing).  The options for these companies are generally very limited (when it comes to capital raising).  Its good to see someone focused on this end of the market.  It helps drive innovation.

2. Paul has an “operating” background (i.e. he’s founded a company before).  From what I have read, his company ViaWeb sold for about $50 million “back in the day”.  Though I don’t see this as a huge hit, its big enough to let him do what he does – more power to him.  Having had only modest hits myself, I can relate.

3. He is technically astute (so its easy to like him and respect him).  He’s not a “suit” (which I mean in the most respectful sense possible).  Though some of his views can be a little elitist and impractical (in my humble opinion), this is not a big deal, as this does not seem to cloud his thinking in terms of investments that he makes nor does he seem to bend his portfolio companies to his will in regards to technical platforms and languages.

4. They seem to be pretty quick about their decision making (one of the things I dislike most about the traditional VC process is that it takes so long and consumes so much energy).  The application process at YCombinator seems straight-forward with a relatively quick decision cycle.  As a founder, this means you can focus most of your time/energy on actually solving a customer problem – instead of solving an investor problem (which is rarely ever the same thing).  [Note To Self:  Could be a good topic for a future article, “The Dangers Of Trying To Solve The Investor’s Problem”].

5. There is a strong “communal spirit” amongst the portfolio companies.  This is great.  One of the hardest things about startup companies is that it can be very lonely.  I think its great to be associated with other people that are doing similar things (and are at a different stage).

Having said that, there are some things that I think require deeper inspection and are worthy of analysis:

1. YCombinator invests about $6,000 per founder.  I’m not saying this is too low (or too high), but it seems arbitrary.  I have a hard time believing that all possible ideas can be validated (or invalidated) with the same amount of cash.  I would like to see a little more thoughtfulness put into how much capital is infused.  Though simple is often good, there is sometimes the danger of too simple.

2. The “pre money” valuation (i.e. what the startup is worth before the cash comes in) seems to range from $100k-$200k.  Based on the kinds of companies that are applying, this is probably appropriate.  However, its important to note that the average pre-money valuation through most other channels (including angel investors) seems to be higher.  Obviously, the upside for the founder is that the higher the valuation, the less equity (percent of the company) has to be given up – all other things being equal.  Since there is rarely any competition for these deals (you either take money from YCombinator – or you don’t), its hard to assess whether the valuation is fair or not.  See #4 below.

3. Part of the value you are getting is the Paul Graham “label” applied to your startup.  For the right kinds of companies, this has immense value.  Paul Graham has a loyal and passionate following (myself included).  However, if your business idea is not a mainstream “web 2.0” kind of startup then the value that the Paul Graham label can bring to you is severely reduced.  If you’re building software for the plumbing industry (lets say), then its doubtful that pool of potential customers gives a flip about Paul Graham or YCombinator or the fact that you got “chosen” from hundreds of possible applicants.  One of the dangers of startup land is that it’s a very small circle of people (selling to each other), and we often become disconnected from the “real” world.  In many cases (reddit.com for example), that’s OK.  The model is not necessarily for the mainstream right now anyways.

4. I’m a little emotionally disturbed by my use of the word “label” in #3 above (and its connotations back to the music industry).  Basically, at a micro-level, YCombinator has almost zero competition.  You as the aspiring founder/entrepreneur are hoping to get “picked”.  If you do get picked, that’s a great badge of honor and often puts some wind in your sails simply for being “under the label”.  Though there is definitely value here, there’s a dark side as well.  Anytime an entity has little (or no competition), this implies a lot of “power” (or leverage) in the transaction.  When there is an imbalance of power, there is the potential for the weaker party to get screwed.  Its also important to note that malicious intent is not a requirement to being screwed (so even if YCombinator was completely above board and acting with good intent – which I think they are), doesn’t mean that it’s a fair deal for the founder.  This is one of the problems with these kinds of deals:  its not an efficient market.  With only one “buyer” at the table, you don’t know whether you’re getting a fair price or not.

So, all in all, I think YCombinator is a good thing, as long as founders walk in with their eyes open and understand the dynamics of what is going on.  I’m hoping that more “very early stage” investors will fill the capital gap for the next generation of software startups.  Meanwhile, I wish continued success to Paul Graham and YCombinator.  I wish such a mechanism had existed when I started my first two companies.  I could have used the help.