Y Combinator Inspires Imitators

Paul Graham's intensive workshop permits investors and startups to check each other out with a minimum of risk and a maximum of potential

by Kerry Miller

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Y Combinator's Paul Graham with two cofounders of Octopart, a vertical search engine for electronic components.

The weekly dinners Y Combinator hosts are a welcome respite for many of the program's participants.

The cofounders of Fauxto make their pitch to investors at a Y Combinator demo day. Jessica Livingston

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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.

"Cheaper Equity"

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.