Tuesday, May 21, 2013

YCombinator and Rigged Roulette

YCombinator has been making a lot of headlines recently. I am a huge fan of their work, PG is the man,  and I think that they have a well earned reputation for being one of the most productive and successful incu-VC's out there. However, I have to play the bear a bit here, and point out that I think that YC is being overly mythologized. So, in no particular order, let's take a look at some interesting YC factoids.

     A few weeks ago, a piece ran in the NYTimes magazine by Nat Rich, which was very interesting, but I feel highlighted some inherent problems with YC, exemplified perfectly by this quote:

“There are two things that people grumble about Y Combinator that are actually compliments,” [PG] told me. “One is that Y.C. start-ups are overvalued. The only way for a company to be overvalued is if there’s someone willing to pay that price. So what they’re saying is: Going through Y.C. causes companies to raise money on better terms than they would have otherwise. We wouldn’t have the barefacedness to make that claim ourselves! The other thing they say is that they can’t tell on Demo Day which are the good start-ups. Well, it’s not because the good start-ups look bad; it’s because the bad start-ups look good! Which means we’re doing our job."
In case you missed it, that is PG basically stating that YC's job is to get overvalued investment for companies without much of a promising future. That isn't particularly great. 
     Now, let's combine two important facts: YC only accepts highly, highly qualified founders - importantly, a non-trivial percentage of all startups founded by young, qualified tech entrepreneurs apply to YC - and, according to PG "if ... you discover the next Google, you can increase your investment by 'a thousand X.'” So, to make an analogy, imagine that the YC investment pool is a roulette board - except that the payout for a win is several orders of magnitude greater than the bet, and the odds of any one number 'winning' are a lot higher than investment in a random company 
     Viewed in this light, it doesn't take a whole lot of skill to place a huge number of inexpensive chips on a rigged roulette board. Especially when you have thousands of talented individuals throwing themselves at you for a $11,000 + $3000n investment for 2-10% of your company†- which, by the way, is a tremendously favorable deal for YC. Additionally note that just two companies, AirBnb and Dropbox, make up the lion's share - ~75% - of YC's 10B portfolio, which consists ~400 companies. 
     Finally, in the context of startups generally, tech is actually not even the most fertile field for new companies. The substantial majority of successful startups are not in tech. They are in a wide variety of industries, with the two most successful categories being consumer discretionary and industrials. 
     When viewed in the light of all these facts, I think it should be easy to agree that, though YC is hugely successful and deserves recognition and praise for its accomplishments, it is being mythologized to an unnecessary degree. They are positioned at a bottle neck in an industry that happens to be very sexy right now, and, as a result, they are inevitably investors in a few truly major companies. However, that does not mean they are mystical seers with insight greater than those in in similar positions other industries that are less sexy. It just means that YC gets the most ink.
     
† Note that in Mr. Rich's article, he talks about several companies that received six figure investments from YC, and does so in a manner that makes this sort of investment appear routine. As far as I know, this is highly unusual for YC, and I would like to know more about how these companies got this funding from YC, or if, in fact, YC is now in the habit of investing more than the 11+3n detailed above.

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