Sunday, April 20, 2014

Top Accelerator Generates 50X Return - How Can Investors Participate?

Accelerators and incubators have claimed prominent roles in the earliest stages of startup formation. These programs have seeded thousands of new companies and created significant value.

Y Combinator is the program with the longest track record and the largest amount of publicly available information. As of February 2014, Y Combinator has seeded an astounding number of more than 630 startups. At a per company funding of $15,000 to $20,000, Y Combinator has invested $10 million since its launch in 2005.  Y Combinator receives 6% of equity, effectively valuing the startup at approximately $250 thousand. Kawasaki's law of pre-money valuation assigns a value of $500,000 for every full-time engineer and subtracts $250,00 for an M.B.A. For a team composed of two technical co-founders, Y Combinator's investments constitutes a 75% discount compared to this rule of thumb.

Recently, Y combinator announced that its portfolio companies are worth more than $20 billion. AirBnb and Dropbox account for around 75% of that valuation. Assuming, pro forma,  five successive rounds of funding and a 15% dilution per round, the original 6% stake now is down to 2.7%, equal to a value of more than $500 million. In other words, Y Combinator has achieved a 50X total return on the $10 million invested so far. While almost all of these investments are still illiquid, the likelihood of realizing these returns is high. And since Dropbox and AirBnB were members of the classes of 2007 and 2009, respectively, there may be more hits to emerge still.

Until 2009, Y Combinator only invested its founder’s money. In 2009, Y Combinator raised a $2 million fund from Sequoia Capital and a number of angel investors, followed by a $8.25 million fund in 2010. Y Combinator raised and manages these funds to increase the number of startups it invests in.

Since 2011, startups in the program are offered additional funding after the initial Y Combinator equity investment. Yuri Milner and SV Angel launched the YC managed Start Fund to provide $150,000 in convertible debt to every startup in the program. In 2012, YC VC replaced Start Fund with a reduced amount of $80,000 instead of $150,000. Y Combinator was looking for each of the fund investors to provide the startups with advice, and consequently Khosla Ventures replaced Yuri Milner in 2013. In times when capital is cheap, advice is at a premium.

As the Y Combinator case shows, accelerators may prefer having prominent angel investors and venture capital firms as partners in their own earliest stage funds. Other early stage investors can create their own next stage index fund by spreading their investments over a wide range of accelerator startups. The returns can still be above average, but will require significant capital and effort.

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