Tuesday, June 3, 2014

Incubators, Accelerators, and Combinators Have Entrepreneurs Cheering - Here's Why

Since the founding of Y Combinator in 2005, the number of incubator and accelerator programs has rapidly proliferated. Akin to popular rankings for colleges and universities, Forbes magazine and Techcrunch have even published rankings of top accelerator programs.

Many of these programs have modeled themselves after Y Combinator. Just to mention a few, Techstars launched in 2006, 500 Startups, AngelPad and the Citrix Startup Accelerator launched in 2010, and Alchemist in 2012. Each of these programs operate based on a similar business system. They source small start-up teams  of one to three founders, screen them in a concise interview process, provide some seed funding, nurture the team in a three to six months long process, and graduate them at the so-called demo day. Most programs offer admission twice a year.  

The impact on company founders and on early stage investors has been profound. This post sets out to shed some light by asking three key questions: How do these programs operate? What value are they providing for entrepreneurs? What impact do they have on the early stage investing landscape?

Sourcing of Founders

Many first time entrepreneurs are looking to become of part of a startup ecosystem. These programs provide an equal opportunity to gain instant access to such network.

Y Combinator initially built a follower community through Hacker News and Paul Graham's blogs. The Google pedigree of Angelpad’s founders helped attract other ex-Googlers. 500 Startups has gone out of its way to recruit entrepreneurs in Korea, Mexico, and many other locations from outside of the U.S.. Other programs are building reputations in specific focus areas. For instance, Alchemist is an enterprise focused program, and Rock Health is health focused. Eventually, successful programs attract founders because of the strength of their program brand alone.

Candidate Screening

Research on angel investment returns shows a strong correlation between investment success and time spent in due diligence. Accelerator programs often attract founding teams with little startup track records, and therefore place an emphasis on the founder versus their business ideas to reduce team risk. Applicants are asked to submit videos and describe critical moments in their lives. The tendency is to bet on teams who have worked or at least studied together. The actual interview process is conducted in batches, is limited to a few minutes, and decisions are made within 24 hours or less. Dave McClure of 500 Startups has further minimized the due diligence process and stated that the portfolio itself replaces due diligence.

The class sizes continue to change and vary from 10 (Angelpad ) to 50-70 (Y Combinator) to hundreds each year (500 Startups). Admission rates are in the single digit percentages, similar of top university programs.

Startup Funding

Y Combinator pioneered a model where the start-ups are giving up a single digit share of equity in return for funding that lasts the team for the duration of the program. The exact funding amount has varied over time, and is a function of team size, duration, and program reputation. Most often the terms are in the form of a convertible note with a conversion cap, although the structures vary and evolve over time.

The funding amount and structure appear to play less of a role in the entrepreneurs’ decision where to apply compared to the program reputation, although corporate programs tend to offer the most entrepreneur friendly terms. For early investors, the prevalent convertible note structure offers an easy way to invest, but often at the price of high valuation expectations.

Incubating and Accelerating

Successful angel investment outcomes are also strongly correlated with mentoring, coaching, providing leads, and monitoring performance. Incubator and accelerator programs have taken this participation to a new level where they emphasize different elements of advice and networking. The class type collaboration, competition, rhythm and co-location facilitate regular discussions, dinners, office hours, and social events. Program participants can show weekly progress on their product development and in meeting their target metrics. For content, many programs leverage Eric Ries’ Lean Startup approach and Steve Blank’s Customer Development process. The 24 week Alchemist program is extending this approach from three to six months by splitting the program in to a first half focused on customer development, the second on product development.

The efficiency of the partner advice is maximized by the condensed time frame, the co-location, and by the partners not taking board seats. And some programs like AngelPad and Alchemist have chosen to keep the class sizes small to deliver consistent advice.

Those programs wanting to further scale are adding more partners, and are growing the network of external advisers. As the accelerators mature, executives from former incubated start-ups are being recycled and brought back as advisers.

As Y Combinator’s Paul Graham has stated ‘... startups at all stages benefit from YC. That’s probably the best word to describe the atmosphere. For 3 months, it’s all start-up, all the time.’’ This is in marked contrast with a more traditional angel approach. There, advice is delivered on a one-on-one basis for the duration of the relationship, and is based on the strength of the individual angel and her network.

Follow-on Funding

The concept of a demo day is an attempt to ‘formally’ graduate start-ups, although the businesses are at widely varying maturity stages. Demo day also creates a 'American Idol' like marketplace where a large number of seed investors and early stage startups compete for attention and money. Some incubators have been able to generate demo day momentum and attract venture capital for a significant number of their incubated companies. For startups, the exposure to a large number of investors and the time saved in fundraising is extremely efficient.

VCs and angels can get early access by participating in the mentoring of the programs' participants. That way there are no signalling risks, and the demo day simply creates the urgency for them to make an investment decision before everyone else.

The usefulness of the demo day itself has been questioned by many investors. The limited time to get to know the company, to do research on the market and the competitive landscape, or to get meaningful customer references often force investment decisions under duress.

The program's brand can also be strong enough to crowd source follow-on funding for the whole portfolio of class participants. AngelPad is using the Angellist syndicate model where the momentum from the demo day is leveraged to attract additional investors who are not demo day participants.

Summary and Outlook

The impact of Y Combinator and other programs on the entrepreneurial landscape and on early stage investing has been enormous. They have built repeatable processes bringing together large numbers of startups and investors. As Angellist’s Naval Ravikant has stated, ‘Accelerators have branded advice and have institutionalized it.

Participants in the programs, and in particular first time entrepreneurs, very highly value the advice, the network and the funding acceleration. Post demo day, the power of the program's alumni network also helps recruiting and providing the seeding ground for new products and even new companies.

The corollary is also clear: Why should an experienced founder give up expensive equity if the product has some traction and the founder knows how to build a company? However, there have already been some cases where the team opted to join a program if even only one of the pieces was missing.

Programs make the first investment into founding teams with little track record. As valuation expectations rise significantly in the three months from inception to graduation, the demo day effectively creates a new investment 'gate'. This may leave traditional angel investors for these types of investments in a lurch. At the front end, they may not be able to compete with incubators in delivering services in a consistent and timely fashion. At the back end, valuations at demo day often reach levels which make it unattractive for angels to participate.

Thanks to Ken Arnold, Ryan Nichols, Mike Palmer, Riley Scott and David Wu for commenting on the draft version of this post.