Angel investing in tech startups is a gut wrenching and risky business. It sometimes feels like buying $25,000 lottery tickets. Most of them lose, but sometimes you invest in a “unicorn” and make 100 times your money or even more. The MIT Blackjack team figured out how to beat the odds in Las Vegas. Paul Graham from Harvard and Robert Morris from MIT teamed up with Trevor Blackwell and Jessica Livingston to found Ycombinator, and in the process figured out how to beat the odds in tech investing.
Ycombinator is the largest and most successful startup incubator in history, and it was started right here in Cambridge, Massachusetts. Startup incubators and accelerators are everywhere today, but were relatively unknown when Ycombinator started 10 years ago. Ycombinator has deep roots in the area. Co-founder Paul Graham got his Masters and Doctorate degrees from Harvard. Robert Morris, another co-founder, was a professor at MIT.
Paul decided to start Ycombinator after giving a talk at a Harvard Computer Club on how to start companies. Paul and his co-founders wanted to get involved in Angel investing but wanted to do it in a scalable way, involve lots of friends and advisors, and be more “hands on” than the typical Angel investor. There was no scalable way to do that at the time. Thus was born Ycombinator.
Over the past 10 years YCombinator has been amazingly successful, funding 842 companies worth an estimated $30 Billion. Those companies have raised over $3B from outside investors, and 32 of those companies are now worth more than $100 Million each. Some of the most successful companies include; AirBnB, DropBox, Stripe, Twitch, Reddit, Instacart, Zenefits, Mixpanel, Weebly, Parse, Heroku, and OMGpop. At last count 89 Ycombinator companies have been acquired, while at the other end of the spectrum, 84 Ycombinator companies are no longer active and total wipe-outs.The remaining 669 companies are still operating.
To put this in perspective, most early stage tech investors expect that half their companies will fail, sometimes very quickly. They all look like winners when you write the check...you just don’t know which ones will fail. But if you invest smartly, and spread your risk over a large portfolio, the winners will pay for all the losers and return a nice overall profit. The return on investment in AirBnB or Dropbox could pay for all other investments. But, no matter how smart we think we are at avoiding risky startups, we can miss on surprising “unicorn” winners too.
DropBox is one of those Ycombinator Cambridge winners that most investors missed, including me. Drew Houston was born in Acton, and met his co-founder Arash Ferdowsi at MIT. They were part of the Ycombinator Cambridge class of 2007, after being rejected by YC in 2005 and 2006. I remember the Demo Day in 2007 where DropBox presented to about 30 Boston area Angels and Venture Capital investors. None of the local VC firms invested. Seeing little opportunity here, Drew and Arash moved the company to Silicon Valley later that year. They got their initial funding of $1.2M from Sequoia Capital and have gone on to raise over $1 Billion from VC investors. Dropbox is expected to IPO in 2015 at a valuation exceeding $10 Billion.
In fairness to the investors in the room that day in Cambridge it was not at all obvious that Dropbox would succeed. The problem they were solving was not one I had experienced, and the product demo didn’t work very well at the time. Two years earlier I saw another Boston based startup called Carbonite pitch a similar cloud backup solution to investors. Many investors passed on that too. The reason was that Microsoft, Google, Apple, and other large technology companies already offered cloud file storage and backup for free or very low cost.
How could Dropbox possibly compete with Microsoft, Google, and Apple? Well, Dropbox focused on User Experience, ease of use, and cross platform support. Dropbox was so simple to use, anyone could do it. Simply drag a file and drop it in the Dropbox icon. No navigating through drop-down menus, file structures, etc. Dropbox also synched all your files in the background automatically. No action required. In addition, YC helped them identify the early adopters, how to get viral growth, and how to get the “Freemium” upsell model to work.
So, what is Ycombinator? It is literally a mathematical term for a recursive function in calculus, and a good metaphor for what YCombinator does. It is a startup that creates more startups. Ycombinator acts like a recursive loop that attracts the best entrepreneurs, which attracts the best investors, and the highest valuations, which attracts the best advisors, which comes full circle to attract the best entrepreneurs.
Why do startups join the Ycombinator program? It is like a 3 month boot camp for startups. You learn everything you need to know about how to build a company. Ycombinator brings in the most successful startup founders to share their experiences building startups. They bring in experts in legal, finance, marketing, business development, design, engineering, advertising, growth hacking, and other areas. You get help refining your product vision, identifying the market, working out your business model, putting together your investor pitch, and at the end of the program, the Investor Demo Day. You will present in front of hundreds of the most successful Angel investors and Venture Capital investors.
For several years Ycombinator held a summer session in Cambridge, Massachusetts and a winter session in Mountain View, California. After comparing the results of the program, and especially the local investor participation, it became clear they could be more successful holding both sessions in Silicon Valley. Despite deep local roots in Boston and strong ties to Harvard and MIT, they decided to shut down Ycombinator Cambridge and moved everything to Silicon Valley in January of 2009.
Back in 2005 no one anticipated the success of YCombinator, not even its founders. Two years later in 2007 I interviewed Paul and asked him why he started Ycombinator. He said “Actually we're doing it more to help the world than individual founders. We think the world would be immensely more productive if the best hackers started their own companies instead of marching off to work in cube farms. Think how much more Larry and Sergey did as startup founders than they would have done if they'd gone to work for a big company. Imagine that multiplied by a hundred or a thousand.
We want to make at least enough money that we don't have to stop. It would be nice to make more, but so far we have no idea whether this would be worth doing from a purely financial point of view. Classic VC funding is a well-understood model. What we're doing is very different. We have no idea if it will work.”
Eight years later we know it worked spectacularly well. Ycombinator, the incubator of billion dollar unicorns, is a unicorn itself.
This is amazing when you consider that back in 2005 Facebook, YouTube, Twitter, iPhone, and many of the successful product platforms that enabled startup innovation didn’t exist or were not well known. There were no billion dollar unicorn startups. The typical tech startup would raise about $1M on a $3M valuation. The average investor would invest $25K to $50K, and hope for an exit in 5 years that might return 5 to 10 times their money.
The first few years at Ycombinator there were about 10 companies per session, and maybe 20 to 30 investors would show up at demo day. The presentations were folksy and unpolished. The companies were valued at around $3M, and rarely above $5M.
Ten years later there are 114 companies presenting very polished pitches to over 500 investors spread over two days. The valuations have skyrocketed to $10M to $20M or more. The hottest companies close their investment rounds very quickly, and typically have half the money raised from inside advisors before the Demo Day. The prices have increased substantially, but the risk has not been reduced commensurately.
It has never been easier to start a company, but it has never been harder to build a sustainable business. It is cheaper and easier to start a company today, and there is ample investment capital to fund it. There are lots of startup accelerators to help get the company off the ground. But, there is also a lot more competition for attention.
Some investors are now spending more time prospecting startups in Boston or New York where valuations are more reasonable, and the competition is less intense. Steve Case, former founder of AOL, Startup America and Revolution Ventures, has taken it a step further. His “Rise Of The Rest” campaign goes to middle America to fund startups outside of the big tech hubs, where the valuations are far lower, and the capital is much more needed.
Ycombinator started in Cambridge 10 years ago. Its greatest legacy, beyond the many successful companies, might be that it paved the way for many other startup incubators to be successful in attracting talented founders.
TechStars Boston and MassChallenge are doing a great job accelerating local startups. Bolt, Blade, UMass Venture Development Center, and several others are also supporting the Boston startup ecosystem. The city of Boston recently announced a new “startup czar” to help stimulate the local startup community.
Boston area investors have been more cautious than their west coast counterparts. Facebook was started by Mark Zuckerberg in his Harvard dorm. He moved the company to Silicon Valley to find the risk takers who would join him in building the company. This must change! Boston has great universities, experienced entrepreneurs, and plenty of venture capital. We need a concerted effort from investors to step up, get involved, and support local startup founders.
Don Dodge is a Partner Developer Advocate for Google, and an advisor to Google Ventures. Don is also an Angel investor in over 30 technology startups, several of them from Ycombinator and TechStars. Prior to Google Don was a Technology Evangelist for Microsoft.
This is a longer, unabridged version of a guest column I wrote for the Boston Globe Sunday edition.