Y Combinator, the X Factor of tech

IT SOUNDED like an oddball idea, but that is how many breakthroughs in Silicon Valley begin. In late 2008 three young men applied to Y Combinator (YC), a school for startups, looking for help with their tiny firm, AirBed & Breakfast, a website that helped people rent out inflatable mattresses in their living-rooms during conferences. Paul Graham, one of YC’s founders, did not think much of their idea, but liked their pluck. Strapped for cash, the three had sold novelty breakfast cereals during the presidential election (Obama O’s and Cap’n McCains) to earn enough money to keep their startup going. Mr Graham and his partners at YC helped them to refine their idea and meet early investors. Today Airbnb, as their firm is now known, rents out whole apartments in 190 countries and is one of the most talked-about startups, valued at $25.5 billion.

Since 2005 YC has taken on batches of promising founders, and this month will celebrate the funding of its 1,000th startup. Though about half of its startups have failed, which is typical of early-stage investing, it has had a head-turning record of success. In addition to Airbnb, YC has had a hand in Dropbox, a cloud-storage firm, and Stripe, a payments company (see table). Eight of its firms have become what Valley folk call “unicorns”, valued at $1 billion or more. Combined, the companies it has invested in are worth around $65 billion (based on their most recent funding round), although YC’s share is only a small fraction of that total—perhaps $1 billion-$2 billion.

It is because of this record that YC has become a juggernaut in Silicon Valley. Today fast-growing startups, not big incumbents like HP (see article), are celebrated as the centres of innovation and influence in technology. By providing training and producing a group of successful alumni, YC has helped popularise the idea that startups are a viable career.

Aspiring entrepreneurs clamour to attend the three-month YC programme, as much for what they learn there as for the stamp of approval and network they can claim when they leave. Just as an Ivy League degree opens doors in certain professions, graduating from YC is a priceless asset in the tech industry. For its spring 2015 batch YC received more than 6,700 applications and accepted around 1.6% of them. In contrast, Harvard’s admissions process this year was the most competitive in its history, yet its admissions rate was 5.3%.

Investor, teacher, talent-show judge

Paul Graham, an entrepreneur who sold his startup, Viaweb, to Yahoo in 1998, started YC with Jessica Livingston, a banker, and two Viaweb colleagues, Trevor Blackwell and Robert Morris, ten years ago. They hoped to devise a more efficient way to invest in startups but never expected to make a fortune. They stumbled upon a formula that melds the best of an investment firm and a university, and which in some respects also resembles television talent shows such as “The X Factor”. YC admits batches of startups in classes, and each receives coaching on how to refine their product—though they are usually not quite as blunt as Simon Cowell.

YC’s small campus in Mountain View, a short zip down the freeway from the Googleplex, has long tables reminiscent of a dining hall. The classroom setting creates a sense of paranoia and competition, encouraging entrepreneurs to accomplish in a few months what might otherwise take far longer. The programme teaches engineers—some of whose idea of a polished pitch is to look at your shoes rather than their own while speaking—how to sell their ideas to investors.

At the end of three months they graduate at “demo day”, when they deliver a presentation about their business to a group of the Valley’s top investors, who plan their schedules around it, like tennis fans booking seats for the Wimbledon finals. Demo day fosters a sense of urgency, because investors have only a limited opportunity to see a business and decide whether to back it. Venture capitalists complain that YC has pushed up prices for startups, which is probably true. YC typically pays all those it admits $120,000 in return for a 7% stake, valuing each one initially at more than $1m. Sam Altman, YC’s president, says there is “no question YC has driven up the price of early-stage investing…But I think in the long run it’s going to be in investors’ interest, because there will be better companies.”

In its investments YC has benefited from the power of “network effects”, the notion that a platform becomes more valuable the more people use it. As it grows, YC has become better at what it does, by enlisting its alumni to find new applicants, advise those going through the programme and be the first testers of their products. Some of the earliest users of Stripe, for example, had come out of YC, says Patrick Collison, one of Stripe’s founders. They even have their own private social network, cheekily titled Bookface. Mr Graham’s frequent blogposts on his startup philosophy are quoted like scripture by many in the Valley.

YC has also given startup founders more negotiating muscle with investors by acting as a sort of union to protect their rights. “If an investor is abusive toward a YC founder, we’re going to remember, and we’re going to let other YC founders know about it,” says Paul Buchheit, a partner who was the creator of Gmail, Google’s e-mail service. YC discreetly maintains a ranking of investors, and lets its startups, but no one else, glimpse at it. All this has changed the power relationship compared with the past, when “venture capitalists treated entrepreneurs like employees rather than the talent,” says Steve Blank, an entrepreneur and academic.

YC has taken care to avoid one of the pitfalls that many firms, in tech, investment and other industries, fall into: succession. Last year Mr Graham, who had been running YC, chose Mr Altman as his replacement. He had been among the first batch of YC startups and sold his firm, Loopt, in 2012, for around $43m (it is not known how profitable this was for investors). The energetic and ambitious Mr Altman, aged 30, wants to make YC even more influential than now. Last month YC raised a $700m fund to invest in YC startups at later funding stages. This sort of investing requires different skills, and risks annoying the venture capitalists YC works with, whose turf it is invading.

Mr Altman is also setting his sights beyond the Valley. YC is investing in companies that have not typically been of interest to tech investors, including one that works on nuclear fusion. This year YC launched a “light” version of its programme, an eight-week fellowship, so more people can take part without moving full-time to Silicon Valley for three months, which the core programme requires. This may help attract a more diverse group, and earlier-stage ideas, but it might, again, be a risky move away from YC’s successful formula of the hands-on cultivation of small groups.

Tech firms’ fortunes can turn rapidly, and no one knows that better than a startup factory. Most of YC’s profits are still on paper. With the exception of Twitch, a firm that streams videos of people playing games—acquired by Amazon for nearly $1 billion last year—none of its biggest successes have gone public or been bought. Their valuations could just as easily fall as rise. Some wonder, for example, if Dropbox will be valued so highly once it goes public. If the valuations of some of its stars droop, this could hurt perceptions of YC’s Midas touch.

YC’s partners seem surprisingly uninterested in money, or competitive threats. There are hundreds of other “accelerators” worldwide that have replicated YC’s investment and training philosophy, but none with its brand or its record. The greater risk is not that founders choose to go with a rival, says Mr Altman, but that they decide they can do without advice from any accelerator. That would be another sign that YC had changed the environment for entrepreneurs for the better. But no firm wants to put itself out of business.