How Y Combinator Built A Billion-Dollar Brand For Startups

Seven years ago, Paul Graham and his now-wife Jessica Livingston founded a startup accelerator, Y Combinator.

Since then, it has become the most competitive startup program in the world. Its acceptance rate is compared to that of an Ivy League school, with similar prestige stamped on each graduating startup.

To date, more than 460 startups have gone through the accelerator, and they've gone on to raise more than $1 billion collectively.

Among them are Dropbox, a file sharing and storage company that has raised $275 million at a $4 billion valuation. Airbnb, a consumer-to-consumer room-rental service, has raised $120 million at a $1.3 billion valuation. Socialcam, which graduated from Y Combinator's program in March, was acquired this month for $60 million.

Thanks in part to these successes, Y Combinator startup valuations are climbing. In fact, one Silicon Valley investor thinks Y Combinator's valuations are so high, they're making startups more expensive across the board.

"YC has single handedly jacked up the price of early-stage startups over its last two batches," this investor says.

"The Winter 2012 batch's [average] valuation was $10 million pre-money," he complains. "In 2011 it was $8 million pre-money. The companies have raised at such a valuation that the next step has to be a $50-60 million valuation."

Graham, while flattered by the statement, doesn't believe it.

"If it's true that would be a great compliment, but I don't think we have that much influence," he told us over email.

We spoke with a number of investors; all agreed Y Combinator startups are overpriced. They say Graham has turned Y Combinator into a luxury brand—the Prada of the startup world. And VCs are willing to overpay just to have a Y Combinator outfit in their closets.

How did that happen?

As one investor put it, "Paul Graham is really smart."

Like any luxury product, presentation is everything for a Y Combinator startup.

"Think about alcohol marketing," says a investor.

"What's the difference between a premium vodka and a non-premium vodka? The presentation. Y Combinator knows how to create a luxury product. It knows how to create a sense of scarcity. And it knows how to create a sense of mystery."

A good presentation starts with polishing up the founders. Historically, entrepreneurs have been taken advantage of by VCs. Graham is meticulous when teaching entrepreneurs how to pitch their products so they appeal to both press and investors.

Angel investor Paige Craig explains: "YC is good because it has given a lot of power and education to founders. They learn how to pitch their companies, as well as the tips and tricks of dealing with investors. I see a lot of great companies who really shoot themselves in the foot because they don't know how to play the investing game or explain their products. Graham is giving them a leg up in how to play that game."

"These guys are being coached to go for the jugular of the investor," another investor said.

Investors also say YC startups come in with an attitude most other entrepreneurs don't have. They're elusive and borderline cocky.

"There's a formula for how to go and get people excited," an investor tells us. "People who see a ton of deals can see through it to some degree. But YC is very good at creating the sense that a deal is 'Going, going, gone!' It's not the same process you go through with a non-YC company."

A YC startup founder tells us participants aren't formally coached on how to deal with investors during the program. There's no mandatory class on investor etiquette; most of what's learned comes from discussions over weekly dinners where entrepreneurs can ask guest speakers anything and absorb information.

This founder said the confidence and salesmanship comes more from the situation than from anything Paul Graham teaches them. VCs know hundreds of other investors are eyeing YC companies; YC companies realize they have their pick of the litter. "Normally it's an adversarial relationship between investors and entrepreneurs. Y Combinator just makes the playing field more level," the founder says.

It doesn't hurt YC startup valuations that Graham arms his startups with cash.

YC invests an initial $18,000 into each startup. On top of that, Yuri Milner, the Russian tech investor behind Facebook and Groupon, and Ron Conway's SV Angel offer them $150,000 convertible notes. Investors know the founders aren't money-hungry, which changes the fundamental dynamics of the meeting.

Graham knows he's created a unique situation that tends to work in the entrepreneur's favor.

"Because YC-funded startups are a known quantity to investors and get introduced to enough of them to create serious price competition, companies tend to get higher valuations than they might otherwise," he writes in a blog post.

"I would bet any day that my cap was significantly higher (probably 2x) as a direct result of being part of YC," a YC founder wrote.

Just like they're trained to handle investors, YC founders are trained to impress journalists. Sometimes, Graham reaches out to investors and journalists on behalf of startups to help sell them.

"Graham has been able to create this amazing hype machine," an investor says. "I think it's brilliant to be honest."

So, are Y Combinator startups worth these high valuations?

"It's not a trick," says an investor.

"There are a lot of amazing, amazing companies coming out of Y Combinator. They typically have technical founders too, which is something a lot of other programs don't have. And there's a ton of competition to get into YC. As an investor, it means you have to pay more."

For some investors though, Graham's luxury price has become too much.

"If you're a smart investor, you're not going to participate," we were told.

"A startup that is worth $3 million is able to raise at $5—some wouldn't be able to raise at all if they weren't in YC.  It's a bloat on the price because YC startups get so much press, they're marketed the right way, and it's frustrating," an investor said.

"My guess is you'll see valuations go back down to a more reasonable level," says Craig. "Graham is sharp. He's probably thinking about this already. You can't have a massive investor backlash."