A little more than a decade ago, it used to be a much costlier undertaking to start a new technology business, particularly in software. The cloud and distributed computing has changed all that.

So has the growth of accelerators, like Y Combinator and TechStars and others that provide small amounts of seed funding to startups in exchange for some equity in your business. But in contrast to a decade ago, that small amount of money goes further. That, plus the connections and mentoring that accelerators typically offer, has gone a long way toward displacing the importance of traditional venture capitalists in financing early stage companies. And that's likely to be a good thing for you.

"Now, if you go to an accelerator like YC or Techstars you have exposure to huge numbers of investors and a big network to help you," says Yael Hochberg, Ralph S. O’Connor Associate Professor in Entrepreneurship at Rice University Jones Graduate School of Business. Hochberg also compiles an annual ranking of best accelerators.

In the past, venture capitalists had the upper hand, Hochberg says. You had to get a "warm" introduction to one, and then they took their time getting back to you, especially if they were interested in your company and knew you were running out of money. You also needed larger sums from them--typically on the order of millions of dollars. And even if you you didn't always approach them for money--say for instance, if you were also interested in leveraging their connections to help get your business off the ground--the dynamics of operating in a closed environment also favored them and the deals they made.

A New Paradigm

Accelerators have turned all that on its head. The seed funding they offer, generally between $25,000 and $100,000 in exchange for an equity stake of between five percent and seven percent, is a lot more useful and sustaining to entrepreneurs now than it might have been years ago. The best accelerators also have a thicket of connections every bit as useful as venture capitalists who come in for later funding rounds. And when they send their companies out for so-called demo days, not one but dozens of venture capitalists show up to bid.

"When you talk to VCs on demo day, 100 people are competing in an atmosphere that's closer to an auction," Hochberg says.

That, in turn, is driving up the value of startups chosen by some of the leading accelerators. The average valuations of a Y Combinator-funded firm in 2013 and 2014 was between $40 million and $50 million, according to TechCrunch and others. The success of businesses that have emerged from accelerators--and they are some of the biggest names in tech today, including Airbnb, Dropbox, Reddit, which all cycled through Y Combinator--has also edged out VCs in other ways. Typically the funds associated with accelerators relied heavily on investments from venture capitalists, who often took on roles as limted partners to establish a window on the accelerator companies. The huge success of many of the portfolio businesses has allowed some of the funds to begin operating indpendently, Hochberg says. 

Nevertheless, some venture capitalists claim to like the changes brought about by accelerators, even if that means more competition. Canaan Partners, of Westport, Connecticut, for example has invested in several Y Combinator companies in the past year, including cost-cutting travel startup RockeTrip and online grocery shopping company Instacart. Those companies received $2.6 million and $44 million respectively in funding in 2014. 

"Because the ecosystem has become more transparent you are always competing with other firms," says Ross Fubini, a partner at Canaan, who adds startups are still likely to choose the best venture capital firm, rather than the highest valuation.

Entering the Fray

Meanwhile, some VCs have started their own accelerators to spot and support early stage companies that might make worthwhile investments later on.

Second Century Ventures (SCV), which invests primarily in real-estate focused companies, started an accelerator it calls REach in late 2012. The accelerator, which works with companies that are pre-revenue to $11 million in revenue annually, takes an equity stake of between two percent and five percent, but not in exchange for money. Instead, it offers a nine-month educational program, as well as mentorship and a 1,600 person "insights panel." The panel, made up of real estate companies, lets the accelerator companies test their products directly with them.

Of the 15 companies that have participated in the accelerator, nine have raised close to $30 million, primarily from other VCs, but also from SCV. And some, including electronic signature startup Docusign, have found their products resonate outside the real estate industry. 

"Between the mentorship and insights panel, it helps the companies develop strategically and create products designed for this industry" and potentially others, says Constance Freedman, a managing director of REach and SCV. 

 

Published on: Sep 12, 2014