Y Combinator & Other Seed Funding Basics for Entrepreneurial Business Students
At some point during business school, many MBA students will have an opportunity to join a startup company and some will even launch startups as founders. For some students, launching a startup is the objective that drives their applications to business school, especially to schools known for their knack for spawning successful startups like the Stanford Graduate School of Business and Harvard Business School.
One of the earliest choices facing MBA startup founders involves how to go about raising the initial capital for their firm, which is known as “seed” capital. This report presents some tips for MBA students on how to approach this challenge.
Some of this topic’s most useful thought leadership has originated from startup accelerators. Also known as seed accelerators, these organizations blend investments with several of the best elements of an MBA program. These features include cohort-based education, combined with mentorship and networking connections among a community.
But unlike MBA programs, many accelerators culminate after several months in a public demonstration or pitch event before an audience of potential investors that’s live-streamed online. Also, unlike business schools, accelerators typically operate in partnership with private funds that invest in portfolio companies in exchange for a share of the firm’s ownership.
What is Y Combinator?
Although thousands of accelerators now exist, one of the oldest and perhaps the best known of these accelerators is the Silicon Valley-based Y Combinator, or YC for short. Firms launched by Y Combinator include several unicorns, startup companies with valuations over $1 billion. These include Stripe, which at the time of this writing was valued at over $35 billion. They also include Airbnb, Dropbox, Cruise, Coinbase, Instacart, DoorDash, Zenefits, Reddit, and Twitch. We discuss several of these unicorns in our study of the highest-valued unicorns with MBA founders.
Although about 13,000 companies applied for a recent Y Combinator cohort of only 240 firms—making it more than twice as difficult to get into as Stanford University—the accelerator’s leadership has made some of their best advice available online at no charge.
Why Fundraise for Startups?
Geoff Ralston, Y Combinator’s president, offers some useful advice about seed fundraising. Ralston points out that right away, startups need to rent office space and purchase equipment. More importantly, startups require fast growth. In fact, one of Ralston’s colleagues—Y Combinator’s co-founder Paul Graham—defines a startup as a company designed for fast growth. That definition stands in contrast to that espoused by Professor Steve Blank, who defines a startup as a temporary organization designed for business model hypothesis testing.
Ralston asserts that in almost every case, a startup will require outside capital:
Without startup funding the vast majority of startups will die. The amount of money needed to take a startup to profitability is usually well beyond the ability of founders and their friends and family to finance. . .High growth companies almost always need to burn capital to sustain their growth prior to achieving profitability. A few startup companies do successfully bootstrap (self-fund) themselves, but they are the exception.
Mailchimp is a good example of a bootstrapped company, and there are others, especially in software and online services. Moreover, experts recommend that, if they can, founders try to self-fund by generating income through sales for as long as possible. That’s because every dollar raised in seed funding extracts a price from the founders, who need to relinquish a share of the firm in exchange, which dilutes their ownership stake.
But successful, self-funded firms are relatively rare. Besides promoting growth, cash infusions provide competitive advantages over other startups against whom the firm needs to win market share. Those advantages accrue because investment capital allows a firm to hire key staff and conduct effective business development, marketing, sales and public relations.
When Should Founders Approach Investors?
Ralston believes that founders first need the ability to tell potential investors a persuasive story containing three elements:
- A real, sufficiently large market opportunity
- A compelling business concept
- A founding team capable of realizing their vision
A few investors will only need those three story elements, plus the founders’ reputation. Some investors won’t even need to see a pitch deck.
But most need not only a concept but also a demo of a working prototype along with “traction,” which is startup lingo for sales to early adopters. Fortunately, these days developers can build an MVP—a minimum viable product—in a remarkably short period, especially if it’s a mobile or web application. And since about 2006, when Amazon Web Services introduced cloud computing, the costs of the infrastructure needed to host and scale these products has plummeted.
Those essentials might be necessary, but they’re not sufficient, claims Ralston. He cautions that investors will also need to see a close fit between the product and the market, as well as growing traction. Once they meet those tests, founders will be ready to start raising capital as soon as they are certain they have identified the customers, understand the market opportunity, and delivered an MVP that meets customer needs. Because founders need to impress investors, Ralston suggests that, ideally, a brisk adoption rate of 10 percent per week indicates sufficiently rapid adoption.
Types of Seed Investors
The current “seed fund boom” has resulted in a wide variety of investors. Generally, angel investors are wealthy amateurs who invest their own seed money in startups, often at a fast pace, on their own terms, and for emotional reasons.
Venture capitalists (VCs) are professionals who invest other people’s seed funding, often pooled through investor syndicates. One estimate reports that a typical Sand Hill Road venture capitalist in Silicon Valley’s Menlo Park evaluates a deal flow at the rate of about twenty a day—almost three proposals an hour—but only invests in a handful each year.
As we point out in our guide titled Business Plan Competitions – Rice University & Others With Large Prize Pools, somewhere between angel investors and venture capital firms lies an intermediate category comprising “super angel” or “micro VC” investors. This type of investor funds new, seed-stage startups and is extremely active at funding the finalists in university business plan competitions like the Rice Business Plan Competition and the International Business Model Competition. These investors also tend to appear on websites like the FundersClub and the AngelList.
Prioritizing Investor Contacts
There are three stages of priorities in efforts to meet investors. A rare opportunity to meet a lot of investors rapidly would be through a presentation at a demo day event. Examples include those held by an accelerator like Y Combinator, the online publisher TechCrunch’s Disrupt SF Conference held each October in San Francisco, and yearly in other venues in the United States and Europe.
The second stage would be through a warm introduction in which angels introduce promising founders to their investor networks. MBA founders might also be able to find someone in their network, possibly through their business school faculty or LinkedIn, who might offer an introduction to a potential investor.
For founders without other options, the third stage involves research to disclose fundraising opportunities. Fortunately, the names of investors who have supplied seed capital within the past year or so to startup founders who are MBA students or recent graduates are not state secrets.
Poets and Quants publishes an annual roundup of these firms, although not every one of these investors will work with all founders. Besides accelerators like Y Combinator that restrict entry through their own competitive application processes, some universities have set up networks for their own students and graduates, such as StartX for Stanford’s community and the Graduate Syndicate for Harvard’s. But a fair number of investors on this list would welcome proposals from any founder irrespective of their university affiliation. One example involves the Dorm Room Fund that works through a network of affiliates through college campuses across the United States.
But even though one can obtain the names of potential investors from lists published by Poets and Quants and those disclosed periodically by publications like TechCrunch and Forbes, should one take that process further? Another Y Combinator executive, Aaron Harris, offers advice in this YouTube video lecture:
Most investors are very happy to tweet about things that interest them, like companies they’ve invested in. They write blogs about ideas they have and companies that they want to see exist. They have prolific profiles online based on the companies they’ve started in the past. You should go and research every single investor that you want to talk to and figure out a way to get in front of them with a custom introduction that is relevant to them—and to you.
Sample Messages to Investors
Are investors receptive to cold email messages? Absolutely, says Harris. All investors are receptive to email messages from founders. However, some email messages are better than others. For example, consider this example provided by Harris of a terrible email message:
Dear Sir or Madam —
I have noticed, in my research on the internet, that you are an investor in technology companies. I’d like to introduce you to an opportunity to make money in this new and exciting field!
May I come to your office for an hour to present you with this opportunity?
What’s wrong with this email message?
- It’s a canned, impersonal form message; the founder doesn’t even address the recipient by their name.
- The author fails to introduce themselves by telling the investor who they are or what they do.
- The first line is a useless “so what?” that wastes an opportunity to grab the reader’s attention.
- The writer says nothing to suggest that they’ve done any work to understand what the investor might be interested in.
- The tone seems patronizing. The second line makes the writer appear foolish because savvy technology investors already know about most current opportunities.
- The third line asks for too much of an investment: it asks the reader to sit through an in-person sales pitch lasting an hour—an eternity for most investors. The only constraint that limits investors is their time, so according to Harris, they want to give that time to the people that matter the most.
Now consider the following message:
I’m building a marketplace for home cleaners. I have a novel approach to this — all of the cleaners are robots. We’ve launched, and are just starting to grow.
I think you’d be a great investor for us because of your experience with Homejoy. I think we’ve solved unit economics and reliability. Can we discuss this for 15 minutes? Happy to email if that’s better for you.
What’s better about this email message?
- It’s personal: the founder, Aaron, addresses the recipient by name. What’s more, this message shows that the author has done their homework because Aaron knows that Adora previously built a successful online marketplace for home services, called Homejoy, and knows she thinks robots are cool. Without delay, Aaron mirrors their shared experience in the first line.
- The founder suggests that they’ve already differentiated their product against competitors through a novel approach.
- Aaron not only talks about their launch, but talks about growth as well. According to Harris, this language clearly tells Adora the stage of the startup. The buzzwords in this “magic language” implies that the new firm is already gaining traction through early sales. “Launched” is great because it proves activity. But “just starting to grow” is intriguing; the latter language prompts the investor to want to ask a series of questions like, “How much are you starting to grow? How fast? How are you measuring growth? And how do these things—the robots—work?”
- Aaron doesn’t ask for much. He only asks for 15 minutes, and neither asks for a personal meeting nor any mechanism of communicating with Adora. Adora should love the line “Happy to email if that’s better for you” if she’s busy or traveling because that way she can address the first set of questions over email. Harris says that if a founder asked thoughtful questions over email, he is more inclined to meet the investor, and will walk into the meeting with a positive understanding of their actions and context.
- The additional magic language “I think we’ve solved unit economics and reliability” will immediately resonate with Adora, who has talked about why these concepts are so important in her YouTube lectures. She is well aware through her experience that these are two of the most difficult challenges faced by this kind of business. Overcoming these challenges indicates this firm may already have achieved a viable product/market fit.
Harris calls this message a “slam dunk” that’s almost certain to get a reply from Adora, even as a cold email. Instead of spam, it’s a specific, relevant message about a product the investor will find interesting.
Legal Steps Before Investor Meetings
To be sure, the founders will first need to take a few legal steps before contacting potential investors through an email campaign like this one. For example, they’ll need to have previously incorporated because the business risk would be too great for investors to involve themselves otherwise.
They’ll also need to familiarize themselves with equity investments through which they can exchange partial ownership of the firm for investors’ cash. One such vehicle that has gained popularity is known as a SAFE, or “Simple Agreement for Future Equity.” Similar to a warrant, this is a contract between the firm and an investor that grants the investor rights to a future equity stake, even though the contract doesn’t stipulate a specified price per share of stock at the time of the initial investment. Instead of convertible notes, SAFEs offer a simpler mechanism through which startups can obtain seed funding.
But after paying attention to the legalities, founders should find that the tips above go a long way towards helping an MBA student startup receive their first infusion of critical seed funding.