Why the seed investment bubble is exactly that

Jed Christiansen wrote a thesis on the rise of Y-combinator and other seed-accelerators. He also released the data behind his research, which gives an insight into the success of the seed-accelerators. It’s fascinating to look at these numbers, because Silicon Valley is seeing a bubble emerge — and unlike the previous ones like the Dot Com boom when people realised the potential of websites, or the Web2.0 bubble where shiny AJAX and social was the new black — now we are seeing a bubble emerge on the ‘backend’ through the capital investors.

Why is it a bubble? Well first of all, the hype. Last March at SxSW, I met Mark Nathan who told me he was helping yet another seed accelerator. He told me that 44 of them had been created to date in the US. That and the recent success of Angel List by the Venture Hacks crew — which is effectively commoditising the seed market — is seeing a mini revolution occur in the tech sector.

But as I sit here with my buddy Stephen Weir: a serial entrepreneur who’s invented the spoon-less yoghurt cup, licenced super model of the world for a reality TV show, tried the tech startup thing (like launching the biggest online invitation website in Japan and a reward based mobile gambling application on all three carriers in Japan) but now works in property — we asked, are the returns actually supporting this hype?

How good a business is it

Christiansen says the following:

Y Combinator and TechStars are two of the oldest seed accelerators, and are the only two to have had substantial exits. The TechStars exits have likely already generated a profit, and there are several companies that may still exit at some point in the future. The Y Combinator company exits have likely already brought Y Combinator to break-even, even after having funded over 100 companies. More impressive is that there are a good number of companies in the portfolio that could reach substantial exits at some point in the future. (And potentially a handful that could reach the vaunted $1billion+ exit.)

Y Combinator for example has funded 206 companies to date. At an average $10k in capital as well as $600 in travel costs (applicant companies can get up to $600 in reimbursement costs), they’ve put at least $2m in seed capital and assuming 10-20% of companies get accepted (an assumption by us), then reimbursed travel costs are between $450-900k.  (Note: this is extremely conservative to the point of unrealistic, as companies receives $10k per person so the cost is actually  closer to double or $4m in seed investment — but we’re doing this to prove a point.)

And what’s the return? According to Christiansen, of the 206 companies invested in Y Combinator there has been $89,008,000 in exist value generated. Y Combinator claims the average stake in each company is 6-7%, so the group made $5,340,480 on a 6% return. But we think the companies that actually exited would have been able to negotiate a lower rate, as well as the fact Y Combinator would have got diluted by some of the companies that took additional funding. If we use 4%, then the return is $3,560, 320.

After five years, that’s a gross profit of between anywhere between 500k (assuming 900k travel costs, and 4% return) to $3m (assuming 450k travel costs and 6% return). That means on a conservative back-of-envelope guess, the operational side of Y-Combinator gets about $600k a year, which is what a fund manager would make.

Our conclusion

When paying out salary costs and other admin expenses, break-even seems very likely. Or at least, the profits are very ordinary right now. Put a more realistic capital base of 20k per startup, and you’ve got a terrible loss making business in the medium term. Now to be fair, this is doing it over only a few years. For this analysis to be really accurate, it needs to take into account that the window for a return is ten years – you can’t do dollars-in dollars-out in just three years. Otherwise, how would firms like Sequoia have existed so long. And Y Combinator has got some super-star startups that are the talk of the town now, like Dropbox and Airbnb — an exit on either of those will make a huge difference.

But that said, looking at this at a  high level, we’re not sure if the hype is justified. Paul Graham may emerge a wealthy man, but we don’t know how the other 43 seed accelerators will.

4 Responses to “Why the seed investment bubble is exactly that”

  • Elias: while i won't dispute there may be a seed bubble, i'm not sure your numbers are on target. your math may be reasonably accurate, however your data is highly suspect and your sample size is extremely limited. you draw very specific numeric conclusions from either limited or no data at all, which i'd suggest is misinformed numerical analysis at best (& shoddy blogging / journalism to boot).

    even if you're anywhere close to accurate, to assume that 2 single incubators (YC & TS) are an indictment of the entire industry — an industry that might have widely varying models, diff ownership, diff follow-on models, etc — seems extremely narrow-minded. again, while i may not disagree there's a lot of idiots out there (myself perhaps included) throwing capital to the wind, YOU HAVE VERY LITTLE DATA TO MAKE ANY INFORMED ANALYSIS WHATSOEVER.

    other folks with such limited data might either offer an extreme amount of caveats and mea culpas about any opinions they might draw… and others even more thoughtful might just keep silent entirely until there was a hell of a lot more data to draw any such conclusions.

    biased & respectfully yours,

    – dave mcclure

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