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Investing in undervalued human capital: the Y Combinator model

by Michael Nielsen on March 13, 2008

Y Combinator (YC) is a small Cambridge-based firm that for the past few years has been carrying out a remarkable experiment. What they’ve been doing is investing money and training in (mostly) young hackers, helping them get technology companies up and running to the point where more more conventional investment processes like venture capital can kick in. Many YC funded companies have been successful, with several making their founders wealthy at an early age.

At first glance, YC may appear only of interest to business or technology people. In fact, there are broader things one may learn from the model, with applications and importance outside business and technology.

If you’re not familiar with how YC works, it goes something like this. Twice a year, YC calls for applications to be submitted, either for its Winter or its Summer programs. Applications are submitted by small teams of people (“founders”), typically in their twenties, who would like to start or have recently started a technology company. YC evaluates the applications, and the best are asked to join the YC program. Successful applicants typically receive $5k + $5k per founder to support them for three months, and are required to move to Boston (for the Summer program), or the San Francisco Bay Area (for the Winter program). All the YC teams meet together once or twice a week, to talk with each other and with the YC partners, as well as with a changing cast of expert entrepeneurs specially brought in from outside. The three month program concludes with “Demo Day”, where the founders demonstrate what they’ve built to a large group of angel investors and venture capitalists, in the hopes of sparking further interest. In return for this program, the founders give up a small percentage of their company, typically between 2 and 10 percent.

What makes the YC program successful is that YC have identified a large group of people whose talents were previously undervalued and underutilized, in large part because of their age and lack of experience. For more than thirty years, high-school geeks have played with technology, gone off to university, where they continue to play with technology, often doing astounding and innovative things, but rarely having the entrepeneurial skills or connections to turn their ideas into marketable products. At the end of it all, they go off to work for a big established technology company like Microsoft.

YC has asked a big “what if?” question: what if we gave these talented people an opportunity to build their own company, from the ground up, and gave them training in entrepeneurial skills they lack, complementary to their existing technical ability? Might it be that if we provide this training (which is relatively easy to do), then these people will create more value than if they were off working for big existing technology companies?

It is evident from the above description that this process can be abstracted away to a core unrelated to technology:

  • Identify a talented group of people who are at present undervalued, i.e., not being given an opportunity to contribute commensurate with their talents.
  • Set up a competitive program whereby people in your target group can apply for support.
  • Select the best applicants for support.
  • Help educate successful applicants, trading off the costs of the education against the value that comes from their increased probability of success.
  • Make sure you market yourself to the desired group of people, so you get the best possible pool of candidates (e.g., here and here).

What’s special about YC is the group they’ve identified: young hackers, whose lack of experience means they often have a hard time being considered seriously by existing investors such as venture capitalists. Ironically, this is in part because the venture fund model typically involves investments that are, at a minimum, hundreds of thousands of dollars. Given a choice between investing that money in a 35-year old Harvard MBA’s startup, and a team of three unshaven 21 year-old hackers, most venture partners will go for the Harvard MBA. Part of YC’s insight is that in 2008 many technology companies can be launched for just a few tens of thousands of dollars, far less than the venture funds provide.

Other organizations have adopted an analogous strategy to YC, but for a different group of otherwise undervalued people. A good example is microfinance organizations like the Grameen Bank, which provide small loans to assist entrepeneurs in the developing world. The success of the Grameen Bank indicates that investors previously underestimated the talents of the lendees to build successful businesses. An interesting social consequence common to YC and the Grameen Bank is that both empower people who are otherwise somewhat disenfranchised. (Obviously, the effect is far greater in the case of the Grameen Bank.)

This process of identifiying a talented group of people who are undervalued by the investment market is a curious one. An uncritical advocate of the free market might counter that such people shouldn’t exist – surely investors would have already tracked them down, and offered to invest. In fact, YC is a clear case where (up to now) the market has failed badly, due to the blinkered narrowness of investors. Is it more risky to offer one million dollars to finance a Harvard MBA in their new technology venture, or to fund twenty groups of talented twenty-one year old hackers, at a cost of about $50k each (including the training costs and other overheads)? My money would be on the twenty-one year olds to make a greater aggregate return, but I suspect most investors would feel much safer going with the Harvard MBA – even if they fail, it’s a lot easier to defend your choice to your peers.

What other undervalued sources of human capital might this general model be applied to? When I started to think about this question, I quickly came up with dozens of possible groups. Here’s the first few that came to mind:

  • Talented people who happen to have been born in the wrong place for their talents to flourish. The top students at (for example) the big IITs in India are incredibly talented. While India offers increasing opportunities for technology entrepeneurs, imagine the results of bringing some of the more entrepeneurial students to Silicon Valley, and helping them get set up with technology companies. Think YC with a visa program.
  • The elderly. As a society, we cut many extremely talented and active people off from contributing society, at great cost to them, and to society as a whole. It’d be great to find ways their talents could be made better use of.
  • Bright PhD students in insanely competitive and challenging academic subjects, where even extraordinary students may have trouble getting good academic jobs, and where those same students may lack the connections to find jobs outside academia that make good use of their talents.
  • My current hometown of Waterloo, Canada, is a pretty good setting for a YC style program. It has a growing startup culture, and two universities (University of Waterloo and Wilfred Laurier University) with, respectively, strong technology and business programs. As a rough indicator of student quality, in programming and mathematics competitions, University of Waterloo students are routinely competitive with the best from MIT and other top US Universities. At present, many of these students go to work for large technology companies elsewhere – the University of Waterloo is sometimes said to be Microsoft’s single largest recruiting target. Something like YC would, I think, be highly successful here, although it would need to compensate for a relative paucity of local investors.

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6 Comments
  1. “An uncritical advocate of the free market might counter that such people shouldn’t exist – surely investors would have already tracked them down, and offered to invest.”

    This raises an interesting paradox, which I really hope the economists have already thought of. Namely, suppose investors believe that the market works in this way. Then they won’t bother tracking down people like those that YC invests in, because surely somebody has found them already! So they don’t… which leaves YC to come in and actually find those people. The market is efficient, it appears, if and only if people believe it isn’t.

  2. Michael Nielsen permalink

    And then there’s the old story about the economist who would’t lean down to pick up the twenty dollar note somebody had dropped on the ground – if it was really there, somebody would have picked it up already.

  3. Robin Blume-Kohout permalink

    Isabel,

    Your conclusion — “The market is efficient… if and only if people believe it isn’t” is a trenchant and pithy summary of a curious situation! Another phrasing makes it look a bit less paradoxical, though: The market is efficient only because it rewards people who fix its inefficiencies.

    So, from this perspective, YC is an integral part of a market investment system — because the ability of the whole great beast to find optimal (efficient) configurations depends on the fact that when there’s a flaw, somebody smart like Paul Graham will come along and fix it. While making a bunch of dough in the process.

  4. Vaidya permalink

    I’m delighted with this article … from last couple of years i’m suggesting YC model for India and Canada mainly because I’m an Indo-Canadain so I have first hand experience regarding huge talent pool in these two countries. It is just the matter of time but its sad that YC model is not yet in available in these countries. If i get little bit of support (mainly from VCs) then I would start on my own to tap these talents.

    Any takers?

  5. There’s been a lot of talk and ever-present rumors about starting up a ‘YC-like’ clone in the Waterloo region. Only time will tell if it will ever come true..

    On that note, Michael one thing you did not consider is the concept of ‘incubators’ vs YC. There are at least 3-4 early stage incubators in the Waterloo-Toronto region, but you barely hear about them, nor have I seen or heard of any spectacular successes coming out of them. The question begs itself: what’s different, and why aren’t they jumping at the opportunity?

  6. Michael Nielsen permalink

    Ilya: yeah, I’ve not heard much about them, either. I don’t know enough about them to know why that is.

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