How to do a startup, according to YC data
Lessons learned from studying 4,000+ YC Companies
By most standards, getting into YC represents a success: the admission rate is less than 1%, it invests a significant amount of capital often pre-revenue, and you become a member of an exclusive group that includes the founders of Airbnb, Dropbox, and DoorDash. For the analysis, I used an LLM to embed the companies’ value propositions in a vector space, ran a clustering algorithm on top of the embeddings, manually analyzed the results, and used ChatGPT to edit the draft. The conclusions are surprisingly elegant and powerful.
1. Driving efficiencies
The most common mechanism for creating a venture-backed business is by bringing efficiency to existing markets. This approach is the simplest and least risky because the demand for the product already exists. The promise is to deliver a product that is quantitatively better than what currently exists. There is often little technological uncertainty, as existing technology is applied to a new domain (low R&D). However, it causes significant disruption because it directly challenges existing players. Fundamentally, driving efficiency involves capital reallocation, where the end customer benefits from the disruption of the intermediate layers in the value delivery process.
There are clear distinctions between B2B and B2C startups that aim to drive efficiency. In B2B, efficiencies are geared towards improving or reducing the workforce. Unsurprisingly, sales receive the most attention, as it is a human-driven activity. Another source of efficiency in business is the reduction of transaction costs, which may involve reducing bureaucracy. Typically, it is expected that through automation, workforce productivity will increase, resulting in larger profit margins as the business grows and providing a competitive advantage for early adopters. Consequently, we can expect a myriad of new startups powered by AI as the possibilities for automation increase. Conversely, I was surprised by the large volume of B2B driving-efficiency startups created before the advent of generative AI, as there was little seismic technological movement enabling the entry of new players. I hope that the surge of SaaS is the result of process improvements based on insights discovered through repetition (process power). If so, I would expect the rise of AI startups to gradually increase, peaking somewhere in the next decade.
Consumer-oriented startups that drive efficiency are slightly more interesting but substantially more complex. In B2C, efficiency is passed down to consumers by aggregating demand or creating a marketplace. The first follows a business model similar to Costco, while the second is akin to Uber or Airbnb. Both models require significant capital investment as they depend on creating economies of scale to drive efficiency. This tends to result in winner-takes-all markets, a risky proposition for investors and founders who, despite investing substantial revenue, time, and effort, may end up with nothing. Speed is critical, as the first startup to reach a critical mass has a disproportionate advantage in capturing the market. For the rest, acquisition is the best alternative, but timing is crucial because the business model requires subsidizing the price for customers until economies of scale are reached. I suspect the business acumen of the founder plays a substantial role in the success of these startups, particularly in their ability to attract capital, deliver a superior customer experience (a new paradigm), and act boldly.
Optimally, capital is allocated to offset the switching costs for customers to adopt the new paradigm. In this scenario, venture capital provides the financing for customers to enjoy the efficiency benefits without an upfront commitment. However, there are downsides. First, for customers, there is no guarantee that after switching, the efficiencies will be passed to them indefinitely (cornered resource). Second, companies are exposed to the risk that a new paradigm might replace them by driving greater efficiencies. Given the minimal technological innovation, defensibility needs to be built around size or branding. Third, growth often comes at the expense of triumphing over competition, which creates moral dilemmas not suited for the noble-hearted. Your company may be selling productivity to stakeholders, but it may also be asking to cut jobs to realize the gains associated with the transaction. There is an inherent contradiction in the incentives between the startup and the customers: the startup wants to grow as big as possible, while customers want to maximize efficiency. Personally, I would find it difficult to build my value proposition around driving efficiency without also having the guiding principle of delivering value and taking responsibility (creating parallel solutions) to remediate the value destruction.
2. Removing limitations
After the dire passage through Schumpeterian economics. I’m glad to move forward to startups with brigther aspirations. I was pleasantly surprised by the significant number of companies whose core purpose is serving and bringing value to underserved communities. Particularly in FinTech, which I once considered one of the most uninspiring business models, I now believe that successful startups have some of the most noble missions.
Startups in this category possess greater technological defensibility compared to efficiency-driven startups, striking a delicate balance between technology and domain expertise. Rather than disruption, there is a focus on adaptation and creativity, where novelty, and originality take precedence. However, they encounter the same limitation as efficiency-driven startups: their valuation is constrained by market size. Although the market can grow, or the startup can enter adjacent markets, each expansion attempt carries a commensurate risk due to the absence of true technological innovation. Estimating demand is also more challenging, as it remains unclear what price customers are capable or willing to pay. An unwelcome surprise could arise if, after consolidating the market, the business proves to be unprofitable. Moreover, there are contrarian incentives at play; while removing limitations adds value for customers, it also renders the startup redundant. This necessitates the exploration of business models that only partially solve the problem, potentially fostering long-term dependence or focusing only on recurrent problems.
Adapt an existing solution for underserved communities: Indeed, this is where FinTech finds its niche. A considerable proportion of YC FinTech startups operate on an international market, targeting regions where financial services have low market penetration. This category also encompasses what is known as “technology tropicalization” bringing solutions from advanced ecnomomies to developing markets. I identify three primary reasons that facilitate the establishment of businesses catering to underserved communities. Firstly, incumbents may have been sluggish in expanding into adjacent markets. Secondly, margins may not be lucrative enough to incentivize market leaders. Thirdly, regulatory or regional challenges may necessitate significant modifications to existing solutions. The growth potential of the market is a crucial factor in valuing its economic potential. While the opportunity might not seem significant today, being an early entrant can yield substantial advantages in the future. Typically, the most effective founders have an emotional connection with the community and possess a profound understanding of its needs. However, it’s equally plausible for an expert in a particular solution to seek out a community in need of that solution. The most successful teams may possess deep expertise across both aspects: domain, and solution.
Solve emerging problems, often due to scale, using data: As companies expand, new challenges inevitably arise. Solutions that were effective at smaller scales often prove inadequate when operating across hundreds of countries, with millions of employees, and serving billions of customers. Utilizing data to automate existing solutions emerges as the most successful method of scaling. Data provides the insights that enable the replication of solutions that were previously feasible only through manual efforts. While these solutions may not be flawless, they are operational. One advantage of this business model is that with continued growth, complexity increases, leading to greater rewards. Additionally, data fosters network effects, bringing processing power, and creating a moat around the solution that improves its effectiveness with each new customer. Cloud startups play a significant role in this domain, and the importance of AI is also steadily increasing here. Ideally, founders have firsthand experience with these challenges and possess deep technical skills: new problems require innovative solutions.
Apply technology to increase the availability of a good: Envision a luxury item that is currently beyond your financial reach, but with technology, you could enjoy a comparable experience. This process often involves the productization of a service. This category is evenly balanced between consumer-oriented goods and business-oriented solutions. If a domain expert, such as a consultant or teacher, can replicate the service they provide using technology, they hold the potential to become a successful technological business. Additionally, there is a connectivity component within this category. If an activity benefits from increased participation, technology can enhance the value delivered by overcoming the limitations of the physical world. Remote-oriented solutions serve as a prime example in the B2B realm, providing a digitalized substitute for valuable human interactions. As this category addresses decreasing scarcity, it represents the closest approximation to an unconstrained market thus far.
3. Advancing technology
The crème de la crème. The most adventurous, creative, and entrepreneurial way to start a business is to move technology forward. It offers the highest upside, but entails the largest risk. Initially, the market may be undefined, and the likelihood of developing the technology is low, but when it happens, the impact is substantial. The market becomes unconstrained, offering long-term defensibility, and pushing the boundaries of our limitations. When advancing a technology, the solutions are not restricted to a single market. Truly transformative technologies can address multiple problems across industries. Expansion is seamless because differentiated value is provided by the technology. Capital is primarily required for research and development, and occasionally for capitalizing on created value and protecting intellectual property. The ideal scenario occurs when processing power accompanies the technology’s usage, enhancing its effectiveness with usage, and time.
From YC data, three broad categories encompass the advancement of technology: healthcare (biotech), industrial (including climate), and until a couple of years ago, AI. I suspect that the commoditization of Generative AI will shift the focus of deep tech towards robotics. The diversity of companies and technologies would warrant a thorough analysis on its own. It would be intriguing to explore how trends have evolved over the last 20 years and attempt a causal analysis of success. I anticipate that the academic background of the founding team would play a crucial role, and I am curious about the extent to which business acumen influences the success of landing moonshots.
As I surveyed the list of deep tech companies, I couldn’t help but feel slight disappointment in the venture capital industry. Its aversion to risk and lack of innovation in its business model are glaring. From my understanding, most investments occur only after there is already a proof of concept for the technology, resulting in a limitation of scope (ambition) and audience (those able to afford the risk). It’s likely that a significant portion of deep tech advancement originates in academic institutions, only to be capitalized upon once the most promising research emerges. However, this process is serendipitous, slow, and relies heavily on individuals, governments or non-profit willing to absorb the risks involved in financing the education. Investors, have greater risk tolerance, industry knowledge, and connections. They could potentially do a better job at allocating the brightest minds to the most pressing societal problems. This insight was recognized by Thiel’s Fellowship over a decade ago, but as a non-profit has not capitalized on its returns. Perhaps I’m being naive or overly optimistic, but I fail to see why half a million dollars couldn’t be invested to incubate a technology over 3 to 4 years, rather than attempting to accelerate a business in just 3 months.
Conclusions
When I began studying YC companies, I didn’t anticipate writing about it. It has been a rewarding process that reminded me of the benefits of slowing down and carefully examining data. The conventional narrative suggests that starting a business is challenging, and a startup even more so. Through research, I’ve gained clarity on two of the biggest causes of failure: offering something that customers do not want, and overestimating the size of a market. I refer to the first as ignorance and the second as greed. Estimating a business opportunity should be straightforward: evaluate the size and growth of the market, the potential penetration rate, and the likelihood of successful execution by the team. Make decisions based on quality data over a three to four-year horizon, and repeat. Capital becomes an advancement of future earnings, as it should be. Ultimately, I discovered what we are always taught: that demand cannot be created, at least not by us as founders.
The research also serves as a playbook for future founders. Not everyone aspires to build a multi-billion-dollar company; many of us find satisfaction in a respectable million-dollar online business that offers flexibility, independence, and freedom. Defining a technology business involves three key components: the market you are serving, the value you are providing (quality, price, scale, availability, etc.), and the technology that supports it. Consequently, the process of building a business is transparent: i) identify an inefficiency, underserved community, emerging problem, or limited good that could benefit from technology, ii) filter out possibilities where network effects are likely to dominate (winner takes all), and favor those that benefit from differentiated offerings (competition), iii) construct a value proposition aligned with your skills and experience. Self-awareness is crucial. Avoid greed, and you’re likely to lead a fulfilling life.
Finally, the research also illuminates a pathway to positively transform the venture capital industry. Not long ago, the industry was predatory, limited to a select few, and confined to Silicon Valley. Today, it has become accessible, transparent, and global, albeit not perfect. There lies an opportunity to embrace more adventurous approaches, further distinguishing venture capital from private equity. which typically focuses on providing credit. Venture capital holds the privilege of envisioning and shaping the future, empowering innovators to pursue bold ideas and catalyze change. I leave it to the reader the reflection whether today’s fundraising models are optimized to create value or if, instead, we are thinking too small, constrained by certainty, and focused solely on what exists today rather than on what we can create tomorrow.
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
-Adam Smith
Acknowledgments: The depth of the analysis owes much to the groundwork laid by brilliant business strategists. Special mention goes to the books “Blue Ocean Strategy” by Renée Mauborgne, W. & Chan Kim, and “7 Powers: The Foundations of Business Strategy” by Hamilton W. Helmer, as well as “The Product Market Fit Method” by First Round Capital, and the “Acquired” Podcast. But most importantly, a huge thank you to you, the reader, whose curiosity and engagement inspired this work.
Originally published at https://amvizion.org.
