Even to outsiders, the inner workings of startup accelerators has become familiar: pumped up on camaraderie and energy drinks, scrappy founders do product demos onstage before a room full of buzzy journalists and investors.
Fast-forward two years into a pandemic and, even a stint with the return of hacker homes, much has changed about the way launch pads for startups look, feel and show value today. The earliest investors are rethinking signaling risk, dilution and, most surprisingly, the worth of a traditional demo day.
Pro rata
Let’s start with a juicy topic: pro rata.
Signaling risk happens when a VC chooses to not do pro rata, or follow-on investing, in an existing portfolio company. The idea is that investors who know you best — the ones who bet on you earlier than others — are choosing not to invest in you in your next phase of growth, which must mean that the deal isn’t that great. Negative perception can trickle down to other investors who, despite what their Twitter bios will tell you, are pretty risk-averse folks.
Accelerators have an interesting role to play here. If an accelerator like Y Combinator ever gets to host 1,000 startups per batch, an automatic pro-rata investment in each startup would be both capital-intensive and perhaps unintentionally dilute its own signal. Like clockwork, in 2020, the accelerator changed its policy on automatic pro-rata investments and chose to invest on a case-by-case basis, just like 500 Startups.
“We have significantly exceeded the funds we raised for pro ratas, and the investors who support YC do not have the appetite to fund the pro rata program at the same scale,” the accelerator wrote in a post then. “In addition, processing hundreds of follow-on rounds per year has created significant operational complexities for YC that we did not anticipate.
“Said simply, investing in every round for every YC company requires more capital than we want to raise and manage. We always tell startups to stay small and manage their budgets carefully. In this instance, we failed to follow our own advice.”
I always expected this choice to be more controversial because it brings more favoritism to an already extremely exclusive batch of startups.
NextView is opting for a more balanced investment model that doesn’t show favoritism but still helps cohort startups avoid signaling risk. The firm launched its accelerator program by saying that it will participate in the next round of funding for startups, but it will not be the lead investor in said rounds.
Dilution or non-dilution
Stepping away from the culture of check-writing, accelerators also seesaw between offering dilutive capital or non-dilutive capital.
“Our accelerator check is really our primary opportunity to build ownership into the company, given the smart work that we do,” said NextView VC partner Melody Koh. The choice to not lead the next round, though, has helped startup founders feel more comfortable with the firm on the trials and tribulations that come with the fundraising process. In other words, dilutive capital may formalize the relationship between investor and founder — but she thinks that can enable a more transparent working relationship than you would with a more casual adviser.
While NextView’s take is pretty incentive-aligned — investors want ownership — there can be some counterintuitive strategies here as well. Some firms launch accelerator programs as more of a way to source deal flow than land eventual returns.
For example, Cleo Capital, founded by Sarah Kunst, launched a fellowship for laid-off workers, free of charge. By not taking any equity, Kunst noted that she hopes any startups that are born as a result of a fellowship will give Cleo the chance to invest.
More recently, startup community Launch House spoke to the outdatedness of equity as a way to attract interesting, successful founders to your community.
“Great founders have tons of options, and we think that in order to get people into your community you can’t demand equity upfront,” co-founder Brett Goldstein said. “It’s kind of an antiquated model.” Instead, Launch House makes money through a membership-fee model. Live-in members are given a one-year free membership to the community with residency costs, then after that it is an annual subscription.
The trio of founders behind Launch House recently filed paperwork indicating that it plans to raise a $10 million venture capital fund. The move, along with the team’s choice to bring on venture capital for their own startup, could change the way they do business.
And finally, demo day
Demo day, the annual or biannual shindig in which founders pitch to a room of eager investors and founders, may soon outdate itself as the pinnacle of an accelerator.
NextView Ventures, for example, thinks demo days can distract founders from more pressing and legitimate goals. “We don’t feel like the artificial kind of deadlines, and the demo day date format, is the best use of your time,” Koh said. “The way we engage with every company is that ‘OK, each of you has a different set of milestones that make sense for you,’ so we don’t really focus on demo day as the right way to expend their energy or our energy.”
It’s not a possessive move; the firm still has a significant stake in the company and, as mentioned previously, doesn’t plan to lead next rounds. So, in some ways, it feels like venture firms are incentivized to have demo days because it brings fresh publicity and perhaps key follow-on funding to the startups that it seeded. In other words, validation.
“Our objectives and motivations are a little different — we really want to use the opportunity to engage with earlier-stage companies that we otherwise might not have a chance to work with,” Koh said.
The firm’s cohort startups still have continued to raise $25 million in follow-on funding, from investors including Khosla Ventures, Founders Fund and SoftBank, plus acceptance into Y Combinator and Techstars.
Contrary Capital, which recently landed a new $20 million fund, similarly opted to no longer offer demo days for founders that go through its summer accelerator program.
“We realized that specifically in this environment, doing things in a programmatic and an annual fashion is not the move,” founder Eric Tarczynski said in a previous interview. “I think the idea of telling founders that ‘Oh, now is the time that you should raise for your company,’ when their timelines can be totally different, didn’t make much sense.”
Instead, he thinks that companies within Contrary’s accelerator usually pursue a more closed-loop model when it comes to raising first rounds or gaining early traction; the firm has been building up a community of diverse college students and star employees at startups for years, creating an alumni group that can be especially helpful in advising.
Ditching demo day is not entirely a new phenomenon, but it does feel like the venture industry is shifting to focus beyond financing as a success metric for their earliest bets.
We’ve been preparing for all of this. As capital gets further commoditized, early-stage investors are going back to the drawing board to see what is truly — and excuse my language here — a value-add service.
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