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The Start-up Guru

Paul Graham's business school and investment fund, Y Combinator, has launched 145 companies -- for a lot less money than you would think

by Max Chafkin from Inc. magazine on Jun. 1, 2009

Of all the things that Paul Graham hates about running a start-up -- and there's not a whole lot about it that he likes -- the customers bug him the most. Everyone has a problem with your product, and people are constantly calling to complain about things you cannot possibly fix. Then there is the fact that you are doing everything for the first time, which creates a crippling sense of uncertainty, as well as a persistent fear that a single bad decision could doom the whole enterprise. There are squabbles with co-founders and combative negotiations with investors and that gut-wrenching period when you realize that success isn't going to come quickly or easily -- Graham calls it the Trough of Sorrow. Graham's start-up days are more than a full decade behind him, but he can't help recalling them with a shudder. "It's like talking to someone who went to war," Graham says. "It sucks to run a start-up."

It's odd to hear Graham speak this way, because he now oversees what is perhaps the most ambitious campaign of start-up creation ever attempted. His company, Y Combinator, is a hybrid venture capital fund and business school that invests in, advises, and, literally, feeds 40 or so early-stage businesses a year. Investments are small -- less than $25,000 per company -- but Graham supplements the money with smart advice, introductions to later-stage investors, technical help, and a sense of community. The model has produced many promising companies, a few sizable acquisitions, and copycat funds in cities across the country and around the world.

Why is Graham, an avowed start-up hater, doing this? Because for all the pain, he believes that founding a company is the most efficient way to create wealth -- for investors, for founders, for society at large -- and because he thinks he can make starting a company a lot less painful. "There's this classic pattern that has happened over and over again throughout history in which something is made one at a time, very expensively and unreliably by hand, and then someone comes along and figures out how to make large numbers of them cheaply and reliably," Graham says. "We're pulling this kind of transformation with venture funding. We're mass-producing the start-up."

Graham is 44 years old and possesses the combination, often encountered in entrepreneurs, of extreme intelligence and a hint of arrogance. He holds a Ph.D. in computer science and has several years of formal training as a visual artist. Before starting Y Combinator, he founded Viaweb, a dot-com software company that helped retailers sell online; it was acquired by Yahoo in 1998 for $49 million. After leaving Yahoo, Graham won renown as an essayist, the creator of a new programming language, and the guy who invented spam filtering as we know it. Today, he funds more start-ups in a single year than a typical venture capitalist backs in a decade.

These exploits have made Graham something of a folk hero to a generation of ambitious techies, who debate his essays, read his books, and pitch him start-ups by the hundreds. But that's not to say that only tech entrepreneurs and the professionals who invest in them should pay attention to what Graham is doing. "Everything is becoming software," Graham argues. "Saying there are too many software companies in 2009 would be like saying that there were too many companies related to words after Gutenberg invented the printing press." In fact, Y Combinator is rewriting the rules of starting a business in almost any industry -- making the case for companies that are smaller, cheaper, and faster -- at a time when credit availability is plummeting and venture capital investment is lower than it has been in more than a decade.

For aspiring business owners, this is a very good thing. Falling bandwidth costs, improvements in open-source software, and the emergence of cloud computing have made it much cheaper to get a company off the ground. But it wasn't clear just how cheap it had become until Graham launched Y Combinator, in 2005. His plan was to gather together a group of smart kids, give them just enough money to keep them in instant noodles and Wi-Fi, and help them bring their ideas from napkins to fully formed companies. (A "y combinator" is a mathematical function that makes other functions, just as Y Combinator is a company that makes other companies.) The program was founded in Cambridge, Massachusetts, but has since moved to Silicon Valley, where Graham hosts two groups of about 20 start-ups a year, in January and in June, for three months at a time.

It's too early to say for sure how successful Y Combinator will become. Early-stage investors expect a return within five to 10 years; if Y Combinator has indeed financed the next Google, it could be a decade before anybody knows. Still, the results so far are impressive. Of the 145 companies Graham has funded, seven have been acquired and two have merged with other Y Combinator start-ups. Just 27 -- less than 20 percent of the total number -- have failed, and the rest continue to operate. A quick survey of start-up activity in Silicon Valley yields dozens of Graham's offspring -- red-hot Web 2.0 companies such as Scribd, Xobni, and Loopt. Meanwhile, funds modeled on Y Combinator have sprung up in a dozen cities, including Boulder, Colorado; New York City; London; and Greenville, South Carolina.

Y Combinator can already claim credit for creating about 500 jobs, a number that will probably grow rapidly as the start-ups, most of which are less than two years old, mature. This success has made a session at Y Combinator a hot ticket for anybody with dreams of launching something big. "I would have given up almost anything to work with Paul," says Sam Odio. In December, the 24-year-old entrepreneur packed up all his possessions and drove west to claim a $10,000 investment in his new venture, Divvyshot. Three months later, Divvyshot had a product -- a photo-sharing website for groups of people -- and Odio presented his company at Y Combinator's Demo Day, a two-day event held at the end of each class at which start-ups pitch angel investors and VCs.

When Graham started Y Combinator, most of the investors at Demo Day were old friends from Yahoo and Viaweb. Now, Demo Day draws representatives from the top U.S. venture capital firms. "Y Combinator is transformative," says the venture capitalist and blogger Fred Wilson, whose New York City–based firm, Union Square Ventures, has made investments in Twitter and two Y Combinator companies, Disqus and Heyzap. Wilson says Graham's model takes some of the risk out of starting a company. "Paul gives these kids money, but he also gives them a methodology and a value system," he says. "I don't mean this in a negative way, but Y Combinator is more like a cult than a venture capital fund. And Paul is the cult leader."

On a chilly Tuesday night in early April, the members of Y Combinator's winter class gather for their final meal together. Demo Day has already passed, and the evening has taken on a somewhat celebratory quality, which means that a few founders have decided that they can afford to indulge in a mug of beer. Most are staying sober so they can squeeze in a few hours of work after the meal. Some are simply underage. Because Graham works mostly at home -- he and his wife, Jessica Livingston, are the only full-time employees -- Y Combinator's headquarters isn't much to look at. There's a small private space where Graham holds "office hours" -- short weekly meetings with founders -- and a large, brightly lit dining room in which everyone gathers once a week for dinner. The space is painted orange, and its walls are covered with spiky soundproofing foam to keep the volume down. An enormous wooden table spans the length of the room.

When I arrive, I find Graham standing in the parking lot, chatting with a group of young people. I introduce myself, and he looks back blankly. "What's your story about again?" he asks. Graham tends to have an air of impatience, as if even a momentary distraction is too much to bear. He keeps meetings short and makes investment decisions based on a single 10-minute interview. Before I have a chance to answer his question, he grabs the shoulder of the nearest twentysomething and, as he steers me inside, introduces us. "You should give Max a demo," Graham says.

The entrepreneur is Alex Polvi, a recent graduate of Oregon State University who wears horn-rimmed glasses and has an unkempt mass of curly dark hair. His start-up, Cloudkick, helps companies manage cloud-computing servers. "We've built a unified interface for working with different providers," Polvi says, looking at me with the satisfied expression of someone who has just made a great deal of sense. Before I fully understand what he's talking about, two more entrepreneurs sidle up, each eagerly awaiting a chance to pitch me.

That Polvi's elevator pitch is a little rough is no accident. Graham encourages founders to spend all their energy on product development, not on PR. In most cases, companies are expected to release a finished version of something -- whether it be an iPhone app or a photo-sharing widget -- before the three-month program is over. That's an incredibly short amount of time for a two- or three-person team. It requires that founders work more or less around the clock while ignoring pedestrian concerns like cash flow or hygiene. The dinners provide a welcome respite from the frantic pace.

Tonight's feast consists of mountains of white rice and a ketchup-hued chili served out of several large electric Crock-Pots. The founders eat standing up or hunched over laptop screens. A quick scan of the Y Combinator pantry, which includes six gallon-size cans of pinto beans, seven large cans of sloppy joe sauce, and a copious amount of canned tomatoes, confirms that the meal is typical. "Goop on rice -- the same every week," Graham says with a smile, as he shovels the stuff into his mouth. He used to cook the meals himself but recently ceded that duty to a professional cook.

Cheap meals are, in a strange way, part of Y Combinator's formula for start-up success. Graham wants founders to spend as little money as possible. Live cheaply enough, he believes, and you can become cash-flow positive without going on a lot of sales calls or spending too much time talking to investors. Graham calls this "ramen profitability" and says it allows companies to say no to bad investment terms and forces them to think about long-term viability. It also ensures that most Y Combinator founders are in their 20s -- or, for the few who happen to be older, that they are capable of living in dormlike conditions. "That culture of frugality and discipline is really important for the Y Combinator mindset," says Sam Altman, founder of Loopt, a graduate of Y Combinator's first class. "The start-ups that do well are the ones that are working all the time."

Like many software entrepreneurs, Graham has been writing code since his teenage years, but he also has a range of interests not common among computer geeks. He was an aspiring short-story writer as a high school student and majored in philosophy at Cornell as an undergraduate. After deciding that he found philosophy incomprehensible, Graham landed in a computer science Ph.D. program at Harvard. He excelled as a programmer, but about halfway through graduate school, he started taking classes in Harvard's art department. After receiving his doctorate, he enrolled at the Rhode Island School of Design with a plan to become a painter. He took classes at RISD that summer and in the fall enrolled at Florence's Accademia di Belle Arti, a nearly 500-year-old art school founded during the Renaissance. When I suggest to Graham that this was a weird life plan for someone with a computer science degree from Harvard, he says simply, "I never cared about the official rules."

Like many recent graduates who adopt this pose, Graham quickly ran out of money. The following year, he dropped out of school and went to work as a software engineer at a Boston start-up. From 1991 to 1995, he bounced among art school, temporary software-development jobs, and long periods spent painting. "I was doing this thing where I would consult for a while and then run out of money and be in a panic," he says. Eventually, he decided it was time to make some real money.

Graham teamed up with a friend he had met at Harvard, a brilliant hacker named Robert Morris, who is notorious for crippling the Internet in 1988 by accidentally deploying a computer worm. Their idea was to build software for retailers. "Netscape was about to do this big IPO, and they had a huge PR campaign," Graham remembers. "Netscape was saying that people were going to buy and sell a lot of stuff online. So we thought, OK, we'll write software for people to buy and sell things online."

In the fall of 1995, Graham and Morris raised $10,000 from a friend named Julian Weber, a corporate lawyer who was married to one of Graham's painting teachers. They used the money to buy a Web server and then started writing code. "It was one scary moment after another," Graham says. "We didn't know what a term sheet meant or what a valuation was or that companies had boards of directors. All of those things just seemed like words we'd read in a newspaper."

By the end of the year, Viaweb had a product, and Graham started calling on potential customers, offering to set up and manage their online stores for a fee of $100 to $300 a month. He was a lousy salesman but managed to persuade a few retailers to try it out. Because Viaweb was a software program that ran inside a Web browser -- hence the name -- Graham was able to continually respond to customer feedback. "We learned quickly by paying attention to the users," Graham says.

By Christmas of 1996, Viaweb had 70 clients, including Rolling Stone and International Male. A year later, the number had quintupled, and Yahoo came calling. In 1998, Viaweb accepted a $49 million buyout offer. "Viaweb was the prototype for the kind of company we fund now," says Graham. "The reason we know that it's possible to start a start-up with about $10,000 and someone to help with the paperwork is because that's exactly what we had."

Graham worked at Yahoo for a year and a half and seems to have suffered through every minute of it. "Running a start-up is like being punched in the face repeatedly," he says. "But working for a large company is like being waterboarded."

After leaving Yahoo, Graham spent most of his time writing essays about technology and business and developing a new programming language. His best work was collected in a book, published in 2004, called Hackers & Painters: Big Ideas From the Computer Age. "Everything around us is turning into computers," he writes in the preface. "So if you want to understand where we are, and where we're going, it will help if you understand what's going on inside the heads of hackers."

In March 2005, Graham was invited by the Harvard Computer Society, an undergraduate group, to talk about starting a company. "I told them to raise money from angel investors, preferably people who have started start-ups themselves," he says. After delivering that line, he glanced at the audience and noticed that everyone was looking at him expectantly. Fearing a deluge of bad business plans from bright-eyed Harvard students, he quickly added, "Not me." Later that day, while having coffee with some of the students, he remembered that if he hadn't been able to find his own angel investors, Viaweb never would have gotten off the ground. He decided it might be worth seeing what these kids could come up with.

Y Combinator began as an experiment in angel investing, conducted during the summer of 2005. Graham recruited Morris, Livingston, and a Viaweb employee named Trevor Blackwell to join him. The pitch was straightforward: $6,000 for a company with one founder, $12,000 if the company had two founders, and $18,000 if the company had three. In exchange, Y Combinator would get roughly 6 percent in common stock. (Exact ownership stakes vary. The most Y Combinator has taken is 10 percent; the least is 1.4 percent.)

Graham promoted the program with an essay that he posted on his website and that quickly found its way to many college students' e-mail inboxes. "We give you enough money to live on for a summer, as with a regular summer job," he wrote. "But instead of working for an existing company, you'll be working for your own; instead of showing up at some office building at 9 a.m., you can work when and where you like; and instead of salary, the money you get will be seed funding."

Graham received 227 applications, mostly from computer science students, and he invested in eight start-ups. Half went on to raise additional funding, and two turned down acquisition offers. Graham knew that most of the companies would probably die, but he also believed he was onto something. For example, Loopt, which develops software for cell phones that allows users to see where their friends are, managed to raise $13 million from two Sand Hill Road firms. Another company in the first batch, Reddit, operates a social news website similar to Digg. It was acquired by Condé Nast just a year and a half after its founding and before it had hired any full-time employees. Though the price was not disclosed, reports have pegged it at anywhere from $10 million to $13 million, which means that Y Combinator generated a sizable return, as much as 25 times its initial investment.

Reddit is a good example of what happens to a Y Combinator company when most things go right. But few Y Combinator start-ups enjoy such a straight line to success. That, in part, explains why Graham encourages companies to release products quickly. Doing so, he says, is the best way to turn a bad idea into a good one. "As long as you pay attention to your users, you can change a bad idea," he says.

Case in point: The wildly popular online video site now attracts 41 million viewers a month. But it has its roots in a failed start-up called Kiko. The company, a part of Y Combinator's first class, began with a plan to do for online calendars what Google's Gmail had done for e-mail. Things went well at first, but then Google decided to do for calendars what it had done for e-mail, making Kiko suddenly irrelevant. Co-founders Justin Kan and Emmett Shear bailed out and sold the company on eBay for $258,000.

Graham lost money on the idea but nonetheless decided to back Kan and Shear's next venture, a bizarre take on reality television. Kan attached a video camera to his head, wore a backpack stuffed with cell-phone modems, and broadcast his life 24 hours a day. The idea was that would produce similar programs and sell equipment to aspiring reality stars. "I thought it was insanely weird," Graham recalls.

Kan's life attracted a few thousand fans and reams of press. But Kan soon noticed that instead of broadcasting from hat-cams, some users were interested in more traditional types of broadcasting. "People were e-mailing us saying, 'I want to broadcast a bike race or a talk show or a concert,' " Kan says. "We were like, 'OK.' " Kan stopped wearing the camera and focused on building a live video platform.

This kind of meandering path, Graham says, is encouraged at Y Combinator. "A lot of great companies started with different ideas," Graham says, noting that Steve Jobs's first plan for Apple was to sell do-it-yourself plans for building computers. "You need to listen to your users, figure out what they want, and do that." When founders are accepted into Y Combinator, they are given a gray T-shirt that says, "Make something people want." When a company sells, the founders get a black shirt that says, "I made something people want."

Despite having spent five years painting, Graham long ago put away his brushes. None of his work is on display in his home in Palo Alto, and he's none too eager to talk about matters of technique or style. But one thing painting taught him was the value of living frugally. "It taught me how to do cheap in a cool way," Graham says. Artists, Graham discovered, don't pretend to be rich; they live in sparsely decorated lofts and wear cool vintage clothes. "A start-up is that philosophy applied to business," he says.

Graham loves saying things like this. Investing in 145 start-ups so far -- and interviewing nearly 1,300 founders -- has taught him a lot. He has learned that start-ups with four or more founders tend to be less successful than those founded by smaller teams. "I think these people are afraid to do a start-up," he says. Another insight: If ownership stakes for founders are unequal, the start-up will probably get torn apart by infighting. "In theory," Graham says, "we ought to get to the point where we can just look at a start-up and be able to tell if it will succeed or fail."

Twenty-seven more companies will join Y Combinator in June, the program's biggest class yet. Earlier this year, Sequoia Capital, the venture capital firm that backed Google, agreed to give Graham $2 million to put to work. Graham hopes to use the money to expand Y Combinator, to fund 60 companies or more every year. I ask Graham why he is so intent on growing. Why does the world need so many little software companies? He looks at me as if I'm insane. "Imagine that instead of starting Google, Larry Page and Sergey Brin had taken jobs in some research lab," he says. "They would have written a little piece of an operating system that might not even get used and maybe some boring academic papers. Think of how much more they did for the world as start-up founders."

As the interview ends, we go inside his house and start to say our goodbyes. But before I can leave, Graham has something new to show me. It's a software program called EtherPad -- developed, of course, by a Y Combinator company. The program lets writers collaborate on a single document simultaneously. He thinks I might be able to use it back at Inc.'s offices.

"But what you really should do is start a start-up," he says. He stops and thinks for a moment. "You know what? You should do a news website for finance. You could be like Bloomberg, but you'd be just one person." His mind is going faster than his mouth. "What about Blogberg as a name? Is taken?" Before I have a chance to respond, he flips open his MacBook to check, using a clever domain-name search tool developed by another Y Combinator founder, Beau Hartshorne.

"Damn," he says. The name is already registered. "Do you know anyone who can program?"

"Not really," I reply.

"Maybe someone from school?"

I recall that a number of founders have warned me that Graham has the habit of throwing out business ideas at a rapid clip, without really thinking through what he's saying. Still, says Kan, "you always come away feeling energized. You could be working on the most boring piece of software, and you talk to Paul and you think, Man, I'm excited to go back to work."

Indeed, there's something exhilarating about Graham's optimism, especially at a time when so many once-great companies are sitting on the verge of bankruptcy. Graham believes, deeply, that start-ups are the answer to the world's problems; that they are easy to make if you are determined enough and cheap enough; and that it's getting a lot easier to start one. We shake hands, and I leave, with a sudden desire to make something.

This article originally appeared at: 4,177 words.

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