by Y Combinator7/31/2019
Today’s episode is a preview of the Startup School podcast.
We’re putting all the Startup School lectures on their own podcast feed. You can subscribe here:
This is the first lecture from Startup School 2019. It’s Kevin Hale on How to Evaluate Startup Ideas.
It’s also not too late to sign up for Startup School.
The course just started and the deadline to sign up is August 4th. Select companies who complete the course will also receive 15,000 dollars in equity-free funding.
00:00 – Why we’re starting with evaluating ideas
1:25 – YC doesn’t just fund companies with traction
2:50 – How can I predict if an investor will like my idea?
5:15 – A startup idea is a hypothesis
6:55 – The problem
10:55 – The solution
12:35 – The insight
14:00 – Founder’s unfair advantage
15:00 – Market growing 20% a year
15:40 – Product 10x better
16:30 – Acquisition model
17:55 – Monopoly
18:50 – Threshold belief
19:10 – Miracle belief
20:10 – Example: YC
23:20 – Example: Wufoo
Craig Cannon [00:00] – Hey, how’s it going? This is Craig Cannon and you’re listening to Y Combinator’s podcast. Today’s episode is a preview of the Startup School podcast. We’re putting all the Startup School lectures on their own podcast feed. I’ve linked it up in the description so you can subscribe. This is the first lecture from Startup School 2019. It’s Kevin Hale on how to evaluate startup ideas. You can find Kevin on Twitter @ilikevests and it’s not too late to sign up for Startup School either. The course just started and the deadline to sign up is August 4th. Select companies who complete the course will also receive $15,000 in equity free funding. Sign up for free at startupschool.org. All right, here we go.
Kevin Hale [00:42] – This is how to evaluate startup ideas. This is actually a new set of content that we’ve developed based on a lot of feedback that we saw from the last Startup School and what we noticed is a lot of people’s challenges. Last year’s curriculum, actually had a lot of content that ended up being when we looked at the data for who’s participating in Startup School was like, oh, this is much more advanced, it’s much further along. A lot of people, for instance, like I had no idea or I have too many ideas that they don’t know which one to pursue because the main reasoning why a lot of people are only able to work on their startups sometimes part-time. Yes, they might be stuck without resources but they didn’t have conviction, they didn’t know, “Oh, what would I have to believe in order to say I’m going to quit my job.” This is also really great skill to have because if you are realizing you need to pivot, how do you evaluate if you need to do that and then also if you’re pivoting to something else, how do you evaluate whether something is worth going to. If you already have a launched company, then you might have problems with why isn’t this growing or how do I improve it and evaluating your startup especially in the way that investors evaluate startups ideas we find is going to be really really useful. There this myth about Y Combinator is that people think YC only funds companies who have tons and tons of traction, right? That nowadays, the only way to get into YC, you have to have lots of revenue with tons of users already
Kevin Hale [02:17] – and part of that has to do with the press and then the exposure of the companies that make it to demo day. Those are the stories you tend to here. But that being said, there’s lots of great examples of companies who actually got accepted just with an idea. Zenefits is a really good classic one. Parker was a single non-technical founder who pitched an idea to YC and he got in that way. We also had Reddit, technically they were forced to pivot right away so they hadn’t written a single line of code. Then my experience in YC is actually exactly the same so when I founded Wufoo and we entered that second batch, we also had not written a single line of code. PG had invested us at just the idea stage and so I feel fully committed now as a partner to always be trying to find and dedicate time and energy to funding companies who are just at the idea stage. A lot of our efforts here for working on Startup School is to help us help you work on how to talk and think about your startup. And that if we can fix that, it could help you inspire us to be like, “Oh, yeah, I can believe in what you’re doing.” A lot of times, founders get in the way when they’re telling their narrative. How can I predict if an investor will like my idea, that’s ultimately what we’re trying to figure out. The answer is really easy. And so for us at YC, the definition of a startup is a company that is designed or created to try to grow very quickly. If you’re not trying to build a company that grows very very fast, then you’re just building a normal company,
Kevin Hale [03:57] – it’s a small business and there’s nothing wrong with that but these companies are the ones that investors are interested in. If you’re hoping to build something that will have tons of users that will have huge valuations that we’ll be able to track venture funding then the evidence that we want is evidence that shows that your company can grow quickly. I have a confession to make if you ever meet me or talk to me about your startup and recruiting or at one of these events, I will never tell you that I do not like your idea. Yhere’s a reason for that. It is not to be nice to you, it’s not to blow smoke up your ass. I learned this way of thinking from Paul Graham. He says, look, the average investor or a lot of the investors that you see when you talk to them about your idea it feels like they’re trying to poke holes in your idea. They’re trying to figure out what’s wrong with it and then they’re trying to show just how smart they are. He explained that his job and the way he sees our work at YC is that it’s not to figure out what’s wrong with the company but to figure out how it could possibly win because our bets, the ones that win, are the ones that are non-obvious, right? For us to figure out the non-obvious stuff it’s going to not sound obvious when they first tell you. We have to work on our imagination, we have to work on our optimism to figure out, “Oh, what is the way that whatever story that they’re telling me could become a billion-dollar company.” Then a great investor pictures that back to the founder.
Kevin Hale [05:41] – I figure out all the ways that I think whatever you’re doing could possibly become big and then I’m trying to convince you that this is what needs to happen so that I would have the evidence or that you will be on the right path to have a company that grows quickly. A startup idea is basically a hypothesis and this is the way you should think about it. It’s a hypothesis about why a company could grow quickly and your job is to figure out how to construct your hypothesis, basically the pitch, to the investor so they understand how it can go grow quickly. A lot of times, people make the mistakes of trying to just accurately describe or over describe a lot of different parts. I’m going to break this down. Just like a normal hypothesis has a pretty decent structure for this this will hopefully help you workshop understanding, “Oh, this is exactly all the reasons why this should succeed.” And so even before we start even building anything, we can have an understanding of, “Oh, here’s the position of path of this company,” or, “Here’s the things I need to prove to show that this company could do well.” The first is the problem. So a startup idea is composed of three parts. The first part is a problem and it’s basically the initial conditions. You have to explain to me what is the setting for this company that allows it to be able to grow quickly? The second is the solution. This is basically what is the experiment that you’re basically running within those conditions for it to grow really quickly? The third is what’s your insight? So what’s your explanation why the thing
Kevin Hale [07:19] – that you’re going to try, your experiment, is going to end up being successful? Those are the three components that I’m always trying to figure out when I’m listening to someone’s pitch. Here’s a tip for talking about the problem or to know whether your problem, your initial conditions, are correct. The first is good problems, they’re popular, so a lot of people have the problem. You want to avoid problems that there’s a small number of people that have it. We like problems that are growing so therefore the market basically like is it growing at a rate that more and more people are going to be having the problem and it’s growing faster than other types of problems. We like problems that are urgent, ones that need to be solved very very quickly. We like problems that are really expensive to solve because if you’re able to sort of solve it then you can charge a lot of money potentially. We like problems that are mandatory, right? So therefore it’s like, people have this problem and they have to solve it. We like problems that are frequent, ones that people are going to encounter over and over and over again and often in a frequent time interval. What you want to have is some aspect of the problem that you’re working on, at least one of them and it’s ideal if you have multiple of them. You don’t have to have all of them but it’s one of those things where it’s like if your work company isn’t growing or if someone’s not as excited about the problem it’s probably missing some of these characteristics.
Kevin Hale [08:51] – The last one about frequency is super important because I like problems and you’ll find a lot of the other YC partners like problems a lot that gives people a lot of opportunities to convert. Part of that has to do with some theory. B.J. Fogg, he’s a researcher at Stanford, and he tosses his formula up all the time. He says basically if you’re trying to change someone’s behavior, you have three things you need to have in place. You need to have the motivation, the ability, and the trigger. They need to all happen at the same time. The motivation is like, “I have this problem, I need to solve,” whatever it is. The ability is your startup and the last is the trigger. What’s going to be the thing that gets them to all of a sudden realize, “Oh, I need to solve it with your thing.” And so a lot of companies will have like, oh I build something but for some reason no one’s signing up or they’re not using it or they’re not engaged, I have no retention. A lot of the times is because you’re hoping that they will somehow just remember on their own that they have the problem and to start using you and oftentimes most companies don’t send enough, for example, email notifications or triggers or reminders or figure out ways to come back into the app or figure out ways to be back in front of the user at the right time. If you can’t figure out those opportunities it’s really hard to get people to switch over to using your solution, service, or product. Our ideal problems are millions of users, right?
Kevin Hale [10:23] – Millions of people have it, that’s why people like to work on consumer companies, it’s why some investors like to focus on them. We like markets that are growing 20% a year, the problem is growing quickly. We like problems where people are trying to solve it right now, immediately. We like problems that just cost a ton and can sell billions of dollars, all right? Or at least they all add up to some billion dollar total addressable market. We like problems where the law has changed. The law has changed and regulation is put up there and now people to solve a bunch of problems. You saw a ton of healthcare startups were born after Affordable Care Act was passed. A lot of that had to do with there was now all of a sudden opportunity, this problem that all these hospitals and clinics had to solve. We like problems that people need to solve multiple times a day or will use it multiple times a day. Facebook’s the classic example but people also really love Slack, right? Because it’s like, “Oh, I’m going to be engaged and using it multiple times a day during the work day.” Solution, so there’s pretty much only one piece of advice I really have for the solution. That’s the best advice that you can ever follow and that is don’t start here. What I mean by that is at YC we have an acronym for a problem that we try to avoid or basically an application that we have to go like, “Oh man, I wish they had started with a problem first,” and we call it SISP. It means solution in search of a problem and often what happens is, you’re an engineer,
Kevin Hale [12:04] – you’re excited about technology, some new technology has come on the scene, let’s say it’s blockchain, right? Let’s say it’s like React Native or whatever the new thing is and you’re like, I want to build something with this. It’s a large reason why you start working on a side project and then you go like, “Okay, what kind of problem can I solve now? I want to use this no matter what,” and then you try to shoehorn a problem into the solution. What ends up happening is that’s a much more difficult way to grow the company. It’s not impossible for companies to grow this way, it’s super inefficient. It’s much better to be like, let’s see what problems people have and then I will use whatever is necessary to solve them. And therefore it’s much more likely that you will grow as a result. Because the other way around is you might have to go and try to drum up the problem or you have to brand a problem as something that people have and it’s so much more difficult and you end up going much more slowly as a result. So look at what you’re building right now or look at the reason why you’re trying to do the startup and is it because you only care about the technology and building something in that or have you started with a problem, you go like, I’m going to do whatever it takes to solve people, users, customers issues. The last one’s a little tricky. It’s what is the insight? What’s the reason why this solution is going to work and this is where a lot of companies sort of get tripped up because it’s really about what is your company’s unfair advantage?
Kevin Hale [13:33] – Why are you going to win versus everyone else? Why you going to be the fastest one to sort of grow because that insight is what’s needed for the investor to choose you over anyone else. It has to be related to growth. You have had an unfair advantage that explains why you’re going to grow quickly. If it’s not related to that then it’s not going to be something that an investor is going to find valuable. The last one is you need one. You can’t just be like, I have a problem, I’m solving it, and then have no explanation why. Without that last sort of explanation I can’t use my imagination. I can evaluate just solely on how well you’ve thought through this problem, right? And so let’s go through the types of unfair advantages that your company have. There’s five different types and companies do not have all of them. Really great ones not surprisingly will have all of them and we’ll go through two examples but you want at least one and it’s nice if you can have two or three but for most of you it’s probably just one. Yhe first one, so how do you know if you have a founder, unfair advantage? All of these will be connected to numbers actually which will help this make this really easy. It’s like, are you one in 10 of all the people in the world who can solve this problem? Are you a super expert? 99% of the people we find at YC, do not fall into that category. If you think it’s like, well I’m a Product Manager at Google, there’s a lot of product managers at Google. If you say you’re an engineer at Microsoft, there’s a lot of engineers at Microsoft.
Kevin Hale [15:19] – It’s like, great but it’s not one that will make me think, “Oh you have a greater unfair advantage than someone else.” If you’ve done a PhD, and let’s say you’ve done it on some kind of crazy biotech research and you have a special patent to be able to cure some kind of disease, then you have a founder advantage. Your market, is it growing 20% a year? By default, if you just build a solution in this space, you should just automatically grow because you’re just following a trend. If this is your only company advantage then it’s one of the weakest ones that you could have. It is great to be in that space but you want to have something in addition to this. You’re going to do better than average because you’ve picked the right problem space and the right set of customers that want your problem. But again, if you’re in a market that is stagnating or shrinking, then you’re going to have investors worried about the long-term viability of your company as a result. Product, so this is super simple. Is your product 10X better than the competition? If it is, then you potentially have an unfair advantage. It has to be very very clear. Someone should be able to look at your product and go like, “Oh shit, this is so much better than everything else I’ve ever seen. It is 10X faster, it is 10X cheaper,” etc. and if it’s not in order of magnitude, let’s just say it’s 2X or 3X, again that’s nice but it’s not enough for an investor to go like, “Oh this is a slam dunk.” In regards to that 10X product and showing that you are able to have that.
Kevin Hale [16:59] – Later in Startup School are going to do electron pricing and will talk things about cost and value and that will help you sort of better understand how to better prove out that 10X multiple using sort of metrics and numbers and pricing. Acquisition, so a lot of people think that if you go to an investor and you’ve done a bunch of Facebook or Twitter or Google ads and you show your CAC and LTV that you will be able to prove that you have a sustainable sort of acquisition model. I want you to know that if paid acquisition is the only way that you were able to grow your company, then I’m going to discount that channel of growth greatly. That is because if you actually get really popular, you’ve actually start being someone significant, let’s say becoming a hundred million dollars revenue company, then you’re going to attract a lot of competitors in the space and that advantage is going to quickly dwindle over time. Blue Apron is a really good example of this. Almost all their acquisitions were paid and then once it ate through that there was almost nowhere else for them to sort of go. You want to find acquisition paths that cost no money. My favorite companies, the ones that become really great, are the ones that can grow by word-of-mouth as is a good percentage of the way they grow and so in the early days of your startup, if you don’t have any money that’s actually a very great way of exercising how do I grow this without having to pay for it? In the beginning, we tell you to do things that don’t scale but this is what you sort of want to accomplish.
Kevin Hale [18:33] – It’s like, do I have an advantage that is free? And the last one is, do you have a monopoly? And so we don’t mean this in the Monopoly game sense. As your company grows, is it more difficult for you to be defeated by competitors, do you get stronger and so good examples of that are companies with network effects and marketplaces where marketplaces where it tends to be a winner takes all, one company with tend to win. Network effects is just basically as my network grows, the strength of my company and the value of the product or service also grows with it. Not every company has it but when you do have that, it works out great. There’s something to keep in mind. Also, that’s other things I’m looking to believe about a company and that is something that trips up a lot of founders and so there’s two types of beliefs that I have about a company. There’s the threshold belief which is like, what’s the default just for them to even succeed. Often times for me, it’s like, “Oh, them building it, can they even build it?” That’s a threshold belief. If they can’t even build it, none of it even matters. And so to me that question is not the most important. What will determine whether I’m going to win the Lotto is a miracle belief that like, “Oh my God if I believe that they could do this they’re actually going to be able to take off really well.” Some times they’re really simple. If you are a heavy engineering team or doing a BDB or enterprise startup, again, the default is you have to build it.
Kevin Hale [20:14] – If you can’t even build it, then it’s not even going to work so I don’t spend actually a lot of time looking at that. For me, I’m trying to figure out success will be determined by how well you can do sales, how well you can tell the story, how well you can actually convince customers and work through a sales process. I want evidence that shows that you know how to work through that and make that happened. All of my work with most of those companies is not working on product, it’s like, “Hey, all right, let’s prove this other thing,” that if you have that, that’ll be the thing that actually will help people go like, “Oh shit, they have this super combo.” I’ve got some quick examples. YC is a good one because we like to think of YC as a startup. The problem, the way we’d word this is it’s hard for founders to raise money without knowing someone in venture capital. At the time it was started, you basically had to be an insider and that was the only way you can sort of get money and that super sucked. And the solution, that basically Paul Graham came up with, is investing companies through an open application. You don’t need to know anyone, you just tell us your idea, tell us a bit about yourselves and that should be enough for you to get funding. Now, there’s a bunch of unfair advantages that YC had. Number one, the founders are pretty incredible. Paul Graham had wrote a textbook on LISP, RTM wrote the very first worm, he’s amazing programmer and they had built and sold the first SaaS company, that was Viaweb to Yahoo.
Kevin Hale [21:53] – They were kind of experts at both evaluating technology and also understanding kind of starts in that whole process. The market, basically believe that future billion-dollar companies will be technology companies. They’ll be powered by software and the wonderful thing about tech companies especially at that time was Moore’s Law was making it cheaper and cheaper for software companies to be started and they needed a whole lot less money and he could make a lot more bets as a result. The product, so basically they pay the founders, they come for three months, they get some advice, they work on their product for a relatively small amount of money and then at the end of the time instead of offering co-working space they work from their own home and then they pitch to a bunch of different investors and the idea was that would be so valuable to a potential founder who had no connections that it would attract a lot of really great minds or a lot of people who were hungry to get into the space. Acquisition, so most people don’t realize this it’s like PG was able to sort of build up YC and attract the right talent because he had a huge reach and audience when he got started. He had written that textbook, yes, but he also wrote all these popular online essays and it had a large audience of his target users, hackers to come and evaluate his product. You can acquire them relatively cheaply just by making a website and letting it be known. Then the last one is something he didn’t even realize when he started YC and that is that as the YC alumni network grew
Kevin Hale [23:36] – it got more powerful and more valuable over time. The results are funded thousands of companies, there’s 4,000 founders, they have the CEOs of some of the biggest companies in the world. They are over 15 companies worth over $1 billion, there’s 93 companies with over a hundred million dollars. Our total market capitalization is over hundred billion dollars. I’m going to do one more example with you guys. Wufoo, this was my startup and it’s an online forum and survey builder. And so for us it was basically, every website needs to collect some kind of data at some point but you need to know how to code or hire a programmer to be able to do it. The solution was to build something that what they see is what they got. Basically, a drag-and-drop visual editor and that any non-technical person sort of create and that if we did that we would solve that sort of specific problem. So very quickly the market, it’s kind of ridiculous. We were asked in the early days, calculate our TAM but it was like, every website needs I don’t really understand, what website doesn’t need a form eventually? It allowed us to grow really really quickly. Our product was easily shown to be 10X faster and it’s against the direct competition with other builders because it was so much faster to do the drag and dropping and visually see and then it was usually 100X faster than a lot of traditional routes for very custom forums for hiring a programmer and very cheaper because we had this freemium model. That also led to an acquisition unfair advantage
Kevin Hale [25:13] – and so we actually had started off with building a blog and building an audience as well. Started off with 100,000 developers subscribe to our blog, we launched it out to them after building up that audience for a year and that’s actually what we applied to YC with. We had built up this audience, we had proved that all these other things are in place and then part of the other acquisition model is that you could embed these forms on people’s websites and then our users basically spread our forum and software for us as a result. We never had to hire any salespeople. The results are, our product is used by every industry, market, and vertical you can imagine. Tons of super large companies and we did this with a relatively small amount of team. When we were acquired, we were a weird outlier compared to all the other acquisitions. The average company raises $25 million before an exit and this is their average return. And for Wufoo, we only raised $118,000 for the whole life of the company and our returns were over 30,000% Okay, so in the end this is very simple exercise but super enlightening once you actually go through it and to try to figure out that narrative and story. I turn it back to you, go through and try to answer those questions about problems, solution, your unfair advantage. Figure out where are my holes, do I have one and then question becomes, “Oh, what do I need to prove, what do I need to work on to make that happen?” Your startup idea is a hypothesis about why you’re going to grow quickly.
Kevin Hale [26:50] – For our next lecture, we’re going to talk about the first ways we try to prove it out to basically test our hunches and that is by talking to users.
Craig Cannon [27:01] – All right thanks for listening. As always you can find the transcript and video at blog.ycombinator.com. If you have a second, it would be awesome to give us a rating and review wherever you find your podcasts. See ya next time.
Y Combinator created a new model for funding early stage startups. Twice a year we invest a small amount of money ($150k) in a large number of startups (recently 200). The startups move to Silicon