UD #01: Software is eating the rest of the world

A first in a three-part series on the funds that are enabling the deployment of technology-enabled business models in emerging markets.

This newsletter is supported by Rally Cap Ventures. Rally Cap Ventures is a venture collective investing in early-stage fintech across LatAm, Africa, and Southeast Asia. Rally Cap’s exclusive global community is powered by strategic LPs, from companies such as Stripe, Plaid, Jumia and MercadoPago.

NBA, NFL, and MLB are only held among teams based in the USA and Canada. Yet these leagues frequently crown 'World Champions'. Similarly, in Hollywood superhero movies, 'saving the world' usually just means 'saving the USA'. Marc Andreessen famously declared that 'software is eating the world'. One look at a16z's portfolio makes it clear that, until recently, he really meant software is eating the USA. a16z has started to make its first steps outside of the USA, but asides from the occasional opportunistic deal, the fund continues to primarily focus on the USA.

This piece is the first of a three-part series covering three funds that, unlike a16z, have bet big and early on technology-enabled business models across the world.

This is the first real edition of Unevenly Distributed, and if you never read another edition, you'd be able to track the diffusion of technology, entrepreneurship, and venture capital across emerging markets by simply closely following three funds that I will cover in this series.

The Launch Pad

[He] has been one of the most positive forces in startups ever in that he shifted the balance of power away from business speakers to the coders. In the first generation of the web, it cost millions of capital to write your first line of code so you had to raise money on the back of a business plan. That business plan had to be written by an MBA and that MBA took it to the venture capitalists and the venture capitalists back then were ex-bankers cause they needed to liaise with the bankers who would ultimately take you public and [companies] went public every week.

[He]... went to all the coders like 'you know what? I can actually teach you all this stuff. It's not as complex as you think. I can demystify the legal papers and I can demystify the business terms and you can be a business guy'

— Chris Sacca talking about the founder of The Summer Founder's Program

David Beirne joined Benchmark in 1997 as the fifth partner, he joined from Ramsey Beirne Associates, a recruiting firm he co-founded. At the time, companies needed to raise a couple of million dollars from VCs to launch their product. A lot of that capital went into things like buying servers and launching nationwide television campaigns. VCs were loathed to put millions of dollars in the hands of an inexperienced founder and so often, the first order of business after backing a company was to replace the founder with an experienced CEO - typically an executive from a large corporation like Oracle or SAP. In this context, David Beirne's background as a recruiter was invaluable.

The Summer Founder's Program launched in 2005 with a cohort of 8 companies. It invested $11K-$20K dollars into each company for 7%. In 2005, the venture capital world was drastically different from the '90s. The cost of computing had dropped significantly, the internet had enabled cheaper forms of reaching customers, and companies like Yahoo and Google had proved that young, first-time founders could scale large technology businesses.

The program, now known as Y-combinator, was built on these trends and specifically, three assumptions:

  1. Software was eating the world and the internet, together with its associated technologies, will transform every industry

  2. Startups could be launched with smaller amounts of money due to drastic reductions in the cost of computing power and the ability to quickly achieve scale through the internet.

  3. Young, technical founders are the ideal founder profile. If they can build a great product, they can learn how to scale a company.

Paul Graham understood in this world, the old school VCs were dinosaurs. You did not need a VC with a background recruiting executives because you were not putting >$2M into each company and you certainly were not replacing the founder. YC was not writing large cheques to MBAs with a business plan. YC's approach had three main parts:

  1. Give small amounts of capital to many young founders

  2. Share with them the playbook for starting a company and gaining traction

  3. Showcase them to investors who could provide follow-on funding

The model was simple - founders would come to YC to meet the best investors and the investors would come to YC to meet the most promising founders.

But in the early days of Y-combinator, the fund faced a challenge that would be familiar to anyone operating in a nascent ecosystem.

There are companies that will give $20k to a startup that has nothing more than the founders, and there are companies that will give $2 million to a startup that's already taking off, but there aren't enough investors who will give $200k to a startup that seems very promising but still has some things to figure out. This territory is occupied mostly by individual angel investors—people like Andy Bechtolsheim, who gave Google $100k when they seemed promising but still had some things to figure out. I like angels, but there just aren't enough of them, and investing is for most of them a part time job.

Why aren't there any more Googles by Paul Graham

Ultimately, the problem would not remain unsolved for very long. As more internet companies became successful, both super angels and early-stage VCs, emerged to fill in that gap.

The opportunity is a lot less unexploited now. Investors have poured into this territory from both directions. VCs are much more likely to make angel-sized investments than they were a year ago. And meanwhile the past year has seen a dramatic increase in a new type of investor: the super-angel, who operates like an angel, but using other people's money, like a VC.

The Future of Startup Funding by Paul Graham

In 2011, Yuri Milner and Ron Conway agreed to invest $150K in every company in the winter batch. Sequoia Capital, arguably the most successful venture capital fund in the world, invested directly into YC. Its partnership with YC has been very fruitful. Sequoia is one of the biggest investors in YC companies. 4 of YC's top 5 companies (Stripe, Doordash, Airbnb, and Instacart) count Sequoia as an early investor. Today, YC has no problem attracting investors for its portfolio companies. Demo days often have more investors than companies, with the average batch having 250 companies and attracting close to 2000 investors.

Author, Randall Stross, in his book The Launch Pad, described YC’s reputation like this: "YC remains preeminent... and investors show the highest regard for YC graduates, informally voting Y Combinator’s companies, collectively, as Most Likely to Succeed."

YC has leveraged this role as a gate-keeper to give itself great economics ($125K for 7% is a great deal for YC). More importantly, it has shifted the balance of power from investors to the founders. YC has done this in two major ways. First, it pioneered the SAFE, which has become the most common instrument for raising early-stage capital. It's a flexible instrument that allows founders to quickly raise from multiple investors at standard terms, compared to the traditional priced round, which takes more time as founders need to find a lead investor and negotiate terms/valuation. Secondly, YC set the behavioural norms for dealing with founders. If you break any of YC's rules, you could be blacklisted and lose access to the most promising founders.

YC has become one of the most successful and influential funds in Silicon Valley. In its next phase, it looks to replicate that success across the world.

Going Global

The world is increasingly becoming global. I mean, YC started a decade ago, and pretty much all the startups were US-based. Today, out of the 2,500 plus startups we funded, 27% of them are headquartered outside the US. More recently, in our batches at least 40% of our startups are international. I think if you play this a decade out, I think at least 50% of YC startups are going to be headquartered outside the US. Innovation is just happening everywhere. Specifically, markets I'm excited about: there's a lot being written about China. China is probably further ahead than other markets, but emerging markets I'd say, very bullish on India, Indonesia and Latin America.

— Anu Hariharan (Partner at Y Combinator's Continuity Fund) on Invest Like The Best

As YC expands globally, it meets ecosystems in different stages of maturity. In each new market, it brings with it a strong brand, a network of founders, and access to Silicon Valley's top investors, but it faces two challenges.

First, its method of mass selecting batches loses fidelity in markets where it is less familiar. In these markets, YC leans heavily on guidance from local investors and its early alumni, but it still primarily chooses companies through a simple application form and a 10-minute interview. It's much easier for Silicon Valley-based YC partners to quickly evaluate the background of a Silicon Valley-based founder and the viability of a Silicon Valley-focused business than it is when it's a Nigerian company and founder.

The second challenge YC faces is that its curriculum is not necessarily tailored to the nuances of building in an emerging market. Similarly, while some of the investors in demo day will invest outside of Silicon Valley, and that is usually enough for most companies to raise some capital, most of its investor base is still focused on the Valley.

The strength of YC's value proposition and the types of challenges it navigates depends on the maturity of the ecosystem. YC provides the most value when it enters ecosystems that are still nascent, where capital is scarce, and the local investor community is developing. In these markets, it does exactly what it did in Silicon Valley - it helps the local angel investing community develop and shifts the balance of power from investors to founders.

Take Nigeria, when YC selected Paystack and Flutterwave in 2016, capital at the early stages was scarce and not always available on founder-friendly terms. YC presented a compelling alternative: fly to silicon valley and raise at terms that are closer to SV standards than those in Nigeria. Successful companies at demo day often raise enough capital to get them beyond product-market fit and to meaningful traction. At that stage, while the company might still raise capital at an 'Africa discount', fundraising becomes more about the company's traction than the market it operates in.

For the most promising Nigerian companies, YC becomes a way to transcend the limitations of their local ecosystem. For better or worse, the ecosystem has started to orient itself around YC. Large chunks of the ecosystem are optimised for getting companies into YC. Many early-stage VCs see the number of portfolio companies that have gotten into YC as one of their most visible sign of progress. They fund companies that are likely to get through YC's application process then provide pretty extensive coaching on how to pass the process.

For companies, applying when you only have a form and a 10-minute interview, means you must compress. This has given rise to Nigerian companies being increasingly marketed as X for Africa. Nigerian companies that have gotten into YC include Stripe for Africa, Plaid for Africa, Twilio for Africa, Flexport for Africa, and Coinbase for Africa. It would be unfair to call these companies clones of SV companies, they are all solving local problems and adapting these models for their local context. Indeed, the 'X for Africa' language is rarely more than just a marketing spin. However, it is undeniable that the types of companies that are being started and funded is heavily influenced by the pull of YC.

The system works for most people involved. The companies raise capital at great terms, early-stage VCs get quick mark-ups from post-YC rounds, and YC has built the best portfolio of any fund investing in Nigeria (Flutterwave, Paystack, Kobo360, 54gene, and Helium Health are all portfolio companies). However, in the long term, as the ecosystem evolves, and the local investment landscape matures, there will be an opportunity for local players to not just optimise for YC, but to compete with it.

It's a useful exercise to contrast YC's experience in Nigeria with its experience in India. YC selected its first India-focused company, ClearTax, in 2014. Over the next few years, its batches included a handful of Indian companies. It met an ecosystem that had already developed a playbook for building technology companies and a robust funding landscape.

YC's initial offer of $7k for 20%, its requirement that founders travel to Silicon Valley on their own dime for the interview, and it's SV focused curriculum meant that it wasn't the most compelling option for all Indian startups. While there are >30 Indian Unicorns, only 1 is a YC alumnus, out of >50 companies from India that it has invested in.

It was only in 2017, after an 11 country tour that included India, that YC started to ramp up its selection of Indian companies. It started doing interviews in Bengaluru, India, the first time it has done so outside of the USA. It brought on Kunal Shah as an advisor. Kunal is the founder of CRED. He's a respected founder in the Indian ecosystem who exited his previous company, FreeCharge, for $450M. YC considered bringing Kunal as a part-time partner but ultimately decided against it. Today, India is often the second most represented country in YC batches after the USA.

Sequoia Capital, which entered India much earlier than YC and maintains a strong local presence, has faced its own challenges but has had more success. It has multiple unicorns in its portfolio including Ola, Zomato, OYO, Byju’s, Freshworks and MuSigma, but it was not an early investor in any of them and most of these investments happened at the growth stage. It launched an accelerator called Surge in order to get into the best Indian and South East Asian companies at the early stage.

Surge is loosely modelled after YC but has important differences. It offers founders $1M-$2M for ~15%-20%, it is based in India but with trips to SV, China, and Singapore, and it has an impressive group of local mentors including Kunal Shah and founders/operators from many of the most successful Indian & SE Asian companies. For the most promising founders, Surge presents a credible alternative to YC.

As YC expands across the world, it should expect this type of competition. Local operational expertise and networks become a very compelling value proposition in mature ecosystems with developed sources of capital. In order to continue to attract the most promising founders from across the world, YC will need to adapt. The next few decades of YC's global expansion will test the limits of its centralised model.