When DoorDash went public at the start of last month, many were quick to point out its roots in the Y Combinator (YC) accelerator programme.
The food delivery business is one of many successful tech firms, including Stripe and Airbnb, to have received early-stage financing from the start-up incubator.
That programme has also generated big returns for YC.
The company provides $150,000 in funding for a 7% stake in any business that takes part in its start-up accelerator. Aside from financing, start-ups that take part in the programme can build connections and get pointers on how to grow their business.
Of course, from an investment point of view, the 7% stake is what makes all of this worthwhile for YC. The company paid $120,000 for its share in DoorDash. It’s unlikely that YC still holds the full amount but, at today’s share price, a 7% stake in DoorDash would be worth close to $3.6bn.
Getting in early
Such high returns will leave many wondering if they can do the same. The answer to this is both yes and no.
The first thing to be aware of is that YC is only investing in very early stage start-up businesses. These are private companies and aren’t listed on exchanges, so you can’t just open a Freetrade GIA, for example, and snap up shares in them.
That doesn’t mean it’s impossible to invest in early-stage companies. Crowdfunding platforms, like Crowdcube, are one way to get direct access to them.
Another more indirect method is to buy shares in listed companies that invest in start-ups. This could include venture capital firms, like Augmentum Fintech or Draper Esprit, or trusts that invest in private companies.
Obligatory risk warning
It should go without saying that investments that have a high potential return also carry a high level of risk.
By some metrics, 40% of YC companies fail — and that’s not taking into account those that sell off in an effort to save face.
It also ignores the fact that most of YC’s investments have taken place over the past five years, which means that percentage could easily rise in the years ahead.
And in the wider world, somewhere in the region of 90% of start-ups end up failing.
The point here is to remember that early-stage investment is a risky business, even for the professionals. That’s not to say that you should never do it but that you should be aware of the risks inherent in doing so.
Do your homework
If you don’t feel like putting your cash into riskier businesses, there are still a couple of good lessons to be learnt from YC’s investment process.
The first is to do due diligence. YC is in the lucky position of having thousands of companies apply to be a part of its incubator programme.
That means it can sift through the applications and decide which ones to pick and which to ignore.
But in a sense, you as an investor are in the same position. No company is strong-arming you into investing in them. You are the one who can sift through their financials, look at their management team and decide how successful their products or services are likely to be.
Those are exactly the sorts of things that YC does. Sam Altman, the company’s former chairman, has said openly that he would look at a start-up’s management team, product, growth prospects and costs when deciding whether or not to invest.
And this logic is applicable to companies that are big and established, not just start-ups. It may sound like a simple thing to do but looking at these factors, and not just jumping on the next hype bandwagon, could help make you some money when you invest.
YC’s success is predicated on its ability to buy a stake in a company at an extremely low cost relative to its future value.
This is effectively what all investors want to do — buy low and sell high — it’s just that the difference between ‘low’ and ‘high’ in YC’s case is much greater.
Applying this to the stock market is a little trickier.
That’s partly due to the fact that companies listing on an exchange have already been funded privately but also because undervalued stocks tend to get snapped up quickly, so that they don’t stay undervalued for long. We saw this earlier in the year when the markets crashed and then promptly shot up again as investors swooped in to buy up cheaper shares.
But there’s also a distinction to be made here between those companies which are genuinely oversold or unfairly unloved, and those which are cheap for a reason.
Not all low prices are bargains.
And this is where it pays to look beyond the balance sheet and have a look at the team running the business itself. Are they in it for the long term? Do they have skin in the game that aligns their interests with shareholders’? And are they willing to admit when they get things wrong (which they will) or will their ego get in the way?
Like a movie studio, YC can afford to get quite a few decisions wrong because, when they get one that works like DoorDash, it can make up for all the others and then some.
That approach rarely makes sense for individual investors with life goals carrying set timeframes like house deposits or weddings.
What we can take away from YC is that assets should definitely be competing to make it into your portfolio — you shouldn’t be adding anything of low quality just on a hunch.
This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.
Freetrade is a trading name of Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).