Everyone is figuring out that Y Combinator has it figured out

We wrote about our admiration for Y Combinator last week, and discussions on their incubation / seed / micro-vc / business model have been continuing inside our office and out. The New York Times is taking notice too.

Y Combinator is aiming at even smaller firms, and its approach is decidedly unorthodox. It chooses companies for financing in two batches of 8 to 12; one batch is selected in the winter from companies based in Silicon Valley, the other in the summer from those in Cambridge, Mass.

Mike Arrington decided to dig a little deeper at TechCrunch, where he reveals who many the Y Combinator companies are. There are some powerful concepts in the batch, my personal favorite is Thinkature, which is a cool Ajax powered digital whiteboard for collaboration.

So, more to the point, what has Y Combinator figured out that we are all trying to emulate?

1. It’s the value creation that matters! I am as guilty as all the other VC’s and Angels out there who are trying to piggyback Web 2.0 to riches. But, what Y Combinator has realized is that capital is just another resource that is required to get these companies off the ground, like broadband and RedBull. But capital left alone alone just gets burned. The creation of new technologies, new communities, and new platforms is where the value is created. Paul Graham is a technologist first an investor second, and that is reflected in his model.

2. Small is the new big. I had a conversation with a Marc Nathan yesterday and it dawned on me why the traditional VC’s are the ones being disrupted by the Y Combinator model. In a traditional VC fund the fund manager takes a 2% annual management fee and then 20% of returns subordinate to the investors take after the 3 to 5 year liquidity events for the funded companies. With the much smaller capital requirements of Web 2.0 companies, the VC’s can’t put their money to work on these small investments. Y Combinator’s $6000 per founder model keeps the founders hungry but more importantly is easy to make nice returns on in a exit environment that is dominated by acquisitions not IPO’s.

3. The exit is acquisition. Most of the successful companies that are being created in Web 2.0 right now will end up as pieces of other companies. What is exciting about the current landscape is that it is basically a shift of R&D budgets of the larger companies from internal to external. Companies can survey the scene of innovative products that are being created by Web 2.0 upstarts and pick and choose what fits best in their portfolios. The key to this is having a profile like Y Combinator because success begets success.

We’re excited to continue to build our companies, and as we’ve said before, right now it is looking like Y Combinator is the model to beat for the current Web 2.0 generation of companies.