By , Scott Shane
Published May 03, 2016
AngelList, the online platform that matches high-potential companies with startup company investors currently lists 467 startup accelerators. That’s a big increase from one in 2005.
Why have we experienced such tremendous acceleration in accelerator formation?
The answer is that accelerators offer a lasting solution to problems that business angels and venture capitalists face in financing high-potential “pre-seed-stage” companies.
Before I explain why, let me first describe this innovation: A startup accelerator is an organization that provides very-early-stage startup companies with the opportunity to participate in a fixed-length program (typically around three months) that provides mentorship, office space, a small amount of money (typically around $25,000), and an opportunity to pitch to angels and venture capitalists at a graduation event. In return, the accelerator receives a small equity stake in the company (typically around 8 percent).
Startup accelerators solve several problems that financiers face when investing in pre-seed-stage companies. Many business angels and venture capitalists want to diversify their investments across more startups. However, most of these investors lack the structures and processes to make a large number of small investments. Organizations that typically invest $3 million in a single early-stage venture deal, as venture capitalists do, are not designed to evaluate and assist 120 ventures that each receive $25,000. By giving money to specialists (accelerators) that have the structures and processes to make these types of decisions, venture capitalists and business angels can easily diversify their investments.
Accelerators allow investors to treat investments in very-early-stage startup companies as real options. Everyone knows that a small number of startup companies will succeed and grow, while most will fail. But no one knows ex-ante which business will be winners and which will be losers. By allowing angels and VCs to invest small amounts of money in many companies at a very early stage, accelerators give investors the right, but not the obligation, to make additional investments in the most promising ventures.
Accelerators reduce investors’ cost of searching for businesses in which to invest. These organizations typically accept applications from entrepreneurs that are located in a wide variety of places. Selected entrepreneurs are asked to relocate to the accelerator for a short period of time. The temporary relocation of promising entrepreneurs helps investors identify promising targets to back. Because the accelerators are generally located near investors and because they typically run “demo days,” where their graduates pitch their ideas to financiers, these organizations allow venture capitalists and business angels to find out about a wide variety of ventures more cheaply and easily.
Moreover, accelerators help investors obtain better information about potential portfolio companies. Angels and venture capitalists are often tapped to serve as mentors to businesses in the accelerators. Serving in that role allows investors to gather information about which startup businesses have the greatest potential.
Accelerators speed the development of pre-seed-stage companies. Because these organizations are specialists at providing the type of hands-on assistance that entrepreneurs need at the pre-seed stage, and because entrepreneurs are co-located with the accelerator directors, the people running accelerators can provide more intense help to startup companies than most angels and venture capitalists, speeding up the development of the companies. Moreover, co-location with other entrepreneurs breeds competition among business founders, which pushes the companies forward more quickly. Faster development, in turn, benefits investors whose returns are enhanced by a shorter time-to-exit.
Startup accelerators are an innovation in the process of funding early-stage, high-potential ventures. Because they solve real problems that business angels and venture capitalists face in financing pre-seed-stage companies, accelerators are not simply a fad. Rather, they represent a lasting change in the venture-finance marketplace.