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Do Startup Accelerators Deliver Value? The Economics of Creating Companies (Part 2 of 2)

Do Startup Accelerators Deliver Value? The Economics of Creating Companies (Part 2 of 2)

Aug 22, 2011

As alluded to earlier (see Part 1), startup accelerators may contribute to firm growth in four ways: human capital growth, reduction of search costs, signaling, and reduction of the rental rate on capital. However, the significance of any of these effects has yet to be proven empirically.

Human Capital
The role of human capital in startup formation cannot be underestimated: economists have always recognized human capital as the main factor determining economic value in countries as well as companies . Accelerators generally bring in a variety of education resources for the founders and employees of their participating companies. The education can be formal—training in finance, accounting, marketing, etc—and informal—off-the-cuff discussions with organizers, mentors, and other participating companies. Accelerators put a tremendous amount of effort in to bringing in brand name speakers and mentors.

However, it is worth asking whether a few weeks of educational programs will have any significant effect on founding teams, which in many cases are loaded with highly educated teams of PhDs or MBAs. The efficacy of these programs remains unproven, and formal programs may just be crowding out other educational avenues where people would regularly learn the same material (books, university classes, etc.).

It is hard to make any determination about whether or not the educational component of an accelerator has a significant role because it will be near impossible to separate out the effect of the education from everything else that an accelerator offers. But turning again to our higher education analogy, the return on a year of education generally diminishes after two years of graduate school: what long term impact on return does a 3 month program have?

 

Search Costs
Accelerator organizers put an extensive amount of effort into connecting their companies with mentors, additional investors, and other entrepreneurs, in the hope that these connections can facilitate their ongoing growth. This networking effort presumably reduces search costs for firms (search costs are part of the broader category of transaction costs).

Search costs are the time, energy and money an agent or firm expends researching a product or service (including employees!) for purchase. Search costs can be external—such as the monetary and opportunity cost of acquiring information—and internal—the mental effort needed to find and sort needed information. One can only choose whether or not to incur external costs, but one cannot change their level. Internal costs are determined by the agent or firm’s ability to undertake the search, and this in turn depends on intelligence, prior knowledge, education and training.

Entrepreneurs face search costs in a variety of situations with friction, including finding other founders, recruiting employees, building an advisory board, and most visibly, raising capital. The venture capital and angel industry is a far cry from the relatively liquid capital markets of Wall Street; by most measures, it is a high friction, low information environment dependent on personal connections. Accelerators are supposed to help lower the cost for entrepreneurs to reach higher quality people, services, and funding, making it more likely they would do so. Indeed, an active mentoring process certainly increases network connections. This in turn creates a more liquid market of intellectual and monetary capital, albeit to an unknown extent.

 

Signaling
Getting accepted into a top accelerator program is a public sticker of approval. These programs use rigorous judging processes in order to determine which teams can enter their accelerator and receive funding.

The need for signaling in any transaction arises from asymmetric information in principal-agent relationship, where in this case the agent is the startup firm, and the principal is the customer, investor, acquirer, or anyone who is putting resources into the startup. The problem is that the startup firm knows more about how it is doing than anyone on the outside: only the firm would truly know if they are having technical, financial, or personnel problems. It is comparatively easy for the startup to misrepresent  their progress (intentionally or unintentionally), and more importantly, they have every incentive to over-represent themselves. Outside principals know this and play the part of the untrusting customer.

A startup can get around this by finding ways to credibly convey information about itself, which economists call signaling. The key point here is that the information must be credible, and the principal much have some way of ascertaining that credibility. To maintain credibility of the signal, the signal must be lower cost, i.e. easier to obtain, for agents who are of higher value to the principal. 

The classic example of the principal-agent relationship involves an employer and prospective employee. The prospective employee knows more about her own skills than the employer does, so the employer may look for signals from the employee which may not represent actual skills, but may be correlated. A college degree serves as a great indicator and signal of skills; regardless of whether or not the employee actually learned anything at all during college, the act of just getting the degree is a powerful signal to an employer. More importantly, it is less costly—easier—for a higher-skill employee to get the degree than a low-skilled employee.

Startups are no strangers to the signaling process. For example, a startup may take on advisors to their board for no other reason than to build credibility, most notably in the life sciences space. How many pharmaceutical business plans have you seen that have handfuls of Harvard Medical School faculty on the rolls? Do we really think that all of those listed faculty interact in any meaningful way with the startup?

Nonetheless, investors prospecting these life sciences startups will generally look for long lists of famous scientific advisors as a signal towards the viability of the startup’s technology. This method is effective because it is less costly for a startup to bring a well-known researcher to their board if their technology is credible: it would be easier to convince the researcher to put her name on it if she thought the company was going to succeed and not fail and hurt her reputation.

The same is true of the startup accelerator: it is less costly for a more valuable startup to enter and be accepted into an accelerator, which has a competitive admission process. Therefore prospective investors may assume that startups in the accelerator are likely of higher value.

If accelerators only provide signaling, does that mean they do not provide any value? Not necessarily. Accelerators can provide value in the entrepreneurial ecosystem by addressing the fundamental problem of asymmetric information in the market for new enterprises. For example, there are likely startups that have a great potential, but happen to be in the position that they are ill-connected to people in the entrepreneurial ecosystem. Thus, it is costly for them to build a board of advisors or get referrals to investors—both signals in themselves. However, the accelerators are open to all who apply and presumably less biased towards those with strong personal connections.

Signaling is critical in many markets with asymmetric information—labor, used cars, and even spouses—and is equally important in the market for new enterprises.

 

Cost of Capital
We’ve put off the most obvious value of the accelerators: funding. The funding model varies from accelerator to accelerator, but they exclusively offer funding at levels traditionally occupied by angel investors, who do investments primarily less than $750,000. Y Combinator makes “small investments (rarely more than $20,000) in return for small stakes in the companies [they] fund (usually 2-10%)”. On the other hand, MassChallenge awarded 16 teams prizes of $50,000 to $100,000 last year, taking no equity at all.

Accelerators are an additional capital source in an illiquid market for small investments mostly occupied by angels and micro-angels.  Therefore, these additional funding sources reduce the cost of capital for startups (interest on loans or equity lost).

That being said, which funding model is superior? The MassChallenge model depends entirely on the generosity of their sponsors, which includes government agencies, large corporations, universities, and law firms. Therefore, there is no direct fiduciary connection between the success of MassChallenge and their accelerator companies. The equity based model used by Y Combinator and TechStars looks promising, putting them in the position of involved angel or VC. However, some have raised serious questions about the fairness of the system: for example, Y Combinator made a standard investment in Dropbox—less than $20,000 for 2-10% of the company—and as of the release of this article, are said to have a $5 billion dollar valuation. Even if they only took 2%, that is still $100 million for Y Combinator. While the cost-benefit of various funding models can be debated, the fact remains that funding is a major reason driving the droves of entrepreneurs towards accelerators.

 

Moving Forward
Accelerators are fairly new and the research literature is still very slim. Economists and management experts are moving forward on studying this field, and various university professors and Federal Reserve economists have already reached out to leading accelerators for the few years of data that are available.

Should you enter your startup into an accelerator? While the benefits have yet to be proven, there aren’t that many strong reasons not to. But one thing is for sure: with their rapid growth, accelerators aren’t going away anytime soon.

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