Y Combinator for Mittelstands

This is a follow-up to my most popular post We Need a Middle Class for Startups.

• Both of these ideas are on my list of solutions to The World’s Biggest Problems.

I want to raise a $1M+ per year rolling fund to build this accelerator.

• DM or email me if you want to invest!

Summary:

Idea: Raise two funds to help founders launch and scale middle class startups:

1. Accelerator: Invest the first $100K+ to help new pre-Mittelstands launch and grow.
2. Ventures: Invest $1M+ to help pre-Mittelstands go from $1M to $10M+ revenue.

Problem: It’s hard to fund pre-Mittelstand startups.

• Most VCs won’t fund niche services and SaaS businesses.
  • VCs expect SaaS startups to 3x+ for two years, then 2x+ for three years, after hitting $2M ARR.
    • See: The SaaS Adventure by Neeraj Agrawal
    • That’s $2M to $72M ARR in five years.
  • A pre-Mittelstand’s growth trajectory looks more like $2M, $4M, $6M, $9M, $12M.
    • That’s “only” $2M to $12M ARR in five years.
• Most PEs wait until $5M-10M+ in annual revenue before investing.
  • PEs typically target 3-5x returns through safe flips and rollups.
    • Example: PE buys three businesses with a combined $20M in revenue and $4M EBITDA for 8X EBITDA ($32M). They combine operations and increase sales and marketing spend and get the company to $30M revenue and $10M EBITDA. They convince a “strategic” corporate or larger PE to buy it at 12x EBITDA ($120M).
  • Micro-PEs are starting to move earlier with holding companies (see Trend below)
    • But these funds are just starting to invest in $1-10M revenue pre-Mittelstands, and no PE is investing in $0-1M pre-Mittelstands.
• Most banks won’t fund new pre-Mittelstands with no revenue history.
  • These founders are expected to bootstrap to $1M+ revenue and profitability.
    • This isn’t possible for most new and aspiring Mittelstand founders.

Solution: Fund pre-Mittelstand startups from $0-10M+ in revenue.

• Accelerator: $100K for 20%.
  • Help new Mittelstands go from $0 to $1M+ annual revenue fast.
    • Founders are currently expected to perform amazing feats of bootstrapping to get through this stage, raising money from friends and family and shows like Shark Tank when possible.
  • For new ($0-500K annual revenue) SMBs.
    • For many aspiring Mittelstand founders, $100K and one investor is enough for them to quit their job and go all-in on their business.
  • Be the first investor and believer in new pre-Mittelstands.
    • Be like Paul Graham circa 2005 – find people who others didn’t think could be founders and coach them from the very beginning to control their companies.
      • The brilliance of Y Combinator is that it built a front door that is easy to find (YC) in front of a front door that is hard to find (VC).
        • Y Combinator for Mittelstands can do this for PE.
• Ventures: $1M+ for 20%.
  • Help established Mittelstands go from $1M to $10M+ annual revenue faster.
    • Targeting $1M to $10M in six years or less.
      • 6 years to $10M revenue = 48.6% CAGR
      • 10 years to $10M revenue = 25.9% CAGR.
  • For established ($500K+ annual revenue) SMBs.
    • These startups are still way too small for even small cap PEs.
    • This category is starting to be called Micro PE.
  • Targeting 5-10x revenue multiples.
    • We can’t do the 10-20x+ revenue multiples VCs are giving SaaS startups now.
    • We can create a sliding scale where larger pre-Mittelstands get more money for 20% (max valuation = 10x revenue).

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Mittelstands vs. VCs:

Thesis: It’s possible to get VC-style 10x+ returns with a much lower risk profile.

• Startups must grow at >100% CAGR to generate 10x+ returns for VCs.
  • $2M to $72M in five years is 104.8% CAGR.
• Mittelstands can generate equivalent returns with <50% CAGR.
  • $2M to $12M in five years is 43.1% CAGR.

Key: All US businesses, not just tech startups, follow a power-law distribution.

• That means there are 10x+ as many $100M companies vs. $1B startups.
  • The entire VC model only works when funds get these $1B+ exits.
    • That’s why we’re seeing the proliferation of $1B+ VC funds and 100+ company portfolios.
  • Mittelstand funds can consistently generate 10x+ returns with 8 and 9 figure exits.
    • This 10x+ increases the pool of investable startups.
  • The probability of $1B+ startups actually drops below the power-law distribution.
    • This suggests there’s a ceiling to startup size that inhibits growth past $1B.
• By building our model to get 100x+ returns with <$1B exits, we can get top-tier VC results investing exclusively in Mittelstands.
  • This pre-Mittelstand zone is currently underrated as an investment sector.
    • Prediction: Mittelstand investing will get hyped in the next downturn.

Trend: A funding ecosystem is starting to form for pre-Mittelstand startups.

• A few VCs are funding these companies using different names.
  • Examples: “Indie” (Indie VC), “Bootstrapped” (TinySeed), “Calm” (Calm Fund)
• Entrepreneurs creating holding companies to buy and grow many SMBs.
  • See: Permanent Equity, Majority Search, Tiny Capital, Enduring Ventures
• New startups and funds are also offering non-dilutive revenue-based financing.
  • See: Pipe, Founderpath, Stripe Capital, Tractor Ventures

Timing: PE and VC returns oscillate based on market sentiment.

• VC has a higher ceiling during booms, but also a lower floor during busts.
  • 2010-2021 has been a sustained boom for VCs.
    • R.I.P. Good Times again?
• Prediction: PE will outperform VC by +10% IRR over the next 10 years.
  • And you can get better than PE returns by investing in pre-Mittelstands.
• PE and Mittelstands are counter-cyclical.
  • They do best in down markets because they’re largely valued on cashflow and assets, not growth.
    • This is the perfect time to start a pre-Mittelstand fund.

Challenge: Can you get YC-level returns with a Mittelstand strategy?

• 90%+ of YC’s projected returns now come from the <1% of their startups that IPO.
  • But this only started in 2018, 13 years after YC’s first class.
• YC’s model is especially hits-dependent because they own <10% of their startups.
  • To get a 100x return on their $125K standard deal, YC needs a $300M+ M&A exit or an $600M+ IPO.
    • This analysis assumes YC owns 2-4% of companies at M&A or 1-2% at IPO:
• Our Accelerator model can get a 100x return on an exit as low as $50M.

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YC for Mittelstands:

Strategy: Be the first (and often only) investor in pre-Mittelstand businesses.

• If one of our Accelerator founders gets a $1M exit, we get a 2x return.
  • This aligns us with founders at the earliest stages, unlike both VC and PE.
• If one of our Accelerator + Ventures founders gets a $10M exit, we get a 3.3x return.
  • If a Mittelstand founder only takes our two rounds, they keep 64% ownership at exit.

Opportunity: Help founders keep control of their Mittelstands for longer.

• Y Combinator did this for startup founders.
  1. YC was predicated on the idea that “Young hackers can start viable companies.”
     • This seems trivial now, but when YC was founded in 2005, the conventional wisdom still dictated that VCs should replace founders with professional CEOs.
       • YC’s funding, education, and spotlight gives founders leverage over investors.
         • More funding options means better terms and more founder control.
• We can do this for Mittelstand founders:
  1. Invest long before private equity gets interested.
  2. Founders get to $10M+ revenue with majority ownership.
  3. This gives them leverage to turn down PE/corporate buyout offers.

Why: These businesses can be way better for founders.

• Majority Ownership: Mittelstand founders keep full control of their businesses with us as their investors.
  • They can choose to exit quickly (we share upside) or slowly (we share profits).
• Higher Win Rate: VCs can rely on their portfolio to cover losses, but startup founders are all in on one business, win or lose.
  • Mittelstands are more likely to win, which makes life easier for their founders.
• More Opportunities: There are many more Mittelstand business opportunities available in every region and any market condition.
• You don’t even have to have a new idea to start a Mittelstand.

Simulation: What are the expected returns for a Mittelstand accelerator?

• Assumptions: Mittelstands grow slower but are more likely to exit.
  • Structure: 100-company portfolio, 2% and 20% fees.
  • Growth: 40% average YoY growth, 6 years to exit.
    • This shows that we can get great returns with sub-50% annual ARR growth.
  • Outcomes: 25% go to 0, 25% return <1x, 50% return >1x.
• Results: 50th percentile – 30.3% IRR, 90th – 67% IRR, 99th – 133.1% IRR.
  • Prediction: Y Combinator for Mittelstands will have 100%+ IRR in 10 years.

Key: Be the whole round each time.

• Mittelstands can get profitable with $1M funding or less.
  • These companies can use non-dilutive funding sources to keep majority ownership forever.
• Mittelstand accelerators should get a right of first refusal to fund any future rounds.
  • This will be key to keeping our ownership at or above 20% at exit.

Advantages: Be fast, fair, and open to all.

• Faster than VCs.
  • Close a $100K Studio deal in 1 week with 1 application.
    • Question: Is it possible to make these investments on metrics alone?
      • This should make our investment selection process fairer.
• Better terms than PEs.
  • Founders can keep majority ownership as long as they want.
  • We’re aligned with founders on pursuing non-dilutive funding sources for these businesses.
• Easier than banks.
  • Get a $1M Ventures deal in 1 month with no personal guarantee.
    • Problem: Banks require Mittelstand founders to personally guarantee their debt.
      • Our deals never require personal guarantees.
    • Problem: Banks take 3-6+ months to process a commercial loan.
      • That includes 100+ hours of collecting, creating, and submitting documents and financial records.
    • Question: How much due diligence/auditing do we need to do to avoid fraud?
      • This is easier if we can connect into their analytics and payment platforms.

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The Future of Mittelstands:

Market: What is the limiting factor to how many deals we can do in a year?

• There are 200,000 Mittelstands in America now.
  • 340 new unicorns were created in 2021. (296 combined in the previous five years.)
    • Let’s say there are ~100 new unicorns per year on average.
  • There should already be 1,000+ new $100M+ Mittelstands created per year.
    • How many of these businesses can we fund at the $0-10M stage?

Potential: How can we inspire many more founders to create Mittelstands?

• YC expanded the pool of potential startup founders by age and origin.
  •  VC used to be more biased towards older founders and executives already based in US tech hubs.
• YC for Mittelstands can expand access to lower income founders.
  • Mittelstands are usually self-funded by middle or upper class founders.
    • This is the classic “family” business.
  • $100K can be a life-changing investment for these founders.

Vision: Lead a movement to create and grow more middle class startups.

• Mittelstands are great for founders, investors, employees, and the economy.
  • The higher likelihood of successful exits better aligns incentives between Mittelstand founders and investors.
  • The lower failure rate of these businesses provide stability for employees and the economy.