A new breed of seed capital is redefining the way start-ups develop. But are entrepreneurs getting value for money?

In March 2005, Paul Graham and Jessica Livingston accidentally invented a new method of funding start-ups. They named their seed capital firm Y Combinator, after an obscure mathematical function. Neither had any experience as angel investors, but both had excellent Silicon Valley contacts and backed each other's ability to pick winners.

Graham and Livingston recognised that seed funding was often hard to come by, especially for bedroom hackers unaccustomed to the language of finance. In return for a stake of between two and 10 per cent, Y Combinator's seed funding—generally $5,000, plus $5,000 per founder—would take care of the bills until the big bucks came in.

As Livingston explained in April last year: "We're trying to be the first gear of funding. We're not expecting the money we invest to be the last a start-up ever raises.  It's just to get them going.  And we want to get as many start-ups going as we can."

Crucial to the pair's new funding model was an intensive three-month period of mentoring. The idea was to "accelerate" young technology businesses to the point where they could learn to stand up by themselves. By providing access to a valuable network of Bay Area mentors and money men, Graham and Livingston were able to inject their investments with valuable commercial acumen.

There was one other crucial characteristic of the new model. The more start-ups you took on, the higher the odds of finding another Google, or at least a business deemed worthy of acquisition by Google. But dealing with high numbers of start-ups in a bespoke fashion, handling mentoring, legal and product issues separately, was time consuming. By processing the start-ups in batches, the duo could be far more efficient. In effect, Graham and Livingston created a kind of start-up processing plant, in which all pitches were assessed together and mentored together. The accelerator model was born.

It wasn't long before the idea crossed the Atlantic. Saul Klein from Index Ventures and 3i's Reshma Sohoni launched Seedcamp two years later, promising to do for early-stage European start-ups what Y Combinator had done for its stateside brethren. Like Y Combinator, Seedcamp processed its pitches in batches—in a competition format—pushing the most likely winners onto intensive week-long courses every September, where thanks to the input of mentors and investors, inexperienced entrepreneurs could develop the requisite commercial skills in a very short space of time. The winners of each Seedcamp competition received €50,000 and a further three months mentoring in exchange for a stake of between five and 10 per cent of the company.

Y Combinator has already seen a number of notable exits, including Reddit, Zenter, Omnisio and Auctomatic. Seedcamp winners, such as Kublax and Patients Know Best, have praised the programme's ability to provide not only much-needed funding, but access to the continent's most experienced and successful mentors. And because Seedcamp operates as a collective of experts, including investors, entrepreneurs, product experts, PR professionals and lawyers, it has quickly gained a solid reputation among the investment community. "Seedcamp opens doors," says Bindi Karia, emerging business lead for Microsoft UK.

But so do seed-level VCs: it's part of the job description. And it's not as if the UK is particularly short of seed capital. In general, Europe's appetite for early stage ventures is not quite on a par with Silicon Valley, but there is plenty of experienced money available for good ideas—typically at lower prices than those charged by some accelerator programmes. For an initial £25,000 stake, seed VCs take between three and five per cent of the business.

Europe is also hardly short of incubator space, particularly in the UK, where entrepreneurs have plenty of opportunity to mix with like-minded innovators. And many seed VCs are happy to play mentor if the situation demands it. All of which begs the question: what do accelerator programmes offer that the established investment community doesn't already?

Sharon Vosmek, who runs Astia, an accelerator programme for women-led firms on both sides of the Atlantic, believes the network effect of accelerators is key. "I do believe that the individual does not scale, and in high-growth businesses, success is largely determined by who is involved and how many are engaged in the success of the company."

Vosmek says that smart entrepreneurs use networks as a shortcut to success. "We all benefit from prior failures and successes and we all need access to a network.  High growth businesses are a network play.  If you ask an investor who they invest in, it is people they know and trust."

Fred Destin provides seed funding at Atlas Venture and is also on the board of Seedcamp. He believes acceleration programmes are suited only to the greenest of entrepreneurs, those with great products but no idea of how to fund them or bring them to market. So what would Destin do if he came across a strong product backed by an entrepreneur with no commercial acumen and no network? Send them straight to Seedcamp? "If I found some guys that I thought were really great, I'm not sure I would refer them to Seedcamp, I would try and invest in them," laughs Destin. "I would try and keep them off market and mentor them if necessary."

It's a tactic that's worked in the past. Atlas invested in DataXu, an online advertising service, on the condition that its founders, "a couple of scientists", brought on board an experienced CEO to launch the product. "We actually identified the business guy that they could start the company with," says Destin. "We matched them with a CEO and funded the package. That was part of making it fundable for us. Would I have referred that to Seedcamp? Absolutely not."

If the idea is strong enough, then, surely entrepreneurs can avoid acceleration programmes altogether? It's not as simple as that, argues Destin. "If we had a deep, highly efficient seed funding market, I would agree, but that's not the case," he says. The Eastern European Seedcamp events were "a sea change for countries like Ukraine," he adds. "I would even argue that in France, Seedcamp is a couple of notches above what you would typically find [in the traditional seed funding market], again because of the quality of the advisers."

Jon Bradford set up his accelerator programme The Difference Engine (TDE) last year in an attempt to attract early stage start-ups to the North East. Bradford says TDE is more closely aligned with Y Combinator than Seedcamp, which in his view has become "a victim of its own success", now preferring to invest in companies that are closer to, if not already, producing revenues, rather than take a risk with "bedroom hackers". Says Bradford: "Seedcamp started out like Y Combinator, but have ended up investing in organisations that are much further down the food chain."

Bradford says he saw a gap at the bottom end of the market, giving "people with ideas opportunities to get things moving." He says his mentor list is filled with "people who have worried about how to pay the bills on a Friday night", with no room for accountants, lawyers, or VCs. Start-up teams get £20,000 for eight per cent of stock, mentoring and free accommodation for 16 weeks.

TDE entrepreneurs are obligated to relocate to the North East for the duration of the programme, but not to stay in the region afterwards, although Bradford hopes they do. Applications for the first group are now closed, with the vast majority of the overseas teams coming from Eastern Europe. "There's not too many people who want to go from Barcelona to Middlesbrough," says Bradford.

What do these bedroom hackers get for their eight per cent? What can TDE offer that The Accelerator Group or Spark Ventures cannot? VCs can accelerate businesses, says Bradford, but not with the same intensity. "It's a numbers game. Some of the VCs you mention will not do 20 teams the way I am doing 20 teams." And the network effect is powerful, he adds. "The feedback I get from applicants is that they want to be stuck in a room with nine other exciting tech businesses for 16 weeks. One of the strongest elements is the feedback within the different teams."

But don't you get a similar level of camaraderie by basing your start-up at an incubator? "There is value in the incubator," agrees Bradford, "but the problem I have with them is they tend to be physical spaces. An acceleration programme is a very defined period. You start at this point and you end at this point." In any case, he adds, with TDE, "all the businesses will be at a comparable point in their lifecycle. Businesses in an incubator can be at any stage, so it's difficult for them to relate to each other."

For budding entrepreneurs worried about early loss of equity, there are other routes. Microsoft BizSpark is a start-up program offering access to the latest Microsoft development tools, as well as a network of investors and incubators. In lieu of equity, Microsoft says it benefits from forming relationships with promising young tech stars. Bindi Karia manages Microsoft's UK start-up accelerator programme. "I'm looking for innovators on the Microsoft platform who tell a good story," says Karia. "They are our salespeople."

In just over two years, BizSpark has mentored 1,800 UK start-ups. She cites the programme's relationship with enterprise software firm Huddle as a good example of its capabilities. "We started engaging with Huddle when there were six of them. These guys use our platform and we want them to shout out to the world that they are using Microsoft."

Karia says the reputation boost from such an association trumps the value of any equity holding. "Historically we've had a bad reputation in this space. I think BizSpark has changed that. I think it's made us more approachable. [It says] that our platform is good [and that] we're not the evil empire that people perceive us as."

Karia says the companies accepted onto BizSpark get access to free technology, access to engineers, and technology support. They also get to tap Microsoft's undoubted marketing and PR skills. "Because we have a press team in the Valley we're able to help our companies get more kudos." She cites Huddle's position in Business Week's Top 50. "When Business Week asked our team 'can you recommend some start-ups?' we were in a position to do that."

In Karia's view, just a single day spent alongside experienced entrepreneurs can add significantly to a nascent company's worth. She cites Lovestruck.com founder Brett Harding, whose dating website recently received a seed investment of £285,000. Harding attended a mini Seedcamp event in April 2009. "He just did the one day. It really helped him shape his business plan and focus his business," says Karia.

But Bradford maintains such success is a rarity. "Many Seedcamp [events] are one day. What do you achieve in one day's worth of mentoring? Even with a week, what do you really achieve? It helps, but it doesn't help enough." The Difference Engine, he says, offers 16 weeks of more intensive coaching: "There's no popping in and out. Full time, 16 weeks, it's pretty hardcore. You're going to be sleeping under your desks, working with [mentors] day in day out."

The Difference Engine is supported by the RDA One North East, Middlesbrough Council and Sunderland City Council. Bradford says he is also talking to Business Link about possible involvement. "This is a valuable programme that a government agency should be sponsoring. It creates opportunities and has sustainability," he says. Bradford accepts that his view is a controversial one, particularly among the VC community. But if public money is going to be involved at all, he argues, surely investment should come in "at the bottom, creating opportunities for the next generation, rather than doing late-stage stuff that commercial VCs should be able to pick up?"

Destin disagrees. "For the RDAs to start funding companies makes no sense to me. Fundamentally it's not their job. I'm giving you money to spend in my region and somehow that's going to kick start a local economy? I don't buy that. It's a perversion of what they're supposed to do. [VCs] have trouble making money, I don't see how the RDAs are going to make money."

And for public money to step in, says Destin, it implies that there is an equity gap, which he doesn't believe exists. "There is plenty of institutional capital that can be funnelled into early-stage funds. What we have is a success gap, not an equity gap."