This peripheral is a good example of innovation that was way ahead of the market. There probably was a market opportunity when the Beadazzler was the nation's favorite "As-seen-on-TV" gadget. Even if it were to be released today for the Wii/360/PS3, the R&D costs would likely far exceed the revenues that it would take in.
Ignore the other site and launch... Full steam ahead! You never know what may happen, and two companies are never exactly the same. Maybe you'll appeal to a different set of customers. I think it's too early to give up especially since you haven't launched.
Depending on how your company is formed could make a big difference. Keep in mind that YC is investing $10-20K in your company, so it may not be appealing if there are $40K in legal costs to create an entity that they could invest in.
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While it would be great for founders to get quantitative and qualitative feedback from PG & team, it would be a pretty daunting task for YC partners to give a well thought out answer to the 1000+ groups.
While 1-2 sentence answer from YC could help out your company, it could open up a whole new can of worms that causes some groups to say, "but wait.." or "good idea, we can pivot...".
Their nice rejection letter is probably the best result the non-interviewees can get.
I used to do it. I've played with both static IP and dynamic DNS. Hosting from home works fine for a web server that doesn't expect a lot of traffic. Otherwise, save yourself the headache and fire up a VPS in a few minutes.
If I recall correctly, the Galileo probe (around 1989) had the same problems from anti-nuke folks that feared a radiation fall-out if the shuttle exploded while bringing the satellite into space.
If you're hungry enough, being rejected may be the best thing that will ever happen to you. Don't let a YC Reject letter stop you from continuing your dream.