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1
Why the Micro-VC Surge Will Drive Innovation Across the US
2
Trump’s Rust Belt and the Hoofbeats of Technology
3
The First Time Founder Discount
4
How Slack and Facebook Are Making Access to Information Less Democratic
5
The Hidden Challenges of Starting a Company in Secondary Markets

Why the Micro-VC Surge Will Drive Innovation Across the US

The following was co-authored by Ezra Galston of Chicago Ventures(@ezramogee) and Samir Kaji (@samirkaji) of First Republic Bank.

Over the last several years much has been made of the opportunity, or perceived lack thereof in technology centers outside of the Bay Area and NYC. From Steve Case’s Rise of The Rest Tour, to Google for Entrepreneurs, to Brad Feld’s Building an Entrepreneurial Ecosystem , the discussion has consistently been overwhelmingly positive.

It’s easy to understand the stance as who wouldn’t want to support entrepreneurship, irrespective of geography? However, it’s hard to discern whether these opinions were borne out of a utopian desire or a sincere belief of true financial viability in markets outside of NYC and the Bay Area.

In Fred Wilson’s widely discussed (and debated) piece “Second and Third Tier Markets and Beyond,” he suggested that the opportunity outside of the Bay Area was significant, citing the successes of USV in New York, Upfront Ventures in LA and Foundry Group in Boulder:

“The truth is you can build a startup in almost any city in the US today. But it is harder. Harder to build the team. Harder to get customers. Harder to get attention. And harder to raise capital. Which is a huge opportunity for VCs who are willing to get on planes or cars and get to these places.

There is a supremacism that exists in the first and second tiers of the startup world. I find it annoying and always have. So waking up in a place like Nashville feels really good to me. It is a reminder that entrepreneurs exist everywhere and that is a wonderful thing.”

In an effort to move past anecdotes however, we wanted to explore one of the components that helps drive and catalyze early entrepreneurial activity in any localized geography — the availability of early stage funding.

Simply put, non-core US tech hubs are reliant on local early stage capital to subsist since seed stage fund sizes often make remote investing impractical (by contrast growth stage investors who manage large funds and have significant resources can easily invest in breakout companies outside their region).

With the hypothesis that quality local seed capital is needed to foster a strong entrepreneurial ecosystem, our analysis is centered on whether the MicroVC surge, has provided (or may provide) a material impact to these “2nd and 3rd” tier US geographies.

Fortunately, there’s good news for entrepreneurs everywhere. Of all of the Micro-VC funds raised since 2010 (this number includes firms currently raising funds), over 40% of Micro-VC’s formed were based outside of the country’s largest tech centers of SF, LA, NYC and Boston, a number we found quite surprising.

In total, those Micro-VC funds raised outside of the four core tech centers since 2010 represent $6.7B in investable capital, the vast majority of which have driven significant investment dollars in their geographies.

More important to note is that the opportunity in these secondary ecosystems is unequivocally noteworthy. Using M&A activity as an evaluation metric, these ecosystems, despite a relative dearth of funding, have performed quite well:

In each year dating back to 2010, the percentage of Micro-VC funds raised outside of SF, LA, NYC and Boston materially lags the volume of M&A activity, on % basis, in those same areas. This suggest that Micro-VC funds located in secondary markets face less competition — and proportionally more opportunity — for strong financial outcomes by betting on that delta. Now, it’s true that these opportunities are a bit geographically dispersed, however it’s clear that certain cities (Seattle, Boulder, Austin, Salt Lake, Chicago) have made great strides in developing great entrepreneurial talent.

This dislocation in M&A proportionality is of course amplified by the concentration of funds in the Bay Area and NYC. Because coastal deals are more competitive due to an oversupply of capital, they boast higher entry prices (valuations) than do deals in secondary or third tier markets — and the effect on a returns basis may also be material. Case in point: according to Angelist, the mean valuation for deals in Silicon Valley since 2010 is $5.1M. That compares to $4.5M in Chicago, $4M in Indianapolis, and $3.7M in Detroit — offering Midwest investors anywhere from a 10–30% discount at entry.

There are other ways of interpreting the data. One could argue that Bay Area deals deserve to be higher priced due to a premium in the quality of founding teams. Or that the pure volume of M&A in the Bay Area and Boston de-risk the level of returns variance for any particular fund. Those arguments may be with merit but are also balanced by data released by Pitchbook that show cities such as Chicago, Seattle and Washington D.C effectively comparable on a multiple of returns basis:

It is nearly indisputable that large technology companies are being built and enormous value is being created outside of the coastal venture markets: examples include Grubhub, Groupon, Domo, Qualtrics, ExactTarget and HomeAway. But these markets will require more patience for company maturity, a willingness by fund Limited Partners to accept greater short-term volatility, and conviction that key talent will stay in non-core markets due to a desire of staying local and the avoidance of the high cost of living present in the major US tech centers.

While the rhetoric around non-core markets has been historically positive, it appears that the early stage capital surge through Micro-VC funds may be a major factor in these areas actualizing on their potential.

Extra special thanks to Peter Christman for his tireless work in helping to analyze, aggregate and process the data underlying this article.

Trump’s Rust Belt and the Hoofbeats of Technology

I am permitting myself one political/policy related post on this blog. I can’t help it. I am child of the beltway: my father served in the Clinton White House and I spent my early years on the floor of the West Wing doing 3rd grade homework. This piece takes no sides. It merely offers observations based on my perch in the Midwest.

President-elect Donald Trump’s historic path to victory was driven by a wave of discontent amongst the Rust Belt’s working class – and specifically by unexpected victories in Ohio, Pennsylvania, Michigan and Wisconsin. It’s a demographic that has experienced thirty years of economic stagnation – median family net worth in these areas in unchanged since 1996, materially lagging the effects of inflation – and many of its previously stable jobs have moved overseas.

The Rust Belt is an area of the country that I’ve spent much of the past decade focused on. I moved to Illinois from New York City in 2007 to help build a startup technology company. And over the past five years, we, at Chicago Ventures, have raised over $100M to invest in technology startups in the central region. Spanning dozens of investments, the firms we’ve backed now employ several thousand individuals and collectively generate hundreds of millions of dollars in revenue. Our efforts follow a broader trend: in 2016 alone, nearly $1B was raised by venture capital funds with a mandated focus on the Midwest and central regions. In 2015, $2.9B of venture capital dollars were deployed into Midwestern companies, a 50% boost from 2010’s $1.9B tally.

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But these efforts are largely irrelevant to Trump’s disaffected base. The areas that have most benefitted from the growth in the technology sector since 2010 are metropolitan cities such as Chicago – 40,000 new jobs, the Twin Cities with 10,000 new technology jobs, even Columbus and Madison. These cities – by nearly every economic and educational metric – are dislocated from their rural surroundings which offer a dearth of high tech jobs.

It gets worse. A Trump White House might well aim to stem blue collar job losses via anti-trade policies, but it will nevertheless face extraordinarily strong headwinds. Software – which Marc Andresseen presciently noted in 2011 – is undeniably “eating the world.” Just last month, Otto – which Uber acquired for $680M earlier in the year – completed its inaugural autonomous trucking delivery. Trucking, with a mean starting salary of $51,000 according to Indeed, employs 3.5 million drivers across the country and is the most common job in nearly every state Trump carried, according to 2015 Census Bureau data. Progress in artificial intelligence and robotics is already threatening tens of millions of additional service level jobs from customer service to nursing, and is even encroaching on white collar industries such as CPAs, financial advisors, even optometrists. The effect on the Rust Belt could be devastating.

New jobs are likely to be created to service growth in emerging technology industries. But they, like many of the 5.8M jobs already open (and unfilled) according to the Labor Department, are also likely to demand highly skilled professionals and skew towards urban areas.

Still, having invested throughout the central region for the past five years, I do believe there is room for optimism. First, the Midwest is home to many of the premier universities and computer science programs in the country. Michigan’s “No Worker Left Behind” experiment, which lasted three years and culminated in 2010, may provide a key. The act, which opened up all of the State’s universities to low income or laid-off workers, retrained 100,000 individuals over that period. According to a 2013 study of 4,500 of its participants, 55% attributed success in obtaining a new job to the program while 58% said they found it helpful in performing their jobs. Moreover, according to former Michigan Governor Jennifer Granholm, the program offered many of the state’s most displaced workers a second chance at “dignity” – which has been an increasing focus of the post-election discussion.

Second, many Midwestern states offer Angel Investment Tax Credits designed to spur innovation and increase jobs in high growth startups. However, these tax credits often make little distinction between investing in distressed versus non-distressed areas, with the effect that the overwhelming majority of rebates stay in existing technology centers. I have watched firsthand as the majority of these credits have supported businesses that would otherwise still have been funded and provided rebates to institutional investors who were largely agnostic. States must work to re-think these programs to stimulate technology development specifically in distressed areas.

Third, and most importantly, more school districts – especially those in rural areas – should follow Chicago’s lead in making computer science education mandatory. A 2015 Gallup/Google poll found that 90% of parents view computer science education as a good use of school resources and 67% want it to be mandatory. CS education is about more than web development jobs – it will provide improved literacy as the digital age spurs a more technology driven, rather than asset driven, economy. This effort, like the others, has the added bonus of improving the dignity and self-confidence of our valuable working class.

Pundits have defined the election as a referendum on the status quo; but the status quo was already in grave jeopardy. This election, globalization took the blame – but in 2020, it may well be technology and automation.

The First Time Founder Discount

Venture is a cyclical business. But in spite of dire bubble warnings, recent unicorn implosions, and a February 2016 nosedive in public SaaS valuations, the NASDAQ has now been on fire for nearly the past decade. In layman’s term, we’ve been on a (only slightly variable) linear up and to the right curve since 2009.

That is contradistinction to the dot com boom of the late 90s which effectively lasted less than five years, from mid 1995 through NASDAQ’s peak in March 2000 – and, more importantly – was quickly followed by a deep recession which lasted for much of the early 2000s.

The effect of this extended period of abundance is a duration long enough for thousands of entrepreneurs to have raised venture money, struggled, solved, raised more money and exited materially (or failed, and, learned something).

As early stage investors, these founders (repeat founders, serial founders, successful founders, what have you) have become increasingly attractive to invest in because they frequently come with the ability to hire and scale up quickly as well as avoid many of the timely mistakes early in a company’s life that can eat up valuable seed stage dollars. Consider this the venture equivalent of a flight to safety, in an otherwise chaotic, early stage market.

The consequence of this flight to safety is that the early stage valuations of first institutional rounds for repeat founders have ballooned and round sizes have increased accordingly. I took a look at the past 24 months of investment data at Chicago Ventures to break out post-money valuation* and round size dependent on founder profile (n=30):

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The highlights are that successful repeat entrepreneurs are raising rounds out of the gate nearly double the size of first time founders ($5.65M versus $2.85M, respectively). Anecdotally, the delta may actually be fundamentally wider as we’ve invested in repeat entrepreneurs far earlier in the go to market cycle (often, even pre-launch) than with first time founders (who typically have significant traction).

The effect of this is that first time founders need to thread often competitive markets on limited resources, and then, even with “traction,” will be blessed with only half the resources of more accomplished peers. This is why I tell entrepreneurs that in spite of press to the contrary, it remains a brutal fundraising market.

If there’s a silver lining, it’s that across both founder profiles, first institutional rounds represent approximately 25% of the fully diluted post-money valuation. Seed/A investors have clear ownership targets and that doesn’t seem to change much based on founder profile.

* For rounds raised on convertible notes I have used the cap on the notes as valuation. I recognize this is imperfect. If all notes converted at the cap, this would actually significantly underestimate the valuations of these rounds (as those caps are mostly pre-money caps) but I’m assuming some % of notes will either not convert (company fails) or convert at a discount.

How Slack and Facebook Are Making Access to Information Less Democratic

Earlier this month Jonathan Libov, an Analyst at Union Square Ventures penned a widely circulated piece on the importance of paying attention to “fringe” technology and interests in the corners of the internet. He noted:

Fringiness, if you will, is in many ways vital to the business of venture capital. Sure, there is a large segment of investments that are wholly mainstream from the start and can be found by some combination of being in the right place at the right time and good execution (e.g., Uber). But there is a large segment that capitalizes on the arbitrage of thought, culture and research. Inasmuch as a venture capitalist has developed ideas and conviction about how the world will develop, hanging around the fringe is an opportunity to participate in big opportunities that are priced well because the majority of other investors haven’t caught on yet.”

I agree with Jonathan. But there’s one problem: the fringe, which used to be accessible to anyone with a mouse and keyboard, has, over the past several years become increasingly opaque and inaccessible. So what changed?

First, some history: My earliest memory of the internet’s fringe was in America Online WaReZ chat rooms a subculture where people swapped files, tried to gain administrative accounts. (It was during this period that I taught myself how to code in Visual Basic simply so that I could write hot-key functions to sit on top of AOL). In those days, conversations within the walls of AOL’s interest groups and chat rooms were undeniably private – neither indexed nor aggregated – and nowadays, probably flushed and lost forever.

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But that would quickly change post-AOL, transitioning into a longstanding period of heavy archival. Online communities and interest groups enjoyed a largely public discourse for much of the past 15 years. Usenet newsgroups (and all the amazing content of the alt. and rec. topics) were initially indexed by DejaNews and later made fully searchable by Google. As Usenet was fading, massively searchable online forums powered by UBB.threads and later by the vBulletin platform were wholly indexed by Google and remain archived and accessible to this day.

And the trend continued with Reddit’s rise to popularity. As the world of micro communities and interest groups began to transition away from individual web forums and centralize within Reddit’s walls, they adhered to the ethos of content accessibility. Although their pages have historically ranked poorly on Google, they do, in fact, rank, fully meta-searchable and transparent.

But Reddit’s advantage – massive amounts of centralized content and interests – was also its curse, yielding an often aesthetically messy, abuse ridden experience. Alex Shye, an entrepreneur in the Bay Area, likened Reddit’s architecture and experience to Craigslist – which had been successfully unbundled into vertical specific marketplaces such as Uber, Airbnb, Thumbtack and others – and predicted that Reddit would be similarly unbundled into vertical specific content platforms and communities.

He was right. Sort of. Reddit is being unbundled. But not by vertical specific sites. That honor has been assumed by massively horizontal platforms: Slack and Facebook.

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Slack, the $3.7 Billion communication platform has expanded from its root as a team based communication tool and now boasts tens of thousands (at least – the number is not publicized) of individual teams/communities. Many of these communities have thriving discussions, but are not fully public – often demanding an application process for entry – nor are they explicitly archived or searchable. How many of the more than 3M Daily Active Users are in interest-based communities is anyone’s guess. But anecdotally, it’s high.

Concurrently, Facebook Groups have been consistently growing in absolute number and engagement for years, now boasting over 1 billion Monthly Active Users. Teddy Citrin at Greycroft Partners recently noted that the launch of Groups’ Discover Flow has for the first time offered transparency into the scope and depth of Groups’ unique memberships. But even so, these Groups are also membership gated and their content remains unindexed by Google and downright unsearchable – unless one is a member.

And there may be one additional macro-trend at play: as messengers, led by WhatsApp, FB Messenger, Line, and Kik continue to incentivize native brand engagement and content/product conversation, that may yield large volumes of incremental content, reviews, comments, and awareness that leave the broader searchable ecosystem.

Admittedly, there has always been discourse existing beyond the internet’s open walls, whether it was cased in e-mail or IRC channels. But excepting e-mail, the conversations have still generally occurred in open mainstream channels. But recently, I have watched my own dependency on Slack and FB Groups increase materially to maintain relevancy of certain interests. [I have also watched more private conversations get revealed on Pastebin – but that is a separate discussion.]

The fringe exists as the “fringe” for a reason – it is by intention intended to sidestep mainstream conversation. But nevertheless, from my vantage point, it’s becoming increasingly opaque. If you are also thinking about this shift in community and information, feel free to shoot me a note, would love to chat.

The Hidden Challenges of Starting a Company in Secondary Markets

Fred Wilson’s much debated post, Second and Third Tier Markets and Beyond, sparked an important discussion about operating and investing in businesses outside of the Valley. Case in point: within 48 hours, the piece generated a heated Twitter exchange (including input from the one and only Bill Gurley), a Pitchbook analysis of the best M&A outcomes by region, and even a capitulation of sorts from Fred.

Wilson identified a couple of important challenges of building in these markets, namely lack of conviction, lack of money, lack of infrastructure, and shallower talent pools:

But there is a dynamic that goes on in these third tier markets where the local investors look to investors in the first and second tier markets to come down and “validate” their investments. And the investors in the first and second tier markets won’t come down and do that without a strong local lead. This game of “chicken” happens ways too often in these markets and is incredibly frustrating to entrepreneurs in these markets. These third tier markets need a few strong Series A focused VC firms who have large enough fund sizes to be aggressive lead investors and also have the conviction and stomach to play that game. That is what USV, and Flatiron before it, did in NYC. That is what Foundry did in Boulder. That is the game Upfront is playing in LA. Every third tier market needs a few VC firms like that. And being that investor is a terrific way to make a lot of money.

The truth is you can build a startup in almost any city in the US today. But it is harder. Harder to build the team. Harder to get customers. Harder to get attention. And harder to raise capital. Which is a huge opportunity for VCs who are willing to get on planes or cars and get to these places.

And his insights are a good start. But as someone who’s lived the Chicago startup scene since moving here in 2007 to help build CardRunners Gaming, I’d like to suggest three other non-obvious challenges of building companies in secondary or tertiary markets. This is a tough love blog intended to provide guidance within secondary markets and enable founders to actualize their potential. If you can get through it and internalize it, it’ll make you stronger.

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The Press Challenge

Although the press outside of SF & NY may not be bulge bracket publications, they are nevertheless not constrained either by distribution (digital solves that), nor by space. But they are constrained by a dearth of quality stories. Meaning that Chicago, for example, has a finite number of private unicorns or venture backed IPOs – so, if you want a quote from the CEO of a Chicago unicorn company for example, you’ve got finite people to call.

The effects are that it can force a cycle of manufactured, often unwarranted positivity, feature stories, even local awards on companies that are downright unproven or even floundering. Moreover, it enables certain founders, especially those with a natural PR inclination, to run from magazine shoot to newspaper interview to conference to panel and back, all the while ignoring the actual company they’re supposedly running. It’s akin to Mark Suster’s admonition to Be Careful Not to Become a Conference Ho: “If you’re a startup CEO — don’t kid yourself. Get back to work. There’s a team in the office in need of your guidance.” But that warning is amplified in secondary markets where founders – sometimes entirely unproven, even occasionally on the brink of shutdown – are paraded around by the press, conference organizers and awards shows as local heroes.

PR is a wonderful tool and an extraordinary opportunity for the right situations (building a story for hiring, consumer marketing, etc). But it is a challenge to ignore the phone when the press circuit is continually calling. Local founders must learn to say no at the formative stages of their business.

The Self Delusion Problem

If an entrepreneur goes to raise money in the Valley and is unsuccessful they are forced to concede one of the following points: either (a) I am not a good fundraiser or storyteller, (b) This should not be a venture backed business*, (c) I have not proven sufficient traction, or (d) This is not a good idea period. [There may be other nuances or derivatives of these four, but you get the idea.]

This is because the Valley funds over a thousand new companies annually, plays host to hundreds of seed stage funds, and has the deepest network of angel investors anywhere in the country. Lots of companies get funded and you didn’t.

But in Chicago, an entrepreneur can ignore all of those failings and instead simply blame Chicago: It is Chicago with its low risk tolerance, or its culture of demanding revenue, or its disposition towards boring enterprise businesses, or excuse Z that are the reason my company didn’t get funded.

Unfortunately, some businesses with outsized potential certainly do fall through the cracks in smaller markets (Fred alludes to this as well). But that simply serves to reinforce the potential for self delusion: wherein founders, should they so choose, never need to admit that their startups do not meet the threshold for investment. This can enable a cycle where local founders become resentful and/or spend years fundraising for a business that will simply not get funded.*

The Cap Table Problem

A big pitfall of secondary markets is poor cap table planning and management from the earliest stages that materially affects long-term growth potential. It typically falls into one of two buckets:

(1) We have met multiple companies that were otherwise intriguing except for the fact that a single investor (often an angel) owned more than 50% of the company. This matters because with an option pool, and 25% dilution of the impending financing, it leaves even a solo founder (let alone a 3-person founding team) improperly aligned for future growth needs.

(2) A company that initially raised money from angels at too high of a valuation, that later took on a bridge or even a fresh round of capital from that same group of angels (again, at a higher valuation). SO, by the time the company had proven product/market fit, it’s prior valuation was dislocated from the market values traditionally ascribed by venture institutions.

#2 is a far more egregious problem, often generating a vicious cycle of dependency on amateur investors. Now, to be fair, every market suffers from questionable practices of non-professional investors. But those practices are exaggerated in secondary markets that lack pre-seed infrastructure or successful entrepreneurs to properly seed the next era of startups.

In almost all markets, even ones without much institutional venture, there are copious numbers of high net worth individuals, successful real estate operators, or financial services pros who are looking to enter startup investing – either because they can’t generate alpha in their core jobs or because startups are sexy.

The problem is this: once the vicious cycle of dependency has been initiated (and because no one has an interest in marking down their investments) it is extremely difficult to disassociate from it. Which isn’t to say that great companies won’t be built with such a founding structure. Many have. But it does make it difficult to attract experienced local entrepreneurs or traditional institutions to the cap table.

Summary

Secondary and tertiary markets provide a lot of benefits for startups looking to build great businesses. Lower costs of living enable a lesser burn rate. Less competition for great talent and easier accessibility to successful advisor networks are also a big positive. That I am very bullish on Chicago should be obvious: despite being an East Coaster (DC & NYC) – and with opportunities in numerous cities – I’ve made it my new home.

But pitfalls and challenges abound. The better informed entrepreneurs are, the better non-SF markets are likely to perform.

* My intention is not to be crass or insensitive. There are many great businesses, digital and offline, that are simply not a fit for institutional venture funding. My first startup, CardRunners Gaming, is one such company – profitable from day one and profitable now, even a decade later, although it’s total market potential was at most $10M. Had the company raised institutional money, it would have imploded upon itself trying to stimulate growth in a market that simply could not accommodate it.

Thankfully, other investors such as Bryce Roberts at Indie.vc are building innovative funding models, intended to accommodate non-venture digital businesses. Here’s a great article on their efforts: Venture Capital and Its Discontents

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