Archive - November 2016

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Why the Micro-VC Surge Will Drive Innovation Across the US
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Trump’s Rust Belt and the Hoofbeats of Technology

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.

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