tech | growth | venture | Ecosystems
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By now you’ve likely seen this week’s The Economist cover story entitled Peak Valley, which features quotes from Claire Haidar.  Claire is CEO of WNDYR, an Intelis Capital portfolio company. The article highlights a mixture of outrageous costs-of-living, poor local government, and high operating costs as the catalysts behind an impending Silicon Valley collapse.

 

We’re skeptical Silicon Valley is “over.” However, we do see its influence dwindling in the next few decades as a direct result of a technological invasion into new sectors that drive the economies of the regions most dependent on them.

 

Every Industry is a Technology Industry 

 

It should come as no surprise by now that almost every industry has come to rely on technology for some core part of its operations.  Yet, there is a large variance in the degree of digitization across sectors that are cornerstones in regional economies outside of the Valley – these sectors have largely been ignored by coastal VCs until the last couple of years.

 

Industries like energy, agriculture, construction, and manufacturing are lagging behind the innovation curve and represent a multi-trillion dollar opportunity for startups and investors alike.  Their importance to regional economies like Texas, the Southeast, and Midwest can’t be overlooked.

 

 

We used the Bureau of Economic Analysis geographical definitions of the Southeast in addition to Texas for our analysis for the graph above.  Sectors such as power utilities (5.2% of SE GDP), oil & gas (2.54%), transportation (3.43%) and construction (4.83%) contribute much more to the regional economy than the US as a whole and while these percentages look may look small, it’s important to note the size of the US economy was $18.5T in 2016 and the region accounts for about 1/3 of total US GDP.

 

The ability to build software products is without a doubt Silicon Valley’s competitive advantage, made possible by an unmatched density of engineering talent. Yet because the aforementioned sectors are largely un-digitized, only a minimal level of improvement is necessary in order to replace current analog processes. Thanks to the spread of technology the requisite level of engineering talent can now be found, for less money, in most metropolitan areas.

 

Additionally, distribution of product is sometimes as important, if not more so.   The density of customers and potential partners in other regions provides startups with a ready-made strategy to build revenue from the outset.

 

These advantages can result in the healthier P&L’s highly-valued by potential acquirers in these sectors, leading to exits that drive ecosystem growth.

 

 

Founder / Market Fit

 

There’s a reason these analog industries have yet to be disrupted.  Often they require highly-skilled and specific knowledge, are encumbered by regulation, have entrenched bureaucracy throughout the entire value chain, or in the worst cases — all three.

 

Witnessing first-hand the ways an industry is broken is crucial to building the foundation of a big business within them.  More importantly, it removes any naïveté a founder might have and prepares them for the potential roadblocks ahead.  A few obvious and successful examples of this are: Flexport (freight), Robinhood (finance), and Farmers Business Network (agriculture).

 

Before, entrepreneurs would have had to move to SV to start these companies due to lack of local resources and talent. However, an explosion of cloud-based collaboration and communication software has now made it possible for these executives to tie into specialized talent from the Valley if and when needed.

 

Moving to the Valley as a contingent of funding is becoming less common distributed work becomes more of an accepted practice, and the rise of new firms focused specifically on not investing on the coasts has given founders more access to capital than ever before. This combination has solved one of the biggest problems of building a business outside of Silicon Valley – access to capital.

 

It’s clear there are several new sectors and regions are primed for the necessary disruption heading in their direction. Undoubtedly, Silicon Valley will play a direct or indirect role in many of the advances, but for the first time ever that role may not be from the driver’s seat.

 

Yesterday, I had the privilege of attending my first AUTM conference after being invited by Kerri Smith of the OWL Accelerator in Houston.  The topic of my quick 10-minute talk was “Ethics in Flyover Ecosystems” and it was part of a broader discussion on “Ethical Challenges Facing Startups”.

From their website:  “AUTM is the nonprofit leader in efforts to educate, promote and inspire professionals, throughout their careers, to support the development of academic research that changes the world. AUTM’s community is comprised of more than 3,200 members who work in more than 800 universities, research centers, hospitals, businesses and government organizations around the globe. The core purpose of AUTM is to support and advance academic technology transfer globally.”

Among the speakers were me, Kirsten Leute, SVP for University Relations at Osage University Partners, and Charles Valauskas of Valauskas Corder LLC.

Kirsten used a term – mirrortocracy -to describe the practice of hiring only those who fit a certain profile for a position. It’s possible I’m late to the game with the term, but I definitely plan on using it moving forward as there are so many possible use cases.

Below are the slides I presented, plus an additional one at the beginning which I left out but spoke to in order to create a frame of reference for what can happen when investor ethics turn in entrepreneurs’ favor.  Once a “market” is created for common terms, it puts everyone on an even playing field which benefits all involved.

Universities have a huge role to play in developing startup ecosystems.  They produce ideas, founders, and affordable talent for startups.  They are taking ethics from faculty, students, and outside parties like investors and mentors very seriously.  I really enjoyed being able to play a small role in their process and to give our perspective on the issue.
Thank you Kerri and the AUTM team for having me!

Pitchbook has released a new study on startup ecosystems and a few things immediately stand out to me:

1) TX has anemic local capital per venture backed startup. It’s WAY behind states with growing ecosystems like Tennessee, Utah, Michigan, Missouri, and Colorado.

Some might argue the number is artificially low due to the angel ecosystem filling the gap, but outside of Colorado and Utah the states mentioned above have very minimal VC activity. Additionally, the number of startups receiving funding hasn’t proven this to be true, bringing me to my second observation.

2) TX seed start-up density (# of startups receiving seed funding / pop.) is low. TX’s number is around 15 – several states are ~20+. This makes sense given the above – seed rounds are often led by local investors, and if there isn’t enough capital then fewer ideas are funded. However, Texas does beat IL which is a surprise given Chicago’s recent success.

3) Unsurprisingly, the density gap between established ecosystems like CA, MA and NY really grows in early-stage and late-stage funding. However, the gap is MUCH wider than I expected. In some cases, TX trails states with more active startup ecosystems by 5X.

All of these things are evident on the ground and it’s good to see data backing up the assumption more capital is needed in TX. The report highlights the need for startups to seek angel / seed funding that really understands the fundraising process and has a network to connect them to follow on capital.

You can find the study here.

Recently, CrunchBase published a new case study on early-stage funding including the different types of deal structures, priced (equity) and unpriced (convertible notes or SAFES).  The post was a useful, if very high level, overview of the early-stage funding process.  However, due to this simplicity, the article painted a naive picture of how unpriced rounds often work in practice. While notes and SAFES have become the norm in recent years, it doesn’t mean they should be, especially in underserved ecosystems like Texas, Pittsburgh, or Atlanta.

In these metros, early-stage capital is scarce, thus increasing an investor’s negotiating leverage.  Given that context, fundraising is often an extremely difficult hurdle to navigate for local entrepreneurs. Ultimately, unpriced rounds making up the majority of early-stage deals in emerging ecosystems can be shortsighted.  Over the long term, it can limit a startup’s ability to raise future rounds and hinders the ecosystem as a whole by sometimes forcing great entrepreneurs to start companies in more favorable markets where investors are accustomed to optimizing for a startup’s long term success.

It’s easy to forget that, just 130 miles outside Chicago, is the University of Illinois’s main campus. “Remember, Marc Andreessen was building Mosaic at U of I, and Max Levchin,” probably best known as the founder of PayPal, “was down there too.” Carter relayed the story of how Levchin came to Chicago to raise money for his first startup, he was spooked by the terms put forth by the independent investors he spoke with. He probably left for the Valley because we [Chicago investors] couldn’t structure a deal,”  – Jeffery Carter, Hyde Park Angels

Convertable notes and SAFES only make the process more confusing by putting off the valuation and thus hiding the potential ownership (i.e. possible dilution) at the time of conversion especially in cases where the startup has raised more than one note on varying terms.  I believe some investors do like this opacity.

Entrepreneurs are not the only ones put at risk by unpriced rounds of fundraising, the investor hasn’t actually put themselves on the cap table which leaves open the possibility of issues such as the renegotiation of their terms by the next lead investor. This puts the seed investor in the awkward position of getting the terms they believe they negotiated or being the “bad guy” who could potentially spoil the next round.

The goal of any aspiring startup ecosystem should be collectively working to eliminate onerous term-sheets to better incentivize founder upside for the ENTIRE lifecycle of a company, not maximizing the “paper” upside of one investor for one round. This perspective enhances the goodwill between investors and entrepreneurs while encouraging both sides to continuously participate in the scaling of great companies.  We achieve this by taking four simple steps:

  1. Use priced seed rounds whenever possible.  Legal fees used to be the main sticking point for doing an equity term-sheet but now the prices can be fairly comparable.  As mentioned above, there remains little reason to delay valuation for sophisticated investors.
  2. Provide extreme clarity in the event the round must be a note or SAFE. One of the best practices we’ve implemented is showing our entrepreneurs pro forma cap tables in the event of down rounds and at the “cap” set in the term sheet.  This allows us to highlight the various levels of dilution possible for founders.
  3. Simplify the terms. We advise the startups with which we work to offer only one round of convertible notes with the same terms to all participants. As Fred Wilson has recently pointed out, $1-2M “feels about right” for the as the maximum size of the raise. Obviously, this depends on the product and other factors affecting the anticipated runway.
  4. Provide a list of established VC resources and discussions of notes.  By doing this, we allow founders to do the research themselves and collect opinions from both sides of the table.  Y-Combinator, Fred Wilson, Seth Levine, and many others have written extensively on this topic.  We encourage founders to seek, and in many cases we provide, these resources.

Anyone who has discussed venture investing with me knows I passionately dislike unpriced rounds though that doesn’t mean I won’t do them.  The ultimate goal for us has, and will always be, to partner with the best possible companies. However, if we do participate in Notes or SAFES we work extremely diligently to make sure the terms are clear and founders thoroughly understand the pros and cons of the structure.

Yesterday, Capital Factory CEO Joshua Baer announced a partnership with The Dallas Entrepreneur Center to bring Texas’ biggest accelerator to Dallas.  In his post, The Texas Startup Manifesto, Baer proposed a “Texas startup Megatropolis” combining Austin, Dallas, Houston, and San Antonio.

The vision is exciting and highlights many of Texas’ obvious strengths:

  1. Growing at a rapid pace
  2. A low cost of living
  3. Diverse both in people and jobs
  4. Full of business and tech talent
  5. Home to great universities
  6. An energy and healthcare hub

It also highlighted many of the weaknesses:

  1. Underfunded
  2. Competitive, not collaborative
  3. Lack of mentorship

The combination of Capital Factory and the DEC will begin to address these issues and increase the diameter of the Texas ecosystem flywheel.  But to take advantage of the work done by Joshua and his partners, we’ll need do to even more to make sure the larger flywheel gets the momentum it needs to keep accelerating at an even faster pace.

We still need a few key ingredients in order to make our ecosystem comparable to the best.

  1. Operators that have scaled AND exited
  2. Density fueled network effects
  3. Follow-on capital

My favorite pieces of reading are those that say a lot without saying much.  It’s a skill of which I am always envious and explains my addiction to Twitter.  Last night, I came across one such tweet:

The more time I spend in startups, the more I’m impressed by those who scale than those who start. Many can start, few can scale. @mosbacher

My partner Jonathan recently wrote about the 80/20 problem being more right-skewed than perceived, specifically in startups. (I.e. the  difference between great and exceptional is bigger than the one between good and great)  CB Insights recently published a report using a cohort of 1,098 companies who raised seed capital from 2008-2010 that illustrates his point. The funnel below puts into perspective the increasing difficultly of each subsequent round.

According to Crunchbase, 184 companies headquartered in Texas raised seed funding last year. Let’s round to 200 for easy math.  Using the successful exit criteria above ($50M+), 8% of companies exit for a desirable valuation.  That leaves Texas with potentially 16 companies from a cohort of seed rounds in 2016 that have operators with both scale and exit experience. Assume each company has 5-10 rockstar employees (potentially more for the companies that truly scale rapidly) that experienced the entire company lifecycle and we’re left with 80-160 people.

In order to reach our full potential at the fastest pace possible, we need those operators to start, fund or mentor companies. This will create an exponentially increasing pool of talent to help new founders scale.  For new companies, the chances of success increase when it’s not your first time down the road. To paraphrase Michael Seibel, partner at Y-Combinator, it’s easier to climb on the shoulders of others to get ahead.

Another point to consider is the density of the nodes (Dallas, Austin, Houston, SA) in the network. Texas has the distinct advantage of having several major cities within a 3-5 hour drive or 45min flight from each other, but what happens inside of those cities will be just as important.

The effects of startup density are obvious.  When talented people who share a passion for startups interact on a regular basis it’s more likely that successful companies will be founded. The Kaufman Foundation defines density as:

entrepreneurial density = (# entrepreneurs + # people working for startups or high growth companies) / adult population

Since that number is almost impossible to easily obtain, Brad Feld asked the team at CityLab to use another indicator of density, deals per capita (100,000 people). I pulled similar data from Crunchbase using findings from 2016.

Unsurprisingly, the cities & metros you’d expect rank well with this metric, but a a few of the top cities may surprise you. College towns Boulder, Ann Arbor, and Austin are more dense with startups than cities like Chicago, LA, and NYC.

City Deals Per 100,000
San Francisco 616 71.2
NYC 521 6.1
Boston 113 16.8
Seattle 704 14.6
Chicago 105 3.9
LA 136 3.4
Ann Arbor 13 10.8
Boulder 37 34.2
Austin 96 10.1
Dallas 33 2.5
Houston 33 1.4
San Antonio 8 .5

 

While this data is certainly not perfect, (# of deals can be skewed by the fastest growing companies raising more than one round annually and Crunchbase only let’s you search by cities, not zip or metro) it illustrates the work Texas cities have left to do to achieve a saturation close to other metros and perhaps further illuminates the need for more venture funding in Texas.

Lastly, Texas is sorely missing the big checks.  While seed stage investors from outside of Texas are beginning to invest more in the state, the evidence is still clear the follow-on capital is hard to come by.

This map by the Martin Prosperity Institute shows the per capita investment of venture dollars. Austin is the only city in Texas to find it’s way into the top 20 at $252.

To be seen as an ecosystem ripe for more institutional follow-on investment we must inject more risk-tolerant capital into promising seed-stage companies to increase total deal flow and subsequently support them with the talent and resources needed to scale. These steps will increase the number of rapidly growing startups and make Texas more attractive to those who deploy growth-stage capital.

Overall, the partnership announcement is a huge win for the Texas entrepreneurs.  The ingredients are here for a vibrant and successful startup landscape.  However, we have to take this momentum and run with it to reach our full potential as an ecosystem.