Chicken and the Egg


This post is by Jeff Carter from Points and Figures


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I wasn’t there for the presentation of Project 33 at the Economic Club of Chicago.   I was out of town.  I did read John Pletz article in Crains.  A couple of tidbits from the article.

This one from Mike Gamson is incredibly positive.

Computer science grads from schools in Illinois are 4.5 times more likely to work in Chicago at some point during their careers than any other city.

“People, we have the people,” he said. “The folks who are looking for talent believe the talent is not here and the talent believes the jobs are not here. That’s a matching problem. That’s a solvable problem.”

Gamson also sent a wake up call and is 100% correct.

“Success is a steady drumbeat of multibillion-dollar exits. . . .There are not enough of them,” and he rattled off the short list of recent hits. “We’ll have achieved success when no one in the can name them all.”

He wasn’t totally joking when he quipped, in a room of more than 250 business leaders at the Standard Club in the Loop, that all of the tech representation in the crowd was seated at two or three tables.

If you don’t know Mike, he was a LinkedIn executive and is a very active angel in Chicago.  He knows what he is talking about because he has personal experience with it.  He’s got the data.

Chicago tech doesn’t need a master plan.  It doesn’t need a bunch of consultants or a non-profit to advocate for it.  Show me Silicon Valley’s master plan.  New York City’s master plan.  Boston’s master plan.  Austin’s master plan.  There doesn’t need to be a mouthpiece either.  Who is the mouthpiece for those other ecosystems?  Who is behind the scenes communicating the message?

Nope.

Ecosystems are built by individuals working to better themselves.  Coase rules.  Adam Smith rules.  You can’t direct it.  The market directs it.  There isn’t central planning.  The network is open.

For venture capitalists, it comes down to math.  VC math is incredibly hard as Dan Primack of Axios found out with his tweet the other day.  Here is the math if you don’t know it.

Percent ownership*Exit valuation/Amount invested

Funds have to return 3x their fund size to be considered successful.  They also have to cover fees which means they really have to return around 3.5x.  It’s why at seed stage, fund managers need to be incredibly disciplined on valuation.  They also have to write meaningful checks to make sure they get enough ownership early to give them a chance at returning the fund.  Oh, and by the way, over the course of the firm’s life you can count on seed investors getting diluted by about 66%.  The holding time is seven to fifteen years depending on the company and the market.  It might be faster if an industry gets acquisitive.

Here is some other impenetrable math.  Around 50% of everything you invest in as an angel or a fund manager will go to 0.  10% to 40% of the deals you invest in will return 1x to 4x.  Those deals that you can get to 4x by working hard on really help you in fund return.  But, they don’t pay for the fund and get you to the 3x return level.  That means out of every ten deals you do, one has to return 30x or better.

This is why fund size matters.  You need the flexibility to be able to invest in a lot of deals.  However, you need to be able to be big enough so you can follow on the ones that look to be winners.  In trading we called it “pressing”.  Pressing allows you to hold onto ownership percentage.

Our fund is $10.75MM.  We write $500k checks at seed and reserve $1MM for a Series A.  You can figure out the math from there.  It took us just over two years to raise the money and hundreds of meetings.  Prior to that, I tried to raise a fund and hit a stone wall.  The state of Illinois told me “no white males”!  Local endowments and family offices told me they didn’t believe in Chicago or that they were sending their money to the Valley.   Many just did “real estate or private equity” because VC was so foreign to them or too risky for them.  The end of it is that Chicago and Illinois money is helping to build the Silicon Valley network at the expense of the Chicago ecosystem.

Funds generally charge 2-2.5% management fee; that usually gets recycled or rebated back to LPs.  LPs take 80% and the fund managers take 20%.  Believe me when I tell you, if you operate a $100MM fund or less you aren’t in it for the management fee.

In Chicago, it is incredibly arduous to raise even a modicum of capital to have a fund.  We have scads of  ten million and sub ten million dollar funds.  Given the math above, you can see why a fund manager is very slow to get into a deal.  They are so capital constrained it almost makes them risk averse in an industry where you are rewarded by assuming risk.

This capital problem isn’t only true for Chicago.  It’s true for Atlanta, Nashville, Columbus, Detroit, Minneapolis, Indianapolis, Kansas City or any other entrepreneurial ecosystem not named Boston, New York City or Silicon Valley.

There are expenses to operating a good fund.  Fund administration, audit from a reputable auditor, office space, and having enough salary so that a manager can operate and live are critical.  If you are big enough you will have to hire some internal support staff.  Deal flow doesn’t just show up on your doorstep. You have to go find it and that entails expenses.

That math flows down to entrepreneurs.

Entrepreneurs have an incredibly hard time raising capital.  It’s a primary reason I co-founded Hyde Park Angels.  Some entrepreneurs could go to NYC or SV and raise capital.  Some do.   We used to lose almost 100% of them prior to HPA starting in 2007.  However, most of them don’t want to move there. Seed stage VCs want to invest close to home and won’t write a check without them moving.  Frankly, if you are building a company in one place it’s sort of stupid to pick up and make everyone move across the country to execute on it.  Entrepreneurs have a hard enough time executing without making them go through the craziness of a cross country move.

What’s the entrepreneur response?  First they get pissed off.  Hard to blame them.  They want to figure out why it’s so hard to raise money.  You get sick of hearing the word “no”, although that’s part of the job.  Then, instead of building a company using venture capital money which would supercharge their growth, they grow using cash flow.  That leads to slower growth.  When they go to raise money again, VCs look at their growth pattern and tell them they aren’t growing fast enough.  Smaller VCs can’t invest because the valuation is too large and they can’t get enough ownership to make it worth their while on a risk/reward basis.

It’s a non-virtuous cycle.

There is only one thing Chicago needs right now.  It has to have larger LP funds of $30MM-$100MM.  Quite a few of them.  That will give fund managers breathing room to make mistakes.  It will also give them enough money to seed a lot of companies.  It should be hard to raise a fund, but it should not be as impossible as it is in Chicago.

Seeding a lot of early stage companies will grow the ecosystem.  Out of those seed stage companies we are bound to have many that hit a decent exit and a few will hit above a billion dollar exit.

Then it’s lather, rinse, repeat.

Entrepreneurial ecosystems are great for a city.  They create jobs.  They don’t just create jobs inside the ecosystem but they create jobs in mom and pop businesses that service the ecosystem.  However, more importantly they create alpha for a city.  They become magnets for all kinds of people that are chasing a dream.  It’s like a gold rush.  Sure, there is lots of failure.  Hand in hand with failure is success.

I saw it and experienced it first hand on the Chicago trading floors.  People came from all over the world to give trading a try.  The trading floors created thousands of ancillary jobs in the city that had nothing to do with trading.

If the money isn’t here, the city will take a significantly longer period of time to build an ecosystem.  Frankly, there will be other places that entrepreneurs can go to find capital.  Right now, all Chicago needs is risk capital.  That should be mission number one on Governor Pritzker’s agenda.