Network Effects and Venture Capital

This post is by Jeff Carter from Points and Figures

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In the last several years there has been a lot of fund formation in venture capital.  New funds have started.  Existing funds have raised much larger funds.  There is a lot more money being put into innovation today than there was ten years ago.  However, the amount of money in geographical areas has remained uneven.  Sort of like income inequality, where the rich get richer while the poor stay about the same.  For example, there are 12 VC funds in Michigan.  There are 12 in one building in Palo Alto.

The Brookings Institute just released a study on venture capital by geography.  It’s an interesting read.  Brookings also did an analysis with some Michigan MBA students.  Several years ago, Stephen Spreiser and graduate students at the University of Illinois did a similar analysis.

Access to capital was one of the I started Hyde Park Angels with my Chicago Booth MBA classmates in April of 2007. It was impossible to raise a seed round of capital in Chicago without going through a network of brokers.  Not only did we organize risk capital, but we didn’t charge to pitch and instead of charging the entrepreneur for legal and accounting on the close, we assumed the cost ourselves.  Accelerate Labs came in 2009 and 1871 in 2012.  Chicago has a growing entrepreneurial ecosystem but it is still minuscule compared to NYC, Boston, or especially the Valley.  HPA doesn’t do as much seed investing as it used to as the group has matured.  There are a couple of other angel groups around but they aren’t as active as HPA or have artificially designed constraints that fit their personal cultures well but don’t lend themselves to being an “invest in anything” angel group.

Companies looking for seed capital in the Midwest can find it, but it’s not easy.

Suppose I am a VC and have a $5MM fund.  Venture math dictates that the money returned is equal to money invested times ownership percentage divided by exit value.  Figure a 60% to 70% dilution hit over the life of the firm from seed to exit.  This means if I have a 5% ownership percentage at seed, I will have a .0325 ownership percentage at exit.  The goal for a VC is to return the fund 3x, or three times the headline size after fees.  The $5MM fund needs to return $15MM plus the management fee, accounting fees, setup fees, legal fees and other extraneous expenses.  That’s about $15.75MM. Or, a $484MM exit.

This is why VC is a home run business.  A $50k seed investment in Uber returned roughly $270M.  But, at seed you had to believe there was a market for hailing black cars off of an app on your phone.

What check size does that VC need to write in order to return the fund on one investment, and at what post-money valuation does that investment need to be made?  As valuations go higher and round sizes get larger, which they have done in the last ten years, microVCs have had a tough time getting into deals and returning capital unless they have been extremely disciplined about how they invest.   At West Loop Ventures we invest $500k-$750k at seed.  We like the company to be valued at less than $8MM pre-money and the typical round is going to be $1MM to $1.5MM dollars.  That means a firm needs to exit at roughly $225MM or more for us to return the fund.  If they are valued at 15x top-line revenue, that means they need to be doing $15MM in top-line revenue. I have seen valuations all over the map, from 30x top-line to 3x top-line depending on stage, space and the competition to buy the firm.

If I invest in 10 companies, the odds are pretty good that at least 50% if not more will fail.  Even though I go through the same diligence process on each firm.  A large west coast family office that has been investing in venture funds and direct investing for the last forty years told me their failure rate is about 50%.  The failure rate increases the pressure on the VC given the math I articulated in the prior paragraph.  Out of those 10 companies, I need one to return 30x to give me a 27% IRR and return the fund.

This is what makes venture capital a very tough business.

If we want to get network effects and the flywheel spinning in the Midwest, we need more capital.  A lot more.  We need it at the seed and Series A round.   The Midwest needs more at-bats.  You don’t build an ecosystem investing in later stages.

Brookings recommendation is a regional fund of funds.  “A regional fund-of-funds would be a vehicle for in-region and out-of-region investors who put their dollars to work with investments in venture capital firms. The regional fund would allocate investors’ money into a network of well-run state and local/regional VC funds, and co-invest with them in promising companies. Such a fund would facilitate much-needed growth in the size and scale of the venture capital network in the Great Lakes/Midwest—allowing it to be competitive in today’s larger and later rounds of funding. This, in turn, would help transform more of the region’s prodigious innovation into new businesses and jobs locally—realizing good returns for investors and fueling economic transformation of the “Rust Belt” economy.”

I am not sure it would work.  Here is why.

Cincinnati started a fund of funds designed to promote local entrepreneurship.  Cincy has tremendous local knowledge when it comes to brands and consumer.  Today, it’s easier than ever to get a consumer play off the ground.  One of the first things they were proud of was becoming an LP in a Silicon Valley fund.

There are several large endowments in the Midwest, large public and private pension funds, large family offices, and large foundations.  So, the money is here in the Great Lakes Region.  It’s just not in the local venture funds.  We found that if they invested in venture at all, they were fully committed to California funds and weren’t allocating money to any new funds.  If they did, they were looking at NYC and places like Boston or Austin.  I like to joke that not only did University of Illinois engineers build Silicon Valley, but the University of Illinois endowment did too by investing in all the funds out there.  It’s not just Illinois.

The coasts benefit from the network effects they have built over time.  When more capital is freed up to invest in venture, it goes through the network following the same path previous dollars followed.  This is not any different than open outcry treasury futures remaining at the CBOT when they went electronic.

I can tell you from experience that it is terrifically difficult to raise a fund in the Midwest.  It is as hard as starting a startup when you are on your first or second fund.  Significantly harder than raising money in California or New York.  There are several reasons for that.

  1.  Risk Preferences.  Midwesterners are less risk-loving with capital and tend to feel comfortable investing in real estate or private equity.  Venture in the Midwest hasn’t had the long track record of outsize returns like the asset class has had in California.  
  2.  Geographic ethnocentricity.  Many managers don’t want their money to cross a border and benefit another state.  Michigan money has to stay in Michigan etc.  No city in the Midwest, except maybe Chicago, is big enough to attract the mix of human capital needed to have a diverse industry startup ecosystem.  Cities tend to specialize.  Minneapolis has a great medical device culture for example.  Shouldn’t a VC that raises money from an Indiana endowment be able to invest in Minneapolis if that’s where the best deal flow is?  Politicians and Managers don’t understand that when Minneapolis does better, Indianapolis does better.  
  3.  Fund sizes.  When you are a smaller venture fund, larger fund managers cannot invest because they cannot write that small of a check given the risk preferences.  If I am managing a billion dollar endowment, I cannot allocate resources to do the diligence on a fund manager raising a $20M fund, nor can I cut a check for $2MM into that fund because it doesn’t move the needle for me as far as return profile goes.
  4.  Control.  I find that Midwesterners want to control their money.  New Yorkers are used to retail and “other people’s money”.  They are used to paying the fees that come with capital allocation.  Same with people in California.  In the Midwest, they want control and dislike paying the fees.  They would rather direct invest.  In the Midwest, there are a lot of one LP funds and family offices (Pritzker, Lightbank, Origin, OCA, DRW, Jump were all initially one LP or very few LP firms)  
  5. Returns.  The Midwest has had some of the best returns in the industry for venture capital over the last ten years.  The problem is the sample size is small.  Given a bigger sample size would the returns hold up?  
  6. Series A Capital.  There is not a lot of Series A capital in the Midwest.  The Brookings study says to concentrate on Series B rounds.  By then the valuations are too high and the return will not be so great. The most bang for the buck in VC is at seed since you are taking the most risk, but making the smallest investment.  Series A capital is the round where it might be comfortable for a Midwest FoF to get the best bang for the buck given their internal risk preferences.  Series A is also where the capital that goes into a company is like rocket fuel.  They don’t all work to be sure but they generally have a chance.  It’s the toughest round to get since rule of thumb metrics are that you need to have $1MM to $2MM per year in top-line revenue.  
  7. Failure.  Failure is just not as tolerated in the Midwest as it is on the coasts. 
  8. Politics.  If you aren’t politically connected you won’t be able to raise money from certain states.  Or, if you aren’t the right “brand” of a political party, you won’t be able to raise from certain endowments, pension funds, or family offices. The two tribes national political scene has affected fundraising and even deal flow in a lot of cases. 
  9. Competition. The competition to get into deals on the coasts is far higher than it is in the Midwest.  That causes VCs to be sharper, more active and causes the entire ecosystem to be better.  More deals getting funded gives the coasts more at-bats and more chances to hit home runs.  This competition can also drive valuations higher impacting returns.
  10. Outcomes. If you live in the Midwest, how many people on your block work for a startup?  How many people do you know that got wealthy from working for or starting a startup?  They are a rare bird.  In the Valley, it is commonplace to chit chat about startups at your kid’s soccer games.  Because Midwesterners have no experience with the outcomes, the entire idea of the startup is foreign to them which makes it uncomfortable to allocate money or time to it.
  11. LP funds.  The Midwest is home to lots of single LP funds and corporate venture funds.  They often invest for different reasons than typical LP funds that are based in the Valley or NYC.  Corporate funds might invest for strategy only, and not for return.  Having a corporate fund on the cap table can limit upside and exit options.  Family offices that invest might not want to exit in order to preserve a stream of dividends, or to continue growing wealth by growing the company for itself.  LP funds are highly competitive and in order for a new fund to be raised, they must return capital to their investors or go out of business.  

This is important.  There is not another asset class that creates both innovation and economic opportunity for the United States like Venture Capital does.  Not one. VC has generated more economic and employment growth in the U.S. than any other investment sector in the last few decades. Venture investment makes up only 0.2% of GDP, but delivers an astonishing 21% of U.S. GDP in the form of VC-backed business revenues.  If we look at the stock market movers, no one is talking about IBM or GM.  They are talking about the FAANG stocks.

When we look at a state like Illinois which has higher unemployment, incredibly large deficits, and anemic growth venture capital is the one thing that can change the direction of the state over time.  Other Midwestern states are in similar boats.

The tangible assets are already in the Midwest.  Top engineering and business schools.  Fortune 1000 companies with capital to become customers and acquirers exist.  In the millennial generation, there is an entrepreneurial streak that exists.  They have watched companies like Facebook, Twitter, Uber, and Lyft be built right under their noses and they’d like to participate too.

What doesn’t the Midwest have?  Capital.  But more importantly, seed and Series A capital.  Local family offices, endowments, pension funds, and foundations need to dedicate 2%-5% of their capital to funds that will base and invest in the Midwest.  They will need to participate in a FoF ecosystem, or internally dedicate staff and resources to investing in Midwestern funds which mean smaller check sizes and higher operating costs.  That will hurt return and in a state like Illinois which is underwater when it comes to pensions, returns are everything-although if you look at Illinois pension return data it’s nothing to write home about.

Anecdotally, talk to fund managers like myself that have tried to raise funds.  It’s brutally hard.  We have a fund manager breakfast and the number one problem for all of us is raising capital to invest.  Anecdotally, talk to entrepreneurs that have tried to raise VC money at seed or Series A in the Midwest.  It’s just as brutal for them.  They have to hop on a plane and go to the coasts to raise the bulk of the capital.  Or, their capitalization tables look like spider webs with all the names of individuals they found that would write a check combined with all the different types of instruments they had to use to get the money in.  I would appreciate it if they left some stories in the comments of this blog.

The Midwest entrepreneurial ecosystems are growing.  But they are growing at a far slower rate than they should be.  There is a huge opportunity cost they are paying.  You can point to the bad political climate in some states like Illinois which is certainly driving talented people away.  However, NYC and Silicon Valley have bad tax environments too.  The real deficiency for a place like Chicago is capital.  Period.

A Fund of Fund ecosystem can work.  However, it has to be more than one monolithic fund of funds.  There need to be several so that they are competitive with each other.  They also can fill different niches since no one industry dominates in the Midwest. Competition creates network effects.

Once those initial FoF start to have success, other fund of funds that have traditionally only looked at coastal venture capitalists will come to the Midwest and actively invest.  FoF have to compete for returns the same as VC funds compete.  It’s just that FoF need to find the best VCs and establish relationships with them over time so they can continue to invest as the VC fund matures.  We are seeing coastal VCs start to come here and dabble at Series B, and down to Series A.  It will be no different for the funds that fund them.