Is Early Exit Disease Bad For Ecosystems?

Saw this piece in TechCrunch.  Adrian Fortino is a partner at Mercury Venture Capital.   His contention is that the Midwest entrepreneurial community isn’t growing as fast as it could because so many companies are taking sub $20M exits.  Here is a link to his whole article and I think you should read the whole thing.

This disease spreads when founders realize sub-$20 million exits. Many of these exits could have grown much larger.

Instead, early exits have been quietly devastating the Midwest region’s startup maturation, cutting off the very process that first created Silicon Valley — and which could create more tech capitals in the middle of the country.

It’s a provocative and interesting point.   I don’t 100% disagree with him.  But, I might look at some facets of it and look at the issue differently.

One point he makes is that the cost of living is significantly cheaper here in the Midwest than it is on the coasts.  That changes the perception.  My counter point would be if you are only in it for the money, you are more likely to fail.   Something has to be driving the entrepreneur besides money.

Another point he makes is that founders and investors aren’t always on the same page when the company is funded.  VCs want big exits, but founders might be comfortable with less.   He is correct.  It’s very important for investors and founders to be on the same page at initial financing.  It’s also important to continue that conversation throughout the life of the investment, and be forthright and honest from both perspectives.  VC’s often would like to see an exit because they want to raise another fund.  It’s a lot easier to have a conversation with investors when you are giving them a distribution check.

Often times employees would rather have salary instead of equity.  They are risk averse.  Entrepreneurs cannot be risk averse.  In the early days of the Chicago startup community, there wasn’t a support network to catch them when they failed.  That is very different today.  There is a place to go when you fail so you don’t have to worry about starving.

One thing that is obvious, but might not be intuitive, is that Silicon Valley is a statistically significantly larger ecosystem than the entire Midwest.  One piece of their ecosystem is hundreds of extremely small exits.  “Acquihire.”  Ironically, this might be one reason why initial valuations creep up.   If MegaCompany is going to buy Startup Company for $10-$15M to get engineering talent, then investing at $6M and riding it for 2 years looks like a good plan for an early stage investor.  Of course, if you invest with this mindset you are guaranteed to lose money.

Once I was talking to an angel from another Midwestern state.  They asked, “How many companies in State X have sold for more than $100M in the last ten years?”  Answer, 0.  Then they asked, “How many companies in State X have been bought by  another Midwestern corporation for more than $100M in the last ten years?”  Answer, 0.  Their strategy is to focus on investments that will exit at $30M or less-and to have all the money at the table in the initial round so they don’t have to go to VCs which demand larger exits.

Midwestern companies are starting to buy more startups.  Monsanto has been active.  Textura bought Gradebeam and then used that technology to help IPO.   At the same time, it would be great if Midwestern companies would become customers of startups at early stages.  Often they are too bureaucratic and the sales process is protracted.  Many times they are so risk averse they won’t integrate new technology into their supply chains or processes.

In addition to the points Adrian makes, I’d like to add a few more.

A recent Compass report that showed Chicago as the #7 startup ecosystem in the world. Chicago has a lot of momentum and things are very different here than they were 10 years ago.   But, one of the things it also showed was that equity wasn’t spread out among a lot of employees in a company.  It was concentrated in founding teams.  Adrian points out that Facebook minted over 1000 millionaires.  That’s not only because of Facebook’s monstrous exit, but because lots of employees held a lot of equity besides the founders. Important for VC’s to educate founders on how to allocate equity.  It’s a tough problem and Mike Moyer’s Slicing Pie is a good way to think about it.

The other thing that Silicon Valley has that the Midwest doesn’t have is an abundance of seed funding.  They get a lot of at bats. If 50% of all tech companies fail, and out of that sample 1% hit home runs, then a startup ecosystem needs a lot of trips to the plate to grow.

a16z VC Benedict Evans says, “VC is not about what will happen, it’s about what might happen.”  That’s why it’s so risky.  It’s why there are a lot of failures.  But, when it hits, the ball goes out of the park.

Midwesterners that have the means to invest love to invest in real estate.  They also like to do private equity companies.  Investing in VC seems extremely risky.  I think a lot of that has to do with the fact that VC investments challenge linear thinking.  It’s not point A to point B to point C.  New industries are created and the companies are very out of the box.  That can be uncomfortable to a traditional Midwestern mindset.

More and more, I am seeing Midwestern VC funds pull back from seed.  They wait.  They’d prefer to be in a Series A than a seed round.  Angel investors in the Midwest will also wait longer than their counterparts in the Valley.  Ironically, that’s where Andreessen-Horowitz allocates most of their money.

Chamath Palihapitiya also thinks that VC’s are a bit broken.  Instead of funding truly novel ideas and taking outsize risks, they are following the herd.  As I discovered in trading, when you follow the herd you often get slaughtered.  When you are contrarian, you fail a lot but you get outsize returns.  Chamath also thinks that VCs are waiting too long.  He says, “And this is the biggest problem with venture capital right now. We have replaced “venture” capital with “product-market fit” capital.”

It takes a long time to build a huge company.  Investors must be patient, and commit enough capital to build it.

In my earlier point about entrepreneurs, I said they should be doing it for something other than the money.  The same goes for investors.  There should be a purpose for investing other than simply gross return.  Of course, your success or failure is measured on gross return-but if you focus on other things at the same time you are more likely to be successful than if it’s only about the numbers.