Midwest Startup Hubs and the Elephant in the Room

“How do we build a sustainable startup ecosystem?”

“What do we need to do to get to the ‘next level?”

“How do we become the next Silicon Valley?”

“What the hell does Chilicon Valley mean?”

Having spent the last four years neck deep in #startupcincy - first, as a co-founder and CEO of one Cincinnati startup and now as a member of the leadership team for another - I can tell you firsthand these are the kind of questions I hear asked all day every day. Okay, maybe not that last one. But definitely the first three. And these questions are often followed closely by:

“We don’t have enough capital.”

“We haven’t had any big exits.”

“We need more talent.”

I don’t know what it is about the human condition that drives us to prescribe simple answers to complex problems, but I can tell you we do it with reckless abandon around here. And, not surprisingly, I think each of these solutions fails to adequately capture the real issue. Let me offer another possibility - it’s all of them.

Standing in the way of Cincinnati, Columbus, Cleveland, Ann Arbor, Nashville, Madison, and every other Tier 3 or 4 Midwestern startup ecosystem is a vicious, self-perpetuating ‘Catch 22.’ And it goes something like this:

• Companies are under-capitalized (in part due to scarcity of capital, and in part because our midwestern sensibilities encourage us to “diversify”),
• which leads to a prioritization of near-term needs over long-term outcomes,
• which leads to premature seven-figure exits instead of ten figure ones,
• which generates uncompelling returns for all but the founders,
• which drips meager returns back into the ecosystem.

Rinse, repeat.

Let me first caveat by saying, I’m not criticizing any of these cities or their investors in any way. There’s nothing inherently wrong with the way we build and fund business in the Midwest. It works. What I am suggesting is that we are a product of our actions. The difference between San Francisco and Cincinnati is not a function of luck or even time - it’s intentional action. So if we want change, we’re going to have to do things differently.

We fund $10M companies, not $1B companies.

At the foundation of the issue is capital, but not in the way most folks in the Midwest like to think. The popular opinion is that we don’t have enough capital, so startups that are worthy of it are forced to go without and ultimately fail. That’s dumb. And wrong. Anecdotally, I can tell you, if anything, more startups are raising seed capital than are seed-worthy, not less.

The issue is that - those that do raise capital - aren’t raising enough. A survey performed by Cintrifuse of Cincinnati startups currently fundraising indicates that, on average, their members are seeking just shy of $650,000. Though the data isn’t public, I’d venture that this number is fairly consistent with the deals in town actually getting done. (As a data point of 1, I can tell you that my first seed round in Cincinnati 3 years ago was $550,000). Contrast the Cincinnati number with the national average reported by TechCrunch earlier this month of $1.14M, and you start to see the issue.

The size and structure of a company’s initial funding wields a lot of influence on its eventual outcome. Redpoint partner and startup luminary Tomasz Tunguz compared the size of seed deals to the likelihood of follow-on funding and found that startups raising more than $600k in seed money were 50% more likely to eventually raise an A round than were startups who raised between $300k and $600k.

Of course, this isn’t a shock. Finding product / market fit and getting to real traction takes time. Jason Lemkin of Saastr would tell you it takes 24 months. If your goal is a $1B outcome, a half million dollars doesn’t get you 24 months. If you’re thrifty, it might get you half of that. But what it’ll also do is force you to trim your vision, substantially narrow your focus, and chase dollars at the first sign of positive feedback. There’s little time to get it right, focus on engagement, build a user base, and then extract value. The clock is ticking you gots bills to pay.

I’m not suggesting starting with little to no capital is necessarily a bad way to build a business - in fact, for most companies, it’s exactly what they should do - but for those startups (or cities) truly looking for a $1B outcome, under-capitalization is like trying to build the Redwood forest in Phoenix, AZ. Not. Happening.

We strive for $10M companies, not $1B companies

Having one or two ‘big exits’ is the holy grail for a city like Cincinnati. Like growth to a startup, it cures all evils. It generates windfall returns to LPs, produces positive press for the city, recycles precious capital and talent (the right kind of talent - the ‘been there, done that’ kind) into the ecosystem, and it validates the experiment, getting the abstainers off the sidelines and into the game.

Because our startups fail to raise enough capital from the beginning, we make the nearly impossible task of building $1B in commercial value even more difficult from day one. But it’s not just that it’s hard to build a billion dollar business in the Midwest - it’s also too easy not to build one here.

For one, a high six-figure payday is life-changing for a Cincinnati founder. You can literally buy a mansion outside of town for that kind of dough.

In San Francisco, the game is different. Opportunity costs are higher, and so are the lifestyles and home prices. Grinding through 70-hour workweeks for four years toward an eventual $500k payday makes no sense in Silicon Valley - nobody is ditching their big paycheck for that kind of result. “Go big or stay at Facebook” I always say.

Secondly, and maybe more importantly, we don’t demand big outcomes. Not yet anyway. It’s a classic externality - the ecosystem needs a big exit, but none of the individuals within the ecosystem need one.

In the midwest, startup capital flows primarily from smaller funds. On the coasts, the funds are much bigger. Billion dollar venture funds need to return multiple billion dollars to shareholders, which means they must have several billion dollar exits to survive. Period. $10M funds on the other hand, can declare victory with just a few eight-figure sales.

So when an acquirer floats an offer for $15M - one that’s life changing for the founders, that’s accretive to the board and preferred shareholders, and that would be universally praised as a ‘big win’ by the press - it’s pretty damn hard to turn that down. So most of the time, we don’t.

$10M companies don’t attract talent, $1B companies do

Raw talent is not the problem in the Midwest. Four of the top ten computer engineer grad programs are located here. In fact, Carnegie Mellon in Pittsburgh, which is the #2 program behind only MIT, is the third most highly recruited school by Google. Silicon Valley is coming here for talent, not vice versa.

Why, then, do Midwestern startups feel the talent shortage so acutely? I’ll tell you why. For highly talented employees, the expected future value of working at a local startup is less than the expected future value of working at a BigCo.

The math here is simple. Startups compensate employees through a combination of base salary, bonus, and stock options. The aggregate compensation for an employee of a successful startup is, ideally, much larger than that of a BigCo, but the cash compensation is almost certainly less. The ‘X factor’ is the stock option.

Stock options are a magical tool - they can align individual interests with long-term value creation, and they reward devoted employees in the event of a successful outcome. We’ve all heard the story of the guy who made $200M painting murals at the Facebook HQ. Well, those sort of ‘rags to riches’ outcomes only occur when the exit values have three commas. In a smaller acquisition - only one or two common shareholders (i.e. founders) earn any kind of meaningful return, if anyone.

And the reason for this is preferred liquidation preferences. Liquidation preferences grant preferred shareholders a minimum return - usually some multiple of the initial investment - before any distributions are made to common shareholders. In a $1B+ sale, the preferences are rarely relevant, but in a small sale, they can eat into a substantial share of the total proceeds before employees see a dime.

Until we credibly demonstrate that “rank and file” employees can get rich, or at least buy new houses, from the stock options exercised in a startup exit, the Midwest talent struggle isn’t getting any easier.

The path from $10M to $1B

I’ll be the first to admit that it’s far easier to identify problems than it is to propose solutions, and I certainly don’t have perfect answers, but let me offer a few thoughts that I think are at least directionally accurate.

First, and this should be self-evident, we need to take ownership for where we are and acknowledge why we’re there. Blaming a lack of capital, or talent, or exits as if they’re these exogenous factors we can’t control is unproductive. And wrong. $1B companies are rarely built by mistake.

Second, cities like Cincinnati need to focus. The same principles apply to building an ecosystem as to building a business - you can’t be all things to all people. Find the one thing you’re best in class at - your niche - and own it. Every Midwestern city seems to want to be the 19th best Silicon Valley, and that’s a losing strategy. We should instead strive to be the place to build X, and if you’re a founder trying to build X, you’d be stupid to go anywhere else.

Third, let the founders take money off the table. Adrian Fortino of Mercury Fund (one of the VC groups that definitely ‘gets it’) proposed this in a TechCrunch article last year, and while controversial, I think it’s spot on. As I mentioned, not building a $1B startup is too easy in the Midwest, and even modest amounts of liquidity can be life-changing. So in mid to late stage rounds of venture capital, get the founders some of that liquidity, and let them swing for the fences without second-guessing the decision to turn down an early offer.

Finally, take bigger bets in fewer companies. Because venture capital is a relatively new asset class for many Midwestern cities, there’s this impulse to take a shotgun approach and diversify our funds among a large number of companies. And while that might be a fine strategy for your 401(k), it’s not a particularly effective one in VC. The shotgun approach is a problem for two reasons - a) it leads to the under-capitalization problem I talked about and b) it spreads the VC too thin.

The great VCs, whether they’d admit it or not, are betting on two things - the company and themselves. Outsized returns are earned when talented, experienced VCs get really close to early stage companies and help them through their moments of truth. That’s not happening with VCs on 25 different boards.

I’m not suggesting these solutions are easy or palatable to implement or that they’d be effective overnight. I also don’t mean this as a criticism of the Midwest or of Cincinnati. There are plenty of exciting things happening in cities like ours throughout the middle corridor, and I owe an awful lot to these places. But there is also plenty of angst, and impatience, and uncertainty about how to build a more sustainable and relevant ecosystem.

And to this, I’d say the Avett Brothers put it best - “Decide what to be, and go be it.”

Ryan Watson is the SVP of Finance & Operations at Ahalogy, a leading performance content marketing solution, and co-founder of Upsourced Accounting, a tech-enabled accounting firm for startups and small businesses.