You Don’t Have to Go to the Valley!

This morning there is a blog post circulating which states that to build a start up anywhere other than Silicon Valley is foolish.  The post, which is presented in a highly respected outlet, states that by looking at financing patters in the venture capital industry a clear conclusion is reached.  To grow a startup you must locate where the money is, and that is Silicon Valley.

While this appears to be very sound logic, it is actually based upon an incorrect view of causality.  Entrepreneurs do not follow the money – the money follows the entrepreneurs.  To look at the current level of funding activity and conclude that entrepreneurs should locate in the Valley is like someone who is interested in cooking some marshmallows looking for the last place there was a forest fire.  The reality of modern startup financing – a VC industry consolidating into larger funds that are chasing shorter investment horizon deals and a growing reliance on Angels and crowdfunding — provides an exceptional level of bias towards momentum investing in industrial sectors that provide a high probability of quick exit.  Within the world of consumer internet and related mobile startups the region of the US that provides this possibility is clearly Silicon Valley.

Last year I released a White Paper on M&A Patterns in Silicon Valley and the Greater Washington Region.  I looked at every M&A transaction reported in these markets from 2006 through 2011.  What I learned was interesting: (i) where there is a high concentration of intra market transactions startup formation and growth is accelerated, (ii) Silicon Valley’s technology M&A market is driven by a relatively narrow range of industrial segments, while the GWR’s M&A market is significantly more diverse and (iii) the GWR M&A market has been surprisingly robust, even in comparison to Silicon Valley.  In fact, measured by numbers of deals, overall M&A activity was comparable.

The most important conclusion from the data is that where you have a high correlation between startup activity and the regional incumbents (the dominant larger companies in an industry), a high velocity of exit activity occurs.  As our public markets continue to punish companies for engaging in R&D, more and more product and service innovation is “outsourced” to the startup sector.  This pattern of behavior recurs in each important technology sector of our economy, particularly as they mature.  What this means is that if you are operating your business in a region that is dominated by companies such as Google, MSFT, Facebook and so forth, you are much more likely to be purchased if you create a business that is useful to them.  This is particularly true if your goal is to be an acquihire.

What is important to ask, however, is whether current M&A patterns will be permanent.  It is also timely to ask whether the current dominance of consumer related Internet businesses is a permanent aspect of tech entrepreneurship.  I believe that we are all missing the point if we look for the last forest fire.  As a society we should be looking forward and not back.

The reality for both entrepreneurs and our policy makers is that industrial waves come and go, and the largest growth opportunities occur at the beginning of waves, not at the end.  The next waves are being funded by national security R&D, and as they become clearer, the regions that dominate them will be where the dominant companies are created and M&A activity will be most dynamic.  That may or may not be Silicon Valley.  Personally, I believe that the Greater Washington Region is likely to be the home of one or more of the dominant companies of the next waves, because of its high connection between government and entrepreneurship (this is an argument I have made elsewhere).

My overall message to entrepreneurs is simple.  If your goal is to grow a business that is sellable in the short term, you should build a business that your local larger companies will want to buy.  If your goal is to grow a business that is durable, you need to grow a business where you can find the resources you need – human capital and customers being the most important.  In my experience, money will follow a compelling business, regardless of location if you can find the resources.  And, if you can grow a business to national importance, and have sufficient organizational development, you can go public and become an incumbent yourself, and startups will grow up around you.

In other words, don’t follow the money to grow a business.  Figure out the strengths of your region to grow the business you want to grow.  And, understand that the dynamics that shape the flow of money are a lagging, and not a leading, indicator of where you are most likely to be successful.