Steve Case’s bus tour, dubbed The Rise of the Rest, showcases how entrepreneurs are coming up with new products and technologies all across the country, not just in the Bay Area. Of course, while innovation does occur everywhere, new data suggest access to the venture capital needed to support innovation has become more, not less, concentrated in the Bay Area.
Through an analysis of national venture capital data from PitchBook, we found that in 2005, 34% of venture capital funding directed towards firms in the US went to firms in the San Francisco and San Jose (Silicon Valley) metropolitan areas. By 2014, that figure jumped to 44%. Given the population of San Francisco and Silicon Valley, the region currently has $4,433 per capita in venture capital, outstripping the nation (at $206 per capita) by a ratio of 21:1.
One explanation for the increased share of venture capital in Silicon Valley is success breeds success. Venture funding is a risky business where most profits are made on very few blockbuster deals. The sheer concentration of deals in the Bay Area has led to far more winners than anywhere else, which in turn, has attracted more venture firms to the region.
Given the success of the Bay Area in attracting venture capital, it is tempting for public and private sector leaders around the country to try to imitate the venture capital market of San Francisco and Silicon Valley. For example, many cities are creating accelerator models that mimic Y Combinator, the legendary Silicon Valley software-specific accelerator.
However, a number of factors suggest that mimicking Northern California is not a formula for success elsewhere. Instead cities should shore up local capital and take advantage of their own unique strengths. First, venture capital in San Francisco and Silicon Valley funds software at a higher rate than the rest of the country. Breaking down venture capital by technology type – such as software, drugs, automotive, electronics – between 2005 and 2007, 13 of the top 25 technology categories – there are more than 200 technology categories – receiving venture funding in the Bay Area were outside software, in areas like semiconductors, communication equipment and pharmaceuticals. This, of course, makes sense, as Silicon Valley got its name by making silicon computer chips, not software.
Over the past three years (2013-15), however, the number of the top 25 technology categories outside software declined to only six. And if measured by number of deals and not average value, each of the top 35 technology categories funded over the past several years were within software. Part of this has to do with a multi-decade decline in the US semiconductor industry, as well as a national shift in venture funding towards software. But it is undeniable that, in terms of venture capital, albeit only one measure of innovation, Silicon Valley is looking a lot more like Software Valley.
Capital formation strategies for software are an odd fit for many places because many times one round of funding is enough for a software company because they can grow quickly through instantaneous downloads. On the other hand, places with venture markets in manufacturing or healthcare often need more patient capital or multiple rounds of funding.
Second, venture deals are becoming larger and later-stage in the Bay Area. Between 2005 and 2007, over three-quarters of venture dollars went to deals worth less than $10m, yet over the past three years that figure had declined to less than half. Again, this is not just happening in Silicon Valley and San Francisco. Across the country, venture firms are seeking to mitigate risk by placing larger bets on later-stage technologies. But the Bay Area is at the forefront of this trend. Larger deals require larger venture funds, which many cities just do not have.
There are two points of concern with the increasing concentration of venture capital in the Bay Area. First, venture capital helps regions achieve economic growth through innovation. If access to venture funds is geographically limited then the ability for cities to achieve technology-based growth is limited. Indeed, research suggests income inequality in the US is driven more by variation between regions than within them. Second, because of its highly unique features, the Bay Area does not provide an easily replicable model when creating strategies to develop local capital elsewhere. This is also important as more national venture firms are moving to the Bay Area.
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But as the share of the nation’s venture capital going to the Bay Area has actually increased over the past decade, this poses the question: Are San Francisco and Silicon Valley good models for most cities to imitate? And with the answer being “no”, what strategies should cities employ to bolster local capital networks?
The answer depends on regions’ technical strengths – different technologies imply different venture capital strategies. A common assumption is that most cities look like Silicon Valley, with software monopolising venture funding, but in many places a mix of different technologies is far more important. Metropolitan level venture capital data from 2005 to 2015 from Pitchbook illustrates how different cities require different strategies.
In Cleveland, for example, more than three-quarters of deals are in clinical care services and medical devices driven by Cleveland Clinic’s world-renowned success in identifying and funding companies creating novel healthcare technologies. However, software and medical technologies require very different venture capital strategies. Software companies need upfront funding but can scale quickly with few additional funding rounds. Medical technologies require government approval and clinical trials, costly and lengthy processes, implying the need to consider whether regional venture capital efforts can provide not only seed funding but multiple rounds. If not, promising healthcare companies may flame out or relocate elsewhere.
Pittsburgh, on the other hand, has a far more mixed portfolio than either Cleveland or the Bay Area, one of the most diverse in the country. Pittsburgh’s top 10 technologies funded over the past decade include laboratory services, energy exploration, battery storage, medical devices, software, and electronic equipment – with none making up more than one-fifth of the metro area’s portfolio. Pittsburgh’s mix of educational and non-profit institutions, like Carnegie Mellon University, University of Pittsburgh and its medical centre, support research in engineering, software, medical technologies and therapeutics. In addition private companies, like Google and Alcoa, and the shale gas boom have provided the region with a blend of market opportunities that are extremely different from that of the Bay Area.
Equally important to the type of technologies funded is how venture capital deals are funded. In the Bay Area private venture capital firms represent the vast majority of funding both in terms of numbers of deals and overall value. Deals from accelerators and universities together equal less than one-tenth of what is invested by private venture capital firms. Given the many private investment firms in the Bay Area, universities and accelerators are better at creating and incubating technologies instead of funding them. Unfortunately, other markets lack such private sector assets and try to jumpstart investments through other methods.
Over the past decade, Pittsburgh made just 3% as many total venture deals as the Bay Area, but breaking that figure down by funding source, universities outperformed in Pittsburgh. There they funded nearly 30% as many deals as universities did in San Francisco and Silicon Valley, a rate 10 times as high as would be expected based the Bay Area norm. One reason for this is Pittsburgh is relatively new to venture funding and may have more research assets than private venture capital firms. Therefore, university funds could fill an important capital gap.
A common worry is these non-private sector deals are poor investments that private firms, with superior market intelligence, simply refuse to make. This argument is most persuasive in regions like the Bay Area, where there is no shortage of private capital to fund good ideas. However, in other regions these investments can prove to be smart precursors to private funding. Also, rarely do public institutions make investment decisions. Instead, public dollars are funnelled through private investment firms to kickstart regional activity. For example, Philadelphia’s new StartUp PHL fund is paid for by taxpayer dollars but investment decisions are made by First Capital, the city’s largest private venture capital fund. The fund requires recipients to stay in the city for at least six months after funding, with the hope of increasing the number of growing technology companies in Philadelphia.
Cleveland and Pittsburgh are specific examples of a general point. Cities have unique technology competencies and pathways to venture capital. Economic strategies to attract outside and bolster local capital should reflect those.
This is an edited version of an article first published by the Brookings Institute