Ecosystems and Venture Capitalists

Gonzalo Miranda is a Chilean venture capitalist. His firm, called Austral Capital, identifies promising high-tech startups in Latin America and brings them to the United States. I was particularly interested in meeting him because he is doing exactly the opposite of what we might expect: he is moving companies from less developed countries with low operating costs to high-cost locations in California and Washington State. The companies that he finances and helps move north end up creating good jobs in America. Since he focuses on early-stage startups, the companies are small when they arrive, but he estimates that the typical company creates about twenty jobs in its first year in the United States, mostly in engineering and support staff. If it succeeds, that number can easily grow to hundreds or thousands.

Miranda tells me that the entrepreneurs from Chile, Argentina, and Brazil that he works with are typically brilliant innovators with world-class new technologies. Their products are so good that even if they stayed in their home countries, they would probably do well. But if they want to make it big, they must move to the United States. One advantage of America’s innovation hubs, he says, has to do with funding, which is scarce in Latin America and dominated by old-style investors who often end up suffocating a company. Another advantage is the legal system. Even in Brazil and Chile, which are among the most pro-business countries in South America, setting up a business can be difficult, and the entry costs are uncertain, owing to burdensome bureaucracies and complicated legal requirements. But above all, moving to Silicon Valley or Seattle means having access to an entire ecosystem. “The Silicon Valley ecosystem ends up being an advantage that more than compensates for the higher costs,” Miranda told me.

The ecosystem that Miranda is referring to includes providers of specialized services that are important to innovative firms, such as advertising, legal support, technical and management consulting, shipping and repair, and engineering support. These services enable high-tech firms to focus on what they are good at—innovation—without having to worry about secondary functions. By the mere act of moving into a high-tech cluster, a firm in effect becomes larger overnight, because it can draw on specialized local expertise. As a result, high-tech firms within a cluster become more productive and more successful. A small software developer in Seattle does not need an in-house lawyer, because there are already plenty of local law firms specializing in intellectual property, licensing, and incorporation of startups. A biotech company in Durham can buy specialized services for its labs from local vendors, and a hardware company can find specialized shipping services. A young entrepreneur in Silicon Valley told me that he needed to have his startup incorporated but did not want to pay thousands of dollars in legal fees. In any other location, he might have given up on starting his business, but because he is in Silicon Valley, he easily found a law firm that accepts equity instead of cash. This firm’s business model, which rests on the assumption that one of the hundreds of startups it incorporates will turn into the next Google, is possible only in a dense high-tech cluster.

 From the point of view of the providers of these specialized services, geographical proximity to clients is crucial. They need to be close to potential clients to assess their needs and show how they can help. This matters less for mature products, but it is critical when a product is completely new. Cadence Design Systems is a leading high-tech company that makes the software other firms use to design electronic systems. Its clients include IBM, Siemens, NVIDIA, Silicon Laboratories, and Casio, most of which have a presence in Silicon Valley. When I asked Chi-Ping Hsu, the company’s senior vice president for R&D, why Cadence keeps most of its R&D workforce in San Jose, he replied, “How do you determine what the architecture of the new product should look like? You go to the customer every other day with a prototype.”

 This is one important factor that keeps the ecosystem geographically together: Cadence is in Silicon Valley because its clients—other high-tech companies—are there. And the clients are there because their vendors, including Cadence, are there. If this sounds familiar, it is because we saw exactly the same thick-market effect with workers and employers. This affects local communities in two important ways. First, it increases the number of local jobs created by high-tech firms. If a city attracts an IBM office, it gains not just the IBM jobs but also the jobs at Cadence, as well as jobs at all the other service providers. This is one reason that the high-tech multiplier is large. Second, it further strengthens the attractive power of cities that have a significant innovation presence at the expense of cities that don’t: it makes IBM more likely to open an office in Silicon Valley.

Take Ericsson, the Swedish phone giant, which is technically headquartered in Stockholm. The Wall Street Journal reports that Håkan Eriksson, the company’s chief technology officer, doesn’t have an office in Stockholm. Instead he works from San Jose, “where Ericsson has more than 1,200 employees engaged in R&D.” In the past Ericsson benefited from its proximity to Nokia, the Finnish cell phone giant. But now the company finds it more important to be near Apple, because of the iPhone and iPad, and near Google, because of the Android operating system for cell phones. “The epicenter for the handset industry has shifted from Finland to Silicon Valley,” Mr. Eriksson said. Incredibly, even Nokia seems to agree; it now has a research center in Palo Alto that employs 380 workers, 80 of whom hold PhDs. Director John Shen told the Wall Street Journal, “To be globally competitive, you really need to have a footprint here in the Valley.”

 Possibly the most important part of the high-tech ecosystem is venture capital. After the subprime fiasco and the Great Recession, financial innovation developed a bad reputation. But a strong financial system is crucial for job creation. Contrary to general perception, a strong financial system is less important for the rich, who already have money, than for those who are trying to get it. Venture capital is a brilliant solution to an old problem. Young people tend to have creative new ideas but often lack the capital to realize them. The job of a venture capitalist is to identify, among the thousands of new ideas, the ones that have promise. It is a very democratic concept and a crucial piece of the American Dream.

I grew up in Italy, a country where financing for innovative ventures is hard to come by. During the Renaissance, Italian banks, especially those in Florence, were market leaders in Europe, but in more recent centuries they have fallen behind. As a consequence, it is typically quite difficult for a young Italian with a bright new idea to start a business in high tech. This constraint creates two very costly distortions. First, it tends to dramatically reduce innovation: Italy has an underdeveloped high-tech sector despite its top-notch engineering schools. Second, the lack of venture capital financing is terribly unfair, because it discriminates against those who come from disadvantaged backgrounds. If you have a good entrepreneurial idea and come from a well-to-do family, you might get financing, either directly from your family or because your family can provide collateral to the bank. But if you have the same idea and come from a poor family with no collateral, you’re probably out of luck. It is a tremendous waste.

In 2010, I decided to take a sabbatical from my job at the University of California at Berkeley to spend the year at Stanford as a visiting professor. Every morning on my way to work, I would drive along Sand Hill Road in Menlo Park. Sand Hill Road contains the largest concentration of venture capital firms in the world. All major VC firms are located there, including the mythical Sequoia Capital and Kleiner Perkins Caufield & Byers, early backers of the most iconic startups in the history of high tech: Google, Apple, Amazon, Oracle, Yahoo, YouTube, PayPal, Netscape, and Cisco. I often saw young entrepreneurs with big dreams entering one of those low-rise buildings, presumably to pitch their ideas. Those low-rises on Sand Hill Road are where venture capitalists determine the future of commercial innovation. The aspect of the VC industry that I find most remarkable is how local it still is. Venture capitalists used to talk about the “twenty-minute rule”: a venture capitalist only considers financing companies that are located within a twenty-minute drive of his office. Today the industry has become more global, but it still has a predilection for local ventures. One study finds that the likelihood of financing new ventures declines quickly with the distance between the VC company and its target.

 This comes as no surprise to Shelby Clark, the founder of RelayRides, an innovative car-sharing startup that enables car owners to rent their vehicles to other users. Clark reportedly had to move his startup from Boston to San Francisco in 2011 “to be closer to the company’s backers, August Capital and Google Ventures, a division of Google Inc.” Jose Luis Agell, who leads the business development of a Spanish startup called 3scale Networks, based in both Barcelona and California, says that “it is tough to get funding as a foreign company.” People have remarked for decades that one of the secrets of the success of Silicon Valley is its deep and articulated venture capital base. But what does proximity have to do with funding? Why, in a world of fast communication and cheap plane tickets, should venture capitalists on Sand Hill Road favor startups near them?

Bill Draper has the answer. He is one of the most experienced venture capitalists in Silicon Valley, with forty years on the job. In his view, money is only one of many things that venture capitalists provide to startups. “There’s a lot of support, a lot of team building, a lot of organization, and relationships between entrepreneurs and venture capitalists that are key in making a successful startup,” he said in a recent interview. Today venture capitalists do not simply write a check and then disappear. An increasingly important part of their job involves active monitoring, nurturing, and mentoring of new businesses. This is why location matters.

 Nurturing and monitoring are clearly easier if the startup in question is nearby. It would be much harder for a venture capitalist in Silicon Valley to monitor the progress of the brilliant but poor Italian entrepreneur, however exciting his idea may be. Google may be the most famous example of the importance of mentoring in the history of venture capital. Among early investors in Google was John Doerr, from Kleiner Perkins Caufield & Byers. His early financing was critical to helping Google survive its early years. But even more important was his insistence that Sergey Brin and Larry Page—brilliant engineers, but at the time still naive businessmen—hire an experienced executive as CEO. Doerr’s guidance led the two founders to pick Eric Schmidt, arguably one of the most defining business decisions Google made in its early years. The Kleiner Perkins Caufield & Byers office is only 10 miles from Google. The search for a suitable CEO took almost a year and there were many dead ends, mostly because Brin and Page were reluctant to follow Doerr’s advice and had to be continually prodded by him. It was like searching for a spouse—very difficult from a distance.

San Francisco–based i/o Ventures finances early-stage high-tech startups and is part of a wave of VC firms that spend a significant amount of time and energy on mentoring. Local high-tech legends such as Russel Simmons of Yelp provide counseling and business advice. Crucially, one of the requirements the company imposes on the firms it finances is that they move to San Francisco. It argues that the benefits from this kind of startup accelerator program—in which the venture capitalists guide firms from idea to product launch—can occur only face-to-face.

In the end, geographical proximity to venture capitalists still matters. Skype and cell phones have not changed this simple fact. This is one of the reasons that the world of high tech is and will remain geographically concentrated.