Monday, February 20, 2012

VC Returns in Silicon Valley versus the rest of the US

I received an interesting question today from an entrepreneur friend who I met a while back at the wedding in NYC of one of my doctoral classmates from MIT Sloan.

He is working on an early stage startup and said that at a Board meeting, they were discussing venture capital and geography and the question was whether there was a higher or lower return on venture capital investments in Silicon Valley compared with other regions?

So he wrote to ask me whether the data back this up. 

This is a very interesting question because it could very well be that due to all the competition for hot deals (startups) in Silicon Valley, this drives up the valuations and thus drives down the venture returns for the VCs. If talent was fairly equally spread geographically,  it could feasibly be a better strategy to look for the less hyped deals that others are not fighting over. Besides the data that coauthors and I have collected from MIT and Stanford alumni, two other papers came to mind. One by a colleague at Stanford:

Robert Hall and Susan Woodward have written one of the most thorough recent examinations of the returns to venture capital and VC-backed entrepreneurs.

However, it did not address this issue of geography.

The other is coauthored by one of the HBS faculty who I learned from, Josh Lerner and it does address geography directly.

They find that defining success as the proportion of portfolio companies that go public (IPO), VCs in Silicon Valley, NY, and Boston have greater performance and their VC-backed companies in those locations also have higher performance. However, the outperformance of these VC firms comes more from selecting better investments when they invest outside of SV, Boston and NYC! If you think about it, this makes sense. If you are a top entrepreneur outside of one of these startup hubs and a major Silicon Valley VC as well as a local VC both give you term sheets, it's going to be very tempting to take the Silicon Valley VC's termsheet.

However, this still did not answer the direct question of whether Silicon Valley firms outperform those in say Boston, MA or New York City. It also only looks at IPO rates rather than at revenues or employees as alternative performance measures.

For this, I looked at the data from the Stanford Alumni Survey. These are preliminary results, but I do find that when you look at revenues or employees, the Silicon Valley firms (defined as those located 60 miles or less from Stanford) have statistically significantly higher revenues and employees relative to those not in Silicon Valley. [$128M in mean revenues vs. $62M, p<0.05]

Yet, when you compare Silicon Valley firms against those in Boston or New York, there are no significant differences in revenues or employees. It is worth noting that the Silicon Valley firms are bigger on average (the distributions are highly skewed), yet this difference is not statistically significant. [$128M vs. $29M, p<0.17 and 307 employees vs. 51 on average, p<0.27]. Since these distributions are so skewed, the median is perhaps more informative [$300,000 vs. $150,000].

Finally, I looked at the current status of the firms.

For Silicon Valley firms, the breakdown looks like this:
Private firm: 55%
Acquired: 23%
Out of business: 18.4%
IPO: 4.2%

For MA and NYC:
Private firm: 67%
Acquired: 15.5%
Out of business: 16.5%
IPO: 2%


Robert E. HallSusan E. Woodward. 2007. The Incentives to Start New Companies: Evidence from Venture Capital. NBER Working Paper No. 13056.

Henry Chen, Paul Gompers, Anna Kovner, Josh Lerner. 2010. Buy local? The geography of venture capital. Journal of Urban Economics.

We document geographic concentration by both venture capital firms and venture capital-financed companies in three metropolitan areas: San Francisco, Boston, and New York. We find that venture capital firms locate in regions with high success rates of venture capital-backed investments. Geography is also significantly related to outcomes. Venture capital firms based in locales that are venture capital centers outperform, regardless of the stage of the investment. This outperformance arises from outsized performance outside of the venture capital firms’ office locations, including in peripheral locations. If the goal of state and local policy makers is to encourage venture capital investment, outperformance of non-local investments suggests that policy makers might want to mitigate costs associated with established venture capitalists investing in their geographies rather than encouraging the establishment of new venture
capital firms.