How Early Exit Disease Stunts the Growth of Midwest Startup Communities

by High Alpha

From TechCrunch:

There is an unnamed epidemic slowly traveling through the middle of the U.S. This epidemic goes by many names, but our venture fund refers to it as “early exit disease.” This disease spreads when founders realize sub-$20 million exits. Many of these exits could have grown much larger.

Instead, early exits have been quietly devastating the Midwest region’s startup maturation, cutting off the very process that first created Silicon Valley — and which could create more tech capitals in the middle of the country.

There will never be a true Silicon Valley clone in the Midwest, given the critical mass of tech companies and entrepreneurs on the West Coast. But we should have the ability and opportunity to build viable and credible ecosystems.

I spend the vast majority of my time in what many call “secondary venture markets” in the Midwest, such as Ann Arbor, Cincinnati and Madison. The dominant discussion in these cities, and others throughout the Midwest, is how do they improve the viability of their startup ecosystems and take them to the “next level”? Most people think capital is the key ingredient to achieving this goal. Others believe the No. 1 roadblock is a lack of talent.

In my opinion, the answer is a unique combination of both, but the binary discussion of talent versus capital is not as relevant as most think. What truly takes startup communities to the next level is a combination of patient and ambitious talent AND capital that strives for very large exits ($500+ million). Large exits tend to create dozens (if not hundreds) of new angel investors, many of whom also launch new “higher bar” startups, and together strengthen the overall venture ecosystem.

However, most successful startups aren’t allowed to fulfill their true potential, and instead exit at a much smaller size. Many of these small exits stunt the growth of Midwestern startup communities. These early departures abort the process of creating a large exit — before they have a chance to explode, and thus feed the ecosystem. There is, however, a potential cure — but it requires founders and VCs to acknowledge the problem. Otherwise, many Midwest communities will continue to fall short of their innovation potential.

The Nature Of The Disease

Most venture-backed tech companies require hundreds, if not thousands, of employees to build platforms and products to a value point that generate $500+ million exits. But this is a good thing, as these large exits can create hundreds of new angel investors overnight. For example, Facebook created more than 1,000 millionaires at its IPO. Reports are in the hundreds for GoPro, and Twitter created nearly 1,600 millionaires. There are, of course, some exceptions like Instagram, which sold for close to $2 billion and had only 13 employees, and WhatsApp, which had 55 employees at their reported $19 billion exit to Facebook.

For the Midwest to build nationally credible and sustainable startup communities, we need the patience and interest from founders and investors to build the larger exits that spin off hundreds of angel investors and entrepreneurs.Here’s what often happens instead. A few years after receiving venture funding, founders grow tired of gutting out a tough market with little salary. They grow preoccupied with finding an escape for some financial safety and/or diminished ambition. That $15-$20 million exit that looked tiny a few years ago now tantalizes.

Here’s what often happens instead. A few years after receiving venture funding, founders grow tired of gutting out a tough market with little salary. They grow preoccupied with finding an escape for some financial safety and/or diminished ambition. That $15-$20 million exit that looked tiny a few years ago now tantalizes.

Founders start to think about how much their lives could change with some money in the bank. Given the added Midwestern benefit of a much lower cost of living (or drawback, depending on your perspective) versus the coasts, a $500,000 payout becomes a truly meaningful amount of money. You can make a substantial change to your life in Detroit or St. Louis with half a million in the bank. That’s not nearly the same case in San Francisco or NYC.

Founders Versus Investors

Early exits in the Midwest are out of proportion to total exits, as compared to the coasts. We’ve seen it happen more times than we can count in Chicago, Madison, Cincinnati and St. Louis, among many other communities in the region.

Now, to be clear, there is nothing wrong with an early exit, if that’s what you and your investors are targeting. I know this firsthand, as I previously managed two small Detroit-based seed funds. Our first investment sold after 18 months for a sub-$10 million valuation. Both the founders and the investors were very happy with the result because our interests were aligned and clearly articulated from the start: The goal was to build initial market traction and sell for a nice multiple — fast.

But that’s not always the case in Midwest venture deals. A founder’s willingness to take a low payout creates a tug-of-war with investors, who typically have larger expectations (especially if the startup still shows promise). A VC will typically remain committed to their original goal of a much larger exit, which is consistent with their own fund investment strategies. Investors need the initial partnership agreement with founders — to build and grow the startup to a meaningful exit for both parties — to stand, whereas founders are, understandably, influenced by an immediate payout.

Founders, however, may not believe their company is as valuable as was previously expected, and that reality is driving them to choose the “bird in hand.” Or else they’re tired, or their lifestyle has changed such that a small exit is meaningful for their young family.

Nobody can begrudge founders for wanting to provide financial stability for their family, but their companies could also have the opportunity to provide that same stability while striving for the very large exit that was initially intended — and that investors are still seeking.

This happens so often in the Midwest that it stunts the growth of our many high-potential startup ecosystems.

It’s Happening

While the Midwest will never compare to the land of unicorns in Silicon Valley, the region has realized a number of recent large exits in Cleveland (TOA Technologies, Explorys), not to mention the huge year Chicago had in 2014. The transformation of Chicago began earlier this decade, leading up to the Groupon IPO in 2011. Slowly but surely, other Midwestern cities are transformed by their large exits. For example, the $2.5 billion ExactTarget exit in Indianapolis has almost singlehandedly transformed their tech ecosystem with new funds (High Alpha) and startups (Sigstr, and, among 20+ others) launched or funded by former ExactTarget employees.

Along similar lines in my home state of Michigan, we’ve had Dan Gilbert as the core driving force investing in the startup ecosystem of Detroit. Dan’s huge success with Quicken Loans allowed him to be at the forefront of developing a tech community through Detroit Venture Partners, which has invested in more than 40 companies, almost all of which are based in Detroit. In nearby Ann Arbor, there are companies like Deepfield, Nutshell and Duo Security that are committed to building the foundation of very large exits, hopefully jumpstarting the city’s tech community.

How Do We Stop The Disease?

Like most ailments, “structural disorders” can be avoided when founders and VCs discuss hard questions in advance (education). That involves both acknowledging that an early exit is possible (symptom) and establishing a course of action to follow if an opportunity presents itself (treatment).

VCs can help mitigate the issue by using starter stock, which allows founders to receive modest liquidations in later rounds (usually Series B or later) that are oversubscribed. The oversubscribed investors purchase this starter stock, which is created as common stock, but changes to preferred stock in the transaction. This “best of both worlds” approach allows the company to include more value-added investors. It also provides founders the much-needed liquidity that in turn makes them comfortable enough to continue to strive for the monster exits originally targeted by all involved.

This starter stock isn’t used very often in the Midwest, primarily due to sensitivities of investors thinking that any liquidity would diminish drive in founders. In fact, I’ve seen just the opposite.

We know the recipe for startup ecosystem explosions in the Midwest, and can realize it when we match founder ambition to investor profile.

Unicorns can be launched and built across the Midwest, and tech ecosystems here can thrive. We (both investors and founders) just need to let them.