July 9, 2019

Quantity has a quality all its own

Quantity has a quality all its own

“Why is connecting the Great Lakes ecosystem critical?” I was asked.

Well I’ve thought a bit more about it and “Quantity has a quality all its own” is a phrase that comes to mind.

  • Startup ecosystems are marketplaces.
  • Marketplaces have strong network effects.
  • Startup ecosystems have strong network effects.
Startup marketplace

With network effects, dominant platforms capture outsized gains.

The bay area is the dominant startup platform. It has more venture capital, startup creation, and a higher concentration of tech talent. It should come as no surprise that the bay area has outsized gains, outsized “quality.” With unicorns as a proxy for quality, we see this is true.

CA has a disproportionate number of unicorns. In 2018, Unicorn density was 3x higher in CA than IL.

(Unicorn density = # new unicorns minted / total VC deals)

Without network effects, unicorn density would remain constant across markets. Illinois would have 2–3 new unicorns instead of 1. Or, California would have added just 10. Imagine that!

2018 Unicorn density in California and Illinois

We can generalize and say:

Without network effects, the expected # unicorns in any ecosystem would be linearly dependent on # startups. (The probability of any startup becoming a unicorn is constant.)

With network effects, the expected # unicorns takes on the shape of an s-curve dependent on # startups. (The probability of any startup becoming a unicorn increases with the density of startups.)

Quality is a function of quantity

On the extremes, this makes sense.

  • Startups in primary markets can raise large rounds on large valuations. Unicorns → more prevalent.
  • Startups in tertiary markets, with supply/demand imbalance and lower cost of living, have smaller rounds and lower valuations. Unicorns → less prevalent.

What about the middle? In secondary markets, startup activity is increasing at an increasing rate

  • More founders launching companies
  • More entrepreneurs “doing it again” or “spinning out”
  • More (micro-)VCs seed investing
  • More bay area VCs following on

These ecosystems are approaching critical mass.

When an ecosystem hits critical mass, it becomes a self-sustaining market. It has enough market participants (startups, talent, capital) to grow and flourish, producing more and more high-growth companies as it does.

The tipping point occurs when an ecosystem hits critical mass

An early sign of hitting critical mass is $B exits.

A slew of new startups spring out of these exits. New startups spin out of those startups. VCs pop up/visit to take advantage of/fuel the new growth. The marketplace starts transacting at what feels like an accelerating rate.

In our own backyard, we’re seeing this evolve with ExactTarget talent and NextLevel capital in Indy.

So, why is fostering community a la Great Lakes important? Without a robust marketplace already in effect, we can hack one together.

These events create synthetic marketplaces with a common thread of geography or industry. They bring together startups and VCs in an effort to reach “critical mass” earlier… to reach a “tipping point” where the laws of network effects and momentum take over.