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Strength in Numbers

Dallas is a nascent cluster city, where like companies gather. Venture capital is the glue, and we need more of it to grow.
By David Croson |

In a widely read 2005 essay, former austin Ventures partner Stephen Straus laments that Texas, despite its ingredients for high-growth, advanced-technology entrepreneurship, risks becoming a venture-capital backwater because capital is not being committed to new businesses. The same concern could be expressed about Dallas. From July 1, 2005 to June 30, 2006, Dallas-based VC firms funded the same number of deals in Austin and San Jose (22 in each city) as they did in their own hometown.

Simply put, there’s a shortage of capital being invested by Dallas-based VC firms in Dallas-based companies. Of the total VC dollars invested in Dallas-based companies, a disproportionately large amount of investment is coming from outside the area and even the state. To understand why Dallas is experiencing a shortage of homegrown venture capital and what can be done to remedy the situation, it helps to know a little about the factors that cause like companies to cluster in one geographic area.

Some cluster cities are easy to identify and understand. It’s hardly surprising that wineries cluster in France, Italy, Australia, Chile, and California. That’s where the good grapes are (and where the mysterious and multifaceted concept of terroir permits excellent oenoculture). Nor is it surprising that ski resorts and equipment stores cluster in Aspen, Colorado—that’s where the snow and the slopes (and skiers) are.

VC Investments by Dallas Venture Funds

July-Sept. ’05   Oct.-Dec. ’05Jan.-Mar. ’06Apr.-May ’06
AUSTIN9346
SAN JOSE6655
DALLAS5944
Source: PricewaterhouseCoopers/Venture Economics/NVCA MoneyTree Survey

Somewhat more surprising is to find clusters of high-technology and biotech companies in Palo Alto, Calif., or Cambridge, Mass. True, that’s where nationally known, prestigious research universities are. And it goes without saying that the local presence of a strong research university is exceedingly valuable to the generation of new businesses (particularly if a meaningful program in entrepreneurship complements strong science and engineering curricula). Texas has benefited from the spinoffs of its universities for decades. If the firms in the cluster are using the fixed assets of the university—such as professors, research staff, and laboratory equipment that can’t be moved—the grape/snow logic certainly makes sense.

But unlike the grapes and snow, and even unlike the physics labs and faculty, university graduates can be easily moved. If the industries in the cluster are simply hiring the graduates of these programs, we have to ask, “Isn’t there a more business-friendly place to start an e-commerce firm than Palo Alto or Cambridge?” Frankly, anywhere would qualify; California and Massachusetts are among the most business-unfriendly states by almost any measure of taxation, start-up costs, and regulation. And yet we still see substantial second-generation startups around California and Massachusetts universities where first-round startups happened.

That’s because these first-round startups serve as R&D anchors that can determine the future shape of an industry and region. One reason why new technology businesses often locate close to existing ones is that a successful new venture requires a mix of new graduates and “old hands” who’ve cut their teeth in the business by working for a previously founded firm. Sometimes these “old hands” are the founders of the new startup, and sometimes they’re brought in by the VCs. These more senior people have put down roots in the community; they’ve bought homes, may be married, and may have children. Suddenly they’re not nearly as mobile as they were when they’d just graduated. So the new startup needs to be close to the old business, not directly because the university’s there, but because the business from which it’s taking its senior employees is there, and the senior employees want to stay in the same community. And voilà—a cluster!

To become a cluster, like companies need not be within walking distance, like fruit stands at a farmers’ market—but they do need to be relatively near one another in travel time. Short-haul air service from American Airlines and Southwest Airlines—which both offer frequent point-to-point service to locations like Amarillo, Corpus Christi, El Paso, and Lubbock, as well as more prosaic business destinations such as Austin, Dallas, and Houston—changes the geography of venture capital in Texas and, by extension, clustering. Why? There are huge economies of scale in running a venture capital portfolio. Five partners and 10 associates can easily handle $250 million in limited-partner contributions and divide up $5 million in annual fees (to say nothing of the 20 percent “carry” earned on successful investments). The limiting factor to growth of capital under management is the attention that the partners can devote to portfolio companies, both in evaluating new investments and mentoring existing ones. One rule of thumb is that portfolio companies should be within two hours of the fund’s headquarters so that partners can thus spend quality face-to-face time with portfolio companies on a regular basis. Note that, since limited attention is a time constraint, the rule of thumb is expressed in hours, not miles.
 

››  THE TAKEAWAY
1 Wineries grow where the grapes do; other industries aren’t so different.
2 Venture capitalists go where they can go easily.
3 Dallas, Houston, and the rest of Texas need to work with, not against, each other.

When driving, two hours is about a 100-mile radius (less in congested urban areas). A lot of Texas (and several other states) is two hours or less from Love Field in Dallas (or DFW International Airport in the center of the Dallas-Fort Worth area), and it’s even possible to read business plans on the plane (don’t try it while driving). “We syndicate (invest with other VCs) in all of our deals,” says Jon Adler of Silver Creek Ventures. “Typically, one or more of the syndicate partners has a local presence with the start-up company. Productivity while traveling is increasing every year. The widespread use of cell phones, Blackberrys, and lightweight laptops means you can carry your office with you.”

What does this time proximity mean for start-up location? On the one hand, there’s no need to locate within 100 miles of your funding any more. But being a venture-backed company close to an airport that Southwest or American Airlines serves has suddenly become much more valuable; these companies can not only get to their customers’ locations, but their VCs (with their technology-enabled mobile offices) can drop in for a chat at any time, dispensing critical advice and solving small problems before they grow into bigger ones. Anticipating this benefit of being able to add value (while defending their investments) makes VCs much more likely to fund such startups. The benefits of being in Dallas, Houston, or Austin (where the money is) thus ought to extend to Amarillo, Corpus Christi, El Paso, or Lubbock. No matter which airline the VCs prefer, the entry of a low-cost, frequent-service airline into a new market (an example of an initial triggering event that encourages rivals to respond) becomes a vital link between prospective entrepreneurs and venture capital—and it shows in the development of clusters. 

We ought to think that venture activity centered in Dallas (and, to a lesser extent, Houston and Austin) would quickly spread into these more remote locations supported both by universities and airline connectivity, and yet the process seems slow. No wonder the state government of Texas has a statewide cluster strategy (even though the state is larger than many nations) centered around the Texas Enterprise Fund and the Texas Emerging Technology Fund, which emphasizes partnerships between academic institutions and new business. The potential of a cluster-driven Texas strategy, combining public and private support with Texas’ existing resources, is positively staggering. Now there can be multiple overlapping clusters within the spheres of influence of Dallas, Houston, and Austin VCs, which could stretch into the relatively venture-capital-thin states of Oklahoma, New Mexico, Alabama, Mississippi, and Louisiana (and recently, due to a change in the Wright Amendment, Missouri).

There are several economic reasons why we should expect that the next generation of high-growth entrepreneurial firms would be especially likely to cluster physically close to each other as well as to pioneering firms in their industries; this makes landing the first few of these firms (the R&D anchors) all the more important.  Thinking about how to be more cluster-friendly is obviously speculative but hopefully intriguing to Texas CEOs and venture capitalists who are considering major investments in these areas.

So how can Dallas in particular, and Texas locations in general, become more attractive for cluster formation? By learning from Seattle, which hosts an astonishing cluster of e-commerce firms (e.g., Amazon, Microsoft, and RealNetworks) as well as a high-end retail cluster (e.g., Amazon, Nordstrom, and Starbucks). Seattle is climate-challenged, has a high cost of living, and is in a state with much less clout (both economic and political) than Texas, despite recently displacing us as the no. 3 venture capital market in the country (behind California and Massachusetts).

Why is Seattle a poster child for a high-technology cluster? All cylinders are firing: great coffee; indie music; a major research university whose business school invests substantially in teaching entrepreneurship; lots of tech-minded people; stuff for twenty-something entrepreneurs to spend money on; ranked no. 3 nationwide for cultural capital (as well as venture capital). It’s the economic epicenter of Washington State (and, indeed, the entire Northwest region). It’s a Southwest Airlines and JetBlue city as well as having excellent connectivity from major carriers such as American Airlines. Washington State is more hospitable to venture formation and home ownership than California (albeit not nearly as hospitable as Texas). Amazon.com, Real Networks, and (especially) Microsoft provide access to seasoned technology executives to bolster young start-up teams.

Dallas has most of these assets already, and the others are achievable. As Jerry White, director of the Caruth Institute for Entrepreneurship at SMU Cox, pointed out recently in the February issue of DallasCEO, there’s no shortage of business opportunities or enthusiastic, educated entrepreneurs. The ball is in Dallas’ court—especially Dallas venture capitalists’—for harnessing this entrepreneurial energy and landing the anchor startups for the clusters that will drive local economic growth in this century.


 

David Croson is associate professor of strategy and entrepreneurship at the SMU Cox School of Business. He advises technology startups and has published work in journals such as Economics Letters, Academy of Management Review, and Journal of Risk Finance.

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