Chicago startup ecosystem update: rounds, funding and valuations

Midwest funding and startup activity accelerated out of the financial crisis, but too-high valuations a risk to the developing ecosystem

THE GOOD: MORE FUNDING AND MORE STARTUPS…

One of the original theses behind Hyde Park Venture Partners was the attractiveness of the growing entrepreneurial ecosystem in Chicago and the broader Midwest on the startup and funding sides. A year into this journey, we wanted to revisit a few of the metrics we first considered when ideating HPVP in 2010 – namely early stage round frequency and capital invested. At that time, we were looking back at 2007-2009 data. We expand on that in the chart below to include 2010 and 2011 data.

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Source: VentureSource, includes business/consumer services and IT only

Midwest dollar investment levels have returned to and surpassed pre-crisis levels and the number of rounds has nearly doubled that of pre-crisis levels. Both of these facts are good news for the startup and investing environment. Not only is capital flowing into the ecosystem, but more opportunities are being funded, widening the funnel at all stages of the startup spectrum.

Given that there are not a lot of new VC funds in the Midwest (and in fact many approaching the end of their investment life), one might wonder where the capital is coming from. While data to prove it is limited, our hypothesis is that there is increased capital flowing from coastal funds and local angels. Anecdotally, we know there are a number of coastal funds showing interest in Chicago. Indeed, some have invested with us (Amicus CapitalGreat Oaks Venture Partners and others).

We also know that angel activity levels in the US are approaching that of VCs and likely surpassing them in the early stages. This is discussed in a recent Wall Street Journal article citing a study by the Organization of Economic Cooperation and Development (read article here). In Chicago, we see very heavy activity by angels – both as individuals and through more institutional entities like Hyde Park Angels. The Angel Resource Institute reported in its 1H 2012 Halo Report that angel activity is increasing significantly in the Midwest relative to other parts of the country and that angel groups are increasingly investing with other types of investors (VCs). This is true in particular for round sizes above $1M, where companies typically need an institutional investor to take a large stake and lead the round, even if angels are involved.

The number of startups being funded is also aided by the development of incubators and other similar support structures in the Midwest in the last few years. In Chicago, there are Excelerate LabsCatapult1871Healthbox and a new entrant focused on social impact startups, Impact Engine. More programs are emerging each year…. welcome Nuevo Labs! These groups help mold entrepreneurs and their ideas into attractive opportunities for investors.

… BUT UP GO THE VALUATIONS, INCREASING ECOSYSTEM RISK

All of this is terrific for the Midwest startup ecosystem, but also correlates with rising valuations seen across the country. Trend data for valuations themselves are not available in reliable form. Anecdotally, however, a seed deal priced at $1.5M three years ago would now go for ~$2.5M. That is a very significant and unsustainable growth rate.

The question is whether higher valuations will allow for long-term risk adjusted returns for capital now flowing into the market, especially for institutional VCs and (larger organized angel groups). VCs and large angel groups are the only consistent sources of capital; individual angels do not invest in down cycles (remember 2008-2009?). So to sustain a startup ecosystem through even normal economic cycles, investment institutions must endure. That requires the delivery of acceptable returns for fund investors.

I was recently looking up Minneapolis VC funds to connect with investors and startups on a trip up there in January. I was amazed at the number of Minnesota funds that prospered in the mid-to-late nineties and then disappeared when returns floundered for their LPs. The same thing happened in a number of other emergent technology centers during Bubble 1.0 – at a significant cost to the entrepreneurs and startups that depended on VCs for funding.

Entrepreneurs are the most important part of a startup ecosystem, and VCs are but service providers (the first things I learned in the Kauffman Fellows Program). Yet there is still a symbiosis. When VCs see great teams and companies with too-high valuations, they must either sit it out or hope that exit prices are going up as much as the entry prices. If too many jump in on the too-high valuations, we will find our Chicago ecosystem starving for capital again in the long run.

Guy is a Managing Director at Hyde Park Venture Partners. Follow Guy at @guyhturner

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