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The Startup Revolution Series Part 4: The Critical Role of the Startup Ecosystem

June 22, 2015 by Compass

— by Max Marmer and Cheyenne Richards

In our previous posts (The Great Transition: Industrial to Information Revolution, The Decline of the Blue Chip and The Rise of the Startup), we’ve argued that we’re in the middle of an epochal societal transition from the Industrial Age to the Information Age, that blue chip companies are becoming less and less able to be the primary drivers of the global economy and that the startups rising in their place are the only creators of net new jobs.

So if our entire global economic future rests on our ability to support the growth of startups, how do we help them thrive? With a flourishing local ecosystem.

Wait… what? Aren’t internet businesses inherently global? Haven’t tools like Skype and Basecamp made location meaningless? If successful traditional businesses get started every day around the world, why do startups need the special support of an ecosystem?

If you’re an experienced entrepreneur, the challenges described below may seem all too familiar and we invite you to provide your own thoughts in the comments section. For the rest of the world, still trying to understand the complex and unique drivers that either support or suppress startup growth, we hope this provides some additional perspective on the importance of the ecosystem.

High growth technology startups are very different from other businesses.

Different success rates

If you begin a traditional business, your odds of succeeding for the first two years are pretty good, around 75%. On the other hand, if you found a startup, even if your idea, team, product and plan are good enough to gain VC backing, you are 75% likely to fail.

That said, you’ll never find a local auto-body shop that reaches a Fortune 500 market cap or hires 10,000 employees, but there are hundreds of startups quickly pushing into those top echelons. This is such a critical point, it bears repeating. Startups rarely succeed, but when they do, they can succeed brilliantly.

Different financing needs

Banks invest in traditional small businesses. If you want to start a dry cleaners, you can make a good business case to a bank for why their loan to you is a solid investment. The bank can compare your projections to millions of other dry cleaners and plug it all into the time-worn risk/reward ratio for making loans. For a well-run bank, this is like being the house at a casino. You may win some and you may lose some, but at the end of the day, the odds are clear and in your favor, so you will win a lot more than you lose.

Venture Capital firms invest in late-stage, proven startups. If your startup has achieved profitability and can show a hockey-stick growth chart, you’ll have to hire a team of bouncers to keep away VC firms from all over the planet looking to fund the next stage of growth in exchange for a piece of your company. VC firms are, by and large, structured to make multi-million dollar investments in a small number of late-stage startups that they can shepherd from strong to stratospheric results.

If you want to start a SaaS company from ground zero, you are likely to fail before you can even agree on a catchy name. Plus, from the point of view of any standard bank your business model is so new there’s almost nothing to compare it to, which makes you a completely unacceptable risk. From the perspective of a VC firm, you’re also too new to be worth the time of day. So who fills the gap for early-stage startups?

The A team: Angels and Accelerators.

The angel investor spreads their investment over a large number of early-stage startups and takes a larger percentage of equity in return. The vast majority of their investments fail, just as one might lose many hands of poker. But the hope is that eventually that royal flush will come up and they’ll find themselves owning a huge chunk of the next ZenDesk or Salesforce.

Accelerator programs are essentially angel investors on steroids. Their business model centers around ‘hacking’ the early stage funding by preparing companies for their first investment, usually within 3 months from their own cash outlay. They invest at market terms, provide access to mentors and training on a broad set of startup-related subjects, and take 5-10% equity in the company.

How do angels and accelerators decide how to invest their resources when a startup entrepreneur has neither a traditional business plan nor multiple years of strong start-up results to show? Is it that killer idea that grabs their imagination?

The ‘great idea’ is perhaps one of the most mythical and misunderstood elements to the entire startup process. Ask anyone in Silicon Valley these days and they will tell you there are no more new ideas. The secretive culture of the late 90s that operated on 10-page non-disclosure agreements and NSA-like hierarchies of classified knowledge, has given away to a culture that understands execution trumps ideas. Today, to walk into any coffee shop south of Market Street in San Francisco, is to hear a dozen fully transparent pitches, challenges, value propositions, target customers and funding needs. It’s not that ideas don’t matter, it’s that they’ve learned that the hard work that differentiates winners from losers comes not in dreaming things up but in getting them done.

So the A Team doesn’t invest primarily in plans, results or ideas. What does that leave for companies that don’t yet have traction? People.

For all the modern tools the information revolution has produced, early-stage startup capital investment still relies on an old fashioned network of trust. Video-conferencing may allow people to communicate, but the ‘growth hack’ for building human trust has yet to be discovered. The majority of investment goes to people an investor has met at an in-person event.

Where can founders and early-stage investors find each other? In a thriving local startup ecosystem.

Different talent needs

Rare personalities

Working for a large company requires having the appropriate experience to match a job description. Day in and day out, there are written goals, established processes and predictable routines to help facilitate output. This type of work is analogous to traveling in a first world country where the trains run on time and the hotel can be booked in advance with your credit card.

Working for an early-stage startup requires figuring out what your job should be every day, how to accomplish things that have never been done before and when you should throw out everything that’s already been done and start over. This type of work is analogous to traveling in a third world country where the ferry is suddenly delayed at least two weeks and you don’t even know if the next town will have a hotel. Myers-Briggs typology? Keirsey temperament sorter? Pick your personality classification system and it will tell you that it is a rare sort of person indeed who has just the right combination of vision and execution, risk-taking profile and fear of failure motivation, leadership qualities and listening skills to be successful on a small start-up team.

Rare talent

Many people can read, write and solve math problems. Very few people can design a user experience to make a completely new process feel intuitive, or decide the right way to parse and visualize data to generate useful insights, or write a string of C# code that solves an unprecedented problem in a scalable way. To gain a sense of just how rare some of these necessary talents are, consider the Silicon Valley Competitiveness and Innovation Project 2015 report that demonstrated a stunning 70% of Silicon Valley software developers are foreign born. This finding is even more astounding considering an immigration environment that requires considerable work and investment by companies to get and keep visas for non-US employees.

Single geography

In-person conversations lead to innovation, especially for early-stage startups where the strategy is likely to change three times between 9am and 5pm, and the best work is often done by a core team after midnight over late-night pizza delivery. Success requires moving fast and pivoting even faster, in a race to find product/market fit before the money runs out. Often there is precious little time to send thoughtful updates to far-flung employees or account for multiple time zones. Look at the office layout of early-stage startups and often you won’t even find desks separated. Instead, the whole team sits around one large table so they can all hear every conversation and informally stay on the same — fast moving — page.

Where can an entrepreneur find the doubly rare combination of personality and talent necessary to build a successful start-up team? In a thriving local startup ecosystem.

Different inputs

If you start a pool cleaning service, odds are you don’t need several months worth of research to tell you what customers need. But for startups, the strategy changes and pivots mentioned in the previous section happen because good entrepreneurs get feedback from potential customers. Lots of feedback. This means founders need ready access to potential customers to shape their product as much as they need access to talent to build it. They need to sit down with these customers, ask questions, watch their processes, uncover their needs. They need structured usability sessions as well as tons of informal conversations about a particular space or pain point. Whether the target is a teenager for a mobile game or a CFO for an ERP system, easy access to a wide variety of potential customers is a requirement.

The same holds true for inputs from mentors. In a fast-paced world, no small early-stage startup team can be expected to know everything about growth strategies, financing, taxes, hiring laws, new technologies, marketing and how to set appropriate expectations internally and externally. Enter the mentor to provide crucial perspective, advice, context, contacts and inspiration to the founding team. This role is so critical, a Compass.co study, The Startup Genome Report, found that entrepreneurs with mentors had three and a half times more growth and raised seven times more money than those without.

Again, for all the technology being glamorized behind startup success, the truth is it is the human relationships that nourish it while the technology is playing catch up.

Where can an entrepreneur find the right concentration of many different types of customers and engaged mentors? Where the culture runs so deep that even the local gym offers free services in exchange for equity in your startup? In a thriving local startup ecosystem. (And yes, this is a Silicon Valley reality.)

Ecosystem winners and losers

All of these factors have led certain geographic locations to have dramatically higher concentrations of startups for decades. While it hasn’t yet been proven if a thriving ecosystem improves the success rates of each startup individually, it does act as a giant factory, producing massive numbers of startups by lubricating every step of the process. After that, it’s a numbers game. You produce enough startups and many of them are bound to be successful. Several of them even wildly successful.

“If you look at a list of US cities sorted by population, the number of successful startups per capita varies by orders of magnitude. Somehow it’s as if most places were sprayed with startupicide. I wondered about this for years. I could see the average town was like a roach motel for startup ambitions: smart, ambitious people went in, but no startups came out. But I was never able to figure out exactly what happened inside the motel—exactly what was killing all the potential startups. A couple weeks ago I finally figured it out. I was framing the question wrong. The problem is not that most towns kill startups. It’s that death is the default for startups, and most towns don’t save them.” — Paul Graham, founder of the leading startup accelerator YCombinator

To extend Paul’s analogy, startups are like seeds sprinkled onto the earth. Most will die. A few will cling to life. A few will take root and thrive into huge fields that feed entire populations — something needed by the entire world economy. So what is fertilizer for startups?

Paris in the 20’s was a hotspot for art. It wasn’t just the presence of painters alone that created the environment, but their support by a vast network of art dealers who could sell paintings and wealthy people who could buy them, which in turn attracted more painters, who saw what people were buying, who helped inspire the existing painters, who created more interesting work, that better supported the art dealers and so on.

So too is the word ecosystem applied to a successful startup environment for a reason. There is no one item that makes an ecosystem fail or thrive, but a combination of many contributing factors. The Startup Ecosystem Report 2015 from Compass.co and many global partners will delve deep into these factors and provide answers, ecosystem by ecosystem, across the globe. You can look for the report’s release in July 2015.

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