How Silicon Valley Works?

Silicon Valley, entitled as Innovation Capital of the World, is attracting brains from all over the Globe. It is the no 1 hotbed for venture capital investments and home to many of the world's largest technology corporations as well as thousands of small start-ups. No wonder that many are aiming building the next Silicon Valley in their home countries or home towns. During Enterprise Estonia Field Trip in October 2012 I had the possibility to get a glimpse of how it works.

Of course, two weeks is a way too short time for getting it all. However, we (7 Estonian start-up entrepreneurs, 2 investors plus organizers of the trip) made quite a tour:

* Visited several companies such as Skype, Google, Nokia, Facebook, Guzik (the doors of Apple remained closed)

* Were introduced to Stanford and its entrepreneurial focus by Keith Devlin, H-Star Institute Stanford University

* Explored co-working spaces and accelerators, incl. Plug & Play Tech Center, NestGSV, Rocket Space

* Attended various pitching events (Keiretsu Forum, Jumpstart days, CloudScale 2012) as observers and pitched at Silicon Vikings

* Talked to the venture capital firms Nexit Ventures and Institutional Venture Partners

* Learned from Richard Allan Horning about legal issues and setting up a company in the US

* Met with local professional Estonians in a pool party

Plus everyone had their own items in the agenda. I, for example, stepped into the Northwestern Mutual, spoke with Krishnan Subramanian who is one of the 12 top thinkers of Cloud Computing, and hiked in Purisima and Madera.

Here is my summary which I have complemented with a few data and facts from other sources.

The “food chain”: an entrepreneur’s perspective

In the old days ambitious people focused on pursuing corporate career: you start as an assistant or junior specialist, next you become a specialist, a senior specialist, head of department, middle manager and so one up to the very top. Your licence to get into the system is formal education.

Nowadays corporate career is not the only route. Young professionals often quit before they become managers. The problem with the old way is that in a large company far too often your learning curve flattens off far before you are actually allowed to make another step forward by the “gatekeepers” (read: your boss and boss of the boss).

Silicon Valley has created another route to the top, which at least seemingly is more appealing: formal education is not a must; by founding or co-founding a company you instantly become a CEO or CTO or whatever title is suitable and sounds good; you start operating with much larger amounts of money than you could have made in your professional career any time soon.

But no illusions and not too much freedom: it still is a formalised process, a “food chain”. It goes something like that (assuming that you succeed on every stage):

-> You come up with a scalable business idea ->

-> You go to an incubator or accelerator where you get some seed funding, a co-working space, access to the network of people who can help you forward etc. ->

-> You validate your business case, write a business plan, build a team, develop an early beta of your product, incorporate an US Inc., create an advisory board etc. ->

-> You start running for angel investors, super angels, venture capital: A round, B round, C round etc. ->

-> Exit for the investors via IPO or M&A whereas the later is by far more common; if you are successful, you get a position in the top management of a corporation.

A few more observations from an entrepreneur’s point of view:

“Think Big. Start Smart. Scale Fast,” they say in US MAC. This ambitious attitude and tendency to be biased towards positive side, countless new ideas, diversity of nationalities, energy and synergy, series of interconnected networks, things happening fast and often unexpectedly – all together make up an exciting environment that supports innovation. The downside is that people, while always either working, networking, looking for money or new business opportunities, trying to meet some sorts of targets, risk with burning out far too soon.

One side-product of Silicon Valley’s set-up is a bunch of fortune seekers who are living from project to project. As failure is not a bad thing in Silicon Valley (rather other way round because every start is considered as an expression of initiative and a practical lesson learned) and there is a high concentration of accelerators, one may get seed funding for a pretty nonsense idea, fail, come up with a new nonsense idea, get seed funding, fail and start all over again. The only thing is that one has to be a good story-teller; a typical sales pitch goes along these lines:

“We are doing this new-new-thing; we have a disruptive technology and a kick-ass team.”

At the end of the day, there are no free lunches, accelerators are for profit, venture capital firms are for profit etc. At every stage you give up certain share of your company and thus a share of the future revenues. By the time of exit, you as a founder are most probably a minority shareholder limited by the numerous unfavourable clauses and restrictions. Still, as angel investors and venture capitalists like to put it: it is better to own 10% of a billion dollar company (i.e. 100 millions) than 100% of a million dollar company (i.e. 1 million). The open question is: can going through the process really increase the future value of my company from million dollars to billion dollars given sound business concept?

Once a start-up entrepreneur has chosen the route of running for venture capital, there is barely a way out. The most frequent reason for later stage start-ups to fail is the inability to attract next round of funds even if the failure is labelled as the lack of focus which results in not fulfilled business goals. In fact, venture capital prompts setting up a way too expensive and inefficient business organisation. Given successful exit, this however makes sense for the entrepreneur and seed investors. The only thing is that based on statistics, eight or nine out of ten venture funded companies do not make it.

Silicon Valley is the place to be if: your partners are there, your customers are there and your competitors are there, and you want to participate in the established process or “food chain”, whatever we call it. Otherwise it costs way too much.

Angel investing and VC business

According to some statistics, average investor relationship lasts longer than average marriage in the US. Thus, partners should choose each other carefully. No one wants “stupid” money – everyone is looking for smart money. Investor should bring relevant competences and network.

Generally investors are on a stronger position than entrepreneurs not only because they have money which is the lifeline for start-ups, but also because they are much better organised into angel groups and venture capital associations. An entrepreneur would most probably benefit from understanding their perspective as well.

Investors too have their specific “food chain”:

-> Seed investors (one of the three “F-s”, the “Fool”) ->

-> Angel investors ->

-> Super angels ->

-> Early stage venture capital firms ->

-> Later stage venture capital firms

While angels invest their own money, venture capitalists invest the money of the others, including pension funds, insurance companies, endowments, foundations, family offices and high net worth individuals. (Note multiple asset management fees: pension fund is charging a fee and investing into a VC fund which in turn is charging a fee.)

More than often even though not always, angel investors have started as entrepreneurs by themselves. Thus investing into start-ups is being considered as giving back. According to Steve Blank, an unspoken Valley culture believes: “I was helped when I started out and now it's my turn to help others.” Of course, angels are looking for returns on their investments, but given the risks involved in early stage start-ups they certainly have to simply enjoy the process of working with innovative ideas and with people who think that they can change the World or at least disrupt some industry.

VC funds have their own life cycle. Typically they are being set up for a 10 years period. At the beginning, they can afford investing into relatively early stage companies; however, as they need to exit all their investments at the end, they start looking for later stage companies as they become more matured.

Venture capital is being considered as an asset class or alternative investment – and not the best performing one, see the 2012 report of Ewing Marion Kauffman Foundation. “Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC.” Poor performance has made several VC firms to close over the past couple of years. Those who have survived are either:

* Large top-tier venture capital firms, or

* Small specialised firms with clear focus.

The moral for an entrepreneur is that if you choose the wrong VC firm which is not able to attract capital from its investors and has no money for the next funding round of your company, you will most probably see much more troubles. This is how the current debt crisis is affecting Silicon Valley: there are fewer funds available to everyone.

All in all, the total amount of money invested into innovations looks rather small: $48.7bn venture capital globally in 2011, including $32.6bn in US out of which $12.6bn in Silicon Valley. These numbers may seem big at first, but compare them to $40 billion monthly purchases of mortgage debt announced by Fed in the frame of QE3 ($40 billion is the amount that Fed is planning to spend for buying crappy mortgages each month)!

The truth is that later stage companies with monthly revenues of at least $10,000 tend to be overfunded while the others are underfunded. On one hand, given the risk of high inflation in a few years perspective, investing into cash flow generating assets is essential. On the other hand, Buffett’s style of investors and analyses based on traditional methods would allocate zero to unpredictable start-ups given the amount of uncertainty involved.

With this we come to a striking question: “How to add a price tag to a start-up company?”

As an entrepreneur, you may be tempted to show classical hockey-stick forecasts. These are generally been considered as laughable by the venture capital as very few of these hockey sticks if any materialise in reality as projected. First of all, angel investors are investing into the entrepreneur and the founding team. Most typically, the value of a company is being estimated in the later round of financing which also defines the ownership share of the initial investors.

VCs quickly teach entrepreneurs being efficient when it comes to avoiding taxes. Most often they require presence in the US and suggest that the easiest way for moving your company is in an early stage when it is still not worth much. In later stage, you have to make your company in the home country look like as if it were on the edge of bankruptcy and only the investment from the overseas company (which, surprise-surprise, has the same owners as the company in home country) can save it.

Most often, angel investors and VC firms are in one or another way partnering with the start-up incubators and accelerators as those are acting as catalysts. However, some do insist that accelerators and incubators are not adding much value and they would suggest an entrepreneur to bootstrap as long as possible. Understandably so as they have their own interests in play: while avoiding the earlier stage investors, they can grab a bigger share later on.

Current trend: scalable intangible assets and B2B business; forget about the hardware which is difficult to pivot; think hard before considering approaching end customers at first because this market is generally way too costly and/or time-consuming to access.

Perspective of large companies

As I see it, large companies love and hate start-up world at the same time.

On one hand, they need innovations that they are unable to produce in-house efficiently enough. They need top talents that they are not able to attract otherwise. Sometimes they are also afraid of competition and/or other sorts of disruption of their business. That’s way they are purchasing start-up companies for an unbelievably high price.

On the other hand, they hate the high valuations assigned by the earlier stage investors. They want to avoid those and have started to create their own specialised accelerator programmes (even though in co-operation with the existing accelerators). For example, I learned that the Volkswagen Group of America Electronics Research Laboratory (ERL) in co-operation with the Plug and Play Tech Center has recently launched a new accelerator program, which will help accelerate 10 start-ups focused on next generation technology for the auto market.

What about building the next Silicon Valley?

As they put it: building the next Silicon Valley would require another Cold War; they see Silicon Valley as the destination for innovation. More bluntly, the rest of the World is being envisioned as a lower stage in the “food chain”: prepare start-ups and continue developing the technology, just bring the most profitable part (sales) to the Valley. Sounds like smart/devious strategy.

Historically, break-troughs have been made by violating the existing rules of the game. I tend to think that the secret of building the next Silicon Valley is not copying and pasting the existing one (for one thing, we had to deal with a moving target) but breaking the start-up process into parts and re-constructing it in a more effective way.