Successful Startups Put Some Distance Between Their HQ and Their VCs

6/22/09Follow @wroush

The conventional wisdom used to be that technology startups should be located as close to their venture investors’ main offices as possible. That way, it’s easier to call on your venture partners’ experience and networks, get them to attend your board meetings, and so forth.

But the conventional wisdom may be dead wrong. Private equity industry news site PE Hub is calling attention today to a new study showing that startups located far away from their venture investors’ offices actually perform better than those headquartered closer to the mother ship. That finding may come as solace to entrepreneurs in cities such as San Diego and Seattle that are slightly off the beaten venture path, or that are losing homegrown firms.

The study, by a group of researchers from Harvard Business School, the National Bureau of Economic Research, and the Federal Reserve Bank of New York, focused on venture firms in the nations’ three largest clusters of venture activity—Boston, New York, and the San Francisco Bay Area—and asked which of their portfolio companies outperformed the firms’ averages. “Surprisingly, much of the VC outperformance in these venture centers arises from their non-local investments,” the authors report. (PE Hub has put the full paper online here.)

The reason for this counterintuitive finding, the researchers speculate, is that there’s a higher “monitoring cost” to investing in a far-away company—because of the expense of traveling to those locations, among other things—and that venture firms therefore have a higher bar for making those investments. In other words, they only bet on companies that they expect to have a higher rate of return, and to the extent that they bet right, they get that higher rate.

This “hurdle rate” effect is so strong, in fact, that the researchers found that outperformance rates actually go down if a venture firm opens a branch office in the same city with once-distant portfolio companies. Harvard Business School professor Josh Lerner told PE Hub’s Dan Primack that the results ought to cause venture firms to rethink their assumptions about geography. Focusing on local investments because they’re less costly might be a “mental trap,” Lerner said, if it leads investors to relax their standards.

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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  • http://www.smartsheet.com Brent Frei

    I believe the primary reason for the study’s results are that venture firms invest outside their geographic focus area only for the very best opportunities. The special attractions that drew them to those investments are the foundational components of the company that make them the winners down the road (great team, great idea, cash flow positive today,…).

    As evidence, look at Seattle’s Madrona Ventures reaching to New York City for a stake in Animoto. Great company with sound fundamentals including positive cash flow. Less risk + higher likely reward = reach beyond our geographical boundaries.

    There may be some truth in the drag caused by “monitoring costs” but mostly because Venture firms’ value add to their investments follow the same Pareto curve as everything else. Only 20% of them are great at what they do, the other 80% will produce varied value with their interactions.

  • http://www.divergent.com Kevin Ober

    Might the real answer be that investments made outside of over financed markets like the Bay Area are priced more attractively?