Attention returns-driven LPs: Seattle is the most under-funded early-stage VC market in North America

The two drivers of repeatable venture-scale financial returns in any given market are (a) talent, and (b) capital. Last week I wrote about some of the long-term trends that are driving many of the world’s most talented people to prefer Seattle over San Francisco. Since money generally chases talent, I thought it made sense to follow up with an analysis of how the capital markets were – or weren’t – responding to this shift.

If you want to dig deeper, prior posts on this theme include:
Regional Seed Investing, from Pariah to Possibility, and
The Venture Capital Stack + Regional Seed VC

Founder Collective, one of the best seed-stage funds in venture (and not coincidentally, one that operates principally outside the Bay Area), recently shed light on this question in a post titled Startup Success Outside Silicon Valley: Data from Over 200 Exits in 17 Cities. In this post the FC team provided a stack-rank of startup cities based on the metric investors care about most: actual dollars returned.

As the FC team acknowledged, “looking at exit data is, by definition, a lagging indicator, and a single major IPO in the coming months could change the rankings dramatically.” And if you look at their analysis, you mostly see a confirmation of the received wisdom in venture: Bay Area returns dwarf those from any other market; the next four of the top five – Boston, New York, LA and Seattle – are running neck and neck for a distant second place. But taken together those four “second tier” VC markets have produced over $200 billion in exit value over the past 10 years (vs. the Bay Area’s $900 billion) which makes them hard to completely ignore.

This analysis confirms what smart LPs have known for a while: real money is being generated in markets well outside the Bay Area, and any early-stage allocator looking for an edge needs to think about how to get exposure to those returns.

Investors in late-stage VC and growth equity can credibly ignore geography as a driver of portfolio allocations. Firms like Tiger Global and Coatue have rewritten the rules of late-stage venture, driving massive returns with an aggressive strategy that pays a premium for the best deals in any market around the world. For LPs who can gain access to (and meet the minimums of) the best global funds, geography may not matter.

But how do allocators who invest in smaller increments – from $1 million to $10 million per fund – use geography to their advantage? Does the Founder Collective analysis point to a potential strategy for outperformance that flies under the radar (and check size) of larger allocators?

With fund investments typically lasting 10 years or more, answering that question requires a more reliable predictor of future market performance. If IPO and M&A returns are lagging indicators, what are the leading indicators of outperformance by geography?

The traditional measure of individual market health – VC dollars invested per period – has become less reliable as companies stay private longer. Just one or two massive late-stage rounds can easily swamp the signal of many smaller, early-stage financings, requiring a finer-grained analysis.

One potentially useful signal is the number of early-stage funds that have recently been raised to support a given market. While many new funds will fail to meet LP performance benchmarks, in aggregate they represent the LP community’s appetite for risk in that market. And since capital moves more freely across geographies as companies move up the growth curve, the relative density of very-early-stage funds in a specific location is the cleanest possible signal of market-specific appetite among LPs.

The explosion of new funds over the past few years has made this number a fast-moving target, but Samir Kaji and Hana Yang at First Republic Bank have done the hard work of compiling a list of firms and funds under $100 million that provides at least a rough tally of new early-stage funds by geography. Their data requires a little massaging* to match up with the Founder Collective analysis, but the results quickly shine a light on some startling imbalances in the relative allocation of early-stage LP dollars by market, particularly when compared to the markets that have actually driven the greatest cash returns over time.

You can access the full analysis here, but a few things jump out immediately:

  1. The Bay Area overwhelmingly dominates the national distribution of early-stage funds (at 257, or 41% of the total count). While this indexes well below the Bay Area’s share of total dollar returns (at 74%), the latter figure reflects the fact that a majority of later-stage innovation capital is also allocated to that region, inevitably skewing the total upward.
  2. The Boston market, the birthplace of the North American venture capital industry and therefore the country’s most mature VC market, is also the closest to equilibrium, representing roughly 5% of both fund count and total returns.
  3. The most over-funded markets — where the share of total early-stage firms is many multiples greater than the dollar share of returns produced by those markets — are: LA / Southern California (at 2.3x), Chicago (at 3x) and New York (at 3.4x). Either LPs believe that these are the most important new markets in North America, and thus worthy of over-allocation, or the narrative about their potential has run meaningfully ahead of their actual performance.
  4. By contrast, the most under-funded markets in North America are Seattle (at just 0.3x) and Salt Lake city (at 0.6x). Despite their tiny fraction of early-stage fund coverage, these two produce a disproportionate share of the total non-Bay Area venture returns in North America (but with Seattle delivering more than twice the total return of the similarly-covered Utah market).

The title of this post may have spoiled the punchline of the analysis, but there’s still much to discover about why early-stage allocators have bet so heavily on certain markets while others have been overlooked. Are the historical results truly not representative of each market’s capacity to deliver future returns? Or — as often happens with financial markets — has the narrative run away from the the facts, leading some LPs to chase returns that will never materialize?

Only time will tell. But in the meantime, any LPs who want to dig deeper into North America’s most overlooked innovation market are welcome to pay us a visit 😉

*By “a little massaging”, I mean specifically (1) parsing the single FRB location field into separated city and state fields, and then (2) tagging each of the many California locations with a further “NorCal” or “SoCal” label to allow resolution into counts that roughly correspond to FC’s “Bay Area” and “LA” designations. The few funds that were listed as having more than one location in the FRB file were also reduced to just one primary location based on the information provided on their public website.