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Recent Research: Does the Clustering of Venture Capital Centers Make Sense?

July 15, 2009

Three metropolitan areas dominate the U.S. venture capital landscape: San Francisco, Boston and New York. These cities are home to about half of all U.S. venture firms and about half of all U.S. venture-backed companies. Though venture firms have sprung up around the country over the past 25 years, the three cities have maintained, and even expanded, their share of national firms and investment. The continuing dominance of these cities may be frustrating to policymakers, industry leaders and entrepreneurs in other parts of the country, but a recent paper argues that there is a logic behind the clustering of firms in a few cities and that this distribution may be optimal for both the venture industry and the high-tech economy.

Authors Henry Chen, Paul Gompers, Anna Kovner and Josh Lerner map the location of main and branch offices of U.S. venture firms, along with data on their investments and the location of the venture-backed firms between 1975 and 2005. This data is used to discern whether individual investments took place within the same combined statistical area (CSA) of the venture firm's main office, a branch office or outside of those CSAs. This data also was linked to the success rates of venture firms and investments, as demonstrated by initial public offerings or mergers and acquisitions. The authors control for outside factors that may influence the venture investments and successes, including gross state product per capita, the state's marginal income tax rate, its long-term capital gains tax rate, the percentage of the population with a college degree and the number of patents per capita.

The results reveal some of the reasons why the industry has become even more concentrated over the years. Venture firms and branch offices tend to open in CSAs where investments have been successful over the past five years. Venture firms favor regions with a proven track record of success over underserved regions where there might be untapped opportunities. This tendency creates a situation in which it is difficult to support the development of a local venture capital industry that does not already have a strong industry presence. Firms also tend to open new offices in regions with higher gross state products per capita and patents per capita.

Venture firms also exhibit a strong local bias, according to the study. A firm is almost six times more likely to invest in a local firm, controlling for other factors. The authors note, however, that out-of-region investments have a higher success rate than in-region investments. One explanation is that firms have a higher barrier to investing out of their home region and tend to restrict their investments to low-risk and higher-yield opportunities.

Despite the greater likelihood of success in out-of-region investments, firms based in venture capital centers outperform firms in other locales. These regions have a greater number of opportunities, pools of talented employees and benefit from knowledge spillovers. The authors suggest that this concentration may be a rational allocation of resources and make sense for investors.

This pattern, however, represents a problem for leaders and entrepreneurs outside of the three top cities. Without a record of success, regions will have difficulty creating a thriving venture industry. The authors advise that anything a region can do to increase the number of successful venture-backed investments in a region can greatly increase the likelihood of future deals. Once a region has experienced a few successes, they are much more likely to become the home of branch offices, which in turn are prone to invest locally. Also, once a firm has invested in an out-of-region area, they are much more likely to invest in that region in the future.

Download "Buy Local? The Geography of Successful and Unsuccessful Venture Capital Expansion," at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1420371.

California, Massachusetts, New Yorkcapital