Can local startups navigate ‘valley of death’ for funding?

Five hundred-ninety three miles away from Pittsburgh Technology Council’s South Side office, 16 of the city’s entrepreneurs chatted with investors at a two-day New England Venture Summit in Boston.

During the program in early December, a few Pittsburghbased startups were selected to give talks in hopes of finding a backer. They had dinner with venture capitalists and networked. But not in Pittsburgh. Why do startup founders attend venture capital summits hundreds of miles away? The opportunities for significant cash beyond the earliest stages are slim in a city with less than 25 major venture capital firms.

That could stunt the startup life cycle for the region’s burgeoning tech industry.

Seventy-six companies in Pittsburgh received $228.6 million in venture capital investment in 2016, according to the National Venture Capital Association, a Washington, D.C.based trade organization. By comparison, 500 companies in the Boston-Cambridge-Quincy corridor received about $6.03 billion.

Pittsburgh is relatively small compared to Boston. The Census Bureau estimates that in 2016 about 303,625 people were living within the city limits and 673,184 lived in Boston. Still, the

numbers are wildly uneven.

That’s not to say Pittsburgh isn’t spearheading efforts to support businesses. North Side-based Innovation Works is the most active seed investor in the country, according to New York financial data company PitchBook.

But there’s a dearth of later-stage funding, and it’s creating a chasm between capital-raising rounds, said John Quayle, a local entrepreneur and growth strategist. It’s often called the “valley of death,” or “no man’s land,” and it’s where startups sputter out or leave.

“Pittsburgh has underlying problems and no one wants to talk about them,” Mr. Quayle said. He thinks it could take over a decade to fix the funding dilemma.

Planting the seed

Investments can be risky at the seed level, when startups might not be far past the idea stage and typically aren’t generating revenue.

Startups may apply to an accelerator program, which helps early-stage companies home in on a successful business plan, find a pocket where the product fits, and determine a fundraising plan.

Sometimes, accelerators act as seed investors. By that framework, startups receive small amounts of funding — usually below $1 million — in addition to advice and services such as coworking space, in exchange for equity.

AlphaLab — an East Liberty software accelerator funded through Innovation Works — invests $25,000 into companies in exchange for 5 percent equity.

The structure for AlphaLab Gear, a hardware accelerator also in East Liberty, is slightly more complicated. Most companies receive $25,000 in funding in exchange for 4 percent equity, or $50,000 for 7 percent equity. Once the startup’s market is validated and it gains customers, AlphaLab Gear may give an additional $25,000 in the form of a convertible note, which basically is a form of shortterm debt that is repaid in equity, not cash. In total, $125,000 is the top-of-line.

Last year, Innovation Works invested $5.9 million in local tech companies per the group’s 2016 Community Report, with 82 companies receiving funding in total. They later found $150 million in total follow-on fundingfrom other investors.

“Most of that money comes from outside the region and helps grow these companies in the Pittsburgh region,” said Rich Lunak, president and CEO of Innovation Works.

The ‘valley of death’

After the seed level and those early follow-on investments, things get complicated.

That’s when the risk is greatest of falling into the “valley of death,” as Mr. Lunak calls the space between seed rounds and the much larger venture capital rounds that typically start at $1 million and are composed of various investors.

By that point, startups should have customers and have begun generating revenue.

Between 2012 and 2016, just 39 venture capital deals were led by venture capitalists in the Pittsburgh region, with funding reaching $235.1 million, according to an Innovation Works report in conjunction with Ernst & Young LLP.

Adams Capital Management Inc. invested an undisclosed amount in Downtown-based smart recycling firm RoadRunner Recycling in 2014, for example, and Blue Tree Capital Group in Wexford invested $667,000 in motion graphics video platform RendrFX, based in Erie.

While Pittsburgh’s number of venture rounds per resident snags the city fifth place with 40.8 deals per million residents — compared to 197.8 in the San Francisco-Oakland-Hayward, Calif., metro area that took first — those deals aren’t necessarily benefiting local companies.

For context, there are 23 major venture capital firms in the Pittsburgh region, according to data compiled by the Pittsburgh Regional Alliance, a nonprofit supporting business in the area.

An analysis of 2017 records on Crunchbase — a website for self-reported investment rounds — found that Strip District-based Birchmere Ventures was the most active fund in the city, backing four local startups. However, that accounted for just 33 percent of the firm’s investments that year.

Sean Sebastian, an advising partner at Birchmere, said the firm has 11 Pittsburgh companies in its portfolio, “which is the most that we’ve had at any given time,” he said.

Some firms hadn’t reported investing in any companies in years. Eagle Ventures in Shadyside and Pi Capital Group, LLC in Point Breeze, haven’t reported funding activity to Crunchbase since 2015 and 2000, respectively. Others, like Downtown-based Draper Triangle Ventures LP, invested in smaller Midwest pools, like Columbus, Ohio, and Troy, Mich., but not Pittsburgh.

Jay Kaparincit, managing director for Draper Triangle, said that on average, the firm invests in Pittsburgh startups in about half of its deals.

However, he expressed concern with Pittsburgh’s long-term funding strategies in combating the valley of death, noting that it’s vital existing firms gain additional capital to play with and that more firms should move into the region.

“It takes an entire ecosystem for the region to find success ... You have to have a blueprint as to where you want to be in 10 years,” he said.

“There’s always a concern that [startups] will leave, but that doesn’t stop us from actively investing in these companies.”

A Midwest problem

Pittsburgh startups do find funding, but a significant portion comes from outside the city, mostly the Washington, D.C.-BostonNew York corridor, Mr. Lunak said.

In May 2016, Strip District-based Astrobotic, a space technology firm spun out of Carnegie Mellon University, raised $2.5 million from Space Angels, an early stage investor group based in New York, for example.

Mike Asem, director for the M25 Group, a Chicagobased “micro venture capital firm” with less than $100 million in capital under management, said the middle of the country is experiencing the same sort of problem as Pittsburgh.

“The Midwest is largely underserved,” he said. “There is great demand for investment dollars and not a huge supply.”

Even in Chicago, which has an active venture capital climate compared to the rest of the Midwest, there is less investment dollars than in Boston or Silicon Valley, Mr. Asem said.

In 2010, Illinois and Pennsylvania received nearly identical venture capital investments relative to the two states’ gross domestic product, according to data compiled by the National Venture Capital Association and accounting firm PwC. Illinois received 88 cents in venture capital per $1,000 of its GDP and Pennsylvania received 89 cents.

By comparison, California received $5.77 in venture capital for each $1,000 of its GDP in 2010. The figure is even higher in Massachusetts, which got $6.26.

“I do think it’s a gap the Midwest needs to fill, whether it’s Midwestern funds being raised or finding better access to coasts,” Mr. Asem said.

Corporate responsibility

Pittsburgh’s behemoth corporations could help bolster the startup economy.

In Cincinnati, Cintrifuse was created to connect corporations with startups. A regional innovation task force composed of companies like Procter & Gamble and Fifth Third Bank coordinated entrepreneurs with the startup funding scene.

Cintrifuse has influenced at least $97.6 million in investment, all without doing so directly. Instead, it created a syndicate “fund of funds,” raised by large businesses like Ernst & Young, as well as the Cincinnati Business Committee and the City of Cincinnati.

The fund, which has at least $57 million to play with, invests in other pools around the U.S., which then invest in local startups.

In May, Kit Needham, entrepreneur-in-residence at CMU’s Project Olympus, invited a Cintrifuse executive to Pittsburgh to discuss corporate involvement in the startup sphere.

Something has to give, Mr. Quayle said. The average capital threshold for a Pittsburgh startup is $100,000-$200,000, he estimated, meaning many startups never receive the funding they need to scale their business. After that, it’s “no man’s land,” and firms might leave to follow the coastal money trail or rely on outside investment.

But there’s hope that Pittsburgh will slowly cultivate its funding landscape.

At a time when total venture capital investment is on the decline, Pittsburgh is showing steadiness. The city ranked 26th of the 40 largest metro areas by population, but ranked 17th in venture capital investment dollars per capita, according to Innovation Works.

That investment, which largely comes from outside the city, doesn’t always translate to losing startup talent, accordingto Mr. Sebastian.

“Five or 10 years ago, a big shot firm would invest 5 or 10 million [into a startup] and they’d relocate,” he said. “Pittsburgh is now being appreciated as a place where a company doesn’t have to leave to thrive.”

At the heart of the issue, Pittsburgh is a small market in comparison to other metropolitan areas, Mr. Quayle said.

“Pittsburgh’s ecosystem just needs to double and triple in size,” he said. “I have a lot of faith in Pittsburgh, but it’s not going to change overnight.”