When VCs overlook the U.S. Midwest, it’s not just Chicago they are missing out on. Over time, many cities across the Midwest have been building out bona fide startup ecosystems, as M25’s annual ranking of Midwest startup hubs makes clear.
Each year, the Chicago-based VC firm puts together a list of the Midwest’s most active tech scenes, using a wide range of criteria. And each year, there are surprises, even for M25’s own team.
The main surprise of 2022? That Indianapolis overtook Pittsburgh’s third spot, M25 managing partner Victor Gutwein told TechCrunch.
Gutwein was surprised by the change in ranking, but it wasn’t entirely out of the blue: He knows the underlying factors that helped Indy race ahead. This understanding is precisely why we pinged him for comments on what’s cooking in the Midwest.
In our discussion, we talked about Indy and Chicago, of course, but also about college towns, public funding done right and more.
Editor’s note: This interview was conducted in two parts and has been edited for length and clarity.
TechCrunch: In M25’s latest list, which ranking change in the 2022 dataset compared to 2021 is the most surprising?
Victor Gutwein: I figured Indianapolis could and would eventually surpass Pittsburgh but didn’t know it would happen this year because there wasn’t a “signature” major fundraise or exit or new fund announced.
What happened is that Indy has laid the groundwork. In the Midwest, it’s common for states to compete in different categories of incentives and funding support to encourage startup growth. Well, Indiana went all out: They have a 25% transferrable angel tax credit, a very active direct equity investing arm (Elevate Ventures) and they launched a $250 million fund-of-funds vehicle to back VC funds based in or investing in their state.
This grand slam of incentives seems to be paying off: Indy has a strong “Startup Momentum” score (a combination of growth rate and raw number of net new startups created in the last five years). Their accelerators/incubators score is high as well, partially because some accelerators have been brought to town with that funding package.
Indy has other favorable factors such as low labor costs, very strong tech employee loyalty and an attractive cost of living.
What public incentives do you think have the most impact to create a flywheel for a strong startup ecosystem?
When I think about what truly creates a flywheel for a startup ecosystem, it almost always centers on a large true venture exit, ideally above $1 billion. Examples like ExactTarget (Indianapolis), Duo Security (Ann Arbor) and CoverMyMeds (Columbus) changed the game and put these cities above their peers.
Why do these exits matter? Because one huge event like that causes an immense amount of recycling, with early employees leaving to become founders, early investors and employees reinvesting capital as angel investors and VC funds, and other growing tech companies pulling experienced talent from that unicorn. There are also “second order” events such as more VCs looking at startups and spending time in that city, or large national customers being more willing to work with those associated with that unicorn.
Because of this, my take is that the best public incentives both create more shots at a future unicorn exit and fill in the early gaps in a startup journey. This is best done with early location-tied grants and direct investment. However, this can be tricky.
In my view, public incentives need to be deployed early enough to complement angel investing or even replace it, given there is generally a dearth of angel investment in many ecosystems but without competing against or displacing private-capital VC funds.
Examples include state-backed direct investment funds like Invest Nebraska, Invest Detroit, Elevate Ventures in Indiana, Keyhorse Capital in Kentucky, Innovation Works/AlphaLab in Pittsburgh and JumpStart/Rev1/CincyTech across Ohio, as well as nonprofit groups like Arch Grants in St. Louis, LaunchLNK in Lincoln, Nebraska, and Render Capital in Louisville.
With some exceptions, these capital sources should not be active in later stages as the region has shown it’s relatively accessible for high-quality A/B/C+ and growth rounds once real traction has been reached.
Over time, this will smooth out entirely and great opportunities in the Midwest will get fully funded completely independent of public subsidies and nonprofits. We are already seeing this happen in some of the most successful flywheel ecosystems. For instance, Status raised an entirely Columbus-based $2 million pre-seed round founded by early Loop Returns employees and funded by local and national angels and pre-seed funds (including yours truly).
One avenue to prevent subsidized public competition and to better enable more long-term and sustainable private investing in early-stage startups is to better fund the investors, both to incentivize and better allow them to compete on a national level.
This can take the form of angel investment tax credits for qualifying angel investments in many states — Illinois, Indiana, Kansas and Kentucky have some of the most long-running programs — that return anywhere from 20% to 40% of the investment in the form of a state tax credit to individual angel investors.
The other major strategy is geographically targeted fund-of-funds that back fund managers already investing in or based in that city or state. These enable these funds to have more capital to deploy, whether it be for an accelerator to write more checks, a pre-seed fund to be able to lead and fully fill out a round of capital (to better compete against a well-funded coastal competitor) or for multistage funds to maintain check-writing ability and prevent dilution as their companies take off.
Indiana’s Next Level Fund, North Dakota’s Growth Fund and the Illinois Growth and Innovation Fund are public-funded examples, whereas Michigan’s Renaissance, Wisconsin’s NVNG and Cincinnati’s Cintrifuse are a mix of public/private examples.
Which Midwestern college towns have had the most success at fostering startups?
Ann Arbor is No. 1, with two unicorn exits (Duo Security and Llamasoft) and highest marks for “Startup Density,” “Educated Workforce” and “Internet Access,” as well as a compelling tax climate and great numbers for tech developers, patents and airport access.
Madison is not far behind, beating out Ann Arbor in government resources for startups, GDP per capita, accelerators/incubators, tech employee loyalty and raw number of exits. It is most known for Fetch Rewards ($240 million Series D this year), Veda ($45 million Series B) and had a host of $20 million to $25 million rounds in the last 12 months.
Interesting to note are big surges in rankings for Bloomington, Indiana; Lexington, Kentucky; and Columbia, Missouri, which are all college towns with noticeable increases in startup activity.
How central does Chicago remain to the larger Midwest venture and startup ecosystem?
Out of our 131 portfolio companies, Chicago has been home to 49 of them (37%). If you look at new unicorns announced in the past 18 months, Chicago had 12 of maybe 24 across the region (hard to get an exact number). If you are a founder based anywhere in the Midwest, you are coming through Chicago to both raise from VCs and sell to customers. Many startups hire out of Chicago as well.
Why is that?
There are several factors in Chicago’s favor:
- It’s the only place in the Midwest where you can schedule a trip and “fill a day” with VC meetings. On one hand, it has the most VCs; other Midwestern ecosystems have at most five seed-stage VCs and most only have one or two. On the other hand, most of these VCs are also happy to invest in Midwest companies, so they will treat a meeting with a Cincy or Detroit startup like a normal one, which has not been the case for Midwestern startups pitching in Silicon Valley.
- It has had a lot of repeat success and so far this has been a very effective flywheel.
- It houses a huge amount of Fortune 500s across every industry. My portfolio companies from Omaha, Indy, Columbus, Kansas City, etc., are always coming through Chicago for sales meetings.
- It’s the largest population by far and it’s centrally located. This can drive other network effects, too. For example, Chicago is the second-highest destination for any Midwest Big Ten school (after the largest city in that state). It’s drivable for most or a short direct flight. It was everyone’s “first huge city” they went to growing up. A rapidly growing Midwest startup is likely to have employees in Chicago even if they are a few states away because their networks are tied into Chicago naturally.
- The airports. Seriously — Chicago has more nonstop direct flights (261) by a huge margin than Minneapolis (152) or Detroit (122). No other city has more than 100, which means you’ll be transferring through it anyway.
- It’s the same culture. I think this is more important than one might realize. The Midwest may think San Francisco, New York City, Los Angeles and Miami are “cool,” but it’s also not ever going to be “home” like Chicago can. For most Midwesterners, it’s easier, cheaper and less stressful to live, work and do business in Chicago, but it’s also a world-class size city with major corporations, entertainment, dining, etc.
When it comes to sectors that Midwestern startups serve, do you expect the relative importance of insurtech to decrease over the next few years?
Yes. For a while, it was the dominant industry for tech startups in the region to be in, and for good reason, as the Midwest is a hub for insurance in the U.S. But we are also a major hub for other industries: transportation/logistics/supply chain, food and agriculture, manufacturing, retail/CPG/finance/banking.
Given both the national and Midwest lens was so focused on insurtech for years, it is time for that to correct. That’s not to say there still won’t be winners. Chicago-based Kin is not doing layoffs or having tremendous burn rate reductions but instead announcing consistent quarterly growth as it nears profitability.
You previously told TechCrunch that startups in the Midwest are seeing fewer layoffs than other areas of the United States. How would you explain this?
We have fewer layoffs because Midwest founders have always had a harder time getting venture capital. Capital efficiency wasn’t an option pre-COVID — it was a requirement. So even if/when they did raise in the 2021 boom era, they weren’t rapidly spending it just to spend it and raise another round. These founders kept burn rates realistic so that if/when the funding dried up, they could simply slow hiring plans and adjust to profitability (seriously!) or delay needing to take on funding.
There are certainly exceptions — Root and Cameo have both had significant layoffs — but it’s not the same percentage as on the coasts.
Discussing exit volume recently, you said that acquisitions in the $25 million to $100 million range were still getting done. Where are these deals happening, who are the buyers and what types of startups are being snapped up?
These are strategic M&A buyers that are eager to buy now at more reasonable multiples. Paying 10x to 20x revenue for a software business last year was a steal and yet this year it’s nerve-wracking (particularly if it’s a very large acquisition above $500 million). But at the smaller end, that type of multiple isn’t pushing strategics away because it isn’t going to impact their balance sheet significantly if they overpay, and there is a good chance that the multiple won’t look bad in a few years while the company can still grow alongside them, often aiding their core business.
On the other side of that deal, founders are facing the question of when/if they would want to take a low-valuation dilutive financing round versus receiving a more attractive valuation with an exit (often with upside) that locks in their gain during a rocky economic climate (especially when hedging with a secondary sale alongside a major B/C/growth round is less likely as these rounds disappear).
Still, these smaller deals may slow down a bit, but they still are happening even when late-stage/IPO/SPAC has gone away completely.
What is the most important piece of advice that you share with founders in your portfolio on selling products and services to Fortune 500 Companies?
It’s not going to be a quick sale nor an easy implementation process and you have to be prepared for that. Selling into a large company often requires a suite of acronyms that will really set a first-timer back if they are not prepared and if they do not manage expectations, burn rate and sales processes carefully.
I get excited when I work with a founder that has already figured this out or has brought someone on board that knows how to work these systems, as Fortune 500s can be excellent long term and reliable customers/partners/acquirers if handled appropriately.
What is your favorite unconventional quality in an entrepreneur?
I love to see a mix of Midwestern humility and grounding, but I am also eager to see founders envisioning a bigger story for their company than just the front page of their local business journal. I tell them to think Wall Street Journal for their IPO or M&A announcement. I think this combination of traits leads to companies that are growing very fast but more sustainably and with a healthy dose of realism that sometimes is missing from other coastal founders in the TechCrunch articles I read!
M25’s diversity report mentions that you always welcome cold emails. Would you like to share an email address that founders can use to send you a pitch?
Yes: victor@m25vc.com. Just make sure you’re actually based in the Midwest.