Middle of nowhere: Loneliness of the Midwest network start-up

Elyria, Ohio, population 56,000, has a history of innovation: The padded bicycle seat, colored golf ball and rubber heel were invented here. Now this Rust Belt city 10 miles west of Cleveland is home to a software company that is among a handful of Midwestern start-ups that have attracted venture capital financing this year.

Banyan Technology, which markets a Web-based logistics service to the trucking industry, received $350,000 from Ohio venture fund JumpStart. Doing business out of a development center at Lorain County Community College, Banyan has more than 40 customers and nine employees. (The company is no relation to the defunct manufacturer of the Banyan Vines network operating system.)

“Even in our dealings with companies in Cleveland, Elyria is perceived as way out in the sticks, although it’s just 30 minutes away,” says Lance Healy, Banyan co-founder and vice president. “A lot of people make sarcastic comments that we’re located in a real tech Mecca. We usually don’t lead our sales pitches with that.”

Banyan is one of six network start-ups located in Ohio to have received venture funds in 2006. In the 12 states that comprise the Midwest, only 25 network start-ups have signed venture deals this year. That’s just 3% of 822 network-oriented venture capital deals closed nationwide in 2006.

In contrast, the top three states for network-oriented venture capital activity – California, Massachusetts and Texas – represent 64% of the deals closed in 2006. California alone, with 371 deals, is home to 45% of the network start-ups funded this year.

“As far as venture-backed companies are concerned, the Midwest is lagging [behind] the rest of the nation,” says Tracy Lefteroff, global managing partner of the venture capital practice at PricewaterhouseCoopers. “They have the research institutions. They don’t have the venture capital and the experienced entrepreneurs to build those companies.”

The statistics above are from the quarterly “MoneyTree Report” by PricewaterhouseCoopers and the National Venture Capital Association. Network World receives a special cut of the report’s data (supplied by Thomson Financial) that is focused on the network industry. (Find out more details on the survey.)

Midwestern venture deals are smaller than those on either coast, according to the latest MoneyTree data. The total amount of venture funding pumped into network start-ups in the Midwest this year is $91 million, a mere 1.5% of the $5.8 billion invested nationwide.

California, Massachusetts and Texas account for $4 billion, or 70%, of the venture funding received by network start-ups this year. Would-be Ciscos and Googles located in California attracted $3 billion this year, or 52% of the funding.

The average deal size in the Midwest was $3.7 million, compared with $7.7 million for the leading states.

“It’s hard to attract venture capital funds to come to the Midwest to oversee small deals,” says Steven Humke, partner with the private equity and venture services group at Ice Miller, an Indianapolis law firm. Indiana has closed two Web-related venture deals this year, representing $2.3 million. “It’s also the culture of the market here,” he says. “Entrepreneurs would rather raise the money themselves and not have the dilution of [ownership] they have in dealing with [venture capitalists].”

Missing in middle America

The Midwest doesn’t lack technical talent. Plenty of computer science and network engineering majors graduate from top schools, including Purdue University, the University of Illinois at Champaign-Urbana and the University of Michigan-Ann Arbor.

“We have very strong universities here,” says David Hofer, CMO of Plexus Online, a manufacturing software company in Auburn Hills, Mich., about 40 minutes north of Detroit. Most of the 100 employees at Plexus are from the region. “People forget that the automotive industry in this town is very technologically adept, so we have deep talent resources,” Hofer says.

Still, Hofer admits, Plexus is a rarity. “There are not a lot of software companies doing development work in Michigan. We’re certainly an anomaly,” he says.

Experts say what’s missing in the Midwest is the entrepreneurial culture found in high-tech centers such as Austin, Boston and San Jose. Cities such as Chicago, Columbus, Detroit and Indianapolis don’t have enough experienced entrepreneurs and can’t attract them from outside the region.

“The first thing a venture firm will do if it is investing in a Midwest start-up is to move the company,” PricewaterhouseCoopers’ Lefteroff says. “You can’t recruit out there, so it’s hard to build these companies. . . . If you’re an entrepreneur or a scientist and you get recruited into a market like Indianapolis and the start-up doesn’t work, there are no other job opportunities out there. In the Bay Area, there are more job opportunities than people to fill them.”

“The money is key,” Lefteroff says. “Nothing happens without the money.”

A dearth of venture funding is what prompted Paul Batcheller – previously on the staff of former U.S. Sen. Tom Daschle – to form PrairieGold Venture Partners in 2004 in Sioux Falls, S.D. PrairieGold focuses on regional investments of less than $2 million.

“We do sense some bias” against Midwestern start-ups in the big venture firms, Batcheller admits. “As we’ve started talking to some West Coast firms for follow-on investment, the bar is higher because of our location.”

PrairieGold has made four investments, including Game Plan Technologies, an Omaha, Neb., start-up selling digital video technology for the sports industry. Game Plan raised $2.5 million in April from PrairieGold and Adena Ventures of Athens, Ohio, and Mountaineer Capital of Charleston, W.Va.

Batcheller sees a lot of advantages to being in the Midwest for start-ups such as Game Plan.

“Life here tends to be a little easier,” he says. “For a focused entrepreneur, who doesn’t want to deal with traffic, high competition for talent and expensive cost structures, there are a lot of advantages of doing business in the Midwest. Companies tend to be more focused. Employees tend to be more loyal.”

Venture capital firms bring more than money to start-ups: They bring experience and IT industry contracts that can help foster partnerships and early customers.

When venture capitalists invest in a start-up, they’re often thinking about the connections they have that can help grow the business, says Rob Daly, president and CEO of Bluespring Software, a Cincinnati start-up selling business process management software.

“A partner at a big [venture capital] firm has a huge Rolodex on his desk. He’s sitting there on Sand Hill Road [in Silicon Valley], and when a big issue comes up, it doesn’t take much for him to call someone 5 miles away,” Daly says. “People will try to tell you it’s a talent problem in the Midwest. I don’t think it’s a talent problem. It’s that the talent on the West Coast also has a Rolodex.”

When Daly was looking for financing for Bluespring, he turned to three Midwest venture firms: Primus Venture Partners in Cleveland; Blue Chip Venture in Cincinnati and Arbor Partners in Ann Arbor, Mich. Daly raised $3.5 million from these firms last year, with $160,000 distributed last quarter.

“We’re trying to be acquired,” Daly says, adding that the 30-employee firm’s revenue will top $3 million this year.

Beyond the garage

When they first get funding, Midwestern start-ups usually are more mature – they have customers and they’re shipping products – than start-ups on the coasts.

Plexus was 11 years old and had 350 customers before it received its first round of financing in June from Apax Partners, a New York private equity firm. The amount of financing is undisclosed.

“We viewed this as a way to augment our sales and marketing effort,” Hofer says. “The investment wasn’t put into product development. Apax took a minority stake.”

The additional cash is helping the company grow. It already has generated $19.5 million in revenue this year, compared with $14.2 million in revenue for all of 2005.

“We weren’t out looking for financing,” Hofer says. “They came to us because they were very intrigued with our business model. They saw the frustration manufacturers were having migrating to new systems and trying to manage their IT departments. They saw how our software-as-a-service application freed up their manufacturing clients.”

That’s why Midwestern start-ups also have the reputation of having more substance than style. Jeff Mills, vice president of channel development for business process management software at Bluespring, says when he worked in Silicon Valley too many start-ups announced products, customers and partnerships prematurely.

“We’re much more grounded here in the Midwest,” he says. “The venture capital community is tougher on us from the standpoint of due diligence vs. more faith on the coasts. The advantage is that we’re selling less vaporware here.”

An unexpected problem for Midwestern start-ups is that potential customers in the region are often risk averse. That’s what happened to Banyan, which couldn’t attract local customers until it already had customers on the East Coast.

“We have customers in Maine, Vermont, New Hampshire and Connecticut. More than 80% of our business is in New England,” Banyan’s Healy says. “We couldn’t get any penetration in our own backyard until we had customers on the East Coast. Potential customers here were kind of fatalistic: How good can the software be if it’s made here?”

Healy says the situation was ironic, because to New England manufacturers, Banyan’s Ohio location was a plus. “In New England, Cleveland is considered warehousing-central,” he says. “Being from Northeast Ohio helped qualify us.”

All in all, being a high-tech entrepreneur in the Midwest is akin to being a fish out of water. “The attitude around innovation isn’t here,” Daly says. “The Midwestern attitude is to respect [money] that’s been sitting around for a long time. It’s respecting someone else’s entrepreneurial instincts rather than the people trying to take new ventures out of the ground.”

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