by Lei Xuan
Five years ago, when Stanford MBA graduate Brian Spaly decided to build his second online fashion startup, he chose Chicago.
“I love the city and felt that running a startup business focused on apparel here would draw much interest,” said the CEO of Trunk Club, a personalized online men’s clothing store that had raised $12.4 million in venture capital before being scooped up by Nordstrom Inc. for $350 million earlier this year.
Spaly’s is one of the success stories in Chicago’s venture capital-backed startup community, which has grown exponentially in the past five years, but still trails many other U.S. cities.
“We encountered no obstacles in building Trunk Club in Chicago, but we did have to source venture capital money from Silicon Valley and Los Angeles,” says Spaly, whose first menswear startup, Bonobos in New York, has raised $127.6 million since 2007.
In fact, in the booming Chicago startup ecosystem, sourcing money from other cities is quite common, especially for late-stage startups and those who need a serious amount of investment capital. For example, before Groupon went public in 2011, the company raised nearly all of its $1.1 billion funding from California-based and East Coast-based venture capital firms.
A recent example is Avant Credit, a Chicago-based online loan company. In just two years, Avant Credit has expanded from three co-founders to a 500-employee company with over 100 thousand customers.
Avant Credit has raised $1 billion in eight funding rounds. Chicago-based Victory Park Capital is a long time partner with Avant Credit, but New York-based hedge fund firm Tiger Global Management and Menlo Park, California-based August Capital led the latest $225 million investment.
“The venture companies that have billions of dollars under their management [and] write checks that are worth $50 million, tend to be on the West Coast and some on the East Coast,” says Troy Henikoff, managing director of Techstars in Chicago, an accelerator that helps early-stage startups. “It is just that they’ve evolved. They started where we are today, but because they’re ahead of us time-wise, they have bigger firms.”
Chicago is the seventh city, not the third coast
Chicago has big ambitions to be the Third Coast of the tech world, just behind the more established startup ecosystems on the West Coast and the East Coast.
The success of startups is usually measured by whether they can eventually go public or be acquired. But before that, venture capital-backed funding plays a crucial role in keeping them afloat as they grow.
By that measure, Chicago falls short of its goal when it comes to venture capital investment. In fact, at the end of the third quarter it was seventh with just $200 million raised, behind Boston, Los Angeles, Seattle and San Diego, according to Dow Jones VentureSource.
By comparison, the San Francisco Bay area raised $4.5 billion and New York raised $1.2 billion in venture capital in the quarter.
Still, progress is being made. Chicago had 271 new startup companies in 2013 and 367 new launches in 2012. In contrast, before 2009 there were only about 20 new launches every year, according to online tech community Built in Chicago.
Data from different venture capital reports may vary due to different statistical methods. Another report from Pitchbook shows Chicago did a good job in the third quarter of 2014, raising $501 million, but still behind New York’s $995 million and the Bay Area’s $4.7 billion.
“It takes a long time to build an ecosystem,” says Henikoff, “Silicon Valley started 50 years ago with Intel. Today it is going wild. What happened in Chicago is it took awhile for us to get enough people who did early-stage startups that grew those companies, got exits and used those funds to do it again.”
Michael Marasco, dean of the Farley Center for Entrepreneurship and Innovation at Northwestern University, says Stanford University has been successfully fostering entrepreneurs for a long time, to the benefit of Silicon Valley.
“Chicago’s ecosystem didn’t have universities that were creating lots of startups, therefore we didn’t have the need for financing and that’s why venture capital firms moved up and started doing larger private equity tech deals,” Marasco said.
He says compared to Silicon Valley, the investment environment in Chicago is still conservative, although he thinks Chicago investment companies have became less conservative in the last few years.
“Some of the venture capital firms (in Chicago) became private equity firms that went after larger-size deals, because there were better returns,” says Marasco. “They take publicly traded companies and make them private. They are not as interested in funding early-stage companies.”
However, the shortage of giant venture capitalists in Chicago is also an opportunity for some firms.
“Fundamentally, investing is a business of supply and demand,” says Guy Turner, managing director of Hyde Park Venture Partners. “There is a huge demand for capital in the East Coast and the West Coast, because there are so many startups.”
But Hyde Park Venture Partners’ strategy is to focus on the Midwest rather than chase deals on the Coasts.
“Four or five years ago,” says Turner, “many successful [Chicago] startups would move to the Coasts because there was almost no capital [in Chicago]. Now a lot of them stay here. That’s very good news. We want to continue to have enough capital to keep entrepreneurs here.”
Extra value from investors
While sometimes Chicago startups have to look for investments outside the city, what they do have locally may be worth far more than money.
“This can be in the form of a recommendation or an introduction to a potential partner or guidance on an important strategic decision,” says Adam Hughes, chief operating officer of Avant Credit, who is referring to Avant Credit’s partnership with Tiger Global. He emphasizes that all of Avant Credit’s investors have been very helpful.
“We are based in Chicago and we made that commitment to Chicago and have had a lot of successful investors,” says Hughes, “And that also shows that you don’t need to be on the East Coast or the West Coast to raise money.”
Spaly shares a similar view when talking about having venture capital partners from California.
“In a way, that can be helpful as it provides more opportunities to expand our networks via these investors, as well as recruit talent from markets where our venture capital partners are based,” he says.
“At the time we were acquired by Nordstrom,” says Spaly, who has been traveling a lot recently as Trunk Club offices open across the nation, “we had a term sheet from a Manhattan-based investment firm that was ready to put another $30 million into Trunk Club. We just didn’t need it.”
“It’s probably easier to raise more capital if your company is based in Silicon Valley or New York City,” Spaly continues, “but for the best companies, it probably doesn’t matter where you are based.”