Aug 19, 2015 · 11 minutes

LA is on track to have a seven-year high in venture funding, according to CB Insights.

LA funding has grown steadily since 2012, and in 2014 LA startups raised more than $3 billion across some 400 deals. The first half of this year has seen 182 deals, but more than $2 billion invested-- a whopping 285% increase in dollars since things started heating up in 2012.

This isn’t a surprise to us here at Pando. We were one of the first tech publications to hire an LA-based reporter in 2012, Michael Carney, just when things were taking off. He did such a good job uncovering and analyzing local gems that he was poached away by Upfront Ventures-- which is by far the most active investor amid this SoCal boom. (More on that in a bit.)

But while we’ve always been-- and still are-- bullish on LA, we’ve covered it closely enough over the last few years to see some warning signs behind the rosy headlines too. Reading CB Insights’ report, I at once started arguing a bullish and a bearish case for betting on LA to myself. It’s important to weigh both whether that “bet” is building your next startup there, heavily investing there, or moving there and hoping for a plum startup job.

Let’s go through the bull case first. That way anyone in LA who doesn’t want to hear the negative part can just stop reading. It’s like leaving a Dodgers game in the fifth inning!

The Bull Case for LA:

  • LA is full of great storytellers. That’s a handy skill because so much of social media is about storytelling. LA startups are good at romancing consumers (and VCs) with the story of a company, not only in a pitch but through their product. Brian Chesky has said he uses a storyboarding technique to build out Airbnb. Many LA-based entrepreneurs approach building and launching a product the same way you’d put a movie together. Why does a consumer want this? Who is the consumer who wants this? Not simply, I could build this in a weekend so I did. Jeremy Liew, of Lightspeed Ventures, talked about this in his PandoMonthly interview that we held in LA, because the bulk of his top investments have come from there.
  • LA knows how to build things that middle-American teens want. Look at the valuations of Whatsapp and Snapchat. Investors care deeply about what teens want, and they are completely befuddled about what that is and why they want it. LA is a far better ecosystem -- in general-- of getting teenage attention.

    Compare the two anonymity apps: Secret got attention because it got a bunch of Valley people spreading gossip about one another and lead to bullying in high schools. Whisper became something very different--  a way teens expressed their hopes and fears and ...occasionally creepy sexual aspirations. Secret produced something viral but malicious. Whisper produced something aspirational and personal. When Secret was forced to put the same basic anti-bullying protections in place that Whisper always had, it absolutely crumbled because that’s all it was. A company that was once valued at some $100 million returned capital and folded within a year’s time.
  • Proximity to the Valley. This is an often overlooked one. But VCs like to invest in companies that are within an hour flight or a day’s drive away. Bingo. That puts LA in the slightly inconvenient space of a lazy VC who has to get on a plane, but some 80% of flights out of SFO go to LA. It’s in the same time zone and there is a continual flow of investors who have moved back and forth between the two cities. Chris Sacca and David Lee moved down to LA for family reasons; Jason Calacanis recently moved back up here and Peter Pham is seemingly pitching something up and down Sand Hill Road every day. Many VCs feel like they can still help a company and provide hands on guidance, even if its in LA. And from the senior exec point of view, it’s a commutable job if you live in San Francisco. That allows LA to draw from a bigger pool of talent.

    Geography gives the two cities a tighter connection than San Francisco and New York or San Francisco and Boston could ever have. Consider Liew: From early bets on ShoeDazzle, Honest, Whisper, and Snapchat, believing in LA early on has made his career as an investor. And he’s done it all commuting down from Silicon Valley.
  • Content is more important than ever before. In earlier waves of tech, platforms were prized above all else, while content was considered messy, unscalable, and mostly something you pirated. Consider: Napster, YouTube, and … well, YouTube still when it comes to music. Today’s music startups that have made it-- Pandora and Spotify-- have comparatively learned to work with the RIAA not against it. Meantime, Netflix is now a content company. Amazon hires filmmakers to produce indie films.

    Suddenly a Silicon Valley that once prized user generated content and the platforms to disseminate it is waking up to the power of great content. And LA has even seen several interesting takes on user generated content: Maker was one of the ecosystem’s biggest exits in recent years when it sold to Disney-- a very LA deal. One of the arguments to build a company in Silicon Valley is that the proximity of startups to big tech companies can enable eventual acquisitions like this. Well, in LA if you are a digital content company, you may similarly have a higher likelihood of getting acquired by a company like Disney. (And, that culture fit not being a total disaster post acquisition.)
  • A Facebook of its very own. Lastly, LA has something that other ecosystems always talk about in rapturous tones and have desperately needed: “A Facebook.”

    Ecosystems like New York, Boston, and Chicago have had a lot more deal activity, strong venture capital activity, a lot of talent and even good outcomes. But they’ve lacked a huge-- huge-- consumer Internet phenomenon that could become a super Unicorn, or a company eventually worth $100 billion or more.

    New York had high hopes for Foursquare and Tumblr, but Tumblr topped out at $1 billion and Foursquare has hit a rough patch. Chicago had Groupon-- the fastest growing startup a firm like Accel had ever seen…. until it stumbled badly. Snapchat was started out of Stanford, so it was mostly a fluke of where the entrepreneur wanted to build the company that it ended up back in LA. But the proximity to the Valley was likely a big factor in it succeeding nonetheless.

    Still, no matter the reason, if Snapchat actually builds a company close to its current venture valuation (some $20 billion) it will be a massive catapult for the LA ecosystem. Super Unicorns are great, but LA will take a deca-unicorn first. A Snapchat at that level of success would draw talent and keep talent in LA, create dozens or even hundreds of local millionaires who can angel invest, and -- perhaps most importantly-- provide the psychological boost and argument to investors that yes, you can build a deca or super unicorn in LA.

    Consider what Microsoft and Amazon have meant to Seattle. It’s rare that a smaller tech market has a hit this big and enduring. Much more common are cities like Boston, New York, and Chicago that have lots of $1 billion plus exits but in less sexy categories like ad tech or enterprise or smaller consumer wins like Grubhub and Care.com.

The Bear Case:

  • A lot is riding on Snapchat and a few other hits. And in the past when LA has pinned its hopes on a one or two hot companies, things haven’t fared well. MySpace, Machinima, ShoeDazzle, Beachmint, Betterworks, even reports of stumbles at NastyGal. These were all hot, hot, hot LA companies that stumbled. And in the case of ShoeDazzle, when they stumbled, they fell apart quickly.

    The LA market-- and the VCs who fund it-- are wary of getting too excited about any company that looks good on paper. Some may have wished Snapchat had taken that rumored $3 billion purchase price and locked in a win. If Snapchat is going to deliver on its promise, building a thriving independent standalone company will be that much more valuable to the ecosystem. But that’s a big if.
  • A lack of off-the-shelf “parts.” One of the reasons that it would be so game-changing for a super unicorn to be built in LA is that most VCs readily admit great companies can start anywhere-- in fact First Round Capital found that its returns were better for companies that weren’t started in San Francisco or New York. But, they added, those companies frequently had to move to a major tech hub to scale.

    In a PandoMonthly years ago, Chris Dixon of Andreessen Horowitz argued this was a big difference between Twitter (such as it is) and Tumblr. Twitter was located in a place where the company could bolt on all those off the shelf “parts” a company needs to scale. The growth hacker who has done it before. The CFO who has prepared a company to go public a trillion times. And all the rest. Growing a company to fifty employees is easy to do in a market like LA. Beyond that it’s still very much unproven-- and not just in LA. It’s unproven most everywhere outside the Valley with a few notable exceptions. 
  • The surge in activity is in dollars not deals. As CB Insights notes, this mirrors a global trend of deal deceleration and mega deal acceleration. That said, in LA it’s particularly dramatic.

    2015 has been skewed up by two deals: A $537 million investment in Snapchat and $186 million into now-acquired Lynda.com. Snapchat caused the 2014 spike as well, having raised more than $1 billion in total so far. That’s a big chunk of the entire ecosystem’s funding. Take a look at this chart: It shows a market funding potential wins already in the pipeline, not so much focusing dollars on new deals. That’s typically not the healthiest of signs for an ecosystem, but again, it’s not totally uncommon in today’s unicorn obsessed, mega-deal market. It underscores the point that general mega-deal funding mania is driving this more than the early stage scene in LA. It’s still cash, but may also represent the peak of a trend.

  • How deep is the bench really beneath Snapchat? The report opens by citing companies “like” Snapchat and Tinder. But really, there aren’t many more… if any.

    Lynda.com was a ten year-plus bootstrap well outside of the “Silicon Beach” fervor that was already acquired. Tinder is part of IAC, which may cap its potential upside. There’s Snapchat and … Whisper? JustFab? Honest? The list starts to get smaller and looks a lot more like the kinds of companies you see in New York and Boston. Some unicorns, sure, but only just.

    Let’s look at exits: The number that ultimately matters most. Returns have quadrupled between 2010 and 2014, which is great. But out of some 128 exits last year, there were only four IPOs, including Rubicon Project and TrueCar, with were valued just north of $500 million. Great for those entrepreneurs, but not the kinds of deals that make an ecosystem or return a fund.

    2015 has seen 77 LA-based exits so far including the $1.5 billion acquisition of Lynda.com and the $420 million IPO of AppFolio. Again, great, but not ecosystem making. CB Insights records only been three unicorn exits in Lynda, Oculus and Demand Media-- and no deca-corns. (I’d add Cornerstone OnDemand to that… not sure why they were left off the list, but they are publicly traded and worth more than $2 billion.) I’d argue Lynda and Oculus were both rarities, not exactly emblematic of the companies you see coming out of Santa Monica every day.

    Ultimately it’s money going out, not money going in that matters. If this is going to be a real and lasting acceleration of capital, LA is gonna have to do better.

One interesting note: None of the top Valley firms are on the list of LA’s most active investors. This could be a good and bad thing for LA. If one of the advantages is proximity to the Valley, and the companies are so great, it’s strange that the big firms-- Accel, Andreessen Horowitz, Sequoia, Benchmark and the rest-- aren’t on all over it in a bigger way.

On the other hand, those VCs may not add the most value, being remote. It may be a plus that firms like Upfront, Mucker Capital, and other locals top the list. At least they won’t parachute out if things turn south.