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How to Navigate the Innovation Ecosystem

by Ajay Agrawal and Alberto Galasso

A thriving environment for innovation contains eight characteristics. Assessing them properly sets the stage for a start-up to flourish.



FOR SEVERAL YEARS, Abraham Heifets had worked on applying recent advancements in artificial intelligence to drug discovery. Developing a new medicine takes an average of 15 years, and Heifets had devised a way to shrink the process to a fraction of that time using advanced machine-learning algorithms running on a supercomputer.

He enthusiastically pitched his idea to all the top venture capital firms in his hometown of Toronto, but the reaction was always the same: Potential investors liked the idea, but weren’t willing to commit their capital. They requested more evidence, wanted more-detailed business plans and demonstrated no sense of urgency. As his funds wore thin, Heifets became increasingly anxious, and eventually realized that he had to relocate his business to Silicon Valley, where investors would understand the potential of his idea and be willing to get involved at an early stage.

The move proved to be a wise decision: By June 2015, Heifets’ company, Atomwise, had raised $6 million in seed funding from five leading science-focused venture capital firms, and soon after, it announced collaborations with Merck, Notable Labs and Harvard Medical School. 

The issues faced by Heifets are not uncommon among high-technology entrepreneurs during the early stages of their ventures. Silicon Valley is widely celebrated as a start-up haven because of its abundance of experienced talent, capital and experimental culture. However, the Bay Area is also well known for its high cost of living and fierce labour-market competition. Thus, buying a one-way ticket to California makes sense only if the benefits of relocating outweigh the costs. For Heifets, the move may well have saved his fledgling business; however, given the financial and other costs of relocating, other high-tech entrepreneurs might be better off staying put in their hometowns.

What factors should be considered when making such a momentous decision? Drawing on two decades of research in Strategy, Economics and Geography, we have developed a simple framework that high-tech entrepreneurs can use to inform their location strategies. This framework — which takes into account the key forces that shape regional entrepreneurial success — is useful not only for start-ups, but also for large corporations, because the location decisions of entrepreneurs are not only shaped by, but also shape the location decisions of certain types of large businesses.


“Innovation productivity is greater where sizable populations of both small and large firms coexist."Tweet this


Eight Crucial Factors

The entrepreneurial success of any region is shaped by eight factors that influence the entry of new high-tech firms and create conditions that affect the growth of those firms. Entrepreneurship tends to flourish in regions scoring high across multiple factors. Let’s take a closer look at each.

1. INVESTORS. For high-tech entrepreneurs, the availability of venture capital across multiple levels of investing stages — angel, seed, Series A and Series B — can be the difference between success or failure. Investors vary in terms of their tastes for certain markets and technologies, their risk tolerance, their knowledge about specific sectors, and having other investments in their portfolio that might present conflicts. An ample supply of venture capitalists in a region therefore significantly enhances the probability that an entrepreneur will be able to find a good match. More than half of the venture-capital offices listed in the Pratt’s Guide to Private Equity and Venture Capital Sources are located in three centres: Silicon Valley, Boston and New York. It is important to remember that venture capitalists are more likely to provide funding and serve on the boards of companies that are local because geographical distance constrains their ability to monitor their portfolio companies and coach the management teams of those businesses.

2. CUSTOMERS. It’s natural for new firms to start selling their products locally before expanding to national and international markets. Thus, the level and quality of local demand will influence the initial growth of a start-up. Significant local demand can lead to cost savings by allowing firms to spread their fixed costs over a larger customer base. Local customers may also provide crucial insights to develop and fine-tune a product.

3. SUPPLIERS. Being located close to a dense network of suppliers is advantageous for a number of reasons. First, it reduces transportation costs and waiting times for inputs. CEO Jeff Bezos’ decision to locate Amazon in Seattle, for example, was primarily because of the short distance from one of the country’s largest distribution warehouses for books. Second, the technological needs of a start-up are often fully understood only with frequent interaction with its suppliers. Third, the presence of multiple suppliers in one area allows the entrepreneur to shop for the best price, quality and product fit. Lastly, some regions provide a natural advantage related to inputs for certain industries, and because office space is a key variable, an assessment of the regional real-estate market should also influence a location strategy.

4. LABOUR POOL. Start-ups must assess the presence of workers specialized in relevant fields as well as their own ability to attract key talent to the region. Larger labour pools have an impact on the number, quality and diffusion of entrepreneurial ideas. Studies show that specialized workers tend to agglomerate in a limited number of locations, and very often, their supply is shaped by the presence of universities, hospitals and research institutes in a region. It’s important to recognize, however, that universities vary substantially in their propensity to cooperate with industry and support local entrepreneurship. One of Silicon Valley’s greatest advantages is that it has a disproportionately large labour force with experience in scaling start-ups.

5. COMPETITION. High-tech entrepreneurs must assess the competitive landscape, paying special attention to other start-ups in their region. On the one hand, there are clear benefits to being insulated from competition; on the other, competition can play an important role in spurring innovation. When assessing a regional environment, entrepreneurs should avoid having a narrow focus and considering as competition only firms with similar products and technologies. They should also assess the nature of competition in terms of inputs, talent and funding. Special attention should be paid to large companies present in the area, which can have a profound impact on a regional economy by stimulating demand for new technology and attracting a skilled labour force. Our research has shown that innovation productivity is greater in regional environments where sizable populations of both small and large firms co-exist.

6. INSTITUTIONS. An effective location strategy requires careful assessment of the strengths and weaknesses of regional economic and political institutions. In particular, high-tech entrepreneurs should monitor local taxation levels, backlogs in regional courts and trends in regional business legislation. Transport infrastructures such as airports, train stations and roads may also have an important impact on a firm’s ability to interact with customers, suppliers, investors and competitors.

7. CULTURE. Picking the right location requires a good grasp of the cultural norms across different locales. Silicon Valley, for example, is known for its forgiving attitude towards entrepreneurs who have failed in previous ventures. Particular attention must also be paid to the local acceptance of different demographic and ethnic groups within a region, as this may influence the ease with which foreign talent may be recruited to the region.

8. SOCIAL NETWORK. Individuals are embedded in local networks of social relations generated by their family, friends and civic ties. The social capital derived from these relationships can be very important for entrepreneurs to raise capital and attract employees, suppliers and customers. As a result, the profitability of a move to Silicon Valley is less clear when entrepreneurs have deep social networks in their home locations. Regions where newcomers can quickly form and leverage social connections are more attractive than those where integration is more difficult.

Toronto vs. Silicon Valley

As indicated earlier, Abraham Heifets had trouble raising capital for his promising technology breakthrough until he relocated his business from Toronto to the Bay Area. However, other Toronto-based entrepreneurs have been able to thrive in Toronto. Mike Serbinis, for example, was successful in raising a $25 million Series A round of funding, largely from Toronto-based investors, for his digital health platform company, LEAGUE. To better understand the crucial stay-or-relocate decisions made by entrepreneurs like Heifets and Serbinis, let’s apply our eight-factor framework to compare Toronto with Silicon Valley. 

INVESTOR COMPARISON. The Greater Toronto Area (GTA) is roughly comparable to Silicon Valley in terms of population size, but the level of funds available for entrepreneurial businesses is much smaller. In fact, the level of venture-capital investment in the GTA is roughly one-tenth that of San Francisco and one-fifth that of Boston. Furthermore, regions with smaller pools of early-stage capital are likely to have thinner markets of investors with specialized expertise.

CUSTOMER COMPARISON. Markets can be broadly classified as either consumer or enterprise. On the consumer side, the population of the GTA is only slightly smaller than that of the Bay Area (roughly six million compared to seven million), so for consumer-oriented products, these markets are similarly attractive. However, the demographics and preferences of consumers may differ in crucial ways across these regions. In the case of technology products, even though Toronto is roughly the same size, many argue that the Bay Area is more attractive because a high fraction of its residents are ‘early adopters’ who are eager to try new products and services such as house sharing (Airbnb, for example) and on-demand valet parking (Luxe, for example).

The geographic distribution of enterprise customers is another important variable. Consider financial services. By various measures, Toronto is the second-largest financial centre in North America, after New York City but ahead of Chicago, Boston and San Francisco. Not surprisingly, Toronto is home to a number of promising financial technology (‘fintech’) start-ups, such as Wealthsimple. To date, however, the highest-profile start-ups in this industry are not based in Toronto, but Silicon Valley (PayPal and Square, for example). Even in Canada, a surprising number of prominent fintech firms are base outside of Toronto Shopify (Ottawa), Verafin (St. John’s), Lightspeed (Montreal), Blockstream (Montreal) and Zafin (Vancouver). This hints that even though there is a larger potential customer base for financial services in Toronto compared to the Bay Area or other regions in Canada, the financial services companies in Toronto may not be sufficiently engaged as customers of new innovations to give fintech start-ups in the region an advantage.

SUPPLIER COMPARISON. Toronto has limited manufacturing of electronic products relative to the Bay Area. Furthermore, many inputs that are not available locally are imported from the U.S., with non-trivial shipping and tariff costs. Moreover, many other inputs are imported from China. Thus, for hardware-related companies, Toronto faces a supplier disadvantage relative to Silicon Valley. In contrast, Toronto offers a greater supply of office space, which is significantly more affordable than in Silicon Valley, and the region is attempting to capitalize on that advantage. For example, Kitchener-Waterloo in the Greater Toronto Area (GTA) recently announced that it would build a large innovation complex specifically aimed at new hardware companies. This complex — which will exceed the size of a similar pioneer facility in Shenzhen, China — is designed to attract companies specializing in contract manufacturing, radio frequency testing and certification, and IT law.

LABOUR POOL COMPARISON. Two distinct types of highly skilled labour are human capital that is either inexperienced or experienced with respect to scaling. Inexperienced highly skilled labour is well trained and may have years of experience working at small and medium-sized enterprises. However, these individuals have not participated in the rapid scaling of an organization. Experienced labour is not only well trained, but has also participated in the rapid growth of an organization that has increased its market capitalization by, for example, one hundred times. Toronto arguably has a more attractive environment than the Bay Area for inexperienced highly skilled labour, because Toronto-based talent is equally well trained yet less expensive and less likely to be poached than Silicon Valley-based counterparts. However, Toronto has only a limited supply of highly skilled labour with experience in scaling — which involves growing a user base from zero to hundreds of millions of users, raising billions of dollars in equity capital, taking companies public, recruiting thousands of engineers and software developers, and outsourcing hardware manufacturing to China. Even when Toronto-based high-tech companies do achieve product-market fit, when compared to Silicon Valley start-ups, they often struggle to attract experienced talent to relocate. The reason? Prospects worry that if the opportunity doesn’t work out, there might be limited other attractive opportunities in the GTA.


“Toronto-based talent is equally well trained yet less expensive than its Silicon Valley counterparts.” Tweet this


COMPETITION COMPARISON. Toronto is home to foreign tech companies such as Cisco, Google, Uber and Facebook, but the size and nature of their operations (predominantly sales offices) are modest and less conducive to meaningful contributions to the entrepreneurship ecosystem relative to their presence in Silicon Valley. More promisingly, General Motors recently announced plans to hire 750 people in the next two years to work on driverless cars, particularly on cold-weather features.

It should be noted that start-ups in the GTA have flourished where competition has been high: Over the past five years, the region has emerged as a front-runner in the area of wearable technologies, led by start-ups such as Thalmic Labs, NymiPUSH, Muse and Magniware, and inspired by Steve Mann, who founded the Wearable Computing Lab at MIT and subsequently moved to the University of Toronto (and is widely regarded as the Father of Wearable Computing).

INSTITUTION COMPARISON. The Ontario government has implemented a variety of policies supporting small businesses—such as the Youth Entrepreneurship Fund and the Starter Company Program — and offers tax rates that are lower than the average of G20 countries. Moreover, tech companies also benefit from the Scientific Research & Experimental Development (SR&ED) tax credit, a Canadian innovation funding program that returns over CAD$3.4 billion to companies every year.

In addition, Toronto has been ranked as the best city to live in North America, according to the 2015 Safe Cities Index. Finally, healthcare is significantly more affordable in Canada than in the U.S. At the same time, several of the most dominant large industries in the GTA are heavily regulated and thus protected from global competition — for example, banking, insurance and telecommunications. As a result, these industries do not seem to foster technology entrepreneurship at a level commensurate with their size. Thus, start-ups in these regulated industries are significantly more prolific in the Bay Area, despite there being fewer established firms from those industries in that region.

CULTURE COMPARISON. Like the Bay Area, Toronto is well connected to other prominent metropolitan areas in North America, given its geographical location and its large international airport. Overall, Toronto has a vibrant, creative community and a number of strong engineering and science programs linked to educational institutions (such as the University of Toronto and the University of Waterloo) that are similar on most important dimensions to those in the Bay Area (such as UC Berkeley and Stanford). Given that foundation, it’s not surprising that the GTA has a healthy concentration of technology talent: About 55 per cent of technology workers in Ontario and about 26 per cent of all technology workers in Canada are employed in Toronto.

Although Toronto has a vibrant and growing technology entrepreneurship community, the dominance of this culture does not compare to that in Silicon Valley. The executive director of C100, an association for Canadian entrepreneurs in San Francisco, recently had this to say: “Tech is everywhere [in Silicon Valley]. It’s in the coffee shops, on street corners, and in everyone’s conversations.” This reflects not only the density of the technology-oriented labour market in the Bay Area, but also a cultural mindset regarding risk taking, work ethic, growth aspirations and other characteristics.

SOCIAL NETWORK COMPARISON. Entrepreneurs leverage every asset they have in their pursuit of opportunity. A wide and valuable local social network becomes an important asset to leverage for access to capital, key recruits, customers, suppliers and regulators. Although Silicon Valley is known as an open community where outsiders are able to establish social networks over time, such establishment still takes effort and resources and thus may be relatively costly for individuals who already have strong social networks at home.

Our Advice for Entrepreneurs

Our eight-factor framework indicates the key issues that high-tech entrepreneurs must examine to assess the desirability of potential locations for their start-ups. In deploying that framework, entrepreneurs should also consider the following. 

THERE IS NO UNIVERSAL ‘BEST’ STRATEGY. The effects of a relocation will differ across start-ups. Entrepreneurs should use a two-step process when evaluating the framework presented herein. First, they should assess how important each of the eight factors is for their venture. For example, cash-starved start-ups like Atomwise should give more weight to investors than to suppliers. In contrast, start-ups that have secured capital and aim to scale up quickly should give more weight to suppliers and labour pools. The second step is to contrast the local ecosystem with the new location by focusing on the key factors that were identified in the first step. Relocating is likely to be the right strategy for a venture only if the new location significantly outperforms the local region for the most salient factors.

MISPRICED FACTORS CAN UNDERMINE THE ANALYSIS. Picking a location is a key strategic decision that is difficult to reverse — so it is crucial to correctly price the various factors. Some entrepreneurs overestimate the costs (both monetary and non-monetary) of moving and treat their business sites as cast in stone, while others underestimate those same costs. Particular attention should be paid to the value of a local social network, which is one of the most likely reasons for an entrepreneur to stay at home rather than move. Although Silicon Valley is well known as an open community where outsiders can establish social networks over time, establishing a network may be particularly expensive for individuals who already have strong social networks at home. Such was the case at Nymi, a Toronto-based start-up producing wearable devices that deliver biometrically secured authentication. A strong local network gave Nymi an advantage in building a team and in obtaining early seed-stage funding. Doing the same outside Toronto would have been much harder and would have required the firm to divert more time and resources away from its core business.

STAY AND LEAVE ARE EXTREMES ALONG A CONTINUUM OF POSSIBILITIES. Entrepreneurs may also consider ‘straddling’ home cities and new locations, through frequent travel between the two sites, the temporary rental of office spaces or the opening of a satellite office. For instance, Karl Martin, founder of Toronto-based Nymi, flies to Silicon Valley every six to eight weeks to meet with his U.S. investors. Venture-capital firms may also provide different mechanisms for straddling locations. California-based accelerator 500 Start-ups offers a program that allows selected start-ups to connect with mentors and industry experts in Silicon Valley without leaving their home location.

In closing

The framework presented herein indicates the key issues that entrepreneurs must examine to assess the desirability of a potential location for their venture. Ignoring these factors may lead founders to pick the wrong location, resulting in difficulties in attracting the necessary funding, talent, suppliers, partnerships and customers. However, assessing them properly sets the stage for a start-up to flourish. 



Ajay Agrawal is the Peter Munk Professor of Entrepreneurship at the Rotman School of Management and founder of the School’s Creative Destruction Lab, which has expanded to six locations including Vancouver (Sauder School of Business) and New York City (Stern School of Business). Alberto Galasso is an Associate Professor of Strategic Management in the Department of Management at the University of Toronto Mississauga, with a cross-appointment to the Rotman School of Management. 

This article has been adapted from the authors’ chapter in Survive and Thrive: Winning Against Strategic Threats to Your Business — a collection of perspectives from the Rotman School’s world-renowned Strategic Management faculty that is available at amazon.ca/com.

Rotman faculty research is ranked in the top 10 globally by the Financial Times.

 



This article appeared in the Fall 2018 issue. Published by the University of Toronto’s Rotman School of Management, Rotman Management explores themes of interest to leaders, innovators and entrepreneurs.

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