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Why Venture Capital Deals Stay in Silicon Valley The growing concentration of venture capital investments in Silicon Valley creates a problem for policymakers in other regions.

By Scott Shane

entrepreneur daily

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Over the past 30 years, policymakers from around the United States have spent countless hours and numerous dollars on programs, policies, and incentives to create venture-capital clusters and to stimulate investments in their cities and regions.

The end result of their efforts? Venture-capital investment activity is more concentrated in Silicon Valley today than it was in the late 1980s, when personal computers were all the rage, Mark Zuckerberg was but a toddler, and the web browser hadn't yet been invented.

Data from the National Venture Capital Association – the industry's trade group – show that 23 percent of venture-capital deals and 28 percent of venture-capital dollars went to Silicon Valley companies in the second half of the 1980s. Over the last five years – from 2010 to 2014 – 38 percent of deals and 43 percent of dollars went to businesses in the valley.

This increase in industry concentration has occurred despite a tremendous expansion of venture-capital activity. Between 1985 and 2014, the number of active venture capital funds in the United States rose from 432 to 1,206, and the count of active venture capital firms grew from 294 to 803. The list of companies receiving financing from venture capitalists increased from 1,160 in 1985 to 3,665 in 2014, and the number of VC investments rose from 1,352 to 4,361 over the same period.

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Many Silicon Valley venture capital funds even opened satellite offices in other parts of the country over the past three decades. Yet a rising fraction of the investment deals and dollars go to companies in a narrow geographic area.

Why have venture capital investments become ever more concentrated along a single stretch of Sand Hill Road in Silicon Valley, rather than diffusing out across the country as the industry has grown? The main reason is that the advantages to venture capitalists of investing locally are self-reinforcing.

As a paper published in the Journal of Urban Economics in 2010 by Henry Chen of the Harvard Business School and his colleagues explains, Silicon Valley was the best place for venture capitalists to invest initially because the industries in which they first invested tended to be concentrated there. The companies they were considering financing could find the technical employees that they needed to make their products, and the management talent that they needed to grow their companies.

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Investors were better able to learn about nearby deals and monitor local companies than ones far away. Moreover, because the VC firms congregated along Sand Hill Road near other venture capital firms, it was easier and cheaper for promising entrepreneurs to pitch their ideas to investors and for investors to co-invest if they were in the area.

The factors that drew entrepreneurs and investors to Silicon Valley in the 1970s, kept them there in the 1980s, 1990s, 2000s and 2010s. Moreover, the initial attractiveness of the region to investors was reinforced by its tendency to attract would-be entrepreneurs. Entrepreneurs from elsewhere who were in need of venture capital to pursue their high-potential businesses moved to Silicon Valley to be closer to their investors and employees. The tendency of high-potential entrepreneurs to move to Silicon Valley increased the local investment opportunities and provided further incentive for investors to focus on local startups. The end result of all this was not only that the valley maintained its share of the venture-capital market, but that the region increased it.

The growing concentration of venture capital in Silicon Valley creates a problem for policymakers in other regions. Government efforts to break the venture-capital dominance of Northern California have not succeeded. In fact, policymakers may not have the tools to offset the natural tendency of the venture capital industry to become more and more concentrated there.

Related: How Investors Choose Startups to Finance

Scott Shane

Professor at Case Western Reserve University

Scott Shane is the A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. His books include Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live by (Yale University Press, 2008) and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Businesses (Pearson Prentice Hall, 2005).

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