Challenges and Opportunities of Developing Startup Ecosystems: Central and Eastern Europe and Turkey Example
The ecosystem term generally refers to a community of living organisms in nature. It is used very frequently in the technology world today. It refers community of network of people; entrepreneurs, investors, mentors, technology enthusiasts, researchers, and others. If you are interested to learn about startup ecosystems, I strongly recommend the book by Brad Feld. It delivers many aspects with a significant depth. In this post, I will look through the ecosystems in developing countries. But first, let’s look at some basics;
In academic studies, business communities were among the most important inquiries of our time. Why do some places flourish with innovation while others not? What are the determinants that help a startup community achieve a critical mass? While countries’ economic development is not democratic and flat, innovation startup ecosystem success is not too. It’s even more anti-democratic and not correlated with economic development of the country. According to Startup Genome Report, the US has leadership in ecosystems and covers 12 of 30. No need to mention the special presence of Silicon Valley to the rest of 29.
Although scaled globalization and improving access to information in internet age claims reverse, location is more important than ever. There are three academic explanations of why some geographies are hotbeds of entrepreneurship.
Economics Point of View
This point of view is led by Michael Porter, he describes the ecosystems as “clusters”. Companies co-located in the clusters benefit from “external economies of scale”. Emerging companies need certain common inputs, infrastructure, suppliers, labor with a specialized knowledge base and capital. Companies in a common geographic area share the fixed costs of those resources external to the company. As more and more companies in an area can share costs of specialized inputs, the average cost per startup decreases for the specialized inputs. This provides a direct economic benefit to companies located within a business community.
Sociology Point of View
The second one is related to horizontal networks. In her Ph.D. work at MIT, AnnaLee Saxenian compared Silicon Valley and Boston’s Route 128. She argues that network effects, a culture of openness and information exchange fueled Silicon Valley’s ascent over Route 128. Silicon Valley culture displayed a horizontal exchange of information across and between companies and labor mobility. As technology quickly changed, the Silicon Valley companies were better positioned to share information, adopt new trends, leverage innovation, and quickly respond to new conditions.
Geography Point of View
According to Richard Florida, innovation tilts heavily toward certain locations with great concentration of creative, innovative people in tightly clustered geographies. The creative class is composed of individuals such as entrepreneurs, engineers, professors and artists who create “meaningful new forms”. Creative class individuals want to live in nice places, enjoy culture with a tolerance for new ideas and weirdness, and want to be around other creative class individuals.
The additional view comes from Y Combinator’s founder Paul Graham. He writes three aspects in explaining the Silicon Valley’s success; 1-Number of rich people(investors who understand the technology and potential investment returns) 2-Nerds(technology talented individuals with ambitious ideas) 3-Great universities. A quotation from his post;
The exciting thing is, all you need are the people. If you could attract a critical mass of nerds and investors to live somewhere, you could reproduce Silicon Valley. And both groups are highly mobile. They’ll go where life is good. So what makes a place good to them? What nerds like is other nerds. Smart people will go wherever other smart people are. And in particular, to great universities. In theory there could be other ways to attract them, but so far universities seem to be indispensable.
The startup ecosystem is a relatively new concept but I think creative-class cluster is not. There are examples even in the ancient world. Ancient Athens was the attraction point of philosophers due to multiple schools of philosophy. Monumental scientific advancements happened in ancient Alexandria where talented astronomers, mathematicians, geometricians met in its famous library. And in the ancient world, significant creative communities did not emerge in many powerful cities like ancient Rome, Sparta or Carthage. The success of intellectual communities in ancient cities was not directly connected to economic advancement or political power of the city.
Ancient or modern, decisive criteria for a creative community is the size of its intellectual network. However, for a significant outcome, a critical mass is needed.
I want to come to my point. What are the challenges and opportunities of developing startup ecosystems? I use the developing startup ecosystem term referring to ones with lower venture capital investment per capita. (Israel €217, UK €80, Poland €3, Turkey €1) I will take into account CEE countries and Turkey. Baltic(Estonia, Lithuania, and Latvia) countries are bit different than the rest, on venture capital investment per capita. However, they are behind on the size of technology talent. When we talk about countries, we generally refer to their major hubs. For the below graph, it’s Warsaw for Poland, Istanbul for Turkey.
Challenges — Founder Migration
Interesting research was done in 2018 by startupheatmap.eu. They asked startup founders in Europe, whether they want to relocate. If they want to relocate, they asked where they prefer and why. Results show advanced ecosystems like London, Berlin, and Stockholm are net founder gainers while CEE (Estonia and Lithuania are exceptions) countries including Turkey are net losers. The main reason is shown below, founders want to be part of more advanced ecosystems
Founder migration has become easier because accelerators, seed VCs are globally picking promising startups and providing funding. Also, many countries grant e-residencies. Today, talented startup founders have much more options in picking a better ecosystem.
We should keep in mind that eastern European countries like Bulgaria, Romania, and Lithuania are having a population decline due to low birth rate and emigration. Being startup founders in those countries are less attractive if the local market itself is already shrinking.
Challenges — Broken Investment Value Chain
Another challenge is the broken investment value chain. In other words, lack of technology investors. Let me explain this with an example from Turkey. In the last 10 years, there had been a huge leap in the number of accelerators, technoparks, incubators, and co-working space.
Based on this increase, we can assume that the number of technology startups in the Turkish ecosystem increased in this period. Some successful ones should receive investment in later stages and we expect to see a similar boost in venture capital investment. Please look at the below table, we see an increasing trend however, it does not reflect the drastic hike of accelerators. Also an important part of this venture capital investment comes from the out of Turkey raised venture capital funds.
So we should ask; Weren’t there enough investors? Let’s take a look to below table;
The issue is not demand side(startup investment demand), it’s supply-side(investment supply). In Turkey, size of deposits in the banking system is more than $430B by January 2020. Therfore the problem is not about the lack of savings to be directed to venture investment. It’s about the lack of investors(Limited Partners in VC jargon) who know what to expect from technology investing and dare to allocate some of their wealth to technology investing. It’s about a lack of investment mediators(General Partners in VC jargon) who can pick promising startups and add value them along the way in venture capital firms.
Challenges — Lack of Positive Signalling
Establishing startups requires some technical and business skills. Establishing a venture capital fund requires years of experience and deep skills in innovation, business, and finance. We are talking about firms that target significant returns after 4–5 years of an investment portfolio. The evolution of the US VC industry is worthwhile to take a look on how it did not show up in one day. I suggest Tom Nicholas’ book VC: An American History. In this book, we see that although there were many initial attempts before the 1960s, the VC model is validated with Digital Equipment Corporation’s successful IPO in 1967. After this moment and more examples, wealthy people were more interested in venture investing while innovation experienced professionals headed to start venture capital firms as GP.
Laurance Rockfeller was one of the first venture capitalists in US who was active between 1950s and 1970s. He once remarked;
“Venture capital endeavors are not for the impatient, the faint of heart or the poor looser. Nor people who can not afford to lose”
I think if there are a sizable developer and founder base, the only needed thing is more success cases. Examples provide attraction signals to other founders and venture capital investors. Because they always ask the same question and compare signals with other investment or career options. Is this place better one than the others? What is the advantage of staying in this ecosystem?
However, this signal interpretation is open to bias of herd mentality. This bias happens when investors blindly copy and follow what other famous investors are doing. Kaufman Foundation published a report in 2012 about the US VC industry and found out that %62 of VC firms failed to exceed returns available from the public markets investment instruments.
Lack or abundance of positive signals create biases for founders and investors. Nevertheless, this is human nature and it is how startup ecosystems work.
Today, developing new unicorns(startups reaching valuation more than $1B) is the most important ecosystem signaling. According to CB Insights, there are more than 452 unicorns in the world today, %50 of them are from the US, %33 from Asia(mainly China), only %14 is from Europe. While creating one unicorn in a CEE country is a fantastic event. Globally, it’s like drop in a pond. According to Deal Room, CEE developed 12 unicorns by 6 countries so far.
Challenges — Lack of Local Innovators and Early Adopters
Innovation needs new value proposition. However the problem at the beginning of the startup’s journey, majority of the target market does not have the need. Once startup founders have a disruptive idea, they need someone who have relevant and genuine need. Those people are potentially innovators and early adopters who will test, comment and purchase the product. Without any initial testing cycle, founders will have difficulty in iterating the product. Besides, accessing this people should be easy and low cost. Let’s think about Facebook story. When they launched, university student network was Facebook’s early adopters. They were low cost to access for him, had email address for unique login, regular face to face interaction, great interest on what the others doing to boost a network effect. Mark has the ability to iterate the product with receiving feedback.
In developing ecosystems, it’s sometimes difficult to find technology enthusiasts, evangelists and thought leaders. In surveys, being close to a target market is a key reason of founder migration. Startup founders need contagious effect of the early adopters to amplify the word of mouth, the lowest cost of marketing.
For developing startup ecosystems, rather than asking why this ecosystem does not thrive, we should also ask how an ecosystem can focus on opportunities?
Opportunities — New Ecosystems Blossoming
Story on few globally leading startup ecosystem has been changing. More startup ecosystems are reaching a significant outcome. According to startup ecosystem report, in 2012 there were 12 ecosystems created value over $4 billion, 29 between 2014–2016, 46 between 2016–2018. The report predicts that 100 cities will create more value than $ 4 billion in the next 10 years. I think that main drivers of this trend;
1- Demand side(number of startups) are growing in every country. Basic technical skills are not difficult for founders to acquire. Self training is abundant. We will see more startups globally.
2- Starting startup(server, hosting) costs keep on declining : This trend will continue for low and mid tech (like enterprise software, marketplace and mobile applications) not on deep or hard tech.
3-Collaboration is much easier across team members : Collaboration tools like (Slack, Trello, Asana) made dispersed teams more effective today.
4- Ecosystem learning goes to developing world : There is an awakening in Middle East, Africa, South America. New accelerators, venture capital firms are coming to scene everyday.
Opportunities — Developer Cost Arbitrage
Today developing startup ecosystems are seen as low-cost development centers. That approach has merit as below graph shows comparison between countries. Developer salaries in CEE and Turkey are less than half of the UK and Germany benchmarks.
Also starting startup infrastructure costs like server rental, hosting, integration decreased significantly. A startup in Romania with a global market target with lower running costs and higher gross margin may have longer capital runway on testing the prototype or receiving earlier market traction.
Many of CEE startups move out and receive later stage investment in more advanced ecosystems. And many of them still keep their development team in their local country. VCs frequently suggest their candidate or portfolio startups “Test Local Go Global” or “Target Global First” strategies.
At earlier stages, where product or market validation takes place and startups focus on problem solution fit or product-market fit, lower cost can be a differentiator. But if you sell the product to your local market, this advantage does not exist because the price point of your product will be lower along with your developer’s salary cost. You need to sell to premium price point countries.
Opportunities — Industry Expertise
The cost can not be a stand-alone advantage. I think a key opportunity is industry or technology expertise which is relevant to Michael Porter’s external economies of scale approach.
Israel has developed this expertise in cybersecurity and nurtured its ecosystem with experienced developers, founders and investors within 10 subsectors. Israeli cybersecurity startups raised $6.32b between 2013–2019.
Ease of finding experts, mentors, developers, investors in this ecosystem delivers the Michael Porter’s external economies of scale. The reasons for this cybersecurity success is to have a long term focus, planning, and collaboration between parties.
1- Government’s role as a business catalyst and coordinator
2- Making the military a startup incubator and accelerator
3- Investing in human capital
4- Embracing interdisciplinarity and diversity
5- Rethinking the cyber out of box
A quotation from Michael Porter;
Firms within a cluster are often able to more clearly and rapidly perceive new buyer needs. They can often discern buyer trends faster than can isolated competitors. Participants learn early and consistently about evolving technology, component and machinery availability, service and marketing concepts.
The isolated firm, in contrast, faces a higher costs and steeper impediments to acquiring information and a corresponding increase in the need to devote resources to generating such knowledge internally.
Final Opinion
Shining will be more difficult for developing startup ecosystems in the next decade as a stiff competition is going on across geographies.
I think below strategies are appropriate for ecosystems to work on ;
1- Focusing on theoretical explanations and understanding strengths and weakness of the ecosystem
2- Developing localized approach with a specialized industry and technology focus.
3-Supporting successful examples for positive signalling
4- Emphasizing investor value chain, developing awareness and incentives, removing regulatory barriers.
