The American Technology Mittelstand: Whitepaper by Strattam Capital

10 April 2017

The 10,000 U.S. Tech Companies Investors Are Ignoring

Even if you’re a savvy tech investor, you might be missing out on a software sector that makes money, delights customers and charts sustainable growth.
Largely unfollowed by analysts and unreported by media, we estimate there are 10,000 private companies toiling quietly outside of Silicon Valley on software that fixes specific problems for their clients while steadily building up revenue and market valuation.
I know this because my firm has visited hundreds of these company CEO-owners in towns like St. Louis, Philadelphia, Scottsdale and Denver.
These are the success stories of the 81% of tech companies not headquartered in the tech trinity of California, New York and Massachusetts[1].
They’re part of the group that employs 73% of all of the U.S.’s tech industry, with employees ranging from a few dozen to a few hundred[2].
I’d like to propose a decidedly un-sexy phrase for this group – the American Tech Mittelstand.  If that sounds familiar to some of you, “Mittelstand” is what Germany’s base of specialized, private and largely family-controlled manufacturing businesses are termed.
Germany’s Mittelstand is acknowledged as the cohort of companies that power its export economy; America’s is focused on business-to-business software.
I believe that the U.S. Tech Mittelstand is on a path of profit and excellence, and these firms deserve a closer look by investors.
Let’s look at some key characteristics of this group:
Established business, 10-20+ years old
Business strategy of specialized niche leadership
Conservative financial management
Business-to-business software and services
Highly connected to supply chain of large companies
Low employee turn-over with family-style values
Selling to a national and often international customer base
Low media profile
Revenues less than $50 million
Geographically diverse
Sound attractive?  We think so too.  But the story of these smaller companies is often drowned out by the dominant narrative of the technology industry that is centered on a handful of big names – primarily, the tech giants and unicorn start-ups of Silicon Valley.
The better-known U.S. technology industry is dominated by large cap global multinationals, fed and sometimes disrupted by the rich, venture-financed start-up ecosystem, and the perception is that everything that really matters is happening in a tiny handful of coast tech hub cities.
Investment flows amplify the story.  Some 76% of all venture capital funding last year went to companies based in California, New York or Massachusetts, and 61% of all the companies receiving venture funding are in those locations[3].  Those three states account for the overwhelming majority of unicorns (start-ups raising money at valuations in excess of $1 billion)[4].  The five most valuable businesses in the U.S. – Apple, Alphabet (Google), Microsoft, Amazon and Facebook – are all tech global multinationals headquartered on the West Coast.
What’s missing from this narrative is the fact that the U.S. technology industry outside CA, NY and MA is just plain enormous, accounting for $787 billion in GDP, or about 5% of the U.S. total[5].  As my partners and I have delved deeper into the U.S. Tech Mittelstand, we found that the story is more than just a contrast of locations.   It is also a business model and values difference.
The business environment in the Bay Area related to start-ups is unique, based on the local resources, business community and norms of that area.  Let’s be clear – these other geographies are not “mini Silicon Valleys.”  Nor do they want to be.  These other companies in “other” places are succeeding in a very different business environment, and with different mindset.  Here is the contrast:

U.S. Tech Mittelstand U.S. Tech Hub
Firm-level profits matter Unit economics matter
15 years old, modest growth, profitable = success 15 years old, modest growth, profitable = zombie
Accepted model: internally financed growth Accepted model: high revenue growth + high losses
Niche product specialization Platform
Low employee turnover High turnover
Word of mouth / Low marketing profile Social media / blog / high marketing spend
“Good growth” =  >10% “Good growth” =  >30%
Founder/CEO age today = 40s-60s Founder/CEO age today = 20s – 40s
Close 1:1 relationships with big clients 1:many clients (mostly consumer)
Adapting existing technologies to specific business purposes Developing new broadly applicable technologies

If you’ve never heard of these Mittelstand companies, do they matter?  It’s true that the U.S. Mittelstand companies do not yearn to change the world.  They are happy to stay put in their communities and run profitable, steadily growing businesses.
When we go around and meet with owners of software businesses in cities and towns outside of Silicon Valley, we don’t find bad versions of huge tech companies we all know.    Back to the German comparison: Their Mittelstand do not make low-end, knock-off versions of BMWs, but rather the essential machinery that BMW uses to make its cars.  Similarly, when Apple wants to optimize its logistics billings, it turns to one of these American Mittelstand companies for the world’s best specialty solution for global freight payments.
In other words, these businesses are geniuses at solving a specific problem in a specific industry, usually born out of the founder’s personal first-hand frustrations. The result has been software deeply infused with her or his understanding of that industry and what specifically needs fixing.  Just a few examples:
— A master electrician in New Hampshire who developed software that reads architectural drawings and composes a complete bill-of-materials, replacing what was formerly done by hand and creating a standard tool used daily by thousands of electrical estimators.
— A consumer products brand manager from Chicago who, in an effort to finally organize and figure out which of his promotional deals was working best, developed a trade promotion management tool now managing billions in spend for companies like Kraft Heinz and Nestle.
— An HR professional in Denver, beset by the problem of getting truly accurate compensation data across all the different job title nomenclature, designed an analytical tool that gathers, normalizes and retains data across thousands of job titles from dozens of point-source compensation providers.
— A coffee distributor CEO from New Orleans, wrestling with how to control spending by his fleet of drivers, developed a secure fleet payment system now used by millions of fleet drivers across the globe.
Let me tell you more about that coffee distributor. I met the CEO in 1997, and our discussion led to the first software investment I ever made at GCC Investments and first corporate board I ever had the chance to join.  The company had less than $20 million in revenue at the time.  Today, FleetCor (NYSE: FLT) has a public market capitalization of $13 billion, and is one of the great, quiet success stories of the past two decades.
Sometimes Silicon Valley companies and startups are accused of coming up with apps and software to solve “high class” problems that aren’t particularly necessary to improving our lives. The American Mittelstand couldn’t be more different. Their innovations adapt existing technologies to hard business problems, developed with a deep understanding of their specific markets and purpose.
Each one took a decade or more to get to their first $10 million or so in revenue, and has used that time to its advantage.  For instance, the long range customer data sets that each of these companies developed are unique information assets that let them provide better analytics and insights to their customers, insights that are simply not available to a new start-up competitor.
Close supplier-customer relationships are another defining characteristic.  It is the large companies who decide not to have employees on their roster for a particular task, but rather to outsource that task to a Mittelstand company.
With success in one area, a specialized technology supplier will often be brought into other divisions or geographies over time.  As a result, client concentration in a handful of long-term, large customers is common in mid-growth stages.
Another characteristic that stands in contrast is the approach to talent.  The depth of technical expertise in the traditional tech hubs is unmatched in other geographies.  In response, what we observe is that the American Mittelstand companies have turned this challenge on its head and made the local talent pool an asset. Companies hire for potential and culture fit, often hiring candidates from different backgrounds, and train for skills.
The lower costs of living and lower salary expectations (versus tech hubs) ease pressure on the overall cost base.  They also reduce turnover, because people joining a company feel loyalty to its success over time – these are respected employers and highly sought-after jobs in their locations.  While management techniques are modern, the overall gradual growth approach leads to more measured employee count growth and fewer RIFs.  It is an approach to hiring and talent well adapted for long term success in these areas.

The role of capital

This universe of companies needs capital and resources, but in a form customized for its needs.  In other countries, support for this industrial base has been led by government action.  The German government has recognized and supported the growing role of technology in its Mittelstand through initiatives such as Industrie 4.0.  There, this segment is recognized as a mainstay of the economy and supported centrally as a creator of the jobs of the future.  In the U.S., we count on the private sector to play more of the leading role in providing resources.
The pools of risk capital in the tech hubs are very deep.  However, the home-run-seeking investing routine of the tech hub venture capitalists is a poor fit for the particular needs of these Mittelstand companies.  These differences can make for a lot of friction and poor fit in practice.
As a result, these firms are systematically under-resourced relative to their potential.  There is a need for a pool of capital and expertise specifically designed to support and benefit from the growth of this large and well-positioned group of businesses.
We of course have a vested interest in seeing the U.S. Tech Mittelstand thrive.  But we also know there is room for others who are as excited as we are by the potential of this hidden potential to provide the financing and know-how to ensure that the Mittelstand in America continues to boost economic prosperity in years to come.

[1] CompTIA: CyberStates 2016
[2] Ibid.
[3] PricewaterhouseCoopers/National Venture Capital Association Moneytree ™ Report
[4] CBInsights, data through December 2016.  CA, NY & MA had 83 unicorn financings, the rest of the country, 16.
[5] US Bureau of Economic Analysis, 2015 cited in CompTIA CyberStates