The top start-up mecca in America is far from Silicon Valley

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Jason Ballard has found Austin, Texas, to be very hospitable to his retail store TreeHouse, a sustainable home-improvement store. The 25,000-square-foot facility stocks eco-friendly items such as bamboo flooring, and thermostats that allow users to turn down the heat when they are away. Since opening in south Austin in 2011, TreeHouse has grown to 50 employees and a reported $10 million in revenue.

"If you're in the home-remodeling or homebuilding business, a growing, thriving city is obviously really, really appealing," said Ballard. "As a community, Austin is just very supportive of new and interesting things," a key factor driving the city's rich arts and music scene.

Plus, with large Silicon Valley tech firms such as Amazon, Google and Facebook running offices in the area and Whole Foods headquartered in the city, he adds, "There's a ton of tech talent — and retail talent."

The store has been so successful, he is preparing to open a second one, in Dallas, in 2017.

Source: TreeHouse

Jason Ballard, founder of TreeHouse, in his sustainable home-improvement store in Austin.

Ballard isn't alone in finding Austin to be an ideal place to run a business.

Austin scored No. 1 in the CNBC Metro 20: America's Best Places to Start a Business. The ranking looks at how cities fair in categories such as environment for small-business success, the cost of doing business, quality of life, labor force and diversity. With a population of 885,400, this city in central Texas punches outside of its weight class when it comes to entrepreneurship, leading the pack in areas such as its labor force, the net company creation rate and speed of population growth.

"Texas is a very business-friendly state, with a good lifestyle and good weather," said Rohit Arora, CEO of Biz2Credit, which contributed to the research. "That is attracting a lot of young people to move there." The city is also diverse, he noted. "University of Texas at Austin is one of the very good schools," he said. "It attracts a lot of foreign students."

Thanks to the presence of University of Texas at Austin and other universities, the city is known among employers for having a well-educated workforce, a big draw for employers and engine of growth. Austin grew its start-ups faster than every city except Washington, D.C., according to the 2016 Kauffman Growth Entrepreneurship Index, with its start-ups growing by 81.2 percent.

The index, which brings together the latest data available on the entrepreneurial trends of the 40 largest metro areas in the United States, claims that the greater Austin area is breeding the highest rate of new entrepreneurs in the country, with 0.55 percent of the adult population becoming entrepreneurs in a given month in 2015, up from 54 percent in 2014.

Austin's start-up scene

Big drivers are low taxes and a cost of living that is low relative to major metro areas such as New York, Boston, Chicago and Silicon Valley. Many small-business owners, who often pay taxes at the individual level, appreciate the fact the state has no personal income tax. The state also has a corporate tax rate of zero. Combined, these factors point to free money that business owners can invest in their ventures.

"It's a great place to hire businesspeople, salespeople, marketing people, product people and designers," said Ryan Farley, CEO of Austin-based LawnStarter, a company that connects homeowners with lawn-service providers.

William Hurley, co-founder of Honest Dollar, an Austin-based provider of retirement plans to freelancers and small businesses that Goldman Sachs acquired earlier this year, says creative talent is abundant.

"It's got the music, the university scene, the hippies and the rule-breakers," said Hurley. "It's very easy to hire people who want to push the limits. It's an incredibly innovative city."

Photo: Philip Arno

Shelley Delayne, founder of Orange Coworking in Austin.

FATHOM, a 150-person software provider to water utilities headquartered in Phoenix, chose Austin when it last year opened a 30-person outpost called FATHOM LAB, which fosters innovation in water conservation. The company had looked at other locales, such as Silicon Valley and Chicago, but found Austin more attractive.

"One of the things that really drew us to that particular community was the longevity that software developers and tech folks have," said Jason Bethke, president and chief growth officer. "They tend to stay at companies way longer in Austin than in Silicon Valley."

But given the fast-growing tech scene, competition in hiring is heating up. "It's extremely hard to find technical talent — namely, engineers," said LawnStarter's Farley.

Austin's uniquely friendly entrepreneurial ecosystem also gives it an edge, by many accounts. "People really get what it means to support each other and be connected to each other — and how much that's helpful," said Shelley DeLayne, founder of Orange Coworking, a membership-based workspace for entrepreneurs, freelancers, small businesses and telecommuters based in south Austin.

Says TreeHouse's Ballard, "People love batting ideas around and examining things. It's a very intellectually stimulating environment."

Josh Hare, founder of craft brewer Hops and Grain, didn't plan to stay in Austin indefinitely when he moved there from Boulder, Colorado, in 2005. But the city grew on him as he transitioned from an early foray in specialty retail into brewing in 2011. Active in a local brewer's guild, Hare found the small but growing community of craft brewers to be incredibly supportive and helpful when it came to perfecting his product.

"Everyone is blown away by how collaborative we are," said Hare, whose business recently raised more than $787,000 to open a new brewery on Wefunder, an equity crowdfunding platform.

By many accounts, the public is also very receptive to the innovation coming out of Austin's many new businesses, among them successful products such as Epic Bars, made from grass-fed beef, bison and other meats.

"In Austin, word of mouth spreads very fast," said Dan Gillotte, chief executive grocer at Wheatsville Food Co-op, a full-service natural-foods cooperative grocery store that has served Austin since 1976. "People use social media and talk about stuff on Yelp a lot of times. Every city has these things, but in Austin they are extremely vibrant. Even on Reddit the latest taco truck gets enthusiasm."

And while the cost of living in Austin is rising, it's still more affordable than tech hot spots like Silicon Valley and New York. The potential to keep costs lean wasn't lost on Sarah Ware, CEO and co-founder of Markerly, who with husband and co-founder Justin Kline moved her 20-person marketing technology start-up, founded in 2012, from Silicon Valley to Austin in 2013.

"Because housing is lower and the cost of living is lower, you don't have to pay your employees the same amount you would in New York City," said Ware. "Texas is really tax-friendly for businesses," she added.

Austin also has a rich entrepreneurial ecosystem, including hubs such as Austin Technology Incubator, located at University of Texas at Austin; the prestigious Techstars Austin accelerator; and a start-up density that puts it in the top 10 for the country, according to the Kauffman Foundation.

But even Austin's biggest fans have to admit it has drawbacks. By all accounts, the venture capital scene, though percolating, has a long way to go before it rivals hubs like Seattle, Boston, New York and Silicon Valley. "The funding environment is what a lot of people complain about here. It not close to the Bay Area," said LawnStarter's Farley.

Paul O'Brien, an Austin-based consultant who develops funding sources for venture capital firms, says a handful of firms — Silverton Partners, LiveOak Venture Partners, S3 Ventures and the Mercury Fund from Austin and Dallas — dominate that action currently. However, Austin Ventures, once the largest venture capital firm in Texas, has left the market, with some of its partners now focused on a middle-market buyout fund. That has left a void.

Many new firms are starting up, but they are still in the early stages, said O'Brien, who relocated to the city from Silicon Valley about six years ago. "Dozens are developing their thesis, raising capital," he noted.

Still, there are encouraging signs of growth on this front. In 2015, 101 Austin-area deals raised more than $748 million in venture capital funding compared to 2014, when 111 companies attracted more than $582 million, according to a survey by PricewaterhouseCoopers and the National Venture Capital Association. So far in 2016, 46 deals attracted more than $276 million in venture capital, the NVCA found.

In June alone, seven Austin start-ups raised a combined $64.6 million — among them rocket maker Firefly Systems, which raised $19 million, and investment firm Serve Partners, which attracted $20.3 million.

The 20 best places in America to start a business

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Another challenge, given Austin's growing popularity, is congestion. Office space has gotten tighter, with CBRE reporting that asking rates hit an all-time high in the second quarter. Citywide rates hit $33.22 per square foot. Meanwhile, driving around town is not as easy as it once was. "Because it has grown so fast, the downtown core is increasingly insane and difficult traffic-wise," says Orange Coworking's Delayne.

Austin's regulatory climate is also a frequent source of complaint. Uber and Lyft recently left the city after the city voted to require ride-sharing services to use fingerprint background checks to screen drivers, rather than their own systems. The city council also passed a recent ordinance that will place restrictions on short-term rentals, such as those made on Airbnb, prompting other complaints.

Regulatory challenges extend to other industries as well, with entrepreneurs reporting frustrations with everything from laws that strip craft brewers of their freedom to distribute their own beer to slow and painful dealings with health and building inspectors. "The city is a little difficult to work with," said Gillotte, the grocer. One local eatery, Dan's Hamburger's, posted an open letter in 2014, complaining about how difficult and expensive overregulation made a remodeling job.

"Never again as a small business could we afford to remodel in Austin," the letter said. "The added expense of the additional building, engineering, architectural and city fees was cost prohibitive."

However, Austin's many strengths outweigh the drawbacks for many local entrepreneurs — enough to allow it to claim the top spot in our ranking. Says Delayne, "I love Austin so much it's hard to admit there are challenges."

— By Elaine Pofeldt, special to CNBC.com