Surprise: California is a good place to doom a new business

Being home to Silicon Valley gets California the reputation as a dreamland for start-ups. But it's a big state with lots of cities, and outside of the San Francisco Bay area — and the Los Angeles–San Diego entrepreneurial region — California is pretty harsh territory for business owners.

CNBC's recent ranking of entrepreneurial hot spots, the CNBC Metro 20: America's Best Places to Start a Business, evaluated the likelihood of start-up success in 107 metro areas across the United States, taking into account factors including tax rates, regulatory environment, cost of living, cost of labor, unemployment level and population growth. No California city made the top 20. But five California towns were among the 10 worst metro areas — among all 107 — to launch a business.

That's a noteworthy corrective for a state synonymous with start-up star power.

"There are big gaps in many parts of the country — and also within many states," said entrepreneur and AOL co-founder Steve Case in an email to CNBC. "Yes, the U.S. continues to be the most entrepreneurial country in the world, but there are some pockets where there is momentum and many places that are lagging. ... California is the classic example," Case said. In 2005, Case co-founded investment firm Revolution, which focuses on start-up activity outside of Silicon Valley and other nationally known start-up hubs.

The five California metro areas that fell within the bottom 10 nationally: Fresno, Santa Rosa, San Bernardino, Modesto and Stockton.

U.S. venture capital investment is heavily concentrated in three states: California, New York and Massachusetts. Those three states receive more than three-quarters of the nation's venture capital dollars, according to the National Venture Capital Association. On its own, California receives more than half of the nation's venture capital dollars. But overwhelmingly, those funds go to start-ups in either Silicon Valley and San Francisco or Los Angeles and San Diego, Case said, adding, "Most of California is in fact not getting much investment." And without access to capital, entrepreneurship communities stagnate.

One reason the smaller cities in California fell to the bottom of the CNBC Metro 20 ranking is because of the elevated cost of living. By contrast, in Austin, Texas, the No. 1 city, the cost of living was cited as very low.

Anna Mason is director of Revolution's investment campaign, called Rise of the Rest, which focuses on start-ups outside Silicon Valley and New York. She claimed that cost of living is the one data point that jumped out at her. "High costs of living can impact a founder's (and early employees') desire and ability to stay in/move to a region to start a business," Mason said via email.

Another factor that affects a city's appeal to start-ups is the tax burden. In Texas, there is no state income tax. That's great news for entrepreneurs, many of whom are operating on bootstrapping budgets, particularly in the early days. Meanwhile, the Sunshine State has some of the highest income-tax rates in the country, according to The Tax Foundation. That means that all of the metro areas in California were penalized across the board for their state tax rates.

Further, the five California cities cited are all experiencing population growth that is sluggish compared to the best business cities, ranging from 3.78 percent in Santa Rosa to 5.95 percent in Stockton. Austin is seeing 16.58 percent population growth. Start-up activity not only depends on low cost of living and a healthy pipeline of capital but also on companies having access to talent. Provo, Utah, No. 2 on the Metro 20 list, has a population growth of 11.2 percent — Provo also has one of the lowest unemployment rates among all U.S. cities. Much of the top from smaller towns in California heads to San Francisco. Mid-size cities in other states can keep some of their talent, while California towns, like San Bernardino and Modesto, don't have enough to keep talent rooted.

"No question, there is clustering happening around cities. The second-tier cities are rising (more than most realize), but the third and fourth tiers are struggling, and that may continue. For example, cities like Atlanta, Nashville and Raleigh-Durham are showing strong momentum, in part because they are regional talent magnets. But some of the smaller cities in those states/regions suffer," Case said.

Ray McKenzie grew up in Atwater, California, which is right between Modesto and Fresno. He went to San Diego State for college, where he majored in management information systems. And then he moved to Silicon Valley. "Upon getting my degree, I didn't want to really move back to where I was from, because there were no jobs in the tech industry, and this is during the first boom," said McKenzie, who moved to the San Francisco Bay area in 2001, where he stayed for the next dozen-plus years.

Among people McKenzie grew up with who still live in Atwater, most work in agriculture, medicine, education or public services, as either police or firemen.

McKenzie is representative of many young college grads from small-town California. Being from a town a few hours' drive from San Francisco is an Achilles' heel. McKenzie was close enough to Silicon Valley to have easy access, but far enough away that he had to relocate to live and work there when he graduated from college.

Today McKenzie is the founder of the management and business consulting group Red Beach Advisors, located in Los Angeles. Looking back, McKenzie said he never considered moving back to Atwater after graduating. "There really is no culture for technology," he said, adding that the same logic would apply to young Californians from any lower-tier city. "You want to be visible in the location of all the other companies that are around you that are possibly your customers. And if there are no customers in Stockton, then why are you there?"

Despite the sluggish start-up culture in small California cities, there are efforts to spark entrepreneurial activity. Fresno hosted a conference at the end of July this summer discussing agriculture issues and potential technological solutions. "The conference helped two agricultural software start-ups receive funding. We also advanced the conversation on how to complete the local capital structure for ag technology start-ups," said Pete Weber in an email with CNBC. Weber is a retired CEO and currently an advisor to Fresno Mayor Ashley Swearengin, serving on multiple nonprofit boards working to promote the regional ecosystem.

Irma Olguin Jr. and Jake Soberal, the co-founders of entrepreneurship center Bitwise Industries, have invested heavily in downtown Fresno, building two technology hubs, one of which is a sprawling 50,000-square-foot "geek palace" for innovation. And they are undaunted by the negative take on their town: In the next five years, they plan to build a 2.5-million-square-foot campus that will house 1,000 tech companies and create 250,000 new tech jobs. Those are lofty goals, to be sure, but they are exactly the sort of shot in the arm some of these small California towns need to hold water in the Sunshine State alongside the start-up juggernaut that is Silicon Valley.

"We invested so heavily in Fresno, because we saw an opportunity to transform a city — not alone, but together with the whole of our community. We believe in Fresno's technology industry, that it can lift up a downtown and a people, and in turn a city and region will be transformed," said Soberal in an email with CNBC. "I believe so deeply in Fresno because of its people; we are a city of gritty and capable people. If only we can give those individuals access to meaningful opportunity, all of the success that we hope for — as a city — follows on from there."

Even with remarkable efforts like those of Bitwise Industries, it's inevitable for some amount of talent to leave smaller towns in favor of larger, metropolitan regions. But efforts like Bitwise Industries in Fresno can keep some local talent rooted.

"Some people will leave to pursue opportunities elsewhere. That is always true and even more true as we live in an increasingly mobile world, and especially true for people living in communities that don't seem as dynamic, creative and growing," Case said. "The best response is for each community to up their game so they can keep their young people and also become a magnet for innovators, investors."

He added, "Leaders are emerging in these places to create a sense of possibility that positions them better for the future. And that can help reverse, or at least slow, the brain drain."