If crazy growth, outside investment, and M&A are your goals, being in the Valley is the place to be. Especially if you are aiming for a consumer app. No question.
If you're going the "DHH path" (profitable lifestyle business, limited outside investment), it probably doesn't matter much.
This is really personally my remaining annoyance with News.YC. Too often, people either agree with a submission, or they disagree with a submission. There are too few posts per day that critically think about what is being discussed.
In this case, I don't remember seeing one post about following a combination of strategies at once (if there were a couple of posts, that doesn't make the situation any less sad.) Making a smart product, having a strategy to grow, and offering a free viral version as well as a paid version that pays your bills is the way to go! In fact, having an abundance of free customers will increase the chance you NEED investment, not just the fact that VC's will be more interested. They're more interested because they know you will need money!
If you have a paid version that pays your operating costs, and gives value, you can keep working on your startup indefinitely. It's also another way to get VC's interested. But except in this case, you logically won't be a little bitch. Instead of having to fake confidence while your cash flow has brought you down to nothing (more likely below nothing), and the only reason you're getting a good valuation is because there are many, many VCs around, and they like that you went to Stanford or something, you will instead be in a situation where you proved people will pay for your product and you don't really need to time selling your company or getting investment in the right cycle of the economy. So which option is better? Whichever one is better at the time! That's what DHH has been saying. If he actually needed investors for a venture, I'm sure he would surely take the money he needs. But he doesn't, so he doesn't. There's no wrong way.
But he's wrong because Silicon Valley gives you that option to pursue VC's in case you need to, and the quality of life seems to be among the best places in the world. And it's sure better than living in the middle of nowhere. And it's great that you can meet cool people and ask them feedback about your apps without receiving questions like "why are you doing a startup" (because working for most companies is a rip off), "wow you must be rich" (people think it's rich people who do startups), and "can you fix my computer" (no explanation needed.)
I like YCombinator's approach, where one can launch and see what happens for a few months before figuring out the best steps -- more angel funding, VC funding, multiple VC funding, selling, quitting, changing an idea, or even having a paid version.
Draw a 50 mile radius circle around Stanford. Get a list of all consumer startup acquisitions in the last 2 years. Put a pin in the map for each acquisition. (This is straight from the mouth of Ron Conway, so apologies to him).
Rinse/repeat for VC investment (which is nearly required for any consumer startup)-- it turns out that VCs tend to invest in Valley companies (because that's generally who they can meet face to face).
If your target path is VC and then acquisition, I'd say proximity to Google is a pretty good idea, wouldn't you? Throw in Yahoo, Ebay, and the many other big players who like to buy companies as a bonus.
The point is-- It's way easier to get funded in the Valley (I'm raising money in the Valley and Seattle right now, so I'm speaking from a bit of experience).
And the data seems to show that it's easier to sell your company if you're in the Valley (which is the only realistic path to liquidity for founders/investors). Even if the data didn't confirm it, it makes SENSE, doesn't it?
I don't know. The last big VC-funded company I was with was in Ann Arbor, MI. When the valley influenced the rest of the VC-backed or acquired companies I worked with, it did so by moving the established company out to California. I've never worked for a company whose opportunities came simply from being located in California.
Meanwhile, the elephant in the room here is that you aren't going to be acquired by Google, in the same sense as you are not going to win the lottery. There's a get-rich-quick mentality behind web startups that is totally not borne out by the numbers, and it cuts both ways: unrealistic hubris that infects judgement (for instance, by moving teams out of comfortable environments to San Francisco), and devastating emo temper tantrums at minor setbacks, like not being accepted into YC.
If you're going the "DHH path" (profitable lifestyle business, limited outside investment), it probably doesn't matter much.