Issues Surrounding Venture Capital, Initial Public Offering (IPO) and Post-IPO Equity Financing for Canadian SMEs

Issues Surrounding Venture Capital Equity Financing

In this section, the issues surrounding the provision of venture capital equity financing to Canadian SMEs will be developed and examined in some detail. These will involve issues related to overall access to venture capital financing and the costs of venture capital, with particular reference to issues related to the differences between the Canadian and U.S. venture capital markets. These latter issues arise from Canadian and U.S. differences in the structure of the venture capital markets, the behaviour of venture capitalists, the taxation environment and limitations on investments. Related to these issues are issues regarding the cross border flows of investment between the two countries.

General Issues: Access to Venture Capital

A fundamental issues regarding venture capital financing in Canada is whether or not Canadian venture capitalists can raise sufficient funds to provide Canadian SMEs with the level of venture capital investment that they require at all stages of activity. In the above statistical analyses of the Canadian and U.S. venture capital markets there is evidence that both the supply of venture capital and total venture capital investment lag behind that in the U.S. relative to the size of the economies and on a per capita basis. This would indicate that Canadian SMEs might not be able to access sufficient venture capital financing in Canada relative to what they need or could effectively use. There are no data available to measure this potential shortfall in access or to indicate how many viable SMEs were unable to obtain venture capital financing. In addition, this shortfall in access, although it may not prevent the establishment of viable SMEs, may restrict their growth and development and, thereby, reduce or threaten their longer-term success in the marketplace.

There is evidence in comparing the Canadian and U.S. venture capital markets that the difference in access between the two markets is focussed in the expansion and later stages of activity where the percentage of total of investment in the U.S. significantly exceeds that in the Canadian market. On the other hand, the percentage of investment in early stage companies in Canada exceeds that in the U.S. market. Given the overall shortfall in venture capital financing relative to that in U.S., this could mean that the squeeze on access to venture financing for Canadian SMEs could be heavily concentrated during the expansion and growth stages of activity. It is during these stages of activity that failure to access this financing means almost certain death for the company.

With regard to sectoral access to venture capital investment, the knowledge-based technology sector has consistently received by far the largest proportion of venture investment in both Canada and the U.S. Since the knowledge-based sector is almost entirely dependent on equity financing for its development and growth, this is a positive element within the overall access picture and, as a result, there are few issues related to the sectoral provision of venture capital financing in Canada. From an economic perspective, venture capital financing should be concentrated in these high growth sectors of the economy.

There are, however, issues regarding the regional access to venture capital financing in both countries as the bulk of investment is concentrated in one region in each country, although there is anecdotal evidence that access to venture investment is spreading modestly to the have-not regions in both countries. Much of this has to do with the nodal approach to investment in the technology sector and the more limited number of investment opportunities in less populated regions but there is still the issue of providing more equal access to venture capital for viable companies in all regions. However, this is not an issue specific to Canada and until the various regions of the country are able to develop a critical mass of companies in the technology sector, access to venture capital financing is probably going continue to lag in the lesser developed regions of the country.

Issue: How can growth-oriented SMEs in lesser developed regions of Canada be identified and developed so that venture capital financing can be attracted to those regions?

Financial Costs of Venture Capital

The financial costs involved in obtaining venture capital equity financing are reflected in the valuations that the investee companies receive on the shares and the dividends and interest they pay on other securities that are acquired by the venture capitalists. If the venture capitalist only receives common shares in the investee company the cost to the SME and its owners is the extent to which the valuation on the shares acquired by the venture capitalists compensates for the dilution in ownership of the company suffered by the existing shareholders. The higher the valuation of the shares, the lower the dilution of ownership and, hence, the lower the cost of the venture capital investment. Therefore, any factors that increase the valuation paid by the venture capitalist for the common shares will lower the cost of venture capital investment to the company and its existing shareholders. In the case of other securities, such as preferred shares or convertible debt instruments, acquired by venture capitalists in providing financing, the cost is usually directly measurable by the dividend and interest rates attached to these securities plus the valuation dilution impact, if and when these securities are converted into common shares.

The issues surrounding the valuation costs associated with ownership dilution arise from factors such as the availability of, and competition for, venture capital investment in the marketplace. Within this framework, financial costs are basically determined by the structure of the venture capital market and the attitudes and behaviour of venture capitalists in the marketplace.

Issue: How can the availability of, and access to, venture capital financing be increased for SMEs through improving the efficiency and competitiveness of the venture capital market in allocating the available supply of venture capital financing?

Time Costs of Venture Capital

The time costs of venture capital financing involve the time and effort that management of a company has to put into the process of searching for and obtaining venture capital investment. The major cost associated with these efforts results from the diversion of management personnel from actually initiating and expanding the company's business operations to the search for financing. The greater this diversion, the higher the cost in terms of lost opportunities to grow and strengthen the business. On the other hand, the future of the business is totally dependent on obtaining adequate equity financing and management has no choice but to divert its attention to this task. The major factors that are important in determining these costs are the structure and efficiency of the venture capital market and the attitudes and behaviour of venture capitalists; e.g. because of a lack of specialized knowledge among venture capital firms or if venture capitalists are highly risk adverse. These time costs also tend to vary in accordance with a company's stage of activity with companies in the early stage of development requiring more time and effort to get themselves known within the venture capital community and to explain their business plans to a new audience.

This makes early venture capital financing generally more time costly to obtain than follow-on financing. In this case, the company has already obtained some initial venture financing and the venture capitalists providing this initial financing have a vested interest in championing the company with other venture capital firms with whom they would like to share the next round of financing. Also, venture firms are more interested in pursuing a company with a track record within the venture capital industry and become less risk adverse if another known venture firm has already invested in the company. Finally, the original venture investor is also usually interested in investing further in the company, particularly if the risk can be spread further among other investors in the process. The time costs also vary with the size of the venture investment required by the company, with a very small investment from one investor probably being less time consuming than a large investment requiring negotiations and relationship building with a number of investors, who may also have to build a relationships and reach agreement among themselves.

Issue: How can the market structure and behaviour of venture capitalists be changed so that a company's management is not required to spend large amounts of time and effort to find the right venture capitalists for their business?

Specific Issues: Structure of the Venture Capital Market

The structure of the venture capital market can give rise to a number of issues related to access to venture capital and both the financial and time costs of obtaining venture capital investment. In this analysis, the structures of the Canadian and U.S. venture capital markets will be compared to develop issues that could account for the divergence in performance between the two markets. The Canadian market over the 1997 to 2000 period has lagged the U.S. market both in terms of raising funds for venture capital investment and in making venture capital investments on a per capita basis and some of this divergence may be accounted for by the differences in structure between the markets. Issues arising from an examination and analysis of these differences in structure, if dealt with, could lead to improvements in the performance of the Canadian venture capital market.

One of the major differences between the Canadian and U.S. venture capital markets is the dominance of the private independent venture capital firms in the U.S. and the greater involvement of government-related firms in the Canadian market. The private independent firms in the U.S. operate funds that are organized as limited partnerships with the firms acting as the general partners. Each firm may have a number of these funds (often as many as 6 or 7), each of which is organized independently of the others with its own investors (limited partners) and general partner. The investment strategies of these related funds may be similar or quite different, with some of them being generalist funds and others being specialist funds. Evidence in the U.S. indicates that currently over 50% of the capital raised by these funds comes from public and private pension funds, with the remainder coming from endowments, foundations, insurance companies, banks and individuals. Analysis of institutional portfolios in the U.S. indicate that the average institutional investor will allocate 2% to 3% of their institutional portfolio for investment in alternative assets, such as venture capital investments through these funds.

Canadian Market Structure

In Canada, the largest participants in the venture capital market over the past few years have been the LSVCCs, which raise funds from small investors through the provision of government tax incentives. These funds, over the past few years have provided approximately 50% of the total funds available for venture capital investments. Although these funds have grown rapidly since their creation there are signs that their growth is flattening out as small investors find it difficult to add further to their investments in riskier assets and the tax incentives to do so have been reduced. Over the past year or so, the amount raised by these funds has remained relatively static. As a result, if the Canadian venture capital market is to grow substantially sources other than LSVCCs are going to have to be found. In addition, LSVCCs are not very efficient in terms of raising usable venture capital because of the nature of their investors. Reliance on small investors requires them to hold substantial reserves of liquid investments to protect investors and provide liquidity for withdrawals by small investors when they are eligible to make withdrawals. These withdrawals also tend to come fairly early in the investment cycle as small investors are likely to have less patience than large institutional investors. As a result, only about 60% of the actual funds raised by LSVCCs are available for venture capital investment.

Although the Canadian market also includes a substantial number of independent private funds, which have traditionally accounted for about 20% of total venture capital funds raised in the market, although in 2000 this percentage increased significantly to about 25%. However, the growth of these funds has been rather volatile as institutional investors have fluctuated in their participation in venture capital investment. In recent years, there has been evidence of growing institutional interest in venture investment and these funds have been able to expand significant to offset the static performance of the LSVCCs. Canadian pension funds have by far the largest pool of capital in the country and unless they are prepared to allocate a significant and stable portion of their portfolios to venture capital investments, it will be impossible for the private independent firms to play the type of role that these funds play in the U.S. market. Pension plans are the ideal investors to participate in the venture capital market because of their ability to diversify widely across asset types and the long time horizons on their portfolios. Recently, there is also evidence that larger pension funds, such as Ontario Teachers, OMERS and Quebec's CDP, are making direct venture capital investments instead of participating through private independent funds.

Issue: How can participation by Canadian pension funds in the venture capital market be increased to a proportion of the market more similar 50% share of venture capital financing by U.S. pension funds?

A positive development in the Canadian venture capital market has been the growth of corporate venture capital firms, affiliated with both industrial corporations and with financial institutions, particularly the chartered banks. This parallels a similar trend in the U.S. where major corporations have substantially increased their involvement in venture capital financing. In Canada, in 1999, these funds accounted for 17% of total funds raised for venture capital investment while in the U.S. these types of funds made up about 10% of total venture capital investment in the same year. Following regulatory changes involving these types of subsidiaries, the chartered banks became more aggressive in the involvement in venture capital financing both directly and indirectly through investing in independent private venture capital funds. This trend of greater financial institution participation should continue when the new financial institution regulatory framework is in place allowing financial institutions greater flexibility to hold these subsidiaries under holding company structures where they can be regulated differently from the parent institution.

Issue: How can financial institutions be encouraged to continue their growing interest in venture capital financing through an evolving regulatory environment?

Efficiency of the Canadian Market

The efficiency of the Canadian venture capital market may also be less than that of the U.S. market due to the fact that most of the venture capital funds in Canada are generalist funds, that invest in a wide variety of industries, rather than specialist funds. This means that there could be a lack of specialized knowledge in the market with which investments can be analyzed and assessed, particularly in knowledge-based sector. As a result, generalist funds without this knowledge may pass up investment opportunities simply because they do not have the expertise to assess them properly. In a small venture capital market like Canada's there is likely to be far fewer specialized funds than in the large U.S. market and it may not be possible to have a sufficient number of funds that specialize in particular emerging industries.

The absence of specialist venture funds and analytical expertise in the Canadian venture capital market may also increase both the financial and time costs associated with venture investing. This could happen because a lack of specialized knowledge is likely to result in lower valuations being applied to companies receiving venture capital investment, particularly in the knowledge-based sector. This could result in higher financial costs to the companies and their shareholders through greater ownership dilution. In addition, the absence of specialized funds is likely to result in greater time costs for management in terms of their efforts to explain their business to non-experts. In the case of knowledge-based companies it may take a considerable period of time to find a generalist fund that is interested in their business and then to find the people in that fund that have the expertise to understand their business. This is compounded further when a number of generalist funds have to come together in a syndicate to undertake a financing and the company's management has to go through an educational process with multiple firms.

Issue: How can generalist venture capital funds be encouraged and enabled to obtain the specialized knowledge required to participate in new industries where this knowledge is needed?

As an alternative to having more specialist funds, the provision of more specialized expertise jointly to generalist funds could also lower the financial and time costs of venture financing. This could result in greater access for emerging industry companies and could encourage more institutional, particularly pension fund, participation in venture capital investment by increasing confidence in the expertise that is available to venture firms in the investment assessment process.

Issue: Is there a need for specialized consulting and analytical resources that could be available to the venture capital firms on a pooled basis either on an independent basis or through the establishment of a resource facility that would be owned jointly by venture capital firms?

Syndication of Investments

In both Canada and the U.S., follow-on and later stage venture capital financing is often done through syndicated investments among a number of venture capital funds. In the U.S. these syndicates usually involve one venture capital firm that acts as the lead investor and then other firms come in behind the lead to share the portion of the investment not taken up by the lead. The lead investor is normally one of the major independent private firms that already has a network of other firms established, with which they syndicate investments. Within this network, the lead may change for different investments, particularly on a regional basis, but the network of firms often remains relatively constant for each investment. As a result, the company seeking the investment usually has to focus on getting one of the firms in the network (probably the largest and best known) to take the lead position and after that the lead firm usually arranges for the syndication of the remaining investment amount, with the other firms relying on the lead for analysis of the investment. This means that, in many cases ,the company has to spend less time in obtaining its financing and probably gets a better valuation based on the lead investor's interest in the company, which will be more readily accepted by the other members of the syndicate.

In Canada, because of the relatively small and equal size of many of the venture capital firms, there is an even greater reliance on syndicated investments, simply because no single firm has the resources to take on the whole investment, particularly in the case of larger follow-on investments. However, again because there is no dominant group of firms in the Canadian market, there is unlikely to be very many firms that will take a strong lead position on an investment or that can establish a network of firms that will follow its lead in a syndication. As a result, in Canada, syndicates tend to be one-off groups that come together for a specific investment after each has analyzed and assessed the investment. In other words, the company seeking the investment almost has to build the syndication group for its investment opportunity by itself with little help from any particular venture capital firm. This can be even more complicated when attempting to build syndicates between independent private firms and LSVCCs, each of which operates in accordance with different mandates and risk tolerances. As a result of this lack of leadership in building syndicates in Canada, valuations tend to be lower and the amount of management time required higher than in the U.S. This means that both the financial and time costs of venture capital investment are relatively higher in Canada than in the U.S.

Issue: How can the provision of specialized expertise to syndicates and networks of venture capital firms that work together and rely on each other's investment assessment expertise be facilitated, so as to minimize time and effort for both the firms and the companies seeking investment and result in fair valuations for both parties?

Support and Mentoring

Another aspect of concern regarding syndicated venture capital investments is that the venture capital firms may not provide sufficient support and mentoring for the management of the investee company. In the U.S. this is overcome to large extent by the role played by the lead investors in syndicates. These large firms normally also take the lead in providing assistance, support and mentoring to the management of the companies in which they invest and almost always have representatives on the company's Board of Directors. This again increases the confidence level of the other syndicate investors and makes it attractive for them to participate in the investment. In Canada, the risk of management neglect is greater because of the general absence of a strong lead role in most syndicates, which are more syndicates of equals. In these circumstances it is often unclear which members of the syndicate are responsible for supporting and mentoring management of the company in which they have invested. Again, there may be a need for joint resources that syndicates can call upon to support and mentor their investee companies.

Issue: How can relatively small venture capital firms making up syndicates be provided with sufficient resources to play a more active role in supporting and mentoring a company's management?