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

Issues Surrounding Venture Capital Equity Financing...continuation

Behaviour of Venture Capitalists

The overall behaviour of venture capitalists at any specific time is very dependent upon the state of the economy and capital markets at that particular point in the economic cycle. If the economy is strong and the capital markets are in a bullish frame of mind venture capitalists are more optimistic and, therefore, less risk adverse than under the reverse of these economic and market conditions. In addition, suppliers of funding for the venture capitalists are also in a similar state of mind as the venture capitalists in any particular economic and market circumstances. As a result, during these optimistic times venture capitalists are able to raise greater volumes of funds for venture capital purposes and are willing to invest these funds in new ventures more aggressively. This has been clearly demonstrated in the past few years when strong economic and market conditions created an explosion of venture capital activity in the U.S. and pushed Canadian venture capital investment to record levels. More recently, as economic and market conditions deteriorated, the supply of venture capital investment has declined as venture capitalists find it harder to raise funds and become more cautious in their investment strategies. Within this economic and market framework, however, other factors can also affect the behaviour of venture capitalist and the investors that supply the funds to venture capitalists and these factors can vary between the Canadian and U.S. venture capital markets.

Investment Strategies

On the investment side of the market, U.S. venture capitalists appear to be more aggressive in their investment strategies than Canadian venture capitalists, particularly in the knowledge-based sector. This may be partly due to the very large size of many of the major venture capital firms in the U.S., which enables them to diversify their investments over a wide range of investments in many sectors and industries. As a result, they are in a position to allocate a larger proportion of their portfolios for higher risk investments than is the case for Canadian venture capital firms, which are all substantially smaller than their U.S. counterparts. These large U.S. firms also have greater analytical resources with which they can assess riskier investments more thoroughly and usually have a variety of funds made up of both generalist and specialist funds to which they can allocate investments that suit the mandate of each fund, some of which will be higher risk and more specialized. In the U.S. there are also a wide variety of smaller specialized funds that only deal in particular types of venture capital investments and these tend to make higher risk investments within their limited areas of interest. In Canada, the major suppliers of venture capital investment, the LSVCCs, because of the nature of their mandates and funding, tend to be more risk adverse than the independent private funds or corporate funds, particularly in the knowledge-based sector. The relative absence of specialist funds in Canada also makes it more difficult to finance riskier investments in specific sectors or industries that require specialist knowledge of their businesses.

Issue: What can be done to encourage Canadian venture capital firms, particularly the LSVCCs, to adopt risk adverse attitudes to venture capital investment that are more similar to those held be U.S. generalist venture capital funds?

Management Experience

In addition, the background of management personnel in the venture capital firms can also impact on the attitudes and behaviour of venture capitalists in the marketplace. In the U.S., people that have come out of industrial firms, particularly high-technology companies, manage many of the leading venture capital firms. Many of them are also industry analysts that come out of the investment banking industry in the U.S. These managers already have extensive and often specialized experience in the industries within which their firm is investing and as a result they can probably assess the risk attached to investments in these industries more accurately and quickly. As a result, these managers tend to be more confident and aggressive in their investment strategies. In Canada, on the other hand, the managers of venture capital firms have tended to come out of the banking community and, therefore, tend to approach the risk assessment process from a banking perspective as opposed to an industry perspective. This has probably resulted in a more risk adverse investment strategy in most Canadian funds, which often lack the intimate industrial experience that U.S. funds tend to have. This is particularly vital in the case of the knowledge-based sector where such knowledge is key to being able to develop a more aggressive investment strategy in Canadian venture capital firms at the senior management level.

Issue: How can more managers that have an industry background rather than a banking background be attracted into the Canadian venture capital industry, so that more specialized industry knowledge can be built up in these firms?

Suppliers of Funds

On the supply side of the market, the attitudes and behaviour of investors that supply funds to the venture capital firms are also very important in determining the overall availability of venture capital in the marketplace and the willingness of venture capitalists to accept risks in their investment strategies. Canadian pension funds, in particular, are in strong financial shape and there appears to be little reason for an overly risk adverse attitude to venture capital investment on their part. If there are regulatory issues restraining their ability to allocate sufficient proportions of their portfolios to this asset class then the pension fund industry should bring these to the attention of their regulators and seek changes to these regulator provisions. On the other hand, if it is a fear that they do not have sufficient expertise to assess the risks associated with these types of investment they should either invest their funds with venture capital firms that have clearly demonstrated expertise in venture investing or bring on board expertise that will provide them with a higher comfort level regarding this type of investment. Another factor that may be making it difficult for pension funds to be less risk adverse towards these investments is a lack of confidence on their part regarding the level of expertise and experience in Canadian venture capital firms.

Issue: How can Canadian pension fund managers be encouraged to provide a proportion of funding to Canadian venture capital firms that is comparable to that provided by pension funds in the U.S.? Are changes to regulatory requirements or income tax rules needed?

Taxation

Taxation, primarily in the form of capital gains taxes, can have a major impact on the availability of funding for venture capital investment. If capital gains tax rates are not substantially lower than general income tax rates they provide a disincentive for investors to provide funding for venture capital investment. Under these circumstances, investors are not being rewarded for investing in high-risk investments because they receive much the same tax treatment on high-risk income as they do on risk free income. Another impact of high capital gains tax rates is the disincentive to realize capital gains earned on successful venture capital investments and the locking in of not only the capital gains but also the original investment. This means that there is less recycling of funds from successful investments into new venture investments than otherwise would be the case if capital gains rates where substantially lower. If there is an incentive to exit successful investments, in many cases the original investment and a portion of the gains are likely to be re-deployed into new venture investments, thereby increasing the overall supply of funding to the venture capital market.

In the U.S., capital gains rates have traditionally been approximately half the tax rates levied on other personal and corporate forms of income and this provided an incentive for high income tax payers, paying the top personal and corporate income tax rates, to invest in riskier investments and obtain lower tax rates on capital gains arising from these investment. Until recently, Canadian capital gains rates where much closer to income tax rates because of the inclusion of 75% of capital gains in the calculation of taxable income, for both individuals and corporations. This substantially reduced the incentive for Canadian investors to invest in riskier assets, such as venture capital investments, and this undoubtedly had a negative impact on the flow of funds into the venture capital market. With the recent reduction in the capital gains inclusion rate to 50%, Canadian capital gains tax rates are now more comparable to those in the U.S. and a stronger incentive has been established for investment in riskier assets and the realization of existing venture capital gains.

Issue: Will the recent reduction in the Canadian capital gains tax rate improve the inflow of funding to the venture capital industry? How can this be tracked?

Size of Investments

Another striking difference between the Canadian and U.S. venture capital markets is the large difference in the average size of venture capital investments between the two markets, with average investments in the U.S. being almost 5 times larger than average investments in Canada. This is probably due to a number of factors, including the larger size of investee companies in the U.S., the greater focus of U.S. venture capital investors on expansion and later stage investments and the much larger size of U.S. venture capital funds. In the U.S. many independent private venture firms have individual funds that are up to $1 billion in size and, in some cases, individual firms will have multiple billion-dollar funds under their control. It also reflects the overall greater per capita supply of venture capital funding in the U.S. that permits U.S. venture capital firms to make large individual investments while still being able to effectively diversify their holdings.

In Canada, where a large venture fund would be in the $100 million range, the much smaller size of venture funds severely limits the ability of venture capital firms to make large individual investments and still maintain proper diversification. Even syndicating larger investments in Canada can be a problem because of the number of venture capital firms that would have to be involved to raise the funding for such investments could be unmanageable in terms of negotiating the terms of the investments and of managing these investments. The long-term approach to dealing with this problem would be through growth in the size of Canadian venture funds arising from an increased per capita supply of funding for the venture capital market to levels closer to that in the U.S.

Issue: Would the encouragement of cross border syndicates of Canadian and U.S. venture firms provide larger investments in Canadian companies that require expansion phase funding?

Cross Border Flows

Over the years, both Canadian and U.S. venture capitalists have been involved in cross border investment flows between the two countries. For Canada, this has resulted in additional venture capital investment on the part of U.S. venture firms but also a loss of venture capital funds raised in Canada to investments in the U.S. Through expanding the flow of venture capital investment from the U.S. the availability of venture capital funds in Canada could be supplemented to make up for the shortfall in per capita venture capital investment in the Canadian market relative to that in the U.S. In order to do this, the Canadian venture capital environment would have to be attractive to U.S. venture capitalists in terms of unique investment opportunities, the presence of acknowledged Canadian expertise in specific industries, and a relatively stable Canadian dollar exchange rate. Another factor would be the ability of the Canadian market to finance early stage companies to the point where they were prospects for larger expansion phase investments that would be more attractive to U.S. investors than small early stage investments. This would also help in filling the gap in the Canadian market for this type of expansion phase investment and could result in substantial inflows of venture investment from a relatively small number of transactions. This would probably result in a significant net cross border inflow into Canada because the outflows to the U.S. on the part of Canadian venture capitalists tend to be relatively small, usually in the form of small participations in U.S. syndicated investments.

In the past, these two flows have both been relatively small but recently there has been a significant increase in U.S. venture investments in Canadian companies, particularly in specific industries with unique Canadian expertise, such as fiber optics. These individual investments have been mainly substantial expansion phase investments and have usually also involved investment syndications with Canadian venture firms. Over the past two years these U.S. inflows have added significantly to the overall supply of venture capital in Canada and have partially filled the expansion phase financing gap in the Canadian market. It also appears that outflows of funds to the U.S. on the part of Canadian venture capitalists have also increased during this period as Canadian venture firms invested funds in both U.S. companies and in Canadian companies that have migrated to the U.S. However, the size of these investments has been much smaller than the large investments that have come into Canada from the U.S. and, it appears, that Canada has experienced a significant net inflow of venture capital over the past couple of years. As long as there is a surplus of venture capital in the U.S. this trend is likely to continue as U.S. venture capitalists search out opportunities outside the U.S. market but under contracting supply conditions in the U.S. these inflows could dry up quickly.

In order to encourage this trend, Canada must ensure stability for the Canadian dollar and a tax environment that does not penalize U.S. investors. It would also be in the best interests of Canadian venture capitalists to focus on providing adequate early stage financing for companies that would be attractive to U.S. investors in the expansion-financing phase. This could require Canadian venture capital firms to become more specialized and focused in their investment strategies, which could improve the efficiency of the Canadian market and provide Canadian companies with lower financial and time costs for venture capital investment. Overall, because of the disparities in size between the Canadian and U.S. venture capital markets, it would be in the interest of Canada to foster a greater integration with the U.S. market where venture capitalists from both countries could specialize in the type of venture financing in the Canadian market that best suits their circumstances. This could mean the Canadian venture firms would focus on smaller, early stage investments and U.S. firms could provide more of the financing for expansion stage firms. This would tend to reduce the risk profile for Canadian venture firms by holding larger numbers of smaller diversified investments and sharing a greater part of the expansion phase risk with the larger U.S. firms which are in stronger position to accept risks associated with larger investments while still being able to maintain adequate diversification. This reduction in risk could also be a positive factor in encouraging greater flows of venture capital funding from Canadian pension plans.

Issue: Could greater integration of the Canadian and U.S. venture capital markets create more competition in the Canadian market and reduce the flow of Canadian firms to the U.S. through increasing cross-border flows between the two markets?

Exit Strategies

Another important element that can influence the supply of venture capital and the level and type of venture capital investment are the exit strategies available to venture capitalists for recovering their original investment and realizing their gains on investments. In order to maximize the returns on their investments venture capitalists have to pursue exit strategies that allow them to liquidate their investments on the best possible terms. If they are able to do this, venture capital firms are likely to be more aggressive in their investment strategies and will find it easier to raise funds from investors for venture capital purposes. If adequate exit strategies are not available, venture capitalists are caught in a situation where their investments remain illiquid and they cannot recycle their funds into new investments or provide realized returns to their investors. As a result, the venture capital market tends to seize up with both venture capitalists and their investors being unwilling to provide new funds for venture investment, either for new companies or existing companies in their portfolios that require additional financing. This situation can arise in two circumstances: where the opportunities for successful exits are restricted in the marketplace and where cyclical economic and financial conditions are not favorable.

The most common types of exit are an initial public offering (IPO) of stock in the investee company and a merger or acquisition of the investee company involving either another company or the original founders of the company. In the case of an IPO, the venture capital firm will end up holding publicly traded stock in the company but, as an insider under securities regulations, it is restricted in how the stock can be sold and liquidated. These restrictions usually stay in place for up to two years before the stock becomes freely tradable and during this time the value of the stock varies with equity market conditions. At the end of this period, the venture fund usually distributes the stock or cash to its investors who then can decide to either sell or retain their stock holdings. Generally, an IPO will result in a relatively high initial exit valuation for the company but the funds cannot be realized immediately and are, therefore, subject to market variations, both up and down, over the required holding period. Under strong market conditions the stock can increase in value over the IPO value but under weak market conditions the value can decline or even be virtually wiped out before it can be realized.

Although IPOs are the most glamorous type of exit available, the most common type of exit involves mergers or acquisitions. Under a merger or acquisition exit, the venture firm will receive either stock or cash from the acquiring company and distribute these proceeds to its investors who can then hold the stock holdings or liquidate them immediately. In the case of mergers and acquisitions, investors can realize their values immediately and, hence, with greater certainty than in the case of IPOs. Another advantage of a merger or acquisition over an IPO is that the IPO requires sufficient capacity in the IPO market to absorb a large volume of IPO financing and establish appropriate valuations for IPOs in the marketplace, at reasonable costs in terms of both regulatory pricing and management time costs. These issues will be dealt at length in the next section of this study.