SME Financing in Canada, 2002 — Part I: Risk Capital

The Role of Risk Financing

SME creation and growth usually require several stages, of financing, involving a variety of instruments – depending on the type of business, its growth prospects, market conditions and a number of other factors. While debt is the most commonly sought-after form of external financing by Canadian SMEs, no business can be financed by debt alone. All businesses require an equity base, and this can be provided through personal investments by a firm's owners, through the re-investment of income in the form of retained earnings, or through risk capital investments made by outside parties who become part-owners in the firm.

Sound corporate finance requires an appropriate balance between debt and equity based on the nature of the income that a business is likely to produce. A relatively low-risk business with highly predictable cashflows can take on more debt than a firm with variable and volatile cashflows. The advantage of debt is that it does not require an entrepreneur to give up ownership. Its disadvantage is that it normally requires a fixed schedule of repayment, regardless of the performance of the business. If a firm cannot make its monthly payments, it can find itself in default. Lenders are generally less willing to lend to new firms that lack a track record, because these firms' cashflows are much more difficult to predict. In the early stages in a firm's development, a large part of the financing is likely to be in the form of risk capital – the personal stake of the entrepreneur, retained earnings and love money. Risk capital is a more "patient" form of capital, as the returns are linked directly to the earnings of the firm.

Risk capital financing is particularly important for firms in the knowledge-based sector of the economy. Typically these firms do not have many tangible assets, particularly at the early stages in their growth, that can act as security for providers of debt. If the firm is developing a product or service that will take time to get to market, debt is rarely a good financing alternative because the firm does not have the means to pay interest until that product or service is available for sale. Indeed, debt on the balance sheet can be destabilizing for these firms; thus risk capital is usually the most appropriate form of financing.

Rapid-growth firms generally reach a point where the owners must consider taking in outside risk capital investors. This is a key decision for an entrepreneur, because especially at early stages of a firm's growth, outside investors are likely to want to play an active role in management. The vast majority of entrepreneurs decide not to take this step and decide to grow more slowly. For those firms that do take on outside investors, the first step is usually to go to informal investors (also known as business angels or private investors). These are individuals who make relatively small investments in private companies with high growth prospects.

Successful firms quickly outgrow the ability of angels to provide growth capital. The next stage in risk capital financing is usually to go to the venture capital market. It should be noted that this is used by a very small number of firms. In 2001 there were only 1,077 formal venture capital deals shared among 818 firms in Canada. However, these are among the most important firms for Canada's future, as they have the potential to grow exponentially and become the large firms of tomorrow. Firms that grow successfully through venture capital typically get listed on a stock exchange and raise further risk capital in the form of public stock issues.

In the section that follows, the report examines the state of the risk capital market in Canada in 2000. It should be noted, however, that the report does not examine two of the most important sources of risk capital: the personal investments made by entrepreneurs in their businesses, and retained earnings. These sources of risk capital will be the subject of future studies.