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

Venture Capital Market

Investments in 2001: Canada's venture capital (VC) industry broke records in 2000 but faced new challenges in 2001 including limited exit opportunities that dampened the level of investment, sending it to 27 percent below the previous year. Nonetheless, 2001 actually remained well above 1999 levels.

Canadian vs. U.S. VC activity: In the U.S. total investment dropped 65 percent in 2001, bringing the annual total in line with levels experienced in 1998.²⁶ With a smaller relative decline in VC investments in Canada in 2001, this left Canadian VC activity at about 9 percent of that the U.S., taking currency exchange into account, this compares with 4 percent in 2000.

Stage of business development: In 2001, $2.9 billion (60 percent of total for 2001) was invested in early-stage businesses – an increase from the 46 percent of total VC directed at early-stage firms in 2000.

• Value of investment in 2001: As shown in Figure 20 , $4.9 billion was invested in 2001, compared to $6.6 billion²⁷ in 2000.
  
  
• Number of investees, in 2001: 818 companies received VC, down from 1,132 in 2000.
  
  
• Size of Investments: average deal size in 2001 was $4.5 million, up from $4.4 million in 2000. Deals involving more than $5 million accounted for 80 percent of the 2001 deals, slightly higher than the 78 percent seen in 2000.
  
  
• Assets under management: The VC industry had $20.1 billion under management in 2001, up from $18.6 billion in 2000 – an 8 percent increase.
  
  
• Funds available for investment: at the end of 2001, $6.2 billion was available for investment, up from $4.2 in 2000 – nearly a 48 percent increase, representing about 15 months of investment at the 2001 pace of investment.

Figure 20 – Annual VC Investment by Size of Investment

Venture Capital investment: a regional perspective

Considering that a total of only 818 firms received venture capital in Canada in 2001, variation in regional performance can be significant year over year. In regions which have had a small base of investments in the past, a very small number of investments can make dramatic shifts in the regional distribution. Given the small numbers involved, it is perhaps less useful to focus on absolute numbers in any given year, but rather to look at trends over a longer period.

The overall pool of venture capital has been rising. So even if a particular region's "share" of total investments does not change much relative to other regions, this still reflects a substantial increase in actual dollars invested in firms located in that region. For example while, the Atlantic region's share of VC investments was about 1 percent of total investments in 2001, this represented an increase from about $33M in 1996 to about $50M in 2001 – a 50 percent increase.

• VC Funds: the last five years have seen a rapid growth in the number of VC funds in Canada. Moreover, there is an increasing trend toward specialization and less concentration in Central Canada. For example, 181 VC funds have been created since 1996 bringing the total to 293 (216 VC firms existed in 2001). Of the total VC funds in Canada, 162 are specializing in information technology and 78 in life sciences. There are 18 located in Alberta, 8 in Atlantic Canada, 39 in British Columbia, 125 in Ontario, 80 in Quebec, and 23 in Manitoba and Saskatchewan²⁸.
  
  
• Ontario: In 2001 the amount of venture capital invested in Ontario dropped 31 percent from $2.9 billion in 2000 to $2 billion, as shown in Figure 21. This is a slightly higher decline than the 27 percent decline experienced across Canada.
  
  
• British Columbia: In contrast to the national decline of 27 percent in total venture capital experienced in 2001, British Columbia-based firms attracted 8  percent less in 2001 than in 2000.
  
  
• Quebec: in absolute terms Quebec has seen a dramatic increase in the value of VC investments from $323 million in 1996 to $956 million in 2001; however, as noted in Figure 21 this region has seen a decline in VC investments in 2001.
  
  
• Alberta: Firms in Alberta saw a 50 percent decline in VC investment last year, relative to that in received in 2000. A recent report by Ernst and Young LLP²⁹ reported that Alberta firms were having some difficulty raising VC funds in the $1M to $5M range, which the report suggests may be a factor contributing to this decline. It is notable, from Figure 20 on previous page, that this segment has seen a significant decline in the last year.
  
  
• Canadian VC investments in foreign firms: in absolute terms 24 percent of all investments by Canada VC firms went to foreign-based firms, up from 19 percent in 2000. Macdonald & Associates reports that large financings in technology-intensive firms located in the U.S., Europe and Asia have contributed to this growing trend. As this phenomenon has only emerged in the last few years, there has been little study to determine its nature, what is driving it, and what are the factors contributing to it. More study and data gathering will be needed to determine these questions.

Figure 21 VC Investment by Region of Investee, 1996-2001

Ontario	$482	$706	$531	$1,278	$2,939	$2,028
Foreign*	$60	$128	$219	$348	$1,360	$1,158
Quebec	$323	$560	$615	$791	$1,410	$956
B.C./Yukon	$106	$195	$203	$294	$540	$502
Alta./N.W.T.	$40	$53	$86	$133	$243	$119
Man./Sask./Nunavut	$44	$108	$49	$89	$63	$58
Atlantic	$33	$23	$48	$53	$75	$53

Source: Macdonald & Associates Limited, 2002
* Indicates Canadian venture capital invested in companies outside of Canada

Information technology in 2000 and 2001

Information technology companies continued to attract a substantial portion of VC invested. Again in 2001, as in 2000, 65 percent of total VC was invested in the IT sector, while 22 percent was invested in life sciences.

• Communications and networking: claimed one quarter of the total investments, up from 20 percent in 2000.
  
  
• Software companies: received 15 percent of total capital, equal to the previous year.
  
  
• Internet-related firms: In 2001, 12 percent of total venture capital went to these firms, down from 19 percent in 2000.
  
  
• Bio-pharmaceutical companies: within the life sciences sector, attracted 17 percent of total capital, up from 10 percent in 2000.

Figure 22 – VC Investment by Sector in 2001

Early-Stage Firms dominate VC Investments in 2001

Continuing the growing focus on investment in early-stage firms including seed, start-up and other early-stage firms, seen in 2000, 60 percent of capital invested in 2001 was in 451 early-stage firms. This amounted to a total of $2.9 billion invested directly in early-stage firms. This was an increase relative to the 46 percent of total VC investment seen in 2000 which was made in 545 companies totalling $3 billion.

While focus on early-stage firms continues, fewer expanding companies are receiving financing. In 2001, one third of all investments were made in expansion projects, down from 47 percent of total capital invested seen in 2000 (see Figure 23). The number of companies that received financing for expansion dropped to 380 in 2001, well down from the 683 deals in 2000 worth $3.1 billion.

Figure 23 – VC Investment by Stage of Business in 2001

Trends in 2000, 2001³⁰

Foreign VC investors: played a critical role, bringing $1.6 billion to the Canadian VC total annual investment and lifting their share of investment to 33 percent of the aggregate (see Figure 24). In 2000, foreign investors contributed 24 percent of the total, and 19 percent in 1999. Macdonald & Associates Limited suggests that Canadian VC groups may be increasingly co-investing with U.S.-based VC funds in their Canadian investments. This may account for the apparent rapid growth in foreign VC investment in Canada.

Figure 24 – VC Investment by Type of Supplier in 2001

Clearly this is a new trend which will require more study to understand its implications. On the surface it appears to be a good thing that Canadian firms are able to attract foreign-based venture capital investments to support their growth. However, time will tell what impact this trend has on the future of these firms. It would be troubling, for example, if this led to an increase in firms leaving Canada and moving to foreign markets, thereby representing a net loss for Canada. On the other hand it may be that accessing foreign VC also gives Canadian firms more access to important foreign markets which can help them to grow rapidly, both in Canada and in these new markets. As this is an emerging trend, more study will be required to determine its net impact.

Canadian VC investors: the second largest domestic VC investors behind foreign investors, were Labour-Sponsored Venture Capital Corporations (LSVCCs) with 13 percent of total investments in 2001, followed by private independent funds with 12 percent then pension funds and insurance companies (such as Caisse de Dépôt et de Placement, the Ontario Municipal Retirement System, and the Ontario Teachers Pension Fund) which contributed $526 million, or 10 percent of total capital invested in 2001.

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26. Macdonald & Associates Limited, 2002.

27. The previously reported total disbursements for 2000 were $6.3 billion. This discrepancy is explained by new methodology used by Macdonald & Associates. It entails the fact that previously the reporting of RRSP fundraising numbers for the LSVCCs were recorded through the end of the RRSP season (end of February) and reported in the prior year; however, they will now be reported based solely on the calendar year. Historical data has been refined to reflect this change in methodology.

28. Macdonald & Associates.

29. Ernst & Young LLP, The third annual Alberta Technology Report, 2001. http://www.albertatechreport.com/

30. In 2000, methodology for data reporting was revised to account for the increasingly important role being assumed by Canadian institutional sources – particularly Quebec's Caisse de Dépôt et de Placement, the Ontario Municipal Retirement System, and the Ontario Teachers Pension Plan – as direct investors.