SME Financing in Canada, 2003 — Part IV: Profile of Risk Capital Financing

3. Venture Capital Financing

3.1 What is venture capital financing?

VC is long-term, hands-on equity investment in privately-held, high-growth-potential companies, undertaken and managed by professional investors.¹⁰⁰ These investors normally organize themselves into VC firms (through private partnerships or closely-held corporations) that establish one or more VC funds to raise capital from individual and institutional investors — capital that is subsequently invested in equity-type instruments (e.g. shares) issued by SMEs.

VC will never be used by more than a tiny proportion of businesses, since it requires: the dilution of high-growth-potential firms' ownership firms with innovative ideas; potential returns ranging between 30 percent and 40 percent annually over an extended period involvement of the VC firm in the company's management

VC is usually invested in new, young and rapidly growing companies that have the potential to develop into significant players in their respective markets. Venture capitalists evaluate several hundred investment opportunities each year, but only invest in a few companies that have the potential for high rates of return within five-to-seven years.¹⁰¹ According to one study, American venture capitalists finance only one out of a hundred prospective projects.¹⁰²

3.2 Venture capital is not a financing panacea

As mentioned above, venture capital financing usually comes into play during the early and expansion stages of a firm's development. While this type of financing provides essential growth and expansion capital to high-growth-potential firms, it is not a panacea for the range of challenges that SMEs face in accessing financing. VC investments represent very high risks for investors, and these investors expect to be compensated by high returns. Not all businesses are able or willing to make the growth commitment necessary to meet these requirements.

Moreover, the stringent criteria of venture capitalists ensure that this market remains limited to a few high-growth-potential firms. Only a very small percentage of growing SMEs (less than 1 percent of all SMEs in any given year, or approximately 87 000 businesses)¹⁰³ is considered a potential investment target by VC firms. From an entrepreneur's perspective, accessing VC is difficult, costly and often associated with surrendering managerial control or ownership of their business. In 2001, 40 percent of SMEs were not prepared to exchange ownership control for risk capital even if it were to lead to rapid growth.¹⁰⁴

3.3 VC is an active, risky and transitional investment

Venture capitalists play an active role in the management of their portfolio firms. Most VC investors aspire to hold, collectively, a majority ownership position so that they can add value (for example by providing advice, helping recruit the management team, identifying and analysing new market opportunities and providing access to professionals) and influence the management decisions of the company (by visiting the firm periodically, reviewing monthly reports and serving on the board of directors).

According to a 1997 study by Paul Gompers,¹⁰⁵ the disproportionate allocation of control to the VC fund (an outgrowth of the fund's adoption of the financial risk) is a critical feature of this governance structure. While the fund provides a critical influx of capital, this transition of authority is not always advantageous for the entrepreneur: venture capitalists often professionalize the management of investee firms by replacing the "lone-wolf" entrepreneur with a professional manager.¹⁰⁶

One of the major risk factors facing venture capitalists is the lack of information about the operations and performance of potential investment targets. As a result, pricing is problematic and often causes conflict between VC investors and portfolio companies. Venture capitalists often assume great investment risks because they are investing in new concepts and technologies with unproven market potential. These risks are particularly acute in information technology and life sciences investments, due to the length of time between innovative concept and marketplace penetration in these sectors. Long product development cycles compound the uncertainties associated with new technologies and products, since investors risk that the product will not reach full potential before being superceded by a competing technology. To compensate for these high risks, VC fund managers require prospects for rapid and substantial growth and a share in the firm's profits. Once the rapid-growth phase of a company is completed, venture capitalists generally seek to liberate and re-invest their capital or return it to their investors.

The risk that venture capitalists are prepared to accept, particularly at the growth stage, is often dictated by economic and market factors that influence exit opportunities (primarily IPOs or merger and acquisition transactions). The IPO is usually the preferred exit option because it tends to offer the greatest return on investment. However, as will be seen later in Section 4, this is often not the best financing option for smaller firms (with less than $10 million in assets).

3.4 The economic impact of venture capital

According to the results of the most recent survey on the economic impact of VC in Canada, carried out for the Business Development Bank of Canada,¹⁰⁷ the growth of VC-financed companies (particularly information technology and life sciences firms) outstripped the growth of the economy as a whole. On average between 1995 and 1999, the VC-backed companies surveyed increased:

• employment by 39 percent annually (60 percent for information technology firms and 47 percent for life sciences firms)
• sales by 31 percent annually (53 percent for information technology firms and 66 percent for life sciences firms)
• exports by 38 percent annually (58 percent for information technology firms and 52 percent for life sciences firms)
• R&D expenditures by 52 percent annually (56 percent for information technology firms and 60 percent for life sciences firms)

A study by the Graduate School of Business at Stanford University¹⁰⁸ found that the presence of VC financing increased the likelihood that a start-up will bring a product to market by 79 percent.¹⁰⁹

In 2002, VC-backed firms in the US: Contributed nearly $1.1 trillion to the US GDP Employed 12.5 million people directly (15 million indirectly), representing 11 percent of US GDP and 11 percent of employment in 2000 Outperformed other companies in terms of sales, taxes paid, exports and investments in R&D (when adjusted for size) Boosted innovation by financing projects that were far too risky for more traditional financial suppliers Played an important role in creating industry clusters, such as medical, health and computer security Source: 2003 NVCA Yearbook, Venture Economics.

3.5 Venture Capital Activity in Canada in 2001 and 2002

3.5.1 Overview

Slower activity level since 2001, but encouraging developments in 2002
Despite the tightening of the investment situation since 2001, the Canadian VC industry showed signs of vigour and enjoyed a stronger-than-expected year in 2002, investing $2.5 billion in 677 firms. While this figure represented a sharp drop from the $3.8 billion invested in 2001 and the $5.8 billion invested in the peak year 2000, it was in line with the level of investment in 1999, $2.7 billion.

Figure 48
Canadian VC Activity, 1998-2002

3.5.2 VC Activity: Deal Size, New versus Follow-On Deals, Investment Stage

Greater concentration in larger transactions in 2002
The concentration of investments in the larger deal category ($5 million and over) could stem from the financial market turmoil in 2001 and 2002. The tighter investment climate discouraged venture professionals from making new investments and compelled them to inject greater amounts of money into established companies, notably in the information technology area.

Share of total VC investments by size of transaction Very small transactions (< $500 000): -2 percent in 2002 ($57 million) -2 percent in 2001 ($66 million) Small transactions ($500 000–$1 million):  – 3 percent in 2002 ($67 million)  – 3 percent in 2001 ($97 million) Mid-sized transactions ($1–$5 million):  – 24 percent in 2002 ($581 million)  – 19 percent in 2001 ($713 million) Large transactions ($5 million and over):  – 71 percent in 2002 ($1.8 billion)  – 77 percent in 2001 ($2.9 billion).

Later-stage investments accounted for most VC investments¹¹⁰
In 2002, venture capitalists concentrated their investments in later-stage transactions, which captured a 58 percent market share ($1.4 billion). Conversely, in 2001 61 percent ($2.3 billion) of total investments went to early-stage transactions. While this was consistent with the 40:60 historical ratio between early-stage and later-stage investments (Figure 49), early-stage firms did manage to secure VC financing, mostly from LSVCCs.

VC investments by stage Early stage share of total VC investments: 42 percent in 2002 ( $1 billion) 61 percent in 2001 ( $2.3 billion) Later-stage share of total VC investments: 58 percent in 2002 (or $1.4 billion) 39 percent in 2001 (or $1.5 billion)

Most investments went to follow-on financing
In 2002, the gap between new and follow-on investment continued to grow. Venture capitalists invested more money in follow-on¹¹¹ transactions, and scaled back investment in firms seeking new financing. This trend may be related to a tightening investment climate, which limits returns potentials, diminishes exit opportunities and forces venture capitalists to support investments in portfolio companies for longer periods, reducing their capacity to free capital for new transactions.

New investments: 26 percent in 2002 ($646 million) 23 percent in 2001 ($860 million) Follow-on invetsments: 74 percent in 2002 ($1.8 billion) 77 percent in 2001 ($2.9 billion)

Figure 49
Investment Trends by Stage of Development, 1996-2002

3.5.3 Type of Investor

Labour-Sponsored Venture Capital Corporations¹¹²
While most Canadian venture capital investors significantly reduced their level of investments in 2002, LSVCCs maintained their investment pace and captured a 25-percent market share (see Figure 50). LSVCCs made 36 percent of their investments in businesses seeking capital for the first time (compared to 26 percent in 2001).

LSVCCs market share 25 percent in 2002 ($627 million) 17 percent in 2001 ($650 million) Foreign investors market share 26 percent in 2002 ($650 million) 29 percent in 2001 ($1.1 billion) Private independent investors market share 13 percent in 2002 ($313 million) 16 percent in 2001 ($602 million)

Foreign investments continued to play an important role
Since 1999, foreign investors, mainly American venture and strategic corporate funds, have increased their investments in the Canadian VC industry. Their primary investment focus has been on information technology and life sciences (see Figure 50).

Foreign Investors' Activity Total investments: $1.1 billion in 2001; $640 million in 2002 Market share: 25 percent in 2001; 26 percent in 2002 Average deal size: $11 million in 2001; $9 million in 2002 Sectoral Distribution of Investments in 2002 information technology sector: $559 million (86 percent) other technologies sectors (including energy and environment): $40 million (6 percent) life sciences: $36 million (about 6 percent) traditional sectors (including manufacturing, retailers, consumer and business services, and consumer products): $15 million (2 percent)

As capital inflows and the investment levels dropped in 2000 and 2001, foreign investors steadily increased their market share, from 19 percent of total investments in 1999, to 25 percent in 2000 and to 29 percent in 2001. In 2002, foreign VC investments reached 26 percent of total VC activity in Canada and negotiated the largest deals.

Figure 50
VC Types: Trends, 1998-2002

Institutional investors were more active despite their limited role¹¹³
In 2002, institutional investors invested $183 million (7 percent of total investment) compared with $289 million in 2001 (8 percent of total investment) and $1 billion in 2000 (or 18 percent). Although pension funds have recently increased new capital inflows, their average market share over the 1996–2002 period rested at 14 percent. However, recent federal budget measures, the new Canadian funds of funds and the recently published performance benchmarks may encourage institutional VC investment.

3.6 Sectoral Activity

Overall trend

Sectoral VC activity trends confirm high technology firms' dependence on VC
The sectoral distribution of VC activity between 1996 and 2002 indicates a strong focus on information technology and life sciences firms, which attracted:

• 89 percent ($2 billion) of total VC investments in 2002
• 91 percent in 2001 ($3.5 billion)
• 87 percent in 2000 ($5 billion)
• 80 percent of total VC investments in 1996–2002

Figure 51
Average Share of VC Investments and VC Financings by Sector, 1996-2002

Information Technology

Information technology continues to dominate VC activity
Despite the burst of the technology bubble, information technology has driven VC investment in recent years. Renewed activity in communications and networking, software and other information technology sectors accounted for much of the rise in capital invested in Canada.

VC activity in the information technology sector Investments: $1.6 billion in 2002 (44 percent of total VC invested) $2.7 billion in 2001 (70 percent of total investments) in 2001 Investments by information technology sub-sector: communications industries: 42 percent in 2002; 38 percent in 2001 software industries: 22 percent in 2002 24 percent in 2001 internet industries: 11 percent in 2002 16 percent in 2001 semiconductors: 15 percent in 2002; 7 percent in 2001

Most information technology investments were in Ontario
Information technology financings came in relatively large deal sizes (nearly
$6 million — more than twice the average in other sectors), and were mostly located in Ontario, which captured an average share of:

• 66 percent of investments ($1 billion) in 2002 (compared with 22 percent for Quebec and 8 percent for British Columbia)
• 68 percent of investments (or $1.8 billion) in 2001 (compared with 20 percent for Quebec and 8 percent for British Columbia)

Figure 52
VC Investment in Information Technology by Region, 2002

Life Sciences

Small increase in VC activity in 2002
Despite a general downturn in VC investments, the life sciences sector saw a slower decline than overall VC investments. Life sciences investment fell 28 percent, compared with 35 percent for overall VC investment. As a result of these trends, the life sciences sector's share of investments increased from 17 percent in 2001 to 19 percent in 2002.

Life sciences VC activity concentrated in Quebec and British Columbia in 2002

• Life sciences investments in Quebec represented 47 percent ($217 million) of total life sciences investment in Canada. This concentration was rooted in several prominent biopharmaceutical company financings in the Greater Montréal region (e.g. Gemin X Biotechnologies and Phytobiotech)
• Life sciences investment in Ontario represented 29 percent ($134 million) of life sciences investments in Canada
• In British Columbia, VC investments in life sciences have declined significantly in recent years, from 31 percent ($204 million) in 2001 to 13 percent ($61 million) in 2002
• The Prairies attracted 7 percent (or $31 million) of total life sciences investment
• Atlantic Canada attracted 4 percent ($20 million) of VC investments in life sciences (double its share of overall VC investments)

VC activity in life sciences sector Investments: $463 million (19 percent of total VC invested) in 2002 $651 million (17 percent of total VC invested) in 2000 Investments by life sciences subsector: biopharmaceutical sector: 62 percent in 2002; 74 percent in 2001 medical devices and equipment: 27 percent in 2002; 8 percent in 2001 medical/biotech software and information services: 9 percent in 2002; 13 percent in 2001

Traditional Sectors

Investments mostly located in Western Canada
Traditional sectors attracted less VC investment with:¹¹⁴

• $278 million, or 11 percent of total VC investments, in 2002
• $336 million, or 9 percent of total VC investments, in 2001
• the number of financings remaining stable between 2001 and 2002 — 223 and 224

Between 1996 and 2002, VC investors in Manitoba and Saskatchewan focussed their investments in traditional sectors. Average provincial traditional sector investment shares for the 1996–2002 period were:

• 68 percent in Manitoba (compared with 20 percent for life sciences and 11 percent for information technology)
• 60 percent in Saskatchewan (compared with 20 percent for life sciences and 7 percent for information technology)
• 39 percent in Atlantic provinces (compared with 3 percent for life sciences and 2 percent for information technology)
• 33 percent in Quebec (compared with 40 percent for life sciences and 21 percent for information technology)
• 17 percent in Ontario (compared with 30 percent for life sciences and 66 percent for information technology)

Figure 53
VC Investment in Life Sciences by Region, 2002

3.7 Regional Activity

This section reviews regional VC activity in 2001 and 2002, and refers to key trends since 1996.VC investment in Canada, in absolute terms, has concentrated in a few technology-intensive regions — Ontario, Quebec and British Columbia. While the regional concentration of VC activity is endemic to the industry, a relative comparison of the regional data suggests two gaps in the distribution of VC activity across Canada: the Prairies, and, to a less er extent, Atlantic Canada. Data also show that in relative terms, Canada's VC activity over 1990–2002 has been comparable to American activity. Canada experienced neither the extreme upswing in 1999–2000 nor the dramatic drop in activity that took place in the US over the last two years. In Canada, VC fundraising has continued, whereas some US VC funds have been returning investment funds to their investors due to the lack of viable investment opportunities and appropriate performance returns over the last 18 months.

Figure 54
VC Investment in Traditional Sectors by Region, 2002

The analysis of the regional distribution of VC activity in Canada needs to take into account both absolute and relative measures. Given that there are no precise measures of the 'optimal' or 'appropriate' amount of VC investment for an economy (or a particular region), most countries have used benchmarks against the US as a proxy. Unfortunately, basing performance on the American experience is not necessarily appropriate in all situations or for all regions. Nonetheless, on a relative basis, the data reveal that Canada's VC activity over 1990–2002 has been similar to the rate of investment in the US, although some of the US market's volatility has been moderated in Canada.

Understanding the regional distribution of overall VC activity in Canada depends on relative measures. In order to be meaningful and useful to policy makers, the current regional distribution of VC must be analyzed using the most appropriate benchmarks. The most frequently used benchmarks are population, economic activity (GDP) and/or the number of KBI firms in the region. Since VC funding is generally directed towards KBI firms, it is appropriate to use the number of KBI firms by region as a major benchmark. However, this is not a perfect measure. This review will present several perspectives across Canada to make a comparative analysis of the regional distribution of VC investment.

Overall Trend

Strong growth in VC activities in all regions
In terms of dollars invested, VC activity in Canada since 1996 has been concentrated in Ontario, Quebec and British Columbia. In these provinces, market patterns seem very similar. For example, a dedicated technology-oriented focus (information technology and life sciences sectors), particularly in industry clusters centred on Ottawa, Montréal and Vancouver.

While there are some indications that venture capitalists are now more specialized and thus increasingly open to investing in opportunities wherever they are located, VC has historically had a strong local component, mostly because of the management role usually played by venture capitalists. The fading importance of local restrictions can be seen in the increasing level of foreign investment in Canada (and the increasing level of investment by Canadian VC investment abroad) and the growing number of VC funds that invest in all regions.

The type of business that attract VC funding also contributes to the concentration of investment in a few regions. As noted previously, VC is only appropriate for, and used by, a very small number of firms (677 in 2002), which are usually concentrated in the knowledge-based industries. Most often, investment opportunities are found in the technology sectors, which are generally concentrated in specific metropolitan regions such as:

• Ottawa (information technology focus)
• Montréal (life sciences focus)
• Vancouver (life sciences focus)
• Toronto (information technology focus)

Figure 55 illustrates the distribution of VC activities in Canada by region, compared to regional distribution of economic activity and KBI firms. While Ontario received 51 percent of VC investment over the 1996–2001 period, 45 percent of Canada's KBI firms were located in that province. The figure shows that Ontario and Quebec have attracted VC investment in excess of their share of the GDP or KBI firms. This may reflect the achievement of a critical mass of several technology clusters in these provinces. In contrast, VC investment in the Prairies and Atlantic Canada has been lower than these regions' share of economic activity or KBI firms.

In Ontario:

• Ottawa (technology cluster), with only 9 percent of Ontario's population, attracted 56 percent of total VC invested in Ontario-based firms in 2001 and 2002, due to the high concentration of technology firms

In Quebec:

• VC investments in Montréal captured 69 percent of Quebec's VC investment in 2001 and 73 percent in 2002

In British Columbia:

• VC investment to the Vancouver area represented 93 percent of provincial VC investment, and 90 percent in 2002

Figure 55
Regional Distribution of VC Investment, KBI Firms and GDP in Canada, 2002

Investment Gap Observed in the Prairies and Atlantic Canada

Investment gap in the Prairies
On an absolute basis, VC investments in the Prairies increased by 93 percent, from $82 million in 1996 to $159 million in 2002 (with a peak at $309 million in 2000). However, relative to other regions, the 93-percent growth of VC investments in the Prairies has remained below the national average investment growth of 139 percent. The average share of total VC activity in the Prairies (7 percent over 1996–2002, 4 percent in 2001 and 6 percent in 2002) was much lower than its share of KBI firms (19 percent) and GDP (19 percent) in 2001. The average deal size in the Prairies from 1996 to 2002 was lower than the national average, at $578 000 (compared with $2.7 million in Canada over the same period).

As described in greater detail in the next section, compared with other provinces and regions, the Prairies have attracted a low share of information technology (3 percent) and life sciences (6 percent) VC investments since 1996. Over the same period, traditional sectors accounted for 24 percent of total VC investment in Canada. This sectoral distribution and the absence of a critical mass of high technology firms in the Prairies may explain this region's difficulties in attracting VC. However, a recent study on the link between VC and the creation of technology clusters¹¹⁵ concluded that it is not axiomatic that technology clusters can only flourish where ample risk capital is available. The early years of Ottawa's developing technology cluster, for example, showed remarkable growth without the benefit of VC. One positive observation is that the number of VC funds in all three provinces has increased considerably since 1996:

• Alberta — 19 funds in 2002, compared with 5 in 1996 (increase of 263 percent)
• Manitoba — 7 funds in 2002, compared with 3 in 1996 (increase of 43 percent)
• Saskatchewan — 12 funds in 2002, compared with 7 in 1996 (increase of 58 percent)

Investment gap in Atlantic Canada
Annual VC investments in Atlantic Canada increased by 33 percent over the 1996–2002 period, but remained below the national average growth of 139 percent. The number of active funds increased at a faster rate in Atlantic Canada (120 percent) than in Canada overall (117 percent). Over that period, provinces in Atlantic Canada attracted an average of 2 percent of total VC investments in Canada. While this was lower than the region's share of Canada's GDP (6 percent in 2001), it was in line with its share of KBI firms (3 percent in 2001).

Ontario

Most VC activity concentrated in Ontario
As mentioned earlier, information technology has attracted the highest share of VC investment in Canada. Consequently, although VC activity declined significantly after peaking in 2000, VC investments in Ontario (particularly in Ottawa) continued to perform well and to lead other regions investments in 2001 and 2002.

VC activity in Ontario Ontario's share of total investments: 52 percent in 2002 ($1.3 billion) 55 percent in 2001 ($2.1 billion) Ottawa's share of provincial VC investments: 57 percent in 2002 ($735 million) 55 percent in 2001 ($1.2 billion) strong focus on information technology sectors, which attracted most foreign VC in the past two years Large deals captured: 60 percent of total deals in 2002; 62 percent in 2001 59 percent (on average) over 1996–2002

Ottawa cluster
Ottawa-based firms have played a major role in the development of the VC industry in Canada since 1996. Between 1996 and 2002, investment in the Ottawa region accounted for 38 percent of the total amount of VC invested in Ontario-based firms, and this investment was the engine behind Ontario's strong performance over the past several years. Between 1996 and 2002, VC investment in Ottawa increased 1063 percent, from $63 million to $735 million. The number of deals grew by 71 percent between 1996 and 2002, from 38 to 65. The average deal size in Ottawa ($7 million) over the 1996–2002 period was also largely responsible for the growth of the average deal size in Canada ($2.7 million in 2002) over the same period.

Figure 56
Ontario VC Investment in Information Technology, 1996-2002

Information technology industries drove VC investments in Ontario
Despite a steep decline in overall investment and VC activity in 2001 and 2002, the proportion of VC investment activity (in dollar value) in Ontario generated by the information technology sector continued to increase. Concurrently, the life sciences sector's importance in Ontario has faded in recent years.

Ontario information technology sector Share of total Ontario VC investments:  – 81 percent in 2002  – 87 percent in 2001 Share of total information technology VC investments in Canada:  – 66 percent in 2002 ($1 billion)  – 68 percent in 2001 ($1.8 billion)  – 66 percent over 1996–2002 Ontario life sciences sector Share of total Ontario VC investments:  – 10 percent in 2002 ($134 million)  – 8 percent in 2001 ($158 million)  – 10 percent over 1996–2002 Share of total life sciences VC investments in Canada:  – 29 percent in 2002 ($462 million)  – 24 percent in 2001 ($158 million)  – 30 percent over 1996–2002

This decline of life sciences investment in Ontario occurred despite a revival in life sciences investment in 2001 and 2002 across North America, and despite significant increases in public and private investment in life science, health care and research in Ontario. However, it appears that the life sciences sector in Ontario has suffered from the increasing focus on information technology and perhaps from a shift of life sciences investments towards Quebec and British Columbia.

Figure 57
Ontario VC Investment in Life Sciences, 1996-2002

Figures 56 and 57 confirm the increasing investor focus on the information technology sector and away from the life sciences sector in Ontario. Relative to other provinces, Ontario's share of information technology venture capital investment has increased steadily since 1998, while investments in life sciences have decreased steadily. The concentration of foreign information technology VC in Ontario has also increased, from 28 percent of the total amount invested in Canada in 1997 to 86 percent in 2002. This concentration in Ontario could be linked to a number of factors,¹¹⁶ including the strong presence of high technology firms in Ontario, a high concentration of investee firms, networks and other venture capitalists in Ontario and increased regular flights to the area. These factors help decrease search, information and transaction costs, which results in increased rates of return on investment for foreign venture capitalists and their investors.

The majority of foreign investments are in Ontario
With VC investments declining in 2001 and 2002, foreign investors' share of total investments in Ontario rose to:

• 42 percent in 2002 (compared with the national level of 26 percent)
• 38 percent in 2001 (compared with 29 percent)

It should be noted that the increases in disbursement dollars and market share were not limited to Ontario; overall, foreign investors increased their market share from 3 percent of Canadian VC investment in 1996 to 26 percent in 2002.

Quebec

VC activity in Quebec declined in 2001 and 2002. While more capital was disbursed to Ontario firms, Quebec had the highest number of transactions (404) — primarily small and mid-sized deals. Between 1996 and 2002, Quebec averaged 48 percent of the total number of financings in Canada, and the number of VC deals increased by 50 percent — from 269 transactions in 1996 to 404 in 2002. Figure 58 illustrates Quebec's increasing share of small and mid-sized transactions, from 44 percent and 32 percent of Canadian totals in 1996 to 50 percent and 48 percent of transactions in 2002. LSVCCs' tendency to finance smaller deals contributed to this trend: of the 1208 Quebec LSVCC financings over 1996–2002, 1087 (or 90 percent) were mid-sized or smaller deals.

Montréal Cluster
Investment in Montréal has played a critical role in the vitality of Quebec's VC activity in recent years. Investment in Montréal increased by 124 percent, from $236 million in 1996 to $530 million in 2002 (peaking at $1.1 billion in 2000). The average deal size in Montréal over the period was $2 million — slightly higher than that in Quebec ($1.6 million) but lower than the national average of $2.7 million.

Firms in Quebec attracted less foreign VC
Foreign investment fell at a faster rate in Quebec than in Canada overall. Amounts invested by foreign venture capitalists in Quebec:

• Fell from $93 million in 2001 to $49 million in 2002, a reduction of 47 percent, compared with a 40-percent decrease in Canada overall.
• Represented only 7.5 percent of total amounts invested in 2002, compared with 8.5 percent in 2001. Foreign investment accounted for 26 percent of total investments in Canada overall in 2002.

Figure 58
Venture Capital Investment in Quebec, 1996-2002

A number of structural factors may explain why foreign VC investors have demonstrated less interest in Quebec firms:

• Foreign investors seem to be mostly interested in information technology industries, particularly communication and networking sectors, which tend to be concentrated in the Ottawa Valley, while Quebec has been developing a stronger focus on life sciences
• Compared with other provinces, Quebec's VC deals tend to be smaller and more numerous. Given the affinity of most of US VC funds for large information technology financings and the average deal size ($1.8 million in 2002 compared with $6 million in Ontario) and sectoral distribution in Quebec, it is not surprising that foreign venture capitalists tend to invest in Ontario
• The Quebec government's active role in the VC market, particularly the participation of public institutional players, which are usually more active in the seed and start-up phases, may have replaced or crowded-out private sector VC players. Private sector investors may have not been able to invest at later stages, given the large capital requirements of such transactions
• Quebec has a number of significant players, such as the Solidarity Funds, whose social missions may limit their capacity to partner with US private players, particularly at the expansion stage

Evidently, more information on foreign VC investors' characteristics and investment criteria would help to clarify why foreign investors have shown less interest in Quebec.

British Columbia

VC activity in British Columbia declined by 51 percent (compared with 35 percent in Canada), from $514 million in 2001 to $251 million in 2002.

VC investments in British Columbia focussed on information technology and life sciences
Information technology attracted the greatest share of British Columbia's VC investments in 2002, despite a 39-percent decrease in dollars invested (from 2001 levels). Capital invested in life sciences firms fell 70 percent between 2001 and 2002. This significant drop is probably linked to the fact that in 2001, two biopharmaceutical companies (Xenox Genetics Inc. and Cellfor Inc.) secured exceptionally large financings (with a relatively small number of investments, such transactions can affect regional numbers considerably). Nonetheless, the overall distribution of Canadian life sciences VC investments between 1996 and 2002 showed that British Columbia averaged 22 percent of Canada's life sciences investments, third behind Quebec (40 percent) and Ontario (30 percent).

VC activity in British Columbia Share of total VC activity:  – 10 percent in 2002 ($251 million) -14 percent in 2001 ($514 million) Share of total deals:  – 10 percent in 2002 (80 deals)  – 11 percent in 2001 (110 deals) Average deal size declined from:  – $3.1 million in 2002 ($3 million for Canada)  – $4.7 million in 2001 Vancouver continued to dominate the province's VC activity, capturing:  – 90 percent ($226 million) of the province's investments in 2002  – 87 percent in 2001 ($477 million) Information technology led in 2002 with a 51-percent investment share ($128 million), followed by life sciences, with 24 percent ($61 million), and other technologies, with 10 percent ($47 million)

The proportion of Canadian life sciences and information technology VC investment in British Columbia remained stable between 1996 and 2002. Figure 59 depicts changes in the provincial distribution of total life sciences, information technology and foreign investment. Although British Columbia's foreign investment share decreased from 61 percent in 1997 to 11 percent in 2002, the major reason for this change was Ontario's explosion of foreign information technology investment.

Figure 59
VC Investment in British Columbia, 1996-2002

Prairies¹¹⁷

Increase in VC investments
Unlike the other regions in Canada, VC investments in the Prairies recovered to $159 million in 2002 after a decrease to $146 million in 2001. Investors concluded fewer transactions, but negotiated larger financings. This was reflected in the modest increase in average deal size in 2002.

VC activity in the Prairies Prairies' share of total VC activity: -6 percent in 2002 ($159 million) -4 percent in 2001 ($146 million) Average deal size: -$1.8 million in 2002  – $1.4 million in 2001 Number of deals: -88 in 2002 -101 in 2001

Traditional sectors led VC investments in the Prairies
Investors' strong focus on traditional sectors in the Prairies (particularly in Manitoba and Saskatchewan) may account for the region's lower level of VC investment. However, a recent study on the link between VC and the creation of technology clusters concluded that it is not axiomatic that technology clusters can only flourish where ample risk capital is available.¹¹⁸ The early years of Ottawa's developing technology cluster, for example, showed remarkable growth without the benefit of VC.

VC investments in traditional sectors: 20 percent in 2002 ($57 million) 10 percent in 2001 ($36 million) 46 percent of the region's average VC investments over 1996–2002 (against 24 percent for Canada) VC investments in information technology: 3 percent in 2002 ($54 million) 3 percent in 2001 ($77 million) 20 percent over 1996–2002 VC investments in life sciences: 7 percent in 2002 ($31 million) 4 percent in 2001 ($28 million) 22 percent over 1996–2002

A concentration on non-technology sectors may explain this region's inability to attract a large portion of VC investment in past years; venture capitalists prefer to invest in innovative high-growth-potential firms in high technology sectors. Other possible reasons include the absence of a tax credit for LSVCCs in Alberta and the absence of a critical mass of potential VC opportunities. These issues merit further investigation to determine why the Prairies' share of VC activity is disproportionately low compared to its share of KBI firms and GDP.

Figure 60 shows that until 2001, overall and foreign VC investments in the Prairies had been decreasing, along with VC investments in traditional sectors. While overall and foreign VC investment levels have risen since 2001, traditional sector VC investment has increased at a much greater rate. In 2002, LSVCCs provided 40 percent of traditional VC in Canada, whereas they provided only 20 percent of traditional VC in the Prairies. Government, private independent and "other sources" investors financed a sizable amount (60 percent) of traditional investments in this region.

Figure 60
VC Investment in the Prairies, 1996-2002

Atlantic

The Atlantic region's average share of total VC investments remained low in 2002, at 2 percent. The slowdown in investments across Canada, however, was less dramatic in this region. VC investment fell 10 percent between 2001 and 2002 in the Atlantic region, compared with 35 percent in Canada.

Life sciences attracted the highest proportion of VC investments in 2002, notably through a large medical devices and equipment deal.

VC activity in Atlantic Canada Share of total VC investments:  – 2 percent in 2002 ($44 million)  – 1 percent in 2001 ($49 million)  – 2 percent over 1996–2002 Deal size: -$2.2 million in 2002  – $1.7 million in 2001 Number of deals:  – 20 deals in 2002  – 28 deals in 2001 Investments in life sciences attracted 62 percent ($27 million) of VC investments in 2002, followed by information technology with 34 percent ($15 million) and traditional sectors with 2 percent (close to $2 million)

Foreign investors have tended to avoid VC investment in the Atlantic provinces. Over the 1996–2002 period, foreign VC investment in the Atlantic provinces represented less than 0.15 percent of total foreign venture capital in Canada.

Trends 1996–2002
Notwithstanding the lower levels of VC investment compared with other regions:

• VC investments increased 33 percent over the 1996–2002 period, from $33 million to $44 million;
• Number of VC deals declined by 13 percent, from 23 in 1996 to 20 in 2002;
• The average deal size for the Atlantic region, while lower than the national average, increased by 52 percent, from $1.4 million in 1996 to $2.2 million in 2002, with an average deal size of $1.7 million over the period; and
• Number of VC funds increased from 5 in 1996 to 11 in 2002.

3.8 First performance returns data published by CVCA in 2003

As noted earlier, there is a direct relationship between VC investments and investment performance.¹¹⁹ Periods of strong performance returns have led to increased fundraising activities, which in turn have preceded alarming downturns in returns. Before March 2003, there were no performance data available in Canada (in the US this information has been available since the early 1990s). As a result, it is impossible to draw historical links between the growth of performance returns and VC activity in Canada. However, it is likely that the lack of performance data in Canada has had a negative impact on the past growth of the Canadian VC industry, as investors have had no solid information upon which to base their investment decisions. To address this discrepancy, the CVCA, in collaboration with Macdonald & Associates Limited, Réseau Capital and Industry Canada, has recently published the first Canadian performance data on VC and private equity funds, up to the end of 2001.

According to the first Canadian performance returns database (see Table 26), the Canadian VC industry has offered three year returns of 15 percent and five-year returns of 13 percent. This database will allow investors to monitor and evaluate the performance of VC investments, which should increase the flow of capital to VC funds and, downstream, to innovative small and emerging businesses.

Table 26 — Performance of VC and Private Equity Funds in Canada, as of December 31, 2001

	1 Year	3 Years	5 Years
Early-stage VC	-7.2	22.5	17.5
Balanced VC	–12.2	14.3	12.8
All VC	–10.7	15.7	13.3
Buyout and mezzanine	10.6	9.2	15.7
All VC and private equity	–7.9	14.6	13.7

Sources: Canadian Venture Capital Association and Macdonald & Associates Limited, 2003.

3.9 Canada–US comparison¹²⁰

Contrary to the general perception, the Canadian VC market has performed relatively well compared to the US and to other OECD countries. One available measure to compare the relative performance of the Canadian and VC industries involves VC investments and venture capital under management as percentages of GDP. The data reveal that throughout the 1990s, the relative size of the Canadian VC market was similar to the American market.

Figure 61
VC Investments as a Percentage of GDP in the US and Canada, 1996-2002

After the American VC market explosion in 1999 and its collapse in 2001, the gap between the two North American markets narrowed (Figure 61). In fact, most of the negative perception about the Canadian VC market was formed during the 1999–2000 bubble, which was an anomaly for the US market.

The more stable performance of the Canadian VC industry (and the significant decline in the US), has narrowed the gap between Canadian VC investments as a percentage of US investments. In 2002, the value of Canadian VC investments was 8 percent of the value of US VC investments (adjusted to take into account the exchange rate). This proportion was much higher than the 3 percent, 4 percent and 6 percent observed in 1999, 2000 and 2001. The percentage for 2002 was consistent with the relative size of the two economies (Canadian GDP stood at 7 percent of US GDP in 2002) and represents roughly Canada's share of the North American market.

However, gaps between Canada and the US remain:

• Total capital under management (Figure 62), remains relatively smaller in Canada. The American market, which benefited earlier from the technology bubble, is larger, more sophisticated and more mature
• The low levels of institutional investment
• Canada has been more dependent on foreign investment, which tends to be volatile during periods of instability

Canada Total VC investments: $2.5 billion in 2002 $3.8 billion in 2001 $5.8 billion in 2000 US Total VC investments: C$32 billion in 2002 C$61 billion in 2001 C$159 billion in 2000

Figure 62
VC Under Management as a % of GDP in Canada, 1996-2002

Canadian VC investments were more stable than US investments in 2001 and 2002
While Canadian VC investments declined by 35 percent between 2001and 2002, VC investment levels in the US fell by nearly 50 percent over the same period. As a result, investment levels in the US in 2002 were comparable to those last seen in the pre-bubble year of 1998, when $21.6 billion (C$32.4 billion) was disbursed.

Important regional concentration of VC activity observed in the US
The regional concentration of VC investment is not unique to Canada. In fact, American VC activities are highly concentrated in Silicon Valley (California) and, to a lesser extent, the Boston area (Massachusetts). Over the last two decades, California and Massachusetts were the top two states in VC investments in high technology sectors, including information and communications technology and life sciences. More recently, as VC firms in California, New York and Massachusetts have diversified their investments, American venture capital has started to spread to Colorado, Maryland and North Carolina.

VC investments by state California: $14.2 billion in 2002 (45 percent) $24.7 billion in 2001 (41 percent) Massachusetts: $3.6 billion in 2002 (11 percent) $7.3 billion in 2001 (11 percent) Texas: $2 billion in 2002 (6 percent). $5 billion in 2001 (8 percent)

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100. National Venture Capital Association.

101. Ibid.

102. Paul Gompers, July 2001. A Note on the Venture Capital Industry., Harvard Business School.

103. According to Statistics Canada's Study of Growth SMEs in 1996, only 5 percent of growing SMEs (about 0.04 percent of all SMEs in Canada) would be considered potential investment targets by venture capitalists.

104. Université du Québec à Trois-Rivières, Financing Small and Medium-Sized Entreprises: Satisfaction, Access, Knowledge and Needs, 2002 (http://strategis.gc.ca/fdi).

105. Paul Gompers, Ownership and control in entrepreneurial firms: an examination of convertible securities in venture capital investments. Harvard Business School Working Paper, 1997.

106. In one of their most recent studies (On the Fundamental Role of Venture Capital, 2002, Graduate School of Business at Stanford University), Hellman, Thomas, Puri and Manju found that VC is associated with higher degrees of professionalization (e.g. introduction of stock option plan, recruitment of professional staff through professional channels, appointment of vice president of marketing and sales, etc.), value-added services and assistance to companies to become established in the marketplace.

107. Business Development Bank of Canada, Economic Impact of Venture Capital in 2000, 2001.

108. Thomas Hellman, Manju Puri, Graduate School of Business at Stanford University, 2002. On the Fundamental Role of Venture Capital.

109. Based on the Stanford Project on Emerging Companies (SPEC) — an interdisciplinary research project that analyzed 170 technology start-up firms.

110. Stage of investment refers to critical points on the growth continuum for firms assisted by venture capital and other types of private equity. Typically, a venture-backed company receives cumulative rounds of financing to facilitate its progression from one stage of development to the next. See Glossary for a more complete definition.

111. Typically, venture-backed firms go through several rounds of financing. The original round of financing, or "new" financing, is often followed by further follow-on financing as the company grows and develops.

112. The Labour-sponsored venture capital corporations are a mixture of large and small VC funds sponsored by labour unions and capitalized by a large number of individual shareholders who receive tax incentives in exchange for committing their capital for long periods, usually over eight years.

113. Through the late 1980s and the first half of the 1990s, pension funds were generally unwilling to consider VC investments as part of their portfolio. However, beginning in 1999, large public sector pension plans revised their strategies to include direct VC investment in Canadian SMEs as part of their overall investment activities. As a result, a few very large Canadian public sector pension fund organizations now lead the VC industry as sources of new VC investments. The positive impact of tax measures introduced in the recent federal budgets, the emergence of Canadian funds of funds (e.g. TD Capital, EdgeStone Capital and BDC) and the recent publication of performance returns benchmarks should all help to encourage the long-term position of institutional investors in the VC industry.

114. Traditional sectors include consumer and business services, consumer products, manufacturing, retailers and miscellaneous.

115. Colin Mason et al., Hunter Centre for Entrepreneurship in the UK. The Role of Venture Capital in the Development of High Technology Clusters: The Case of Ottawa, 2002.

116. Foreign VC Investment in Canada: A Profile of Foreign Investors and Domestic Investees (Forthcoming).

117. While detailed analyses of each province and territory would be of wider utility, data for some provinces and territories are not sufficient to provide a significant comparison and analysis. The small amount of VC investment in any given year in provinces such as Manitoba and Saskatchewan make it difficult to conclude which factors may contribute to any observed growth or decline, as a few large deals in one sector can significantly change the overall distribution of the investment. As a result, the Prairies and Atlantic provinces are being analyzed and compared on an aggregate basis in this report.

118. Colin Mason et al., Hunter Centre for Entrepreneurship in the UK. The Role of Venture Capital in the Development of High Technology Clusters: The Case of Ottawa, 2002.

119. Paul A. Gompers, Harvard Business School. A Note on the Venture Capital Industry, 2001.

120. For the purpose of this report, an average exchange rate of 1.5 percent has been calculated for 1996–2002 based on United Nations Department of Statistics (www.unstats.un.org/unsd/cdb/sdb_simple_data_extract.asp).