Canadian Venture Capital Activity: An Analysis of Trends and Gaps (1996–2002)

Executive Summary

Context

The 21st century presents a unique occasion for Canada to seize opportunities for growth and success in the global knowledge-based economy. Canada is well placed to lead the new economy — with a highly skilled work force, strong research and development (R&D) infrastructure and high levels of connectivity and entrepreneurship. However, Canada faces considerable challenges, including knowledge transfer and the commercialization of research and new innovative technologies and products.

In that context, policy-makers in a number of countries have become increasingly concerned with the financing of high-growth-potential small businesses, particularly risk capital financing. This interest has not been without substance — these firms are at the vanguard of economic growth, productivity and innovation; they encourage the development and commercialization of new technologies, particularly from universities and government labs.

Venture capital (VC), which is only one element of the risk capital spectrum, is crucial to bringing innovation to market, particularly for the knowledge and skills venture capitalists bring to their investee firms. From that perspective, the federal government must ensure that the Canadian VC market is efficient and meets the needs of Canadian high-growth-potential small and medium-sized enterprises (SMEs). Therefore, policy-makers in Canada must address perceived and real gaps or weaknesses in the VC market through appropriate actions that target the relevant players in the VC industry. These include: suppliers of capital (e.g. individual, institutions, corporations, governments, etc.), investors e.g. private independent funds, labour-sponsored venture capital corporations (LSVCCs), governments and others], entrepreneurs, universities, governments and others.

In this context, this analysis aims to build a common understanding of the Canadian VC market, and foster private and public stakeholder coordination and collaboration to develop sound policies that will address key outstanding issues and gaps in the market.

Goal

The specific goal of this report is to provide a realistic assessment of the state of the Canadian VC market through a review of the following questions:

1. What is the state of VC activity in Canada? What key trends, strengths and weaknesses characterize the VC industry?
2. What is the state of government action — federal and provincial — with respect to VC?
3. Where are the gaps or outstanding issues related to the VC market (e.g. structure, supply and demand)? How do bottlenecks in the VC industry dampen the development, innovation and growth of Canadian SMEs?
4. How can the policy environment ensure the continued growth of the Canadian VC industry and encourage the development of Canadian SMEs from small to medium-sized businesses? How can this environment improve Canada's innovation performance, create jobs and wealth, and encourage these firms to remain Canadian?

Summary of report and key findings

To ensure common understanding and a coherent approach to VC, the report begins with a detailed explanation of the nature and function of VC financing; the characteristics of the firms usually funded by VC; the financing context for VC; and the importance and impacts of VC financing on Canadian firms and on the economy. This analysis reveals that, while VC financing is crucial to the innovation system, it is only one financing option for Canadian SMEs — an option that only fits a small number of very high-growth-potential companies. In Canada, there were 677 firms funded by VC in 2002 (over more than 1.8 million SMEs), compared to 2495 firms in the United States (over more than 16 million SMEs). In general, the literature suggests that less than 1 percent of business proposals reviewed by venture capitalists will get funded. In fact, as a general rule, venture capitalists only invest in firms that show: a high commitment from the owner (who has invested his/her own money); a strong and experienced management team; high returns potentials (in the range of 30-40 percent annual returns over a five-year period; a willingness to share ownership (providing about 30 percent of ownership holdings to initial and subsequent venture capitalists); and a strong R&D, technological and international orientation (see Part I).

Within the context of the nature and importance of VC financing, Part II presents a detailed review of the Canadian VC market's evolution and key investment trends over the 1996–2002 period, with a specific focus on investment trends by size of deals, stage of development, sector, region, and investor type. This review leads to an analysis and discussion of key strengths, weaknesses and policy issues related to the Canadian VC market (see Appendix H for a complete summary of findings).

Overall, and contrary to general perceptions, this analysis shows that the Canadian VC industry has been relatively dynamic and has experienced solid growth since 1996, with increases of:

• 88 percent of new capital raised (to reach $3.2 billion in 2002);
• 117 percent of number of VC funds (for a total of 282 in 2002);
• 217 percent of total capital under management (total of $22.5 billion in 2002); and
• 139 percent of total amount invested (to reach $2.5 billion in 2002).

The key drivers of this growth were the emergence of information technology firms (increase of 1063 percent of investments over the 1996–2002 period) and the increased participation of foreign investors in the Canadian market (increase of 2021 percent over the same period).

Moreover, while the analysis recognizes that the Canadian VC industry has not experienced the astounding growth observed in the U.S. in 1999 and 2000, over the 1990–2002 period, the performance of both markets in terms of VC investments as percentage of gross domestic product (GDP) is comparable, and the Canadian VC market has been relatively less volatile over the 12-year period. Furthermore, the Canadian VC market ranks among leading Organisation for Economic Co-operation and Development countries in terms of VC investments as a percentage of GDP.

However, despite this solid growth and the increasing size and specialization of Canadian VC funds, this analysis reveals a relatively "infant" VC industry (by U.S. standards) that faces a number of specific challenges that can be summarized by four interrelated and mutually reinforcing issues:

• Shortage of investor-ready firms, particularly in terms of the management and marketing skills required to lead to rapid growth, drive high returns, and attract new sources of capital and VC investment.
• Size and experience gap (compared to the U.S.) in terms of: 1) capital under management by the Canadian VC industry; 2) size of Canadian VC funds; 3) average financing size; and 4) experience and expertise of Canadian VC funds. Indeed, improving the skills and expertise of Canadian VC funds would likely result in better investment decisions and higher returns, and lead to increased fundraising and investments.
• Low participation of institutional investors, and the related lack of funding and participation of Canadian private independent funds, restricts the size of the Canadian VC market, and, thus, limits its ability to fund firms that require large capital injections for continued growth and expansion.
• Lower returns of Canadian VC funds, compared to the U.S., and the need to improve awareness and confidence about the performance of the Canadian VC market. This issue, likely linked to the shortage of a critical mass of quality investment opportunities, represents a significant barrier to the participation of domestic and foreign investors, particularly institutional investors. Lower returns potentially reduce the level of fundraising activity and the size of Canadian VC funds, which limits the VC industry's ability to provide adequate funding to high-growth-potential firms.

To complement this analysis of VC investment trends, the third part of the report examines the state of government actions related to VC. Part III shows that the provincial and federal governments have recently made significant progress in addressing some of these issues and improving SMEs' access to risk capital through: indirect initiatives aimed at supporting and encouraging suppliers of capital; direct quasi-equity and equity investment programs designed to increase the amounts invested in Canadian SMEs; and other programs targeted at supporting demand for VC through assistance and services to Canadian entrepreneurs. While most of these programs have likely helped the Canadian VC industry's development, governments' potential contributions pale in comparison to the private sector's potential. Nonetheless, several government interventions have had a significant impact on the VC industry in Canada:

• Provincial and federal tax credits for LSVCCs — through government tax incentives to individuals, LSVCCs have become the most active fundraisers and investors in the Canadian VC market, with an average of 46 percent of total new capital raised and 27 percent of total VC investments between 1996 and 2002 (see Part II and Part III).
• Continued improvements to the Canadian tax system, particularly in federal budgets 2000, 2001 and 2003 (see Appendix E).
• Continued investments in the Business Development Bank of Canada (BDC) for the creation of specialized and seed VC funds and direct VC investments (and other financing instruments) in early-stage and knowledge-based industry firms ($190 million in Budget 2002). As a result, the BDC subordinate financing and venture capital groups accounted for 29 percent (or $107 million) of total quasi-equity investment in Canadian SMEs in 2002 and 4 percent ($89 million) of total VC investments in Canada in 2002 (see Section 3).
• Other programs and services offered through Industry Portfolio agencies and organizations and provincial organizations that have played a significant role in R&D and the commercialization of new products, particularly the R&D grants and quasi-equity financing programs offered through the Natural Sciences and Engineering Research Council of Canada, the National Research Council Canada, Genome Canada and Technology Partnerships Canada (see Part III).

While these programs confirm that the Canadian government has played a significant role in broadening Canadian firms' access to VC, the level of government involvement is lower than is commonly believed. In total, investments made by provincial and federal government-owned funds accounted for an average of 7 percent of total VC investments between 1996–2002 period (and 13 percent in 2002). In comparison, the U.S. government has adopted a number of policies and programs, such as changes to the Employee Retirement Income Security Act "prudent man" rule and the Small Business Investment Companies (SBIC) program. Indeed, the SBIC program played a major role in the expansion of the U.S. market — accounting for 8 percent of total VC investments over the 1994–2002 period. However, as explained above and in Part III, the major difference between the U.S. and Canada relates to LSVCC tax credits.

While government has played (and continues to play) an important role in the development and support of the Canadian VC market, the nature of the challenges facing the Canadian VC industry do not call for significant public sector intervention. In fact, it may not be desirable or appropriate for government to have a growing presence in the direct investment market. Indeed, the analysis shows that in the growth of the U.S. VC industry can be largely attributed to the heavy participation of pension funds (rather than to government investments), and that government interventions may not be efficient or desirable from the long-term perspective of developing a strong and efficient private sector VC industry. However, while these challenges cannot be met by government or any other group alone, they will need to be addressed collaboratively with the VC industry, institutional and other investors, and the educational and research communities.

Conclusion

Given this analysis, and consistent with the government's role as catalyst, this report concludes with a number of key policy questions (see Part IV) to stimulate discussion among key private and public sector stakeholders and to develop a coordinated and collaborative approach to address outstanding issues. As an ultimate outcome, it is hoped that this analysis will clarify how the policy environment can ensure the continued growth of the Canadian VC industry and encourage the development and expansion of Canadian SMEs from small to medium-sized businesses — essential components of Canada's 21st-century economy.