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

Introduction

Background

The financing of high-growth-potential small businesses has become an issue of great public policy interest in Canada and abroad. This interest has not been without substance — these firms are at the vanguard of economic growth, productivity and innovation. These enterprises encourage the development and commercialization of new technologies, particularly from universities and government labs. Homegrown small businesses can rapidly become leading economic actors and can play a key role in driving regional economic development and technological innovation. Research in Motion, Sierra Wireless, Ballard Power Systems and Newbridge Networks are just a few examples of Canadian start-up companies that have made a rapid transition from small-scale regional operations to major international players, and exerted a major influence on the economic landscape in their communities.

Ontario provincial government research¹ indicates that high-growth firms have had a disproportionate and positive impact on that province's economy. Increasingly, evidence suggests that the long-term performance of an economy is directly related to the level of development of its financial system. Specifically, studies point to a direct relationship between economic growth and the ready availability of innovation financing.^{2, 3, 4} By facilitating the development of new and innovative businesses, access to risk capital helps to promote new technologies, stimulate economic growth and create jobs.

Recent surveys point to the unique financing challenges faced by knowledge-based industry (KBI) companies and other high-growth-potential firms. These firms report that the inability to secure timely and appropriate financing is among their major impediments to growth. Most high-growth-potential firms operate in knowledge-based industries, and their financing challenges are both significant and different from those of the majority of small and medium-sized enterprises (SMEs).

Traditional models of financing include borrowing against collateral assets — debt that is usually inflexible, hard-asset-based and requires prompt repayment. Since high-growth-potential firms tend not to rely on tangible assets, they must look to other financing options. Furthermore, because properly financed high-growth-potential KBI firms often require extended periods of research, development and commercialization, they depend on more patient forms of capital than other types of businesses. These companies are subject to significant risks with respect to market acceptance of their products, the inherent uncertainty surrounding new technologies and products, and the long incubation period required for returns on investments. All of these factors push against the use of debt as an appropriate financing instrument for high-growth-potential and high technology companies.⁵

The potential significance of these firms and the financing challenges they face lead to a number of policy questions:

• What policies will ensure the continued development and vitality of these firms in all regions and sectors?
• What legislative, regulatory or institutional changes can the government make to encourage a climate where risk capital and SME financing will continue to flourish?

Several Industry Portfolio organizations, along with other federal and provincial departments and agencies, are examining these questions from a variety of perspectives.

Risk capital is not limited to venture capital (VC) — love money, angel investment, mezzanine investment and other forms of private equity are also components of the risk capital market, and can play an important role in the development of firms. However, differences in the markets, policy issues and available information on these various forms of financing make a combined analysis of the risk capital industry unwieldy. Other projects are underway to assess the nature and function of these markets in Canada, and to judge whether the current public policy infrastructure encourages their continued vitality and expansion.^{6, 7}

This work examines one element of the risk capital spectrum — VC — within the context of the Government of Canada's Innovation Agenda. To ensure a common understanding of and a coherent approach to these issues, this paper will focus on four general research 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?

Goal

This report provides a realistic assessment of the state of VC in Canada, its current role and its potential impacts on Canada's economic policy goals. The emphasis on "realistic" is important, because VC is not a panacea for the range of financing issues and economic development problems that affect all SMEs. There are definite, inherent limitations to VC's role in the overall financing environment (see Part I for further explanation). From the investor's perspective, VC investments carry high risks and are generally only appropriate as a small segment of a diversified portfolio. Moreover, the risks associated with VC investments generally fall outside the risk appetites of traditional financial institutions. VC is only appropriate for a small number of firms with innovative ideas, high growth potential and strong management teams. The limited supply of VC and the specific criteria of venture capitalists ensure that this market will remain limited to a few high-growth-potential firms. As a result, companies will likely always perceive that a shortage of VC exists, and venture capitalists will probably always perceive that firms seeking investment have unrealistic expectations. This report aims to shed light on VC's potential and limitations in contributing to Canada's economic development and innovation performance.

Public policy environment

Venture capitalists can play a crucial role in helping a few firms achieve the dramatic growth that can support a dynamic and innovative economy. Industry Portfolio members, other federal departments, and provincial governments focus on various aspects of economic development, and their interest in VC is directly related to this larger issue. However, most of the public policy levers that govern the development of VC investment rest with departments of finance (federal and provincial) and provincial and territorial securities commissions. The Industry Portfolio and Industry Canada can use their practical experience to guide solid research that will lead to policy recommendations and sound policies and programs that support the VC industry and Canadian SMEs.

The rapid growth of the Canadian VC market in recent years, along with its potential impact on economic development and job creation, make it an especially important public policy issue. However, public policy has the potential both to support and to hinder the VC market. Through the careful analysis of gaps in the function of the private market, government can design interventions that assist the long-term development of the Canadian VC industry into a significant component of the financial services community. Public policy has played a prominent role in that development in Canada, the U.S. and other countries. In Canada, major interventions have included the labour-sponsored venture capital corporations program; changes to the Income Tax Act, such as revisions to qualified limited partnership rules; provincial tax measures; the activities of the Business Development Bank of Canada; and federal and provincial investment programs, such as those promoted by Investment Partnerships Canada and Innovatech. Financial regulations, such as those of the Office of the Superintendent of Financial Institutions and provincial equivalents, have also had a significant impact on institutional investors' willingness to enter the VC market, and will likely continue to do so in the context of securities regulations reform.

Ultimately, the success of the VC industry in Canada will depend on its ability to attract private sector funding, on its success in making good investments in promising companies, and on its provision of healthy returns to investors. Government's role should be to assist the industry in achieving this goal on a sustainable basis — that is, to ensure that the industry will not depend on an ongoing public subsidy. In this respect, governments need to recognize that interventions that push the industry too far or too fast will likely result in negative outcomes. Consequently, it will be critical to find a balance that allows the industry to grow to its potential within the context of the economy's ability to provide opportunities for that investment.

The crux of the matter, from a public policy perspective, concerns the proper or optimal amount of VC for an economy. Addressing this issue is problematic. There has been little research on the demand side of the VC market and, consequently, there are no objective criteria against which to compare Canada's performance. Since 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 U.S. as a proxy. Unfortunately, basing performance on the U.S. experience is not necessarily appropriate in all situations or for all regions.

Given the importance of establishing and supporting an environment that is conducive to the health of the VC industry, it is essential that the development of policy be founded on solid research and accurate analysis. This paper will serve as a starting point for the encouragement of a sustainable, independent Canadian VC industry that can finance a range of promising, high-growth-potential firms across the country. Based on data and analysis published by Macdonald & Associates Limited, this report is presented in four key parts:

This analysis will help to develop a coordinated and collaborative approach to VC among key private stakeholders and government (response to question 4).

In addition, the following appendixes are included in support of this analysis, to provide additional details and statistics on government programs and on VC activity in Canada since 1996:

¹ Government of Ontario, Ministry of Economic Development and Trade, The Universe of Ontario's Leading Growth Firms (Toronto: Queen's Printer, 1999).

² W. Carlin and C. Mayer, "How do financial systems affect economic performance?", X. Vives, ed., Corporate Governance: Theoretical and Empirical Perspectives (New York: CUP, 2000): 137–168.

³ Federal Reserve Bank of Atlanta, Economic Review, 87, 4 (2002).

⁴ Business Development Bank of Canada, Economic Impact of Venture Capital: Eighth Annual Survey (2001).

⁵ Paul Gompers, A Note on the Venture Capital Industry (Boston: Harvard Business School, 2001).

⁶ Industry Canada, in partnership with Statistics Canada, the Department of Finance Canada and the research community, is currently developing a research methodology to measure current and potential angel investments in Canada.

⁷ Other research projects will examine the public market (securities regulations reform and initial public offerings).