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

Part I: 1. What is Venture Capital? How Does it Work?

Definition of Venture Capital

VC is long-term, hands-on equity investment in privately held, high-growth-potential companies, initiated and managed by professional investors.^{Footnote 8, Footnote 9} Each element of this definition is important, and these features are examined below. VC investors organize VC firms (through private partnerships or closely-held corporations) (see Part II, Section 7) that establish VC funds to raise capital from individual and institutional investors. Subsequently, VC funds invest in equity-type instruments (such as shares) issued by SMEs.

According to the National Venture Capital Association in the United States, VC is usually invested in young, rapidly growing companies that have the potential to develop into important players in their industry. Venture capitalists evaluate several hundred investment opportunities each year, but only invest in a few companies that can offer high returns within five to seven years.

Different Players — Different Perspectives

There are a number of players in the VC industry, each with different perspectives and interests:

• Suppliers of capital have a fiduciary mandate or personal objective to optimize returns. They use VC to the extent that it contributes to profit maximization and portfolio diversification, but are not necessarily concerned about the societal or economic impacts of their investments. The suppliers of capital are almost always passive investors — they do not take an active role in the management of the VC fund or the firms in which they invest (see further in this section for a more detailed review of the suppliers of VC funds and their interests).
• Entrepreneurs seek to secure capital under the most favourable terms, with a minimum reduction of ownership or managerial control. They are not only highly optimistic about their business ventures, but also have a vested interest in their success — most, if not all, of their personal assets are at stake. The reality is that very few of the firms that attract VC (which represents a small minority of the firms that seek venture financing) will achieve significant returns for both entrepreneur and investor. Based on the entrepreneurs' assessment of their business, they tend to perceive that VC comes at too high a price, and they often resist surrendering a share of managerial control. Generally, they prefer to use forms of financing that do not include a share in the management or future growth of the firm. Nonetheless, many entrepreneurs in knowledge-based and high-growth industries recognize that VC meets their financing requirements.
• Venture capitalists maximize profits, usually through their share in ownership, managerial participation, or control as active investors (see further in this section for more discussion of the VC investment process). Venture capitalists invest in teams, not businesses, and are not motivated by national economic development, altruism or other considerations.^{Footnote 10} VC is not just an investment; it is a partnership between the entrepreneur and the venture capitalist, a relationship that involves competing and sometimes conflicting interests. For the venture capitalist, the competence of the entrepreneur's team is likely to be the main factor in the investment decision. Most entrepreneurs have absolute confidence in their own abilities and believe that their greatest asset is their technology, idea or business acumen. The transitional nature of VC also leads to misunderstandings. Entrepreneurs want stable, patient investors. Venture capitalists invest in companies based on select criteria, usually for three to seven years, and then seek to free their assets to invest in new early-stage opportunities. For all these reasons, negotiating VC deals and navigating the relationships between venture capitalists and entrepreneurs can be complex and painstaking (see Part II, Section 7).

Venture Capital Financing Process

The VC financing process involves two distinct, sequential steps: fundraising and investment.

1. Venture Capital Fundraising Process

The sources of capital for VC funds usually establish investment criteria for each fund. These criteria can be either general or specialized, and tend to reflect the investment strategies and risk appetites of the providers of capital. In Canada, the main sources of capital are:

• Small individual investors, attracted by federal and provincial tax incentives provided through labour-sponsored venture capital corporations (LSVCCs), which continue to play a significant role in the Canadian VC industry;
• Wealthy individual investors, trust and endowments, diversifying their investment portfolios by funding private independent VC firms;
• Chartered banks, which extend their SME financing activities by funding subsidiary VC firms;
• Industrial corporations that fund subsidiary VC firms to attract and develop new technologies in their sectors;
• Pension funds looking for investments to match their long-term liabilities, either by funding private-independent VC firms or by making direct investments through their own VC firms;
• Insurance companies, mutual funds and other money managers that invest modestly in VC to diversify their portfolios; and
• Federal and provincial governments, which invest mostly through Crown corporations such as the Business Development Bank of Canada (BDC) and Farm Credit Canada, and other public agencies, such as the Atlantic Canada Opportunities Agency, Canada Economic Development for Quebec Regions, the Federal Economic Development Initiative for Northern Ontario (FedNor), and Innovatech.

A more detailed discussion of the role and evolution of these sources of funds is presented in Part II. Part III and appendixes B and C present details on government programs related to VC.

Generally, VC firms invest in companies after concluding their fundraising activities. VC firms' capacity to finance SMEs depends almost entirely on their ability to raise funds from investors, which, in turn, often depends on the returns provided to earlier investors. Ultimately, the VC market's growth depends on its ability to make substantial returns for investors. If these returns fall short of expectations, the flow of funds to the VC market will dry up.

According to a 2001 study by Paul Gompers of the Harvard Business School, a strong relationship has emerged in the U.S. between fundraising and investment performance.^{Footnote 11} Periods of accelerated fundraising activity often precede precipitous declines in returns, resulting in cyclical patterns of boom and bust.^{Footnote 12} For example, when the supply of investment capital in the U.S. swelled during the technology bubble, both the number of venture capitalists and the number of companies financed increased dramatically. This "gold rush" mentality resulted in relatively inexperienced venture capitalists pursuing investment opportunities in too many projects. As the demand for solid investments increased, investors loosened their criteria for financing and invested in less promising companies. Gompers argues that each boom in fundraising sparks uncontrollable growth that overheats the market and eventually leads to diminishing returns and concomitant reductions in VC investment. This cyclical tendency has also been observed in the Canadian VC market in recent years, with the drastic increase in fundraising in 1999 followed by lower investment returns in 2001.

2. Venture Capital Investment Process

After raising money, VC funds generally go through three developmental stages in the investment process:^{Footnote 13}

1. Identification of deals — During this phase, venture capitalists screen the technical and business merits of the proposed company. This screening process includes reviewing business plans and performing due diligence. Venture capitalists only invest in a small percentage of the businesses they review, and tend to adopt a long-term perspective. According to Gompers, U.S. venture capitalists finance only one out of a hundred prospective projects.^{Footnote 14} Investors generally base their decisions on the quality of the business plan, the networking and management team, and the skill and personal ability of the entrepreneur.
2. Structuring of deal — This phase involves extensive investor-entrepreneur negotiations on the contractual elements of financing, including the amount of investment, the timing of capital injections, the form of investment (e.g. common or convertible preferred stocks), the terms of investment (e.g. liquidation preferences, dividend rate, voting rights), options pools, employment contracts, board of director representation, regular meetings, and advice and mentoring to be provided by the venture capitalist.^{Footnote 15}
3. Exit — During the final phase, the investment is liquidated through a merger and acquisition, buy-back by original founders or other VC investors, liquidation, or through an initial public offering (IPO) on a stock market.^{Footnote 16}

Most Canadian VC investments are made under the auspices of VC syndicates. In these associations, one VC firm initiates the deal and then seeks to establish VC partnerships to share the burdens of risk and capital contribution. In Canada, the syndication rate was 2.2 in 2002 and 2.1 in 2001 — meaning that, on average, there were 2.2 investors per financing in 2002.^{Footnote 17} This is also a common practice in the U.S. VC market, where the syndication ratio was 2.8 in 2001, and 2.9 in 2002.^{Footnote 18}

Syndication provides tangible benefits. It brings other venture capitalists into the due diligence process, which provides both a second evaluation and another option on investment opportunities. Syndication also reduces the risk of funding unworthy companies, and encourages diversification into more and different types of investments. According to Josh Lerner of the Harvard Business School, high-quality and reputable VC funds syndicate among themselves, and many venture capitalists seek to break into those syndicates.^{Footnote 19} Syndication is also used by foreign investors to supplement the due diligence process and to reduce the risks involved in financing foreign companies. According to Macdonald & Associates Limited, syndication may explain both the recent increase of foreign investments in Canada and the rise in investments made by Canadian VC firms outside the country.

Venture Capital is Active Investment

Venture capitalists are active investors who take a role in the management of their investee firms. Most VC investors aspire to hold, collectively, an important ownership position so that they can add value (for example by providing advice, helping recruit the management team, identifying and analyzing new market opportunities, and providing access to professionals) and influence the destiny of the company.^{Footnote 20} According to a 1997 study by Paul Gompers, the disproportionate allocation of control to the VC fund is a critical feature of this governance structure.^{Footnote 21}

Venture Capital is Risky and Transitional Investment

One of the major risk factors facing venture capitalists is that, in a private market, there is usually little information about the operation and performance of potential investee companies. As a result, valuation is problematic and often causes conflict between VC investors and those seeking investment. Venture capitalists often assume great investment risks based on projections of how new concepts will perform in the marketplace and, as a result, VC funds are highly selective about the firms in which they invest. However, in general, one out of five investments made will be a success, three will fail to achieve expected results, and one will be a write-off. These risks are particularly acute in innovation sectors such as information technology and life sciences, due to the high capital requirements and the length of time between innovative concept and marketplace penetration in these sectors. To accept these high risks, venture capitalists require prospects for rapid and sustained growth. Once the rapid-growth phase of a company is completed, venture capitalists generally seek to liberate their capital and recycle it into new VC investments.

The risk that venture capitalists are prepared to accept, particularly at the growth stage, is often determined by the market factors that influence exit opportunities (primarily IPOs or merger and acquisition transactions). While the IPO is usually the preferred exit option because it tends to offer the greatest return on investment, IPOs represent only 10 percent of exits. Merger and acquisition transactions may be easier and less costly for smaller firms, and are the more common type of exit. Nevertheless, the current state of the stock market and the low potential for IPOs exits have had major impacts on venture capitalists' willingness to invest.

Size and Stage of Development

VC investments normally come in several rounds of financings at various stages of a firm's development, including seed, start-up, early, expansion, and growth (or even prior to business creation). VC firms can undertake these financings as sole investors, in partnership with other investors, or in syndicates, and the method can vary for different stages of development.

VC firms apply different investment criteria at different stages of development, and SMEs must meet these criteria to receive financing. Early-stage investments, including seed and start-up financings, tend to be smaller and are based on criteria that reflect projected business potentials and the investors' assessments of management capabilities (or the ability of the VC firm to import experienced management teams). Conversely, expansion-stage investments tend to be larger and involve more rigorous investment criteria that require experienced management and evidence that the company has met business goals and targets. Finally, growth-stage investments are substantially larger and are predicated on the growth potential of firms with proven management teams and demonstrated profitability in high-growth businesses.

Relations between Venture Capitalists and Entrepreneurs are Often Difficult

Given the nature of VC, the active participation of venture capitalists in portfolio companies, and the risks that venture capitalists face, VC firms and entrepreneurs face several challenges:

• A lack of experienced VC fund managers. VC funds are labour-intensive and require a knowledgeable staff and an available board of representatives to assist portfolio companies. In periods of intense VC activity, it may be difficult to find or develop the resources needed to undertake and manage VC investments. Ideally, a VC investor should have a solid technical background, extensive financial knowledge and the people skills to be able to work productively with the investee company.
• Businesses seeking VC often lack strong management teams. According to venture capitalists this is a major impediment to higher investment levels, but clearly a factor that firms seeking VC funding find hard to accept.
• Entrepreneurs' unwillingness to give up enough ownership and control to make the opportunity attractive for VC investment. While some anecdotal information suggests that this may be a diminishing trend in recent years, it is still a major concern raised by Canadian enterprises looking for capital and venture capitalists.

These factors limit the number of investments that VC funds (and the VC industry generally) are able to make. Typically, a VC fund manager can invest in only two or three companies a year. In addition, the requirement to provide hands-on involvement often means that venture capitalists restrict their investments to their local market, where they can oversee their portfolio companies efficiently, in a familiar environment.^{Footnote 22} Rapid growth in VC investment, as occurred in North America at the end of the 1990s and into 2000, is difficult to maintain and may come at the price of investment quality. As deal quality suffers and the market overheats, declining returns will have reverberations throughout the funding process and will eventually result in a decline in overall investment activity. Over the long term, the goal of public policy should be to match the growth of the VC market with its ability to maintain a high quality of investment.

^{Footnote 8} National Venture Capital Association (NVCA) (www.nvca.com).

^{Footnote 9} Josh Lerner, Venture Capital, Technological Innovation, and Growth (Boston: Harvard Business School, 2001).

^{Footnote 10} David Gladstone and Laura Gladstone, Venture Capital Handbook: An Entrepreneur's Guide to Raising Venture Capital (2002).

^{Footnote 11} Paul Gompers, A Note on the Venture Capital Industry (Boston: Harvard Business School, 2001).

^{Footnote 12} Ibid.

^{Footnote 13} Ibid.

^{Footnote 14} Ibid.

^{Footnote 15} In the U.S., venture capitalists most often use financial instruments such as convertible debt and convertible preferred stock.

^{Footnote 16} As mentioned in Part I, it should be noted that, between the structuring of the deal and the exit, the investment goes through a holding period of two to seven years, during which the venture capitalist adds value and nurtures the company through regular consultation and the provision of managerial and business expertise.

^{Footnote 17} Macdonald & Associates Limited, VC Activity Report 2002 (2003).

^{Footnote 18} Venture Economics (2003) (www.ventureeconomics.com).

^{Footnote 19} Josh Lerner, "The syndication of venture capital investments," Financial Management, 23, 1994.

^{Footnote 20} Paul Gompers, A Note on the Venture Capital Industry (Boston: Harvard Business School, 2001).

^{Footnote 21} Paul Gompers, Ownership and Control in Entrepreneurial Firms: an Examination of Convertible Securities in Venture Capital Investments (Boston: Harvard Business School Working Paper, 1997).

^{Footnote 22} Paul Gompers, A Note on the Venture Capital Industry (Boston: Harvard Business School, 2001).