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

Part I: 2. Characteristics of Businesses Financed by Venture Capital

VC is best suited to a small pool of high-growth-potential companies with the capacity for high returns in a relatively short time frame. These criteria account for the concentration of Canadian VC investment (89 percent in 2002) on high technology companies, primarily in information technology and life sciences. However, low technology companies with a unique idea or product and tremendous market potential can also attract VC investment.^{Footnote 23} More detailed information on the characteristics of VC-financed companies and the investment criteria of VC firms is available on the Canada's Venture Capital and Private Equity Association's Web site.^{Footnote 24}

The main characteristics of VC-financed firms include:

• High-growth orientation that involves rapid potential and demonstrated growth in sales and market share, based on competitive advantage and dominant market position.
• High rates of return on equity, based on rapid sales growth and wide profit margins (or a high potential to achieve these targets). Generally, venture capitalists invest in firms that can provide annual rates of return in the 35 to 40 percent range over three to seven years (or, at least, returns proportional to the perceived risk).
• Strong management teams with a combination of technical, financial and marketing skills and experience, ideally with a track record in raising and exiting VC investments.
• High research and development (R&D) spending to develop unique products with varied applications, which is required to maintain rapid sales growth and high profit margins in domestic and foreign markets.
• International orientation that includes strong potential to penetrate foreign markets and rapid growth in exports or foreign business operations.
• Ownership structures that provide for approximately one-third ownership holdings by the initial venture capitalists (generally up to a maximum of 50 percent), follow-on venture capitalists and founders.

Given these investment criteria, only a very small percentage of rapidly growing SMEs are considered potentially viable candidates for VC investment; usually significantly less than 1 percent of all existing SMEs in any given year.^{Footnote 25} In addition, many qualified firms may choose not to use VC, preferring not to exchange control of the firm for capital injection and growth. Consequently, at any given time the pool of firms that are potential recipients of VC investment is very small (although the firms that consider themselves candidates for VC investment may represent a significantly larger proportion).

^{Footnote 23} Ibid.

^{Footnote 24} Canada's Venture Capital and Private Equity Association (www.cvca.ca).

^{Footnote 25} According to the Statistics Canada 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.

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