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

Part I: 3. The Financing Context for Venture Capital

VC is only one of several financing options for Canadian SMEs, ranging from short-term and long-term debt to various types of risk capital. While this report focusses on the VC market, it is important to consider the overall SME financing environment when analyzing one aspect of the risk capital market.

Most SME debt is secured by various types of business assets: short-term debt by accounts receivable and inventories; long-term debt by fixed assets, such as land and buildings, leasehold improvements, machinery and equipment, and furnishings. Lease financing also falls into this category, since the leased assets secure the debt. Other financing instruments include various forms of quasi-equity that are either unsecured or secured by a charge against overall corporate assets. These involve flexible long-term repayment options and royalty participation in the success of the business.

Risk capital, on the other hand, is totally unsecured — preferred equities normally have a set maturity date and an attached dividend return, whereas common equities have neither.

While debt is the major source of financing for Canadian SMEs, no business can or should be financed by debt alone. Business creation and company growth usually require several stages of financing that involve a variety of debt and equity instruments and depend primarily on the type of business, its growth prospects, and market conditions. In fact, what is appropriate at one stage of development may not be appropriate at another stage. For example, although it is the most common type of financing used by SMEs, traditional debt is often not appropriate for, or accessible to, fast-growth and start-up knowledge-based industry (KBI) firms, for three reasons:

• These firms are technology-driven, so their assets may be intangible and financial institutions are usually unable to realize any value in the event of default. They are reluctant to use them for security and, therefore, may be less willing to provide debt.
• Their products tend to have long prerevenue and preprofit stages, so the firms may be unable to service the debt during this period.
• They are very risky during their prerevenue and preprofit periods and, since their cash outflows exceed their cash inflows, they fall outside the risk appetites of traditional financial institutions.

Risk capital is a more flexible and patient financing instrument than traditional debt for most high-growth and start-up KBI firms. Figures 1 and 2 show that risk capital financing can originate from many sources, such as the entrepreneur's personal investment, investment by family and friends (love money), informal private investment by wealthy individuals (angel investors), VC investment, and through IPOs on stock exchanges.^{Footnote 26} In particular, these figures show the importance of the business owners' personal stake in the company, and the importance of angel and VC investment, particularly for high-growth and KBI firms. Figures 1 and 2 also demonstrate that angel investors and venture capitalists have been more active in financing high-growth SMEs and KBI SMEs than non-high-growth SMEs and non-KBI SMEs.

Figure 1: Distribution of Equity by Source for Canadian High-Growth and Non-High-Growth Small and Medium-Sized Enterprises, 2000

Figure 2: Distribution of Equity by Source for Canadian Knowledge-Based Industry and Non-Knowledge-Based Industry Small and Medium-Sized Enterprises, 2000

Figure 3 shows that, during the seed and start-up stages, SMEs are almost entirely dependent on the owners' personal resources and risk capital from private investors to finance initial operations, such as research and product development. In the seed stage, equity financing is initially obtained either from the entrepreneur or from family and friends. Subsequently, financing is supplemented by seed capital from informal private investors and, in some cases, by seed financing funds and venture capitalists. In the start-up stage, early-stage VC investment is the main source of outside financing. In the expansion stage, SMEs generally require increasing amounts of equity to maintain R&D and product commercialization while rapidly expanding marketing and sales activities.

As companies continue to expand, they often require growing amounts of equity investment — amounts normally available only through IPOs (or mergers and acquisitions). Not only do IPOs supply growth capital, they also provide exit avenues for venture capitalists and other early-stage investors. Timely exits allow investors to recoup their original investments, realize their gains on investments, and reinvest their capital in new and early-stage companies — where their participation can add value.

Equity investment encompasses a broad spectrum of financing options for companies at various stages of development. These options are interdependent, since market conditions that affect one option often affect the availability of other sources of capital. For example, the availability of VC often depends on conditions in the IPO market. When venture capitalists see high prices and active markets for new firms on stock exchanges, they are more willing to invest in early-stage firms. As recently concluded by Josh Lerner, a healthy public-offering market goes hand in hand with a robust VC sector.^{Footnote 27}

Figure 3: Types of Equity Financing by Stage of Development and Amount Required

Although this paper focusses on VC, Industry Canada's SME Financing Data Initiative is collecting other data on angel investment and IPO issues. This research will broaden our understanding of risk capital options and SME financing issues.

^{Footnote 26} Angel investors are usually wealthy business people who invest in start-up and early-stage firms. They add value to a company by investing capital as well as business experience, which is often invaluable to growing firms. While research to date indicates angel investors are usually active or recently retired entrepreneurs, they can be drawn from many walks of life. A common characteristic is that they prefer to remain anonymous, thereby making it very difficult to quantify or study their contribution. In the U.S., Wetzel (1987) estimates that 250 000 individuals are active in the informal risk capital market and invest between US$20 billion and US$30 billion annually. In Canada, the estimates vary between $1 billion and $20 billion. To improve data on angel investments in Canada, Industry Canada's SME Financing Data Initiative recently held a workshop with some of the top researchers in Canada and abroad (United Kingdom and U.S.) to discuss methodologies to measure current and potential angel investment in Canada. This should lead to pioneering work in this area in the near future. Furthermore, a recent study conducted by Industry Canada's Information and Communications Technologies Branch provided an interesting regional and national perspective of angel investment in Canada.

^{Footnote 27} Josh Lerner, Venture Capital, Technological Innovation, and Growth (Boston: Harvard Business School, 2001).