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

Part I: 4. The impact of Venture Capital

Although VC is usually limited to a few high-growth firms (venture capitalists invested in 677 Canadian firms in 2002), its importance to innovative high-growth-potential KBI firms should not be underestimated. Several reports suggest that, in an increasingly knowledge-based, high technology economy, there is a link between the VC market and overall economic performance. The VC industry finances innovative high-growth companies that have the potential to make significant contributions to economic growth and new wealth creation.

Venture capitalists do not create economic growth on their own; rather they finance and help those firms that create innovative products, jobs and wealth. While there are very few comprehensive analyses of the overall economic impacts of VC, a few studies in Canada and in the U.S. have suggested these impacts are significant.

According to the results of the BDC's most recent survey on VC in Canada, the growth of VC-financed companies (particularly information technology and life sciences firms) outstripped the growth of the economy as a whole.^{Footnote 28} On average, between 1995 and 1999, the VC-backed companies surveyed increased:

• employment by 39 percent annually (60 percent for information technology firms and 47 percent for life sciences firms);
• sales by 31 percent annually (53 percent for information technology firms and 66 percent for life sciences firms);
• exports by 38 percent annually (58 percent for information technology firms and 52 percent for life sciences firms); and
• R&D expenditures by 52 percent (56 percent for information technology firms and 60 percent for life sciences firms).

Similarly, according to a 2002 study, VC-backed firms in the U.S. contributed nearly $1.1 trillion to the U.S. gross domestic product (GDP) and employed 12.5 million people directly (15 million indirectly), representing 11 percent of U.S. GDP and 11 percent of employment in 2000.^{Footnote 29} These firms outperformed other companies in terms of sales, taxes paid, exports, and investments in R&D (when adjusted for size). The study also concluded that VC reinforces the U.S.'s entrepreneurial spirit, lubricates the wheels of innovation by financing projects that are far too risky for more traditional financial suppliers, and also plays an important role in creating industry clusters.

One explanation for this trend is that, in addition to financial support, VC investors provide hands-on technical, managerial and strategic expertise, as well as a measure of discipline (by expecting timely financial information and reports, meetings, and performance milestones) and a modicum of credibility. In fact, according to Thomas Hellmannn and Manju Puri of the Graduate School of Business at Stanford University, venture capitalists provide value-added services, help professionalize the companies they finance and help firms establish themselves in the marketplace.^{Footnote 30} As a result, their contributions can have dramatic effects on a company's market performance. The study found that the presence of VC increased the likelihood of a start-up bringing a product to market by 79 percent, particularly among innovator companies.^{Footnote 31}

Furthermore, according to a 2001 study by Josh Lerner, VC appears to have significant impacts on:^{Footnote 32}

• Individual firms financed by VC — The presence of VC funding allows these firms to invest more steadily (i.e. in R&D, new technology and equipment, human capital) — and, thus, to grow more quickly and more uniformly. The achievement of performance milestones assures these firms of future financing, which eliminates the burden of attracting new equity and reduces liquidity risk. By overcoming the capital rationing engendered by information gaps, uncertainty and soft assets, and by stimulating IPOs, venture capitalists play a critical role in the creation, growth, and development of public companies. In fact, Lerner reported that, in 1980, only 20 percent of IPOs were VC-financed. By 2000 that figure had risen to 50 percent. Firms that attract VC sustain better long-term performance, even after going public, than enterprises that follow traditional financing routes. This cycle of success is rooted in a smoother investment and spending process and the value-added managerial acumen with which venture capitalists support their portfolio companies. As a result, these firms are more likely to develop new technologies and to bring innovative products and ideas to market.
• Economy — VC-backed firms appear to grow more quickly and create more value (going public sooner and generating higher returns) than traditionally financed firms. VC-financed companies create more new jobs (5.6 percent of the total public-company work force; most of these jobs are high-salary, skilled positions in the technology sector). These firms also foster entrepreneurial activity (particularly in young, highly innovative and knowledge-based sectors).
• Innovation — VC-supported firms are more innovative than their non-venture-supported counterparts. VC stimulates patenting at three times the rate of traditional corporate R&D. By 1999, VC investments accounted for about 18 percent of U.S. innovation activity. Lerner accounted for this tendency by venture capitalists' efficient screening process, which is linked to the potential for patent or other intellectual property protections; the advice, monitoring and control that VC firms provide to entrepreneurs; and the staging of investments, which provides incentives to achieve performance benchmarks.
• Geographic regions — The regional concentration of VC activity has resulted in the development of several industrial clusters in the U.S. The local economies of Silicon Valley and Massachusetts have been transformed by local venture investments. VC thrived in these regions because of the links between VC and research universities (Stanford University, Harvard University, Massachusetts Institute of Technology), and the synergy of a vibrant community of technology companies.

The link between clusters, productivity, growth and innovation has been examined by, among others, Michael Porter of the Harvard Business School. For Porter, clusters are geographic concentrations of interconnected companies and institutions that "often extend downstream to channels and customers, and laterally to manufacturers of complementary products and to companies in industries related by skills, technologies, or common inputs."^{Footnote 33} Porter also points out that many clusters include governmental and other institutions — universities, standard-setting agencies, think tanks, vocational training providers and trade associations — that provide specialized training, education, information, research and technical support. Porter argues that clusters support competition by increasing the productivity of companies within the cluster, by driving the direction and pace of innovation, and by encouraging the formation of new businesses.

These studies suggest causal links between VC, economic growth and innovation. However, the relationship is complex and difficult to quantify. As shown in Figure 4, VC is only one link in the innovation chain — albeit an important one. Further research and analysis would help to identify the relationship between these components, and would facilitate optimal economic performance and appropriate public policy action. In this context, the review and analysis of sectoral and regional VC investment trends in sections 5 and 6 of Part II present an overview of Canada's industry clusters.

Figure 4: Components of Innovation System

Source: National Research Council Canada (www.nrc-cnrc.gc.ca)

^{Footnote 28} Business Development Bank of Canada, Economic Impact of Venture Capital in 2000 (2001).

^{Footnote 29} DRI-WEFA, The Economic Impact of the Venture Capital Industry on the U.S. Economy (2002).

^{Footnote 30} Thomas Hellmann and Manju Puri, On the Fundamental Role of Venture Capital (California: Graduate School of Business, Stanford University, 2002).

^{Footnote 31} Stanford Project on Emerging Companies, an interdisciplinary research project that analyzed 170 technology start-up firms.

^{Footnote 32} Josh Lerner, Venture Capital, Technological Innovation, and Growth (Boston: Harvard Business School, 2001).

^{Footnote 33} Michael E. Porter, "Clusters and the New Economics of Competition," Harvard Business Review, November–December 1998.