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

Part II: 1. Evolution and Growth of the Canadian Venture Capital Market 1996–2002

The recent history of the Canadian VC industry has been marked by unprecedented transition, growth and optimism, despite the downturn since 2001. However, the shortcomings in long-term research on the Canadian VC market, as well as the lack of strategic dissemination of economic and policy information, have meant that this success story has remained largely untold. The following section sheds light on the evolution of the Canadian VC market since 1996, on its key overall growth trends, and on the recent market context of VC in Canada. To flesh out the contextual backdrop, this section includes absolute and relative comparisons with the U.S. VC market.

1.1 History of the Canadian Venture Capital Market

The Canadian VC market has shown solid growth since 1996. However, it is still a relatively young industry compared to the U.S., and data on the Canadian VC industry before 1995 are less detailed than those in the U.S. Highlights of the Canadian VC industry's creation and evolution are presented here to provide context and to improve the understanding of recent market trends.^{Footnote 34, Footnote 35} Some of these elements will be discussed throughout the report, particularly in the review and analysis of current government programs and policies related to VC, which is presented in Part III.

1.2 Structure and Growth of the Canadian Venture Capital Industry

As explained in Part I, the Canadian VC industry is composed of professional investors who organize VC firms that establish VC funds. These VC funds first raise capital from individual and institutional investors and then invest it in portfolio companies, primarily young, high-growth-potential SMEs. These investments are usually based on individual funds' pre-established investment criteria, which are based on the investors' investment strategies and risk appetites.^{Footnote 38}

The development of the Canadian VC industry has been shaped by a number of interrelated factors:^{Footnote 39}

• the emergence and success of high technology firms, particularly in information technology (which is concentrated in Ottawa);
• the growth in the number and type of VC firms and funds, which is generally attributed to high-return potential;
• the ability of VC funds to raise new capital from different investors, such as pension funds and foreign investors, which is also related to the high-return potential of high technology firms; and
• the investment practices of venture capitalists, such as the added value that VC investors contribute to their portfolio companies through managerial expertise, specialization, and syndication practices.

The current structure and operation of the VC industry must be understood within the context of the Canadian VC industry's development and the interplay among the key factors that shaped that development. The following section reviews the key trends behind the proliferation of VC firms and funds, their investment preferences, locations, and profiles, from 1996 to 2002. The syndication of VC deals is also discussed as a key development in the investment practices of U.S. and Canadian venture capitalists.

Solid growth in the number of venture capital firms and funds since 1996

As shown in Figure 5, the number of VC funds and firms in Canada has risen significantly since 1996. The number of VC firms increased by 92 percent from 1996 to 2002 (from 95 to 182 firms), and the number of VC funds increased by 117 percent (from 130 in 1996 to 282 in 2002).^{Footnote 40} The overall growth in the number of VC firms and funds, which suggests growing interest from professional investors in creating VC investment vehicles, has been a determining factor in the growth of the VC industry in Canada. The most significant impact of this proliferation of firms and funds has been a drastic increase in fundraising activities and capital available for investment.

Indeed, between 1996 and 2001, capital raised by Canadian VC funds increased from $1.7 billion to $4.6 billion. Although the burst of the technology bubble brought this figure down to $3.2 billion in 2002, this still represented an increase of 88 percent from 1996 to 2002. As explained in Part I, strong fundraising is the first step in the VC investment process because it signals that investors are generally confident in the VC investment climate and in the prospects for future returns. Canadian fundraising activities have been relatively strong (despite the difficult market conditions since 2001), showing the sustained confidence of Canadian investors in domestic firms and potential returns. Section 7 provides a more detailed review of capital under management and new capital raised and invested by investor types between 1996 and 2002.

Figure 5: Growth in the Number of Venture Capital Firms and Funds, 1996–2002

Profile of Canadian venture capital firms and funds

As explained in Part I, the composition of the Canadian VC market (see the following box) is unique because the main players are predominantly government-influenced LSVCCs, rather than private independent funds, as is the case in the U.S. The important position of this investor type changes the basis of comparison, since LSVCCs have significantly different mandates than the other investor types, such as foreign and private independent funds. Furthermore, the relatively lower participation of institutional investors continues to affect the overall growth of the Canadian VC market. The evolution and investment trends of each type of investor are presented in detail in Section 7.

Furthermore, according to several sources (such as Goodman and Carr LLP, Macdonald & Associates Limited, and a survey conducted by E. Wayne Clendenning for Industry Canada in 2002), the Canadian VC industry is also composed of relatively young and small VC funds compared to those in the U.S. VC market.^{Footnote 42} Indeed, the data and key findings revealed that Canadian VC firms tend to have the following characteristics:

• They are smaller than U.S. VC funds. According to Goodman and Carr LLP, Canadian VC funds have an average of C$79 million under management, compared to C$210 million for their U.S. counterparts.
• They have fewer executives and managers on their management teams. Sixty-one percent of the 90 VC firms interviewed had fewer than five executives on their management team.
• They are relatively young. According to Goodman and Carr LLP, the average age of Canadian VC funds is 5 years, compared to 11 years for U.S. VC funds.
• They invest in syndicates with other VC investors. According to Macdonald & Associates Limited, the average syndication ratio in Canada in 2002 was 2.2 investors per financing.
• They are mostly in Ontario and Quebec. The two provinces had 40 percent and 27 percent of total VC funds, respectively, in 2002, as reported by Macdonald & Associates Limited.^{Footnote 43}
• They invest in the early and growth stages of firms, and invest between $1 million and $5 million. The smaller firms invested between $100 000 and $1 million and the larger ones invested more than $10 million. Compared to U.S. investors, Canadian investors tended to invest more in mid-sized deals worth between $1 million and $5 million.
• They prefer investing in high technology firms. According to Macdonald & Associates Limited, information technology and life sciences firms captured 85 percent of total VC investments in 2002.
• They are mostly funded by individual Canadian investors. According to Macdonald & Associates Limited data, individual investors provided an average of 56 percent of new capital raised in 2002.

This general profile of Canadian VC funds confirms that the Canadian VC industry is younger and smaller than its U.S. counterpart, as measured by size of funds and total capital under management, size of management team, and size of deals. These issues are described in more detail further in this section and in Section 9.

Top 10 venture capital investors in 2002

The following table shows the top 10 VC investors in Canada in 2002 (ranked based on the number of companies financed in 2002). Interestingly, this information suggests that the most important investors were either LSVCCs (such as the FTQ, GrowthWorks and VenGrowth Capital Partners Inc.) or government-owned funds, such as the BDC and Quebec government-owned funds such as the Innovatechs. The importance of LSVCCs and other investors is reviewed in more depth in Section 7.

Table 1: Top 10 Canadian Investors in Canada in Terms of Companies Financed in 2002

#	Top Canadian Investors	Location
Source: Macdonald & Associates Limited, 2003
1	Fonds de solidarité des travailleurs du Québec (FTQ)	Quebec
2	Business Development Bank of Canada (BDC)	Quebec
3	CDP — Accès Capital	Quebec
4	Desjardins Venture Capital	Quebec
5	Innovatech du Grand Montréal	Quebec
6	Innovatech Québec et Chaudiere-Appalaches	Quebec
7	GrowthWorks	British Columbia
8	FondAction	Quebec
9	CDP Capital — Technology Ventures	Quebec
10	VenGrowth Capital Partners	Quebec

Distribution of venture capital funds by sector and region

The following two tables show an increasing trend toward specialization, and a relatively constant distribution of VC funds across Canada through the 1996–2002 period.

• Sectoral focus — Of the 282 active funds in Canada in 2002, 133 specialized in information technology (which grew 224 percent between 1996 and 2002) and 83 focussed on life sciences (which increased 219 percent over the same period). Of the other funds, 59 focussed on traditional sector investments (which grew 97 percent between 1996 and 2002) and 52 percent concentrated on other technology (which increased by 300 percent over the same period). This trend toward a greater specialization of Canadian VC funds is very positive for high technology firms such as life sciences firms, which often present technical concepts and risky investment proposals that require specialized skills from the VC fund managers.

Table 2: Total Growth of Venture Capital Funds and Firms by Sector in Canada, 1996–2002

	Information Technology			Life Sciences			Traditional
	1996	2002	Growth (percent)	1996	2002	Growth (percent)	1996	2002	Growth (percent)
Source: Macdonald & Associates Limited, 2003
VC Funds	41	133	224	26	83	219	30	59	97
VC Firms	35	115	229	23	70	204	28	52	86
Total	76	248	226	49	153	212	58	111	91

• Regional focus — VC investors have traditionally shown an affinity for high technology firms. There is a generally well-established relationship between the distribution of knowledge-based industry (KBI) firms, economic activity and VC activity. It is not surprising that the distribution of VC funds across regions, which remained relatively stable between 1996 and 2002, followed the patterns of KBIs and overall economic activity. Most VC funds (see Section 6) are in Ontario (38 percent in 1996 and 40 percent in 2002), Quebec (32 percent in 1996 and 27 percent in 2002) and British Columbia (15 percent in both 1996 and 2002). However, while it is true that regions outside Ontario, Quebec and British Columbia have fewer local VC funds, they also have relatively fewer VC investments (proportionally lower than their share of KBI firms and GDP). Many national funds with headquarters in Ontario or Quebec have substantial exposure to regions outside of central Canada. Also, some local funds may do most of their investing in their home region.

Table 3: Regional Distribution of Venture Capital Funds in Canada, 1996–2002

Region	1996		2002		Total Growth of VC Funds (percent)
	Number of VC Funds	Percentage of Total VC Funds	Number of VC Funds	Percentage of Total VC Funds
Source: Macdonald & Associates Limited, 2003
Ontario	50	38	113	40	126
Quebec	41	32	77	27	88
British Columbia	19	15	43	15	126
Alberta	5	4	19	7	280
Saskatchewan	7	5	12	4	71
Manitoba	3	2	7	2	133
Atlantic	5	4	11	4	120
Total	130	100	282	100	117

Trends toward syndication of deals

As mentioned in Part I, Canadian and U.S. venture capitalists tend to form syndicates in which one VC firm initiates a transaction and then establishes partnerships to share the burdens of risk and capital contribution.

In Canada, syndication has become increasingly common since 1996, and especially since 1999. Syndication represented only 1.4 investors per financing in 1996, but represented 1.9 in 1999 and 2.2 in 2002.^{Footnote 44} This practice is even more common in the U.S., where the syndication rate was 2.8 investors per financing in 2001 and 2.9 in 2002.

The syndication of deals may raise some management challenges, particularly for investee firms. These firms may have to find a lead VC investor (the initial investor generally provides the largest amount of capital and sometimes recruits other investors), and then negotiate (directly or through the lead investor) with several venture capitalists who may have different requirements or expectations. In general, however, the trend toward syndicating VC deals is a positive development for the VC industry and for prospective portfolio companies. As indicated in Part I, syndication allows other venture capitalists into the due diligence process, which provides both a second evaluation and another option on the investment opportunities. As a result, the syndication of investments reduces risk and encourages diversification into more and different types of investments.

This practice likely confers significant advantages to Canadian VC funds, given their smaller size, their limited ability to raise sufficient capital to finance large projects, and their need to build networks and partnerships with other Canadian and foreign actors to ensure the continued growth of the VC industry. As well, syndication may be the only means to ensure that high-growth-potential companies with large capital needs, such as biotechnology firms, get access to the VC financing required to bring innovative products to market.

Performance of Canadian venture capital funds

VC is one asset class among several others, including stock options on such public markets as S&P/TSX, S&P 500 and NASDAQ. Therefore, the performance of VC as an asset class is critical to its ability to attract new capital. According to Gompers, there has been a pronounced relationship between VC fundraising activity (and VC investments) and investment performance.^{Footnote 45} Periods of strong performance returns have led to increased fundraising activity and, consequently, periods of accelerated fundraising activity have preceded alarming downturns in returns. While performance data have been available in the U.S. since the early 1990s, in Canada, until March 2003, there were no such performance data available to draw historical links between the growth of performance returns and VC activity in Canada.

However, given the importance of performance data in investment decisions, it is likely that the shortage of performance data in Canada has somewhat limited the growth of the Canadian VC industry, as investors have had no solid information on which to base their investment decisions. The reticence of Canadian institutional investors may also be traced to other impediments to market participation, such as tax barriers that have inhibited institutional and other investors from backing VC funds, which, in turn, has impaired market growth.^{Footnote 46}

To address this discrepancy, the Canada's Venture Capital and Private Equity Association (CVCA), in collaboration with Macdonald & Associates Limited and Venture Economics in the U.S., has recently published a second set of performance data on Canadian VC and private equity funds for the period ending December 2002. While the data published (see Table 6) present negative returns for one-, three- and five-year periods, there are some important considerations that must be noted before any interpretations or conclusions can be drawn:

• First, to present a reliable picture of the performance of VC funds, performance data should cover at least 10-year periods. Given that the Canadian VC industry is relatively young and that performance data are only starting to be published, current analyses of Canadian data are limited to 5-year periods. As a result, the data may not present the true performance of Canadian VC funds, as these returns were heavily affected by losses incurred during the recent market decline. However, as the Canadian VC industry matures and activity levels recover, the CVCA should be able to produce long-term data that will cover longer periods and allow for a more reliable analysis and comparison.
• Second, while the performance data do not yet present returns by sector, region or investor type, the overall picture may be influenced by some specific regional funds or type of funds, and may not represent an accurate overall performance of the Canadian VC industry. For example, given the dual social and economic mandates of LSVCCs and their dominant position in the market, their performance may affect the overall returns of the Canadian VC industry. Clearly, further breakdowns of the data would provide important information to investors and policy-makers.
• Finally, in the long term, as the Canadian VC industry matures, the performance data should improve and permit Canadian and foreign investors to better monitor and evaluate the performance of the Canadian VC asset class. This should increase the flow of capital to VC funds and, downstream, to innovative small and emerging businesses.

Table 4: Investment Returns for Periods Ending December 2002

	1 Year	3 Years	5 Years
Source: Canada's Venture Capital and Private Equity Association, 2003 Note: These data, published by the CVCA in October 2003, are based on "pooled" information from 84 investment funds. The investment returns reported are annual percentage returns for the stated period and categories. The returns are calculated on an internal rate of return (IRR) basis. These are gross returns from portfolio investments before deducting management costs and other expenses.
Early-Stage VC	-25.1	-5.8	2.3
Balanced VC	-26.5	-11.6	-5.4
All VC	-25.0	-9.6	-3.1
Buyout and Mezzanine	7.0	8.5	11.6
All VC and Private Equity	-21.3	-7.5	-1.3

The CVCA recognized that the comprehensiveness of sector performance data can still be extended and can address such issues as including management fees to provide net return data (as in the U.S.) and developing global standards for the valuation of unrealized investments. To do this, the CVCA works closely with several interested parties (including Macdonald & Associates Limited, Réseau Capital, Venture Economics, Industry Canada, leading institutional investors, the Association for Investment Management and Research, the Institutional Limited Partners Association, and national and regional VC associations in Europe, Britain, and the U.S.) to improve the consistency and comprehensiveness of sector performance data. Particularly, the CVCA has recently recommended valuation guidelines, which have been circulated to CVCA members and others for comment.^{Footnote 47}

1.3 Overview of Venture Capital Investments: Growth, Trends and Analysis

1.3.1 1996–2002 Overall Venture Capital Activity Growth Trends

The Canadian venture capital industry has been dynamic and has experienced solid growth

Whether the Canadian VC industry is in a boom or bust is a matter of perspective. While a short-term review — since 2001 — of Canadian VC activity suggests a bust, the following long-term statistics — 1996–2002 — present a picture of robust growth (see Figure 6) and increasing maturity, diversification and sophistication.

Fundraising activity and capital under management

• New capital raised by VC funds has fed the growth of the VC market since 1996, from only $1.7 billion in 1996 to $4.6 billion in 2001 and $3.2 billion in 2002 — an 88-percent increase and an average annual growth rate of 17 percent (see Figure 6 and Section 7 for more details).
• Capital available for investment rose 196 percent from $2.5 billion to $7.4 billion (see Section 7).
• Capital under management grew from $7.1 billion to $22.5 billion, a total increase of 217 percent (see Section 7).

Venture capital investment activity

• Investments increased by 139 percent (from $1 billion to $2.5 billion), at an average annual growth rate of 29 percent, peaking at $5.8 billion in 2000 (see Figure 6).
• The number of financings (or number of transactions or deals) grew by 39 percent (from 587 to 814; peaking at 1335 in 2000), at an average annual growth rate of 9 percent over the same period (see Figure 6).
• The number of new VC funds created since 1996 totalled 152, bringing the number of VC funds to 282 in 2002, a 117-percent increase (see Section 1.2).
• The average deal size reached $3.0 million in 2002, after peaking at $4.3 million in 2000 — a 72-percent increase from the $1.8 million average in 1996, and an average annual growth rate of 15 percent (see Section 2).
• Follow-on investment grew by 362 percent (from $394 million to $1.8 billion), while new financings increased by only 1 percent over the same period (from $639 million to $646 million) (see Section 3).
• Early-stage investment rose 255 percent (from $295 million to $1.1 billion), compared to an increase of 92 percent for later-stage investment (from $738 million to $1.4 billion) (see Section 4).
• Foreign investment in Canada reached $650 million in 2002, up 2021 percent since 1996, when foreign investment amounted to $31 million. In 2000 and 2001, foreign investment reached a high of $1.4 billion and $1 billion, respectively. This high level of activity resulted in a 788-percent increase of foreign investors' share of total VC investments, from 3 percent in 1996 to 26 percent in 2002 (with a peak at 29 percent in 2001) (see Section 7).
• Canadian investment outside the country increased by 757 percent, from $63 million to $537 million, and peaked at $997 million in 2000 (see Section 8).

Figure 6: Canadian Venture Capital Activity Trends, 1996–2002

Comparison with growth of initial public offerings and stock exchange markets

The data confirm that, compared to the Canadian initial public offering (IPO) market, the Canadian VC industry has performed relatively well over the past few years.^{Footnote 48}

• The number and value of Canadian VC investments increased by 127 percent (from 587 in 1996 to 1335 in 2000) and 462 percent (from $1.0 billion to $5.8 billion), respectively. This performance was significantly better than the decline of 14 percent (from 240 to 206) of the number and 12 percent (from $2.6 billion to $2.4 billion) of the value of Canadian IPOs from 1996 to 2000.
• The average size of IPO transactions was much higher, at $17 million, all transactions are included. However, if you exclude the very large demutualization and privatization IPOs, the average Canadian IPO is similar in size to the average VC transaction. Indeed, between 1996 and 2000, the average IPO transaction was valued at $2.5 million, compared to $2.4 million for the average Canadian VC deal. This confirms that the Canadian IPO market is characterized by very small transactions compared to foreign IPO markets. The average IPO transaction between 1995 and 1999 was $131 million in Germany, $74 million in France, $93 million in the United Kingdom and $84 million in the U.S.

Figure 7: Number and Value of Canadian Initial Public Offerings, 1991–2000

Figure 8: Number and Value of American Initial Public Offerings, 1991–2000

Furthermore, when compared to the stock markets, the data between 1996 and 2002 suggest better performance and more stability for the stock exchange markets in Canada than in the U.S. (e.g. S&P/TSX and S&P 500) (see Figure 9). Between 1996 and 2002, the S&P/TSX grew by 47 percent and the S&P 500 grew by 34 percent, compared to a 139-percent increase in VC investments. The performance of the Canadian VC industry was particularly strong between 1996 and 2000, when the S&P/TSX and S&P 500 indexes grew by 109 percent and 83 percent, respectively, compared to 460 percent for VC investments. However, since 2000, the Canadian VC market has experienced a steeper decline than have the stock markets, falling 57 percent compared to drops of 30 percent and 27 percent for the S&P/TSX and the S&P 500, respectively.

Figure 9: Stock Market Indices, 1996–2002

As discussed in Part I, VCis only one link in the risk capital financing chain. Factors that affect other risk capital markets (such as poor performance of the stock exchanges) can have significant impacts on other sources of risk capital. To illustrate the interdependence of the public markets and the VC market, the following observations show that the poor performance of both the IPO and stock exchange markets in recent years has had significant negative impacts on the behaviour of Canadian venture capitalists and has circumscribed the growth of the VC industry.

• A recent study from Carpentier-Kooli-Suret on the performance of the Canadian IPO market demonstrated that Canada has an active IPO market, but one with marked weaknesses.^{Footnote 49} Canadian IPOs tend to be smaller than U.S. IPOs and, since many Canadian firms go public too early, the success rate or survival rate of Canadian IPOs tends to be very low. According to the authors, these dysfunctions in the Canadian IPO market have hurt the Canadian VC market. Reducing the liquidity of the VC market in a poor IPO market decreases investors' willingness to make VC investments.
• Furthermore, the relatively poor performance of the public markets since 2000, and the recent market uncertainties have undermined venture capitalists' confidence in potential exit opportunities through the public markets, resulting in more cautious investment strategies.

1.3.2 Recent Situation in Overall Canadian Venture Capital Activity

Very slow beginning in the first half of 2003, but rebounding in the third quarter of 2003

Despite the steep decline of investment levels during the first half of 2003, the Canadian VC industry showed signs of vigour and enjoyed a stronger-than-expected third quarter in 2003, disbursing investments worth $361 million in 191 companies. This was an increase of 52 percent from the $238 million disbursed in the previous quarter. This positive third quarter was a very encouraging sign for the rest of the year, but the $920 million invested in 609 companies was still well below the $1.7 billion disbursed in 649 companies during the same period in 2002.

According to Macdonald & Associates Limited, the low level of activity in the first half of 2003 reflected the market contraction of the past two years, which has been compounded by recent world events, including the war in Iraq, and by an economic climate that remains highly uncertain. The slower economic activity level in the U.S. and the increasing strength of the Canadian dollar may also have affected Canadian VC activity in 2003, particularly as it relates to foreign investment in Canada. Interestingly, in the third quarter of 2003, VC activity levels recovered, including investments made by foreign investors.

1.4 International Comparison

Multinational comparisons can provide important context to any review and analysis of national VC activity. Indeed, international comparisons of VC activity, particularly with the U.S., are important benchmarks that help drive VC-related research and policy making in Canada. In that context, the following section discusses the existing definitional and statistical challenges related to international comparison. It then compares the performance, in both relative and absolute terms, of the VC markets in Canada, the U.S. and other OECD countries since 1996.

Overall, the data suggest that, since 1996, contrary to general perceptions, the Canadian VC market has performed relatively well on a number of relative measures. In absolute terms, however, the data confirm that significant differences exist between the Canadian and U.S. VC industries, particularly when it comes to the number of companies financed, the size of VC funds and the average deal size. While other countries may not have the desire or ability to emulate the U.S. structure, lessons can still be drawn from U.S. experiences and initiatives.

1.4.1 Comparison: Canada–United States

Canada and the U.S. use similar definitions and methodologies to report on VC activity. However, caution must be applied when comparing the Canadian and U.S. experiences, and when trying to duplicate the U.S. model. While these comparisons can illuminate interesting linkages, they can also obscure important realities.

• Unique historical factors — U.S. VC activity is highly concentrated in two areas: Silicon Valley and Boston (also referred to as Route 128), while Canadian VC activity is concentrated in Ottawa (often referred to as Silicon Valley North or the Ottawa Valley). Unique factors led to the development of a particular VC culture and concentrations of high technology in these areas. Most regions of Canada (and other countries) lack these essential parameters. To illustrate this point and to confirm the relative maturity of the U.S. VC market compared to that in Canada, the box on this page presents key historical developments of the U.S. VC industry, which confirm that significant differences exist between the two VC markets, particularly when it comes to the age of the U.S. VC industry and the role played by the U.S. government.
• Absolute versus relative size — Geographic and historical factors mean that it is inevitable that Canada's VC performance be compared to that of the U.S. However, given the disparity in size between the two economies, comparing absolute numbers does not accurately depict the strength and dynamism of the Canadian VC industry. Therefore, it may be more appropriate to compare the performance of the VC markets in terms of the relative size of the two economies, through measures such as VC investments as a percentage of GDP (which reflects the size of economic activity in the two countries) and per capita (which reflects the activity based on the population of each country). Such an analysis could examine absolute VC activity numbers to determine whether there are any significant differences or gaps in the size and type of financing (such as the amount of money invested or the number of successful companies launched). This will provide a better picture of the state of the two VC markets, and will better inform Canada's policy objectives.
• Challenges faced in accessing VC — While U.S. firms may have had easier access to VC during the technology bubble, Canadian and U.S. firms generally face similar challenges in accessing VC. Since 2001, U.S. venture capitalists' investment criteria have reverted to the prebubble approach, and they are only financing opportunities that show strong technology, large potential market, experienced management, and rapid commercial viability. In fact, U.S. firms may now face greater challenges than Canadian firms, due to the more severe impacts of the recent economic slowdown and uncertainties in the U.S., which have resulted in a steeper decline of VC activity and an increased emphasis on milestone-based funding and deal syndication.

Keeping these considerations in mind, the following text reviews the historical highlights of the U.S. VC industry, and makes relative and absolute comparisons of the evolution and growth of the Canadian and U.S. VC industries over the past 13 years.

1.4.1.1 Comparison of Overall Venture Capital Activity Growth Trends in Canada and the United States^{Footnote 53}

On a relative basis, Canada's venture capital activity has shown comparable performance since 1990

One of the most accurate measures of the relative performance of North American VC industries is the number of VC investments and the amount of VC under management as percentages of GDP. Contrary to the general perception that Canada's VC sector is tiny and stagnant compared to the U.S., the data (see figures 10 and 11) reveal that, throughout the 1990s, the relative size of the Canadian VC market was similar to that of the U.S. The U.S. VC market exploded in 1999, but the collapse in 2001 narrowed the gap between the two markets. In fact, most of the negative perception about the Canadian VC market was formed during the 1999–2000 bubble, which was an aberration in the market.

However, Figure 10 shows an increasing divergence in terms of capital under management as a percentage of GDP between the two markets since 1999. This may have significant impacts on the future growth of the Canadian VC industry compared to that of the U.S.

Figure 10: Venture Capital Under Management as a Percentage of Gross Domestic Product in Canada and in the United States, 1990–2002

Figure 11: Venture Capital Investments as a Percentage of Gross Domestic Product in Canada and in the United States, 1991–2002

The steeper decline of VC investment in the U.S. and the steadier growth of the Canadian VC industry since 2000 (see Figure 11) has increased the value of Canadian VC investments as a percentage of U.S. investments. In 2002, the value of Canadian VC investments was 8 percent of the value of U.S. VC investments (adjusted to take exchange rates into account). This proportion was much higher than the 3 percent, 4 percent and 6 percent observed in 1999, 2000, and 2001, respectively. This ratio in 2002 was roughly consistent with the relative sizes of the two economies (the Canadian GDP stood at 7 percent of the U.S. GDP in 2002) and represented Canada's approximate share of the North American market.

Links with Canada's innovation target related to venture capital

In 2002, the federal government's Innovation Strategy, Achieving Excellence, pledged to raise VC investment per capita in Canada to U.S. levels by 2010. Recent trends have significantly narrowed the gap between VC investments per capita in Canada and in the U.S. (as illustrated in Figure 12). The volatile and cyclical nature of VC activity makes it very difficult to predict whether this target will be achieved by 2010.

Figure 12: Venture Capital Investments per Capita in Canada and in the United States, 1996–2002

In 2000, for example, U.S. VC investment per capita stood at roughly 2.5 times the value of Canadian investments per capita. At that time, it seemed reasonable to establish a target to raise Canadian VC investment per capita to U.S. levels over 10 years. However, throughout 2001 and 2002, the situation changed radically, mostly due to the drastic decline of U.S. VC investments after 2001. In 2002, the Canadian VC investment per capita totalled C$81, or 69 percent of the corresponding U.S. figure of C$119 per person.

While it is useful to measure relative VC investment, this measure fails to indicate whether the capital needs of Canadian and U.S. SMEs are being met; it may be more practical and effective to define Canada's VC policy objectives in terms of outcomes, such as the amount of money invested or the number of successful companies launched, rather than simply to consider comparative data. However, this type of analysis will require more information on the demand for VC. Section 9 provides a detailed review of key policy issues and questions related to the demand-side data deficit.

On an absolute basis, the United States venture capital industry is more mature and provides larger financings

The U.S. VC market is the largest, most sophisticated and most developed VC industry in the world. The absolute numbers for 1996 to 2002 (see tables 5 and 6) show that the U.S. VC market is relatively more mature than the Canadian VC industry, both in terms of its structure (e.g. number, size, and experience of VC funds) and its fundraising and investment activities (e.g. amounts of funds raised, average deal size, and capital under management). This is to be expected from an industry that was established after 1945 and vigorously supported by private industry and government cooperation in an era of unprecedented economic growth.

Indeed, according to the Goodman and Carr LLP, and McKinsey & Company report on private equity in Canada, the average age of a Canadian VC fund is 5 years, compared to 11 years for the average U.S. fund. As well, in terms of size of funds, Canadian VC funds have an average of C$69 million of capital under management, compared to C$210 million in the U.S. This type of analysis and comparison will provide a great deal of practical experience, which can help accelerate the growth and maturation of the Canadian VC market.

Table 5: Growth of Venture Capital Firms and Venture Capital Funds in Canada and in the United States, 1996–2002

	1996		2002		Increase (percent)
	Canada	U.S.	Canada	U.S.	Canada	U.S.
Sources: Macdonald & Associates Limited, 2003; NVCA Yearbook, 2002; PricewaterhouseCoopers LLP MoneyTree Survey 2003 Note: Unfortunately, data on the average firm size, fund size and management per principal were not collected in Canada.
Number of Existing VC Firms	95	441	182	892	92	102
Average VC Firm Size (C$M)	n/a	167	n/a	426	–	156
Number of Existing VC Funds	130	748	282	1798	117	140
Average VC Fund Size (C$M)	n/a	98.4	n/a	211	–	114
Average Management per Principal (C$M)	n/a	16.8	n/a	44.9	–	168

Table 6: Summary of Venture Capital Investment Activity in Canada and in the United States, 1996–2002

	1996		2002		Increase (percent)
	Canada	U.S.	Canada	U.S.	Canada	U.S.
Sources: Macdonald & Associates Limited, 2003; NVCA; PricewaterhouseCoopers, 2002, 2003
VC Investments (C$M)	1 032	17 400	2 466	31 800	139	83
Number of Financings	587	2 660	814	3 011	39	13
Number of Companies	490	2	677	2 495	38	17
Deal Size (C$M)	1.8	6.6	3.0	10.5	67	59
Funds Raised (C$B)	1 700	18 600	3 200	10 950	88	-41
Capital Under Management (C$M)	7 100	71 250	22 500	425 000	217	496

While seating the analysis within the context of the past seven years does dilute the impact of the technology bubble, it still confirms that, overall, the Canadian VC industry has been active and has been maturing, with more and larger VC firms and funds, solid fundraising activities, and growing amounts of capital under management. In fact, before the 1999 burst, both Canada and the U.S. enjoyed outstanding growth. Although the pace of VC investment has slowed dramatically in both countries, the decline in the U.S. was proportionately larger than it was in Canada.^{Footnote 54}

The steeper drop in the U.S. since 2000 resulted largely from the restriction of corporate technology spending, the continued volatility of public markets, and declining investment returns. The higher concentration in information technology (and, within this sector, the higher concentration on Internet-related sectors and communications and networking) and the absence of other modulating factors left U.S. markets more vulnerable to the technology bust.

Despite its inherent vulnerability to market fluctuations, the VC industry in the U.S. has been an important player in domestic and international investment markets. The recent history of the Canadian VC industry reflects the fact that VC was virtually absent from the Canadian financial scene as late as the early 1990s. As domestic and foreign investors began pouring VC into Canadian SMEs, the VC industry went through a catch-up phase of accelerated growth.

However, the U.S. VC industry's dramatic climb during the technology bubble, and the steep drop when the bubble burst, were less drastic in Canada. Several factors accounted for this tendency: Canadian investments had been diversified across a wide range of information technology and life sciences sectors, while U.S. venture capitalists had concentrated their investments on the Internet and other computer-related sectors. Also, the relative strength of the Canadian VC industry had been supported by unprecedented cross-border capital flows, which suggests the Canadian VC industry's maturation.

This tendency has helped to shelter the Canadian VC industry from the vagaries of the marketplace. When the investment climate cooled in the U.S., U.S. venture capitalists sought promising investment opportunities north of the border. In 2001 and 2002, some of this capital found its way into a number of large U.S. information technology and telecommunications investments in Ottawa's burgeoning high technology sectors. Ultimately, this confluence of factors diluted the effects of the technology bust in Canada. However, Canada also experienced its own bust in the middle of 2002, when activity in the communication and networking sector (particularly in Ottawa) declined precipitously, influenced in part by a perceived sector glut, public market resistance to technology stocks, and the financial and corporate government problems of telecommunications giants such as WorldCom.

Figure 13: Summary of Venture Capital Activity Trends in Canada and in the United States, 1996–2002

Comparison of return performance data in Canada and the United States

As explained in the previous section, the CVCA published the first performance data on Canadian VC funds in 2002 and 2003. While this is a major positive development for the Canadian VC market, some methodological differences exist between Canadian and U.S. returns data, which complicates comparisons of Canadian and U.S. returns.^{Footnote 55} However, keeping in mind these differences, some key observations can be taken from tables 7 and 8, which present the performance of VC and private equity funds in Canada and the U.S. (as of December 31, 2002).

Table 7: Performance Returns of Venture Capital and Private Equity Funds in Canada and in the United States as of 12/31/2001

	1 Year		3 Years		5 Years		10 Years
	Canada	U.S.	Canada	U.S.	Canada	U.S.	Canada	U.S.
Sources: CVCA, 2003; NVCA Yearbook, 2003
Early-Stage VC	-25.1	-28.0	-5.8	18.4	2.3	42.5	–	32.9
Balanced VC	-26.5	-19.0	-11.6	19.9	-5.4	22.2	–	22.0
All VC	-25.0	-22.1	-9.6	15.0	-3.1	26.7	–	26.0
Buyout Funds	–	-8.2	–	-4.2	–	1.6	–	9.1
Mezzanine Debt	–	-1.6	–	5.2	–	7.7	–	11.1
Buyout and Mezzanine	7.0	–	8.5	–	11.6	–	–	–
All Private Equity	-21.3	-12.1	-7.5	1.2	-1.3	8.4	–	15.2

Table 8: Five-Year Rolling Averages: Venture Capital Versus Public Markets

	VC		S&P/TSX	S&P 500	NASDAQ
	Canada	U.S.
Sources: NVCA Yearbook, 2003; CVCA, 2003
1996	–	21.5	–	12.2	17.1
1997	–	24.9	–	17.4	18.3
1998	–	25.7	–	21.4	23.1
1999	–	46.9	–	26.2	40.2
2000	–	45.5	–	16.5	18.6
2001	13.3	34.6	–	9.2	8.6
2002	-25.0	26.7	1.3	-3.0	-7.0

• Generally, the U.S. VC industry appears to outperform the Canadian industry for one-, three- and five-year periods. However, a more detailed review of Canadian returns suggests that for the top quartile, which contains many private limited partnerships, Canadian returns are competitive with the top U.S. quartile.
• Compared to other investment vehicles, such as the S&P/TSX and S&P 500, the Canadian VC industry offered competitive returns before 2002. However, as a result of the technology bust and the market downturn since 2001, the 2003 returns data present a more negative picture. Clearly, data over a minimum of 10 years would provide a better comparison of the performance of the Canadian VC industry versus other asset classes, and would provide investors with solid and reliable data upon which to evaluate their investment decisions.

As explained by Gompers (see Part I), periods of incredible performance returns increase the interest of investors, attract more venture capitalists to the VC industry, and thereby increase fundraising and investment. These tendencies increase the number of venture capitalists, many of whom are relatively new to the industry and, thus, tend to lack the expertise and skills required to adequately assess business opportunities and risks. As the market becomes saturated, a wider range of firms, many of which would not represent viable investment opportunities under normal market conditions, are able to attract VC. In North America, particularly in the U.S., this stimulation of VC activity was followed by a decline in performance returns and a concomitant drop in investor confidence and interest.

1.4.1.2 Recent Situation — Canada and United States Venture Capital Activity Trends Since 2001

The Canadian venture capital industry has been more stable than the United States' industry since 2001, except for the first half of 2003

U.S. VC investments declined significantly in 2001 and 2002, the first decline since 1993. VC investment fell from $105.9 billion (C$159 billion) in 2000 to $40.6 billion (C$61 billion) in 2001 and $21.2 billion (C$32 billion) in 2002. The capital invested in 2002 represented nearly a 50-percent decrease from 2001 (compared to a 35-percent decline in Canada over the same period). As a result, investment levels in the U.S. in 2002 were comparable to those last seen in the prebubble year of 1998, when $21.6 billion (C$32.4 billion) was disbursed. A similar but less pronounced trend occurred in Canada, where VC investments declined by 34 percent and 35 percent in 2001 and 2002, respectively, down from $5.8 billion in 2000 to $3.8 billion in 2001 and $2.5 billion in 2002, which is comparable to VC investments in 1998 ($1.6 billion) and 1999 ($2.7 billion).

The relative trends since the beginning of the decline of VC activity in 2001 were reversed during the first nine months of 2003. In the first three quarters of 2003, Canadian VC activity declined more sharply than U.S. VC activity, with investments totalling C$920 million — a 46-percent drop from the first nine months of 2002. In the U.S., VC investments declined by 27 percent, from C$25.2 billion in the first nine months of 2002 to C$18.4 billion in the first three quarters of 2003.

1.4.2 Comparison: Canada–Organisation for Economic Co-operation and Development Countries

Canada is among the leading Organisation for Economic Co-operation and Development countries

While the comparative performance of Canada and the U.S. can be measured relatively accurately, comparisons between Canada and other countries have been hampered by the lack of a common definition of VC, and by other methodological disparities. Consequently, existing studies on international VC markets must be treated cautiously.

According to the OECD (see Figure 14), Canada's VC market is well placed internationally and stands second behind only the U.S. in terms of VC investments as percentage of GDP allocated to early-stage and expansion investment.^{Footnote 56, Footnote 57} In other words, while the Canadian VC industry is relatively young and small compared to the U.S. VC industry, it is much more mature compared to that of any other OECD country.^{Footnote 58} A more detailed analysis of smaller countries that are trying to develop their VC markets, such as Australia, Israel or India, would probably be more appropriate and useful to Canadian policy-makers.

Figure 14: Venture Capital Investments as a Percentage of Gross Domestic Product Among Key Organisation for Economic Co-operation and Development Countries, 1995–2000

^{Footnote 34} Macdonald & Associates Limited, E. Wayne Clendenning, Alan Riding, and the OECD.

^{Footnote 35} Graham D. Taylor and Peter A. Baskerville, A Concise History of Business in Canada (Toronto: Oxford University Press, 1994).

^{Footnote 36} LSVCCs are provincially based funds sponsored by labour unions and supported by individual investors on the basis of preferential tax provisions.

^{Footnote 37} Mary Macdonald, Venture Investing and Prudence (1987).

^{Footnote 38} Note that the term "investment" refers to the amounts invested in an investee company (as opposed to VC funds) and that the term "fund raised" refers to the amounts of capital raised by the VC funds from individual or corporate investors.

^{Footnote 39} Different studies have attempted to determine which came first: a venture capital industry that could support the development of high technology firms and clusters, or the presence of high-potential technology firms that could attract venture capital. In some cases, such as Ottawa, it appears that a strong entrepreneurship community helped create and develop a venture capital industry, which then reinforced the high technology cluster. While this may not be true of all regions and clusters, the emergence of high technology firms in the Ottawa Valley has strongly affected the growth of the Canadian VC industry over the past 10 years.

^{Footnote 40} VC firms often establish one or more VC funds with different investment focusses, which explains why there are more VC funds than VC firms.

^{Footnote 41} Goodman and Carr LLP, and McKinsey & Company, Private Equity Canada 2002 (2003).

^{Footnote 42} E. Wayne Clendenning & Associates, Assessment and Comparison of Key Issues Regarding the Operation of the Venture Capital Markets in Canada and the U.S. and their Implications for Private Sector Participants and Government Policy. (Report scheduled for publication in winter 2004).

^{Footnote 43} This distribution of investment is generally consistent with the regional distribution of economic activity and knowledge-based industry (KBI) firms. In 2002, Ontario attracted 40 percent of VC funds, 52 percent of VC investments, 45 percent of KBI firms and 41 percent of GDP. In 2002, Quebec attracted 27 percent of VC funds, 29 percent of VC investments, 20 percent of KBI firms and 21 percent of GDP.

^{Footnote 44} Macdonald & Associates Limited, VC Activity Report 2002 (2003).

^{Footnote 45} Paul A. Gompers, A Note on the Venture Capital Industry (Boston: Harvard Business School, 2001).

^{Footnote 46} Kirk Falconer, Prudence, Patience and Jobs (1999).

^{Footnote 47} To consult these proposed guidelines, visit the CVCA Web site at www.cvca.ca

^{Footnote 48} Data for 2001 and 2002 are not yet available for Canadian IPOs. As a result, the growth has been calculated from 1996 to 2000 to permit a comparable period.

^{Footnote 49} Cécile Carpentier, Maher Kooli, Jean-Marc Suret, Primary Issues in Canada: Status, Flaws and Dysfunctions (CIRANO, Université Laval, 2003).

^{Footnote 50} Goodman and Carr LLP, Private Equity Canada 2001 (2002).

^{Footnote 51} Goodman and Carr LLP, and McKinsey & Company, Private Equity Canada 2002 (2003).

^{Footnote 52} Paul A. Gompers, A Note on the VC Industry (Boston: Harvard Business School, 2001).

^{Footnote 53} For the purpose of this paper, an average exchange rate of 1.5 percent has been calculated for 1996–2002, based on information from the United Nations Statistics Division (http://unstats.un.org).

^{Footnote 54} For the purpose of this paper, an average exchange rate of 1.5 percent has been calculated for 1996–2002 based on information from the United Nations Statistics Division (http://unstats.un.org).

^{Footnote 55} For example, Canadian returns data are gross, whereas U.S. data are net of management costs and other fees. As well, the returns data do not reflect the different structure and composition of the Canadian and U.S. VC markets.

^{Footnote 56} John K. Thompson and Sang-Mok Choi, Risk Capital in OECD Countries: Recent Developments and Structural Issues (OECD, 2001).

^{Footnote 57} Guusseli Baygan and Michael Freudenberg, The Internationalisation of Venture Capital Activity in OECD Countries: Implications for Measurement and Policy (OECD, 2000).

^{Footnote 58} Figure 14 only covers the period from 1995 to 2000 and, as a result, does not reflect the recent decline of U.S. activity levels and the relatively stable level of Canadian investments as a  percentage of GDP.