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

Part II: 2. Venture Capital Deal Size Trends

As discussed in the previous section, VC investment data for 1996 to 2002 reveals not only increased levels of VC activity, but also an increasing preference of Canadian and U.S. investors for larger VC deals. This has resulted in an increased average deal size in both countries.⁵⁹ While many factors inform VC investment decisions, the size of the financing appears to be, more than ever, a determining factor of whether a VC deal is concluded. While this can probably be explained by the fact that VC funds have had more capital available to invest, particularly in the U.S., the higher capital requirements of high technology firms, and the fixed costs involved with due diligence of investment proposals and monitoring of investee firms, feeds into the tendency toward syndication and larger deals.

Unfortunately, as explained previously, there is not enough information on the demand for VC, particularly on the amount of capital sought by Canadian SMEs versus the amount secured through VC. As a result, it is difficult to draw general conclusions about whether the current average deal size of Canadian VC investments meets the capital needs of Canadian SMEs, and, more precisely, whether the amounts and average size of financing of very small, small, medium-sized, and large deals are adequate.

Nonetheless, this section examines deal size trends within the context of the large capital requirements of most high technology firms (particularly life sciences companies) and the relative smaller average deal size in Canada compared to the U.S. Outstanding policy issues related to these trends are presented and discussed in Section 9 and in Part IV.

2.1 1996–2002 Overall Venture Capital Deal Size Trends and Analysis

The VC investment data for 1996–2002 reveal two key related deal size trends.

1. Canadian (and U.S.) VC investors increasingly preferred large VC deals. Amounts invested in large deals increased by 274 percent (from $471 million in 1996 to $1.8 billion in 2002), and the average share of total investment grew by 57 percent (from 46 percent of total in 1996 to 80 percent of total in 2000 and 71 percent in 2002). This left fewer resources for very small and small transactions. More details about the growth of large deals compared to small deals are provided in this section.
2. The average deal size grew from $1.7 million in 1996 to $3 million in 2002 (with a peak of $4.3 million in 2000 during the technology boom).

As explained in Section 1.2, several related factors account for the deal size trends between 1996 and 2002.

• The emergence of successful high technology firms, particularly those in information technology and life sciences, has attracted an increasing proportion of VC investments. These firms have high capital needs, so these transactions tend to be larger deals.
• Canadian and foreign VC investors are increasingly confident in the quality of deals and in the future prospects of emerging technology companies (information technology in particular). This confidence contributed to the overall increase in VC fundraising and investment activity from $1.7 billion in 1996 to $3.2 billion in 2002. This increase was essential to the growing amount of VC funds available for investment, particularly since they were targeted to innovative high technology firms with high capital needs.
• The difficult market conditions may have discouraged venture professionals from making new investments. These conditions may have compelled them to inject greater amounts of money into established firms and information technology companies that required large investments and longer timeframes.
• The last factor is the increasing syndication of VC deals, particularly syndication involving U.S. VC investors. In fact, most of those large financings from 2000 to 2002 would probably not have been possible without U.S. and other foreign co-investments, particularly in key information technology sectors, such as communications and networking and semiconductors. While the rates of co-investment are also high in Quebec, financings have not benefited from leveraging U.S. sources to the same extent.

As a result, it appears that the increasing trend toward larger deals, and the increasing average deal size were driven by the emergence and success of Canadian (and U.S.) high technology firms. In Canada, these firms were mostly located in Ottawa, Vancouver and Montréal. Conversely, the growth of the technology sectors in these cities has depended on the VC industry's support. More sectoral and regional trends are presented in sections 5 and 6.

Figure 15: Venture Capital Investment Trends by Deal Size, 1996–2002

Venture capital investments trends by deal size

Very small deals

While the value and number of very small deals (less that $500 000) increased between 1996 and 2002, the data suggest that very small transactions have not benefited much from the overall increase in total VC investments over the period.

In fact, as the amount invested in very small deals increased by 26 percent (from $45 million in 1996 to $57 million in 2002), the amount invested in large deals increased by 274 percent (from $470 million to $1.8 billion). As well, while the number of very small transactions increased by 21 percent (from 232 to 281), the number of large transactions increased by 154 percent (from 57 to 145). As a result, even if very small transactions have attracted more disbursements and deals in recent years, the total capital invested in these deals has remained relatively small compared to the amounts invested in large deals. As a result, over the 1996–2002 period, very small deals' share of total VC investments fell 47 percent, capturing a seven-year average of 3 percent of VC investments.

Despite the declining dollar share invested in very small deals (compared to large deals), the Canadian VC market has been relatively dynamic in terms of the number of very small transactions, with an average share of 38 percent of the total number of VC deals between 1996 and 2002. In fact, Canadian firms, especially in Quebec, seem to have good access to very small deals, possibly because the BDC has recently created specialized seed funds and because of the increasing number of financings in Quebec, where financings are generally smaller. As a result, the average size of deal in this category remained relatively stable at $203 000 over the period.

Small deals

Small deals ($500 000 to $1 million) experienced the smallest growth in terms of dollars invested and number of deals from 1996 to 2002. Small investments increased by only 5 percent (from $64 million to $67 million) and the number of deals grew by 10 percent (from 96 to 106) over the period. This slower growth (compared to other deal size categories) meant that small deals captured a diminishing share of total VC investments and deals over the period.

In 1996, small transactions attracted a 6-percent annual average share of total VC investments and 16 percent of deals, compared to 3 percent and 13 percent, respectively, in 2002. In fact, between 1996 and 2002, small transactions captured a 4-percent annual average share of total VC investments and 16 percent of the number of deals. As a result of this marginal increase in both the amounts invested and the number of transactions since 1996, the average deal size remained relatively constant, at $656 000, suggesting that these deals are at the smaller end of the $500 000 to $1 million range.

These trends reveal that the Canadian VC market has been somewhat less dynamic in providing small VC deals than it has been in financing very small deals.

Mid-sized deals

As was the case with very small deals, mid-sized VC transactions did not benefit much from the overall increase of total VC activity between 1996 and 2002. Mid-sized deals ($1 million to $5 million) grew by 28 percent (from $453 million to $581 million), compared to 274 percent for large deals, and the number of mid-sized financings increased by 40 percent (from 202 to 282), compared to 154 percent for large deals. As a result, their average annual share of total VC investments declined by 46 percent between 1996 and 2002 (from 44 percent to 24 percent) to settle at 30 percent. The average annual share of total transactions remained relatively constant, between 30 percent and 35 percent (with 33 percent of the total number of deals over the period).

It appears that the increase in VC activity since 1996 has had little effect on SMEs' access to mid-sized financings. Furthermore, while the number and amount invested in mid-sized deals has increased modestly, the average amount of financing available in this category remained relatively constant at $2.2 million, in the middle of the $1 million to $5 million range.

Large deals

The investment pattern in large financings confirms the increasing preference of venture capitalists for large deals of more than $5 million. The tremendous growth of this deal category from 1996 to 2002 produced most of the expansion of Canada's VC industry since 1999. These transactions totalled $471 million (46 percent of total VC investment) in 1996, peaked at $4.6 billion (80 percent of total) in 2000, and settled at $1.8 billion (71 percent of total) in 2002. Between 1996 and 2002, the value of these investments grew by 274 percent. As well, the number of large transactions increased by 154 percent, from 57 in 1996 to 145 in 2002.

These transactions were also the key drivers of the increasing average deal size in Canada. The average deal size in this category was $12.4 million between 1996 and 2002. It was $8.3 million in 1996, rose to $18.9 million in 2000, but fell to $12.2 million in 2002. A higher average deal size and a focus on larger deals suggest that, in relative terms, firms seeking smaller amounts are facing increasing difficulties accessing financing. However, the increasing preference of VC investors for large deals has helped the VC industry generally, and can be attributed to their stronger interest in more capital-intensive sectors, such as information technology and life sciences. This strong indicator of the Canadian VC industry's growth has made larger amounts of capital available to high technology firms.

However, little information is available on the demand for VC and on whether the amounts provided through increasingly large deals meet the needs of most Canadian firms. Without such information, it is extremely difficult to determine whether there is indeed a gap in smaller deal sizes. As a result, the key problem appears to be not so much accessing small VC financings but, rather, securing the larger amounts required to commercialize research and development (R&D) products. This may be particularly true for firms in specific sectors that require adequate capital and time to bring a product to market, as is the case in the biotechnology sector.

Sectoral focus — information technology is the driver of larger deals trends

While both the information technology and life sciences sectors enjoyed a considerable boom in VC investments between 1996 and 2002, the information technology sector was the main driver of the overall increase in VC activity in Canada. The large capital requirements of these transactions accounted for the tendency towards larger deals. Information technology attracted an average of 66 percent of large deals (compared to 17 percent for life sciences,14 percent for traditional sectors, and 3 percent for other technologies). In fact, traditional sector transactions (e.g. consumer and business services, manufacturing, and retailers) counterbalanced the information technology and life sciences trends by acting as a brake on deal-size growth over the period. These sectors captured a 40-percent average share of very small deals and 33 percent of small deals. See Section 5 for more sectoral trends.

The emergence of information technology firms led to larger deals and to the increase in average deal size in recent years. It follows that the creation and emergence of more information technology and life science firms will augment the growth of the Canadian VC industry.

However, the deal size data do not address the specific concerns of life sciences firms. In general, life sciences firms tend to require very large amounts of capital to research, develop and commercialize new products. However, according to the data, the average deal size for life sciences firms was significantly lower ($2.7 million) than that of information technology firms ($3.5 million) from 1996 to 2002.

Without more qualitative and quantitative data about the demand for VC by life sciences firms, it is extremely difficult to determine whether there is a deal-size gap in this sector. Alternatively, other shortcomings may prevent these firms from obtaining capital, such as the quality of business proposals, the experience and expertise of the management team, or the long incubation period associated with life sciences investments.

Regional focus — very small and small transactions are concentrated in Quebec and large transactions are concentrated in Ontario

Between 1996 and 2002, most of the VC investment activity — the very small, small, mid-sized and large deals — followed emerging computer-related and high technology sectors to Greater Toronto, the Ottawa Valley and Greater Montréal. However, the deal sizes vary significantly from region to region.

As shown in figures 16, 17, 18 and 19, very small and small transactions were concentrated in Quebec, which attracted an average share of 60 percent and 50 percent, respectively, from 1996 to 2002 (compared to 22 percent and 26 percent in Ontario, and 7 percent and 9 percent in B.C.). Until 1998, Quebec dominated the Canadian VC scene, as measured by number of deals, deal size and capital invested. Since 1999, Quebec has continued to exceed the other provinces in terms of number of deals, but has fallen behind in terms of deal size and capital invested.

Given Quebec's strong focus on life sciences firms, it is hard to explain this lower average deal size, since normally the emergence of life sciences firms' higher capital requirements should lead to larger deals. VC in Quebec tends to involve many small transactions, which lowers the average deal size. More information on the capital needs of life sciences firms would help to determine whether there is a size gap for this sector in Canada, particularly given that the average VC deal for U.S. life sciences firms was much higher (C$16 million in the U.S. compared to C$2.7 million in Canada in 2002).

For mid-sized deals, Ontario and Quebec each attracted 39 percent of the total, B.C. captured 10 percent and Alberta accounted for 5 percent.

Large deals, on the other hand, have been concentrated in Ontario, which attracted 59 percent, on average, between 1996 and 2002, compared to 23 percent for Quebec and 12 percent for B.C. Ontario has also had a greater share of large financings, capturing 64 percent of large financings in 2000, 62 percent in 2001, and 60 percent in 2002.

Figure 16: Regional Distribution of Very Small Deals (< $500 000), 1996–2002

Figure 17: Regional Distribution of Small Deals ($500 000 to $1 Million), 1996–2002

Figure 18: Regional Distribution of Mid-Sized Deals ($1 Million to $5 Million), 1996–2002

Figure 19: Regional Distribution of Large Deals ($5 Million and Over), 1996–2002

To illustrate these trends, Table 9 shows that larger technology financings in Ontario and B.C. (as opposed to the more numerous, smaller financings prevalent in Quebec) have continually outperformed the Canadian average deal size over the last seven years. See Section 5 for more details on regional trends.

Table 9: Average Deal Size by Region, 1996–2002 ($ Millions)

	1996	1997	1998	1999	2000	2001	2002	Average 1996–2002
Source: Macdonald & Associates Limited, 2003
Ontario	2.6	2.4	2.0	4.5	7.9	7.1	5.8	4.6
Quebec	1.2	1.3	1.2	1.6	2.3	2.3	1.8	1.7
British Columbia	2.1	2.6	2.4	3.4	4.5	4.7	3.1	3.3
Alberta	2.0	1.5	2.2	3.2	3.8	3.1	3.1	2.7
Saskatchewan	0.9	0.8	1.8	1.7	2.2	1.8	1.9	1.6
Manitoba	1.7	3.7	1.2	1.4	1.0	0.7	0.8	1.5
Prairies	1.5	2.0	1.8	2.0	2.5	1.4	1.8	1.8
Atlantic	1.4	1.2	1.2	2.1	2.2	1.7	2.2	1.7
Canada	1.8	1.8	1.6	2.7	4.3	3.9	2.9	2.7

2.2 Recent Situation in Venture Capital Deal Size Trends

Greater concentration in larger transactions since 2001, but smaller deals in 2003

While large transactions attracted a commanding 71-percent share of total investments in 2002, and the average deal size reached $3 million, these large deals were almost absent during the first nine months of 2003. Accordingly, the average deal size fell sharply from $3 million in 2002 to $1.8 million. Although not necessarily a lasting trend, this tendency arose as a number of companies began investing significantly less VC. According to Macdonald & Associates Limited, megadeals simply were not concluded in the first six months of 2003. However, the third quarter showed positive developments, and the fourth quarter may reveal continued increases in activity level and size.

Table 10: Top 10 Transactions in Canada in 2002

Name	City	Province	Size of Transaction (C$M)
Source: Macdonald & Associates Limited, 2003
Catena Networks	Kanata	Ont.	113
Innovance Networks Inc.	Ottawa	Ont.	88
Hyperchip Inc.	Montréal	Que.	70
SiGe Semiconductor	Ottawa	Ont.	64
Silicon Access Networks	Ottawa	Ont.	59
Inkra Networks	Burnaby	B.C.	46
Trillium Photonics Inc.	Ottawa	Ont.	44
ITF Optical Technologies Inc.	St-Laurent	Que.	38
Castek Software Factory Inc.	Toronto	Ont.	34

2.3 Comparison: Canada–United States

Canada's VC community is dwarfed by its U.S. counterpart. Between 1996 and 2002, the average size of Canadian VC transactions increased by 72 percent, from $1.8 million to $3 million, and reached an average deal size of $2.7 million. In 2000 and 2001, the average deal size reached $4.3 and $4 million, but the average deal size in the U.S. has consistently hovered between three and four times that in Canada — C$6.5 million in 1996 and C$12.6 million in 2002.

This deal-size gap can probably be explained by three factors:

1. The U.S. VC market has more and larger VC funds, which can access a deeper pool of institutional investment to provide capital for larger transactions. See Section 7 for more details on investor trends, including institutional investment trends.
2. U.S. high technology firms are more successful and more concentrated, particularly in the Silicon Valley and Boston areas.
3. The higher syndication rate in the U.S. has probably, through the pooling of capital and sharing of risk, permitted the U.S. VC industry to finance larger deals.

This higher average deal size in the U.S. often leads many to believe that Canadian VC investors are more risk averse than are their U.S. counterparts, which may have some merit. However, it may also be that U.S. investors have too much capital to do small transactions, which could reflect a lower interest from U.S. venture capitalists in small deals and a more risk-averse industry (particularly since the technology bust). As well, it may be that U.S. investors tend to syndicate more, which enables them to share risks and finance larger deals. As a result, the general perception that Canadian VC investors are more risk averse must be weighed against the relative size of the two VC markets, and must consider syndication practices. Unfortunately, neither the National Venture Capital Association nor Venture Economics report on VC investment trends by deal size, which makes it difficult to answer these questions conclusively.

Nonetheless, there is a significant difference in average deal size, a gap that does raise fundamental issues for Canadian firms, particularly life sciences firms, which tend to require more capital to bring new products to market. The sectoral trends and the deal-size issues by sector are explained in detail in Section 5, while Section 9 discusses key strengths, weaknesses and policy issues. These are also discussed in the analysis of gaps in Part IV.

⁵⁹ The average size of VC investment can be analyzed in two main ways: taking the average size of financings or deals, which is the total amounts invested divided by the number of deals; or taking the average size of investment per company, which is the total amounts invested divided by the number of companies financed. Before 2002, the first method — average deal size — was used by Macdonald & Associates Limited to report on the average size of VC investments. However, since 2002, the second method — average size of investment per company — has been used. While this does not affect the general trends, the average size of investment per company tends to be larger than the average deal size, as some companies may receive more than one deal and the number of deals generally exceeds the number of companies financed.