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Canadian Venture Capital Activity: An Analysis of Trends and Gaps (1996–2002)
Part II: 3. New Versus Follow-On Venture Capital Investment Trends
As previously discussed, the recent market downturn has reduced overall VC activity and fostered a more conservative, risk-averse investment climate. This has had a profound effect on new deal activity. Canadian and U.S. venture capitalists have focussed on follow-on rounds of financing in existing investee firms. This has limited the direction of their disbursements and reduced venture capitalists' appetite for first-time deal activity, regardless of the quality of the innovative businesses that approach them. This trend has created significant challenges for Canadian entrepreneurs seeking initial VC.
This section details the trend toward follow-on investments and shows how this is complicating access to initial VC. These trends raise a number of policy issues and questions, in particular for seed and start-ups firms that are more likely to seek initial VC. These issues are presented in Section 9 and in Part IV as part of the gap analysis.
Highlights
- With the emergence of high technology firms, new VC financings increased significantly during the mid-1990s, accounting for about 60 percent of total investments in 1996.
- However, as investee firms matured, and with the market downturn since 2001, follow-on investments became less risky and more attractive to VC investors.
- There was a 40:60 ratio of new versus follow-on investments from 1996 to 2002. That ratio was 26:74 in 2002 and 30:70 in the first nine months of 2003.
- Despite the decline of new investments in both countries, Canadian venture capitalists remain more willing to finance new investments than U.S. venture capitalists. New deals represented an average of 40 percent of total investment in Canada between 1996 and 2002, compared to 30 percent in the U.S. In 2002, new deals captured 26 percent in Canada, compared to only 13 percent in the U.S.
3.1 1996–2002 Overall New Versus Follow-On Venture Capital Investment Trends and Analysis
Significant rise in follow-on financings
The rapid growth of high technology sectors drove the growth of the VC industry in the 1990s. As a result, new financings increased significantly throughout the early to mid-1990s (along with all types of financings) and accounted for about 60 percent of total investments and 50 percent of the financings made in 1996. As investee firms matured and developed, this trend toward new financings gradually began to reverse in 1997, especially after the market slowdown in 2001. As a result, the Canadian VC industry has become more attracted to the security of existing portfolio companies (see Figure 20).
Figure 20: New Versus Follow-On Venture Capital Investment Trends, 1996–2002
The data from 1996 to 2002 confirm this trend toward follow-on investment:
- Amounts invested in follow-on investments increased by 362 percent, from $394 million to $1.8 billion, compared to an increase of only 1 percent for new financings, from $639 million to $646 million.
- The average share of total follow-on investments increased by 94 percent, from 38 percent in 1996 to 74 percent in 2002. The average share in the period was 61 percent. By contrast, for new investments the share dropped from 62 percent to only 26 percent, for an average share of 32 percent over the period.
- The number of follow-on transactions increased by 96 percent, from 280 deals to 500, and captured a 60-percent annual average of total transactions. New deals declined 52 percent, from 307 (52 percent) to 264 (32 percent).
This trend can be explained by the market context of a tightening investment climate and diminishing exit opportunities, which forced venture capitalists to maintain investments in portfolio companies, and reduced their appetite for new transactions. According to Macdonald & Associates Limited, high technology entrepreneurs seem to encounter fierce challenges when approaching investors for the first time, especially during tightening market conditions.
Deal size focus — large transactions dominate new and follow-on investments
Consistent with overall VC deal-size trends, both new and follow-on financings showed an increasing preference for larger deals between 1996 and 2002. The desire to reduce due diligence costs, and the increasing capital needs of high technology firms may account for this tendency.
- New deals — In 1996, 54 percent of new deals were mid-sized transactions and 33 percent were large deals. By 2000, 84 percent of new deals were large transactions, and the share of mid-sized financings had fallen to 13 percent. The numbers levelled off somewhat in 2002, when 71 percent of new deals were large financings and 24 percent were mid-sized deals. However, large financings made greater gains in new-deal activity (an increase of 242 percent) than in follow-on financings (which increased by 136 percent).
- Follow-on financings — In 1996, 82 percent of follow-on financings were either mid-sized or large deals. By 2002, 96 percent of follow-on investments were mid-sized and large deals. Since follow-on financings are often tailored to meet the larger capital needs of firms at later stages of development, they tend to be larger than initial financings. From 1996 to 2002, the average deal size was $3.1 million (compared to $2.6 million for new investments).
Regional focus — new and follow-on deals are concentrated in Ontario and Quebec
As with the regional distribution of overall VC activity in Canada, most new and follow-on financings were concentrated in Ontario, Quebec and B.C. Over the 1996–2002 period, Ontario and Quebec captured an average share of 54 percent and 29 percent of total new deals, and 51 percent and 29 percent of follow-on deals, respectively, while B.C. attracted an average of 8 percent of new deals and 13 percent of follow-on financings. See Section 6 for more details on regional trends.
Figure 21: Regional Distribution of New Investments, 1996–2002
Figure 22: Regional Distribution of Follow-On Investments, 1996–2002
3.2 Comparison: Canada–United States
Focus on follow-on investments also observed in the United States
The VC industry's strong preference for follow-on financings is not unique to Canada. In fact, Table 11 reveals that U.S. firms face greater difficulties in accessing new VC financing than Canadian firms do. The typical ratio of new versus follow-on from 1996 to 2002 was 30:70 in the U.S. and 40:60 in Canada. As well, between 1996 and 2002, the amounts invested in the first round of financing in the U.S. declined by 14 percent, but remained relatively stable in Canada.
Although the Canadian VC industry is more focussed on new investments than the U.S. industry, follow-investments have experienced stronger growth over the period and still represent the majority of investments. In Canada, the data show that follow-on investments grew by 362 percent (from $392 million to $1.8 billion) compared to 142 percent in the U.S. (from $11.1 billion to $27 billion).
