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

Part II: 4. Stage-of-Development Trends

VC stage of development trends suggest that seed and start-up firms are facing increasing difficulties, particularly in accessing initial and large amounts of capital. This compounds the problems associated with the recent VC investment slowdown, the deal-size gap with the U.S., and the increasing difficulty in securing new VC financing.

Within the context of these challenges, this section presents the key Canadian and U.S. VC trends by the stage of development of investee firms.

4.1 1996–2002 Overall Stage-of-Development Venture Capital Investment Trends and Analysis

Increasing focus on early-stage financings

The data suggest that the Canadian VC industry has been increasingly active in financing early- stage firms. Between 1996 and 2002, capital invested in early-stage financings grew 255 percent, from $295 million to $1 billion. Over the same period, later-stage financings grew 92 percent, from $738 million to $1.4 billion. The number of early-stage transactions doubled over the same period, from 212 to 423 transactions, while later-stage financings grew 4 percent, from 375 to 391 deals.

As a result, early-stage investments have captured a growing average annual share of total VC, from 29 percent in 1996 to 44 percent in 2000 and 61 percent in 2001. As a result, early-stage financing captured a 40-percent average share of total VC investments and 45 percent of transactions over the period. While this is less than the 60 percent of VC investments and 55 percent of transactions for later-stage investments (including expansion and other later stages), it represents a significant difference from the U.S. situation, which suggests that Canadian venture capitalists are more willing to invest in younger and riskier firms.

Furthermore, the increase in overall early-stage financing since 1996 has been mostly targeted toward seed firms. VC investment in seed firms increased by 546 percent, from $14.5 million in 1996 to $107 million in 2000 and $94 million in 2002. The growth in seed investment outpaced the growth in start-up (a 262-percent increase, from $122 million to $442 million) and other early-stage firms (a 223-percent increase, from $158 million to $511 million). The recent proliferation of seed funds across Canada, led by the BDC, may account for this increase. See Part III for more details on specific government programs.

However, despite the positive growth of seed financing, most early-stage investment remains targeted at high-growth-potential start-ups and other early-stage firms, rather than at firms in the seed stage. Start-ups and other early-stage firms attracted an average of 38 percent and 57 percent of early-stage VC investments in 1996 and 2002, respectively. This trend left seed firms far behind, with an average annual share of early-stage VC investments of only 5 percent. This confirms that seed firms have faced significant barriers in accessing VC financing, especially for initial investments and small financings.

Strong performance for later-stage investment

Investment in later-stage firms also expanded over the past seven years, increasing the amount invested by 92 percent, from $738 million in 1996 to $1.4 billion in 2002. Most of this growth was driven by expansion firms, which attracted a 90-percent average share of later-stage VC investment over the period. Later-stage financings tended to be large transactions, resulting in an average deal size of $3 million, which is slightly higher than the national average deal size of $2.7 million.

However, there were only 4 percent more later-stage transactions, an increase of 375 to 391 deals over the same period, resulting in a declining share of the total number of deals, from 64 percent in 1996 to 48 percent in 2002.

Figure 23: Venture Capital Investment Trends by Stage of Development, 1996–2002

Regional and deal-size focus

Early stage

• On average (see Figure 24), all provinces have benefited from increased early-stage investment over the last seven years, particularly in 2001. However, Ontario and Quebec captured an average of 53 percent and 27 percent of early-stage investments in 1996 and 2002, followed by B.C. with 13 percent, the Prairies with 6 percent, and the Atlantic region with 2 percent. Ontario also captured 51 percent of the seed and start-up investments, while start-up investments captured 36 percent of early-stage investments in Quebec, compared to 18 percent for seed financings and 21 percent for other early-stage financings in Quebec.
• Early-stage investment was concentrated in the larger deals, which captured an average of 70 percent of total early-stage deals, dominating in most provinces. However, the Prairies and Quebec attracted significant investments among the smaller deal sizes. The average early-stage deal size increased by 78 percent, from $1.4 million in 1996 to $2.5 million in 2002. However, the average early-stage deal size decreased significantly, from $4.4 million in 2001 to $2.5 million in 2002. Between seed, start-up and other early-stage deals, other early-stage deals were larger, with an average deal size of $3.5 million over the period, compared to $2.5 million for start-ups and $1.2 for seed firms. These numbers confirm the increasing challenge faced by these firms.

Figure 24: Regional Distribution of Early-Stage Venture Capital Investments, 1996–2002

Later stage

• As shown in Figure 25, between 1996 and 2002, later-stage investments tended to concentrate in Ontario (51 percent), Quebec (30 percent) and B.C. (10 percent). The Prairies attracted 6 percent and Atlantic Canada netted 2 percent. In all provinces, expansion investments were emphasized over other later-stage investments.
• Later-stage investments were concentrated in large deals, given the high capital requirements of expanding information technology and life sciences firms. Large deals attracted an average of 68 percent of total later-stage investments between 1996 and 2002. Mid-sized deals were second, with an average of 26 percent, while small and very small deals only captured 3 percent each. As a result, the average later-stage deal size grew by 84 percent, from $2 million in 1996 to $3.6 million in 2002 (with an average size of $3 million over the period).

Figure 25: Regional Distribution of Later-Stage Investments, 1996–2002

4.2 Recent Situation in Stage-of-Development Venture Capital Investment Trends

Later-stage investments regained their lead in 2002 and battled for first place in 2003

Since 2001, early-stage and later-stage investments have vied for top spot as leader of VC activity. After a strong emphasis on early-stage investments in 2001 (61 percent of total investments, or $2.3 billion), 2002 saw later-stage investments regain the lead with a 58-percent average share of capital invested (or $1.4 billion). This was a sharp increase from 2001, when later-stage investments accounted for 39 percent of the market (or $1.5 billion). This is particularly the case for expansion-stage investments, which accounted for 89 percent of later-stage investments (or $1.3 billion) in 2002.

In the first nine months of 2003, the first-place position was shared between early-stage investments (49 percent of total VC investments, or $449 million) and later-stage investments (51 percent of total investments, or $470 million). As a result, while the ratio between early-stage and later-stage investments in 2002 and 2003 showed a preference for later-stage investments, the Canadian VC industry remains relatively active in early-stage financing.

4.3 International Comparison

4.3.1 Comparison: Canada–United States

Later-stage firms also dominate Canadian and American venture capital activity

Comparing the trends of VC investments by stage of development, a stronger focus on later-stage financings is apparent in the U.S., with a 72-percent average share of total VC investments (compared to 60 percent in Canada). While the focus of U.S. VC toward later-stage investments has remained relatively constant from 1996 to 2002, the amount invested over the period did increase 147 percent (from US$6.8 billion in 1996 to US$16.8 billion in 2002). This is a more significant expansion than the corresponding Canadian figure of 92 percent.

Within later-stage development, expansion firms in both Canada and the U.S. attracted the majority of total investments and later-stage VC investments over the period, with 49 percent and 57 percent of total VC investments, and 82 percent and 75 percent of later-stage investments.

Table 12: Summary of Venture Capital Investments by Stage of Firms in Canada and in the United States, 1996–2002

	1996 (C$M)		2002 (C$M)		Increase (percent)		Average Share of Total VC Investments 1996–2002 (percent)
	Canada	U.S.	Canada	U.S.	Canada	U.S.	Canada	U.S.
Source: Macdonald & Associates Limited, 2003; NVCA Yearbook, 2002
Early Stage	295	7 650	1 480	6 557	402	-14	40	28
Start-Ups/ Seed	137	2 250	537	453	292	-80	17	5
Other Early Stage	158	5 400	511	6 104	223	13	23	23
Later Stage	738	10 200	1 419	25 211	92	147	60	72
Expansion	564	7 650	1 272	19 913	126	160	49	57
Other Later Stage	174	2 550	147	5 298	-16	107	11	15

Early-stage firms face more challenges in the United States than in Canada

Early-stage firms in the U.S. faced greater obstacles in attracting VC financing than did their Canadian counterparts. In fact, U.S. early-stage firms averaged a 28-percent share of total VC investment, compared to 40 percent in Canada. While the difference does not seem significant over the 1996–2002 period, the divergence has increased in recent years. In 2002, early-stage investments captured an average of 21 percent of total VC investments in the U.S., compared to 42 percent in Canada.

Furthermore, the data show that the Canadian VC industry has provided better support for seed and start-up firms. Canadian firms increased investments by 292 percent between 1996 and 2002, during which time U.S. firms decreased their investments 80 percent. Seed and start-up firms captured an average of 17 percent of total investments in Canada, compared to only 5 percent in the U.S.

The Canadian VC industry's stronger focus on early-stage firms, particularly in 2001, suggests two conclusions:

1. The Canadian VC industry offers more support for early-stage firms and new investments than does the U.S. VC industry.
2. Canada's smaller VC industry may not have the capacity to finance later-stage firms, so many of these firms are forced to look to U.S. investors.

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

As explained previously, comparing stage of development trends across countries is inherently problematic. Each country uses a different methodology to define and calculate stages of financing. However, a recent OECD report ranked Canada second in terms of early-stage and expansion VC investments as a share of GDP (see Figure 26).^{Footnote 60}

Figure 26: Venture Capital Investments as a Percentage of Gross Domestic Product in Major Organisation for Economic Co-operation and Development Countries, 1995–2000

^{Footnote 60} Gunseli Baygan and Michael Freudenberg, The Internationalization of Venture Capital Activity in OECD Countries: Implications for Measurement and Policy (OECD, 2000).