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

Part II: 9. Conclusions — Key Strengths, Weaknesses/Challenges and Related Policy Issues

The previous sections demonstrated that between 1996 and 2002 the Canadian VC industry experienced solid growth and improved high-growth-potential SMEs' access to VC.^{Footnote 85} If the industry can sustain these growth trends, the Canadian VC sector should remain a vital component of the business and investment landscape, encourage innovation and productivity, and promote new job and wealth creation.^{Footnote 86} However, despite the positive signals from the industry's growth over the past seven years, the Canadian VC market must overcome some structural and practical challenges to meet its potential.

Based on the VC activity trends presented in previous sections, this section concludes Part II with a summary of the current strengths, weaknesses, challenges and central policy issues related to the structure and function of the Canadian VC market. These policy issues will then be analyzed in detail in Part IV to identify gaps or imperfections in the market, to determine the federal government's role in addressing these gaps, and to form policy options that will underpin a more coherent government approach to VC.

Generally, the economics of VC can be analyzed in three components:

The environment and structure of the VC industry — The efficiency and continued growth of the Canadian VC industry depends principally on the general environment surrounding the business and VC communities (e.g. tax and regulatory environments) and on the structure of the Canadian VC industry (e.g. number, size and type of players). The structure and function of other risk capital markets (e.g. angel and IPO markets) are interdependent, and may have strong impacts on the VC market.
The demand for VC — While the surrounding environment is critical to the development of an efficient private sector VC industry, strong demand for VC financing ensures a growing flow of capital to VC funds, and increasing levels of VC investment. Without enough quality investment opportunities (i.e. businesses that present high returns potential), investors will avoid this asset class or redirect their funds to other types of investments with higher returns and lower risks. Accordingly, the quantity and quality of the demand for VC merits serious consideration.

Unfortunately, the demand for VC investment (and for risk capital in general) has not been studied adequately in Canada or in other countries.^{Footnote 87} The lack of data on SMEs' requirements for VC and on the approval rates of businesses seeking investment has meant that the demand side of the equation has been neglected in most analyses. As a result, government policy has not considered demand-side issues.

However, demand must be analyzed to ensure an efficient VC market and to help high-growth-potential SMEs access VC, particularly since Canadian venture capitalists report that their biggest challenge is the lack of viable investment opportunities, rather than the availability of capital. In fact, several U.S. VC funds have recently returned funds to their investors because of the lack of viable investment opportunities.^{Footnote 88} Venture capitalists evaluate investment opportunities based on high-returns potential, skilled and experienced management teams, solid technology and product leadership, and large market potential.
The supply of VC — The Canadian VC industry expanded from 1996 to 2002, whether measured by the number of funds (from 130 to 282), the supply of new capital (from $1.7 billion to $3.2 billion) or total VC investments (from $1 billion to $2.5 billion). This growth demonstrates the Canadian VC industry's dynamism over the past seven years. However, the lack of information on the demand for VC makes it impossible to determine whether there is a real shortage of VC in Canada (see Part IV for a more detailed analysis).

In addition to the need to improve the quantity and quality of demand-side data, the lack of critical information on supply necessitates the development of policy that can sustain the rates of growth in supply and investment evident over the past seven years. A number of relevant issues emerged from the review of the VC industry between 1996 and 2002, suggesting that despite such remarkable growth, the supply of VC could be enhanced through more reliable and transparent information about the industry, better performance benchmarks, higher returns, more skilled and experienced venture capitalists, and the increased participation of institutional investors and private independent funds. Addressing these could stimulate the growth of the Canadian VC industry.

Accordingly, the key strengths, weaknesses, challenges, and related policy issues are presented in tables 18 and 19.

9.1 Key Strengths

Gathering the analyses from previous sections, the following table summarizes the principal strengths related to Canadian VC activity trends since 1996.

Table 18: Key Strengths Related to Canadian Venture Capital Activity Trends, 1996–2002

Strengths

Details

Environment and Structure of the VC Industry — These factors have helped the Canadian VC market and Canada's innovation performance.

Strong economic performance — past and forecasted

Over the past five years, Canada's economic growth (3.8 percent of real GDP) has outperformed that of the other G8 nations. As well, for 2003-07, Canada's forecasted real GDP growth of 3.1 percent exceeds that of most G8 nations (except Russia and the U.S.).^{Footnote a}

Improved regulatory and tax environments

Measures announced in recent federal budgets (e.g. the reduction of capital gains tax, revisions to Qualified Limited Partnership rules, changes to foreign property rules and the gradual elimination of the capital gains tax) should foster an increasingly competitive tax and regulatory environment, which in turn should lead to increased VC investment by foreign and institutional investors (see Appendix E for more details on recent tax changes).

Significant angel investments market

While estimates are far from precise (and do not necessarily capture the most recent downturn in most markets), anecdotal evidence points to a relatively dynamic angel investment market in Canada, which could be as important as the VC market. Available information about this market has grown significantly in recent years as a number of angel networks and associations have developed. In collaboration with angels and key researchers, Industry Canada is studying ways to better measure actual and potential angel investment in Canada. This information should lead to policy options that will improve Canadian SMEs' access to angel investment.

Solid private equity market in Canada^{Footnote b}

As reported by Goodman and Carr LLP and McKinsey & Company, Private Equity Canada 2002,^{Footnote c} despite slower economic conditions, Canadian private equity funds continued to raise significant amounts of new capital and to make material investments in portfolio companies. As a result, the private equity market in Canada was estimated at $49 billion in 2002. Of this amount, 50 percent (or $20.2 billion) was held for VC; 41 percent (or $16.7 billion) for buyouts; and 9 percent (or $3.6 billion) for mezzanine financing. An estimated $8.5 billion was not captured by the survey.

The Demand for VC — These positive factors helped build a critical mass of quality demand for VC, which is essential to attracting VC funds and investments.

Strong entrepreneurship base

According to the OECD and Global Entrepreneurship Monitor, Canada has a relatively strong entrepreneurial base and a high rate of entrepreneurship compared to other OECD countries. This is crucial to healthy levels of VC investment, since venture capitalists only invest in quality investments that can produce high returns. Less demand for VC investment means less VC activity, so entrepreneurial shortcomings can hurt the development of SMEs, VC investment and innovation. Unfortunately, the lack of information on the demand for VC (and for other types of risk capital) makes it impossible to conclude whether there are demand-side gaps in the VC market.

Significant support of research and development

Federal government initiatives have supported university research in Canada. The recent federal budget reinforced this financial support, as part of the Innovation Agenda. For example, the federal government has established a framework agreement with the Association of Universities and Colleges of Canada, in which the universities agree, among other things, to triple their commercialization efforts.^{Footnote d} Encouraging R&D supports innovative firms, which in turn feeds VC investments.

The Supply of VC – These positive VC activity trends were observed from 1996 to 2002.

Solid overall growth of VC activity between 1996 and 2002

The Canadian VC market has enjoyed solid growth between 1996 and 2002 and has remained relatively strong since 2001 despite difficult market conditions in both the VC and public markets in 2001, 2002 and 2003 (see section 1 for detailed data). This growth has been driven by strong overall economic performance in Canada and by the emergence of successful high technology companies, particularly information technology firms in Ottawa and life sciences firms in Montréal.

Canada's VC performance has been comparable to that of the American VC market between 1990 and 2002

The Canadian and American VC industries have performed comparably, in terms of relative VC under management and VC investments as a percentage of GDP since 1990. In Canada, the VC industry has developed more gradually and smoothly than has the American industry. Canada's VC market did not experience the same remarkable explosion in 1999 and 2000, but it has remained more stable since 2001. In fact, the gaps in VC investments as percentages of population and GDP between the two markets have narrowed significantly since 2001 and currently rest at levels not seen since before the technology boom. As a result of the steep decline of American VC activity and the relative stability of Canada's VC market, Canada is several years ahead of schedule in meeting its target to raise VC investments per capita to U.S. levels, a target which had been projected for 2010 (see section 1 for detailed data).

Nonetheless, significant structural and logistical disparities remain between the two markets, particularly in terms of the participation of institutional investors and private independent funds and the discrepancy in the average deal size (see the weaknesses discussed below).

Canada is among leading OECD countries

Considering North America's strong focus on VC investments, it is not surprising that Canada is among OECD leaders in VC investment as a percentage of GDP, particularly for early-stage and expansion financing. However, such international comparisons are limited by the lack of common definitions and methodologies.

Increasing trends toward larger deals and larger average deal size

The average size of VC financings in Canada expanded considerably from $1.7 million in 1996 to $3 million in 2002 (with a peak of $4.3 million in 2000).^{Footnote e} This increase was fuelled by the significant rise in available capital and by the growing number of transactions in Canada. However, the prime factor behind the consistent increase in deal size has been the high capital needs of high technology firms. Despite the increasing deal size trend, the average deal size in the U.S. has remained double or triple that of Canadian deals (see the weaknesses below for more details). A smaller average deal size may represent a meaningful gap for high technology companies and medium-sized firms. However, a higher average deal size also implies that the industry prefers larger deals, which may limit the financing of smaller companies, due to high due diligence and transactions costs. Nonetheless, despite the increasing trend toward larger deals between 1996 and 2002, the Canadian VC industry remained relatively active in financing very small and mid-sized Canadian SMEs (see section 2).

Increasing access to VC by early-stage firms

In recent years, Canadian VC investment has focussed on early-stage firms. Since 1996, the amount invested has grown by 255 percent, the number of deals by 100 percent and the average share of total investments by 49 percent. These figures prove that Canadian venture capitalists have an appetite for high-risk ventures. Early-stage investment has changed from 29 percent of the total in 1996 to 61 percent in 2001 and to 42 percent in 2002, for an average of 40 percent from 1996 to 2002. By contrast, the equivalent American numbers are 44 percent in 1996 and only 21 percent in 2002, for an average of 28 percent from 1996 to 2002. Other OECD countries do not exhibit this trend. This suggests that while some impediments to VC flow remain for early-stage firms (particularly in 2002), these firms have attracted a growing proportion of total VC activity over the past several years (49 percent in the first six months of 2003). Despite current market conditions and a cooling investment climate, Canadian venture capitalists have not become exceptionally averse to the risk of investing in early-stage firms. However, is this level of early-stage financing adequate? If so, is the level of funding provided to later-stage firms also adequate? (See section 4.)

Focus on high technology sectors (e.g. information technology and life sciences)

As explained in Part I, VC fund managers seek to maximize returns. Since few high-growth-potential firms offer substantial returns on investment, few attract VC financing. Traditional financial institutions prefer less risk, and choose investments based on the potential for high growth, technology focus and potential returns as high as 30-35 percent within three to five years. Because of the high-risk nature of these firms and the financing challenges they face (especially in high technology sectors), VC is critical to their development and growth. Indeed, the sectoral trends observed since 1996 confirm that the emergence of high-growth-potential and KBI firms, particularly in information technology and life sciences, has fuelled the growth of the Canadian VC industry. These trends also confirm that VC has played a major role in supporting the recent success of Canadian information technology and life sciences firms.

This symbiotic relationship between high technology firms and VChas led to the creation of industry clusters; information technology in Ottawa and biotechnology in Montréal. The development of these clusters further encouraged the overall growth of the VC industry and remains central to Canada's innovation performance. The strong relationship between high technology firms and VC activity in a few regions has been even more pronounced in the U.S., with the Silicon Valley and the Boston/New York area attracting the majority of VC investments. As a result, it is not surprising that information technology investments drove most of the VC activity in both countries from 1996 to 2002 (see section 5).

Increased VC activity in all regions and continued concentration in Ontario, Quebec and British Columbia

In absolute terms, there has been a significant increase in total VC investment and in the number of VC funds across all regions since 1996. This increase suggests some dynamism in all regions, particularly in those with a higher proportion of KBI firms. However, a relative analysis comparing the regional concentration of KBI firms, GDP and VC reveals that the Prairies and the Atlantic provinces have attracted a lower proportion of VC compared to their levels of GDP and KBI firms (see section 6 for detailed statistics). The lower share of VC activity in these regions (and in other areas outside Ottawa, Montréal and Vancouver) raises challenges and concerns for regional economic development (see the weaknesses and policy issues below).

Evolution in the role and participation of the different investor types

The nature and role of different types of VC investors in Canada have evolved in lock step with the overall economic environment and the development of the VC market over the last 7 years.

LSVCCs regained their status as main players in 2002, providing 25 percent of total VC investment (average of 27 percent from 1996 to 2002). However, their relative importance declined significantly in 2000 and 2001, suggesting that LSVCCs have performed the counter-cyclical role for which they were established. Their participation in the VC market slowed significantly in 2000 and 2001 (from 40 percent in 1996 to 14 percent in 2000 and 17 percent in 2001) when the VC market was strong, and they regained market share during the slowdown in 2002 (back to 25 percent of total investment) and in the first six months of 2003 (with 31 percent of total investment).
Foreign investors have become major players in the Canadian VC industry, accounting for most of the recent expansion of VC activity. Since 1999, foreign investors' capital contributions have grown 2021 percent and the number of deals has increased 300 percent. Since 1996, the average share of total investments has grown 766 percent, from only 3 percent in 1996 to 26 percent in 2002. Foreign investors' increased investment in Canada, mostly in the form of direct investments and partnerships with Canadian venture capitalists, has contributed to the vitality and stability of the Canadian VC market since 1999. Foreign investors favoured information technology firms, particularly those in the Ottawa region, suggesting that this cluster has benefited from a strong entrepreneurial base and that these firms have been particularly successful in promoting their new technologies and offering high returns — and this without much government intervention. Foreign investors were also responsible for most of the increase in the average deal size in Canada since 1999 — the average size of foreign deals was $11 million between 1999 and 2002 (compared to an average of $3.5 million in Canada over the same period). The increased interest of foreign investors in Canadian opportunities is clearly an important development for the Canadian VC market. Presented below are a number of issues and concerns raised by the impacts of these investments on Canadian firms and on the Canadian economy.
Government funds have played an increasingly significant role in recent years. Between 1996 and 2002, the amounts invested increased 433 percent, the number of deals grew 121 percent and the average share of total VC investment expanded 123 percent. The increased participation of government funds can be attributed to the creation of a number of programs and funds, such as the BDC VC funds and BDC seed funds (see Part III for more information on government programs).
Institutional investors increased their contribution to the supply of VC by 15 percent from 1996 to 2002. Nonetheless, they have played a limited role in investment, with a declining share of total VC from 15 percent in 1996 to 7 percent in 2002. However, these investors should soon be participating more, given that the past two years have seen an inflow of capital, new tax measures announced in recent federal budgets and the recent publication of performance benchmarks. The weaknesses related to the participation of institutional investors are discussed below.
Private independent funds did not play a major role in the Canadian VC market between 1996 and 2002. Although the amounts invested grew by 58 percent, private independent investors saw a 14 percent decline in the number of deals and a 34 percent drop in the average share of total investment. However, since these funds increased their contributions to the supply of capital, this group will probably increase their investment activity. The weaknesses related to the participation of private independent funds are discussed below.

(See section 7 for detailed statistics on the participation of each investor type.)

Increasing VC activity of Canadian investors abroad

As with the trend toward increased foreign investment in Canada, Canadian investors invested 757 percent more VC abroad between 1996 and 2002, with most of this growth occurring since 1999. The increasing level of Canadian VC investment abroad and investment from foreign countries (mostly negotiated through syndicates between Canadian and U.S. venture capitalists) suggests two positive developments for Canadian venture capitalists, which bodes well for the continued growth of the VC industry.

First, the North American VCmarket is globalizing. According to the CVCA, an increasing number of venture capitalists no longer consider distance to be a significant barrier to investment. In fact, VC dollars are increasingly flowing to the strongest investment opportunities, regardless of location. However, as Porter (1998) has shown, a critical mass of high technology firms and financial networks is a significant determinant of VC activity and this explains why some clusters or regions have been so successful in attracting VC. Therefore, the continued growth and vitality of the Canadian VC industry depends of the ability of venture capitalists and SMEs in Canada to build on existing clusters and to take advantage of the global VC market. Continued foreign investment in Canada and Canadian investment in successful technology firms abroad can encourage and strengthen these linkages and networks.
Second, according to Macdonald & Associates Limited (2003), syndicating deals with foreign investors is helping Canadian venture capitalists and SMEs by establishing and solidifying networks of communication, expertise and finance between Canadian and American VC investors. These networks allow Canadian stakeholders to learn from the experience of American venture capitalists and to gain technical knowledge of VC investment processes in the largest and most successful VC economy in the world. By bringing in substantial sources of foreign capital, including major players in the American VC industry, networks also help Canadian SMEs by making larger financing amounts available. The weaknesses and challenges related to these inflows and outflows of VC are discussed below.

^{Footnote a} Global Insight forecast, as of March 2003.

^{Footnote b} Private equity market includes VC, mezzanine and buyout financing.

^{Footnote c} These data are from a survey that Macdonald & Associates Limited conducted from October 2002 to March 2003.

^{Footnote d} Additional information is available at www.aucc.ca.

^{Footnote e} With the decline of VC activity since 2001, the average deal size has contracted significantly from $3.9 million in 2001 to $3 million in 2002 and to $1.5 million in the first six months of 2003.

9.2 Key Weaknesses/Challenges and Related Policy Issues

As shown in previous sections, the Canadian VC industry has become an expanding, dynamic sector in its own right. Canadian policy-makers should ensure that this sector continues to grow independently as a private industry. To this end, the following table reviews and analyzes the remaining weaknesses, challenges and policy issues related to the structure and function of the Canadian VC market. These represent significant impediments to the VC industry's future growth and ability to support high-growth-potential SMEs.

Part IV will analyze these weaknesses, challenges and policy issues in greater detail; determine whether there are gaps or outstanding issues in the market that need to be addressed; review the respective roles of the private sector and the federal government; and discuss policy questions.

Table 19: Key Weaknesses and Challenges and Related Policy Issues

Weaknesses/ Challenges

Explanation and Related Policy Issues

Environment and Structure of the VC Industry

Lower performance returns compared to the U.S. and lack of information about industry

Returns are the most important driver of VC activity. In fact, performance returns prompt investors to fund venture capitalists, who then invest in high-growth and high-returns-potential firms. Without reliable and transparent industry information and appealing returns (compared to other investment options such as the public market), capital will not (and should not) flow to VC funds.

Until 2002, there were no data on the performance (e.g. rate of returns) of Canadian VC funds.^{Footnote a} Therefore, it was impossible for investors, particularly institutional investors unfamiliar with VC, to assess the performance of this asset class and to make informed decisions about VC investments.

Compared to the American VC market, this lack of reliable VC returns data represents a significant gap for the Canadian VC industry. According to Goodman and Carr LLP and McKinsey & Company, Private Equity Canada 2002, the lack of timely and exhaustive returns information could hinder investor perceptions about the Canadian private equity market's attractiveness or viability compared to the American or EU markets. In the U.S., VC and institutional investors have used performance returns data to establish benchmarks since the early 1990s. In Canada, returns data were first published in 2002 by the CVCA, in collaboration with Réseau Capital and Macdonald & Associates Limited. However, there are no consistently applied valuation and reporting standards used by venture capitalists. Without transparent and comparable information, investors may continue to resist allocating assets to VC in favour of more traditional investment strategies.

Moreover, the continued growth of VC activity may depend on more than industry information. The VC market needs to demonstrate attractive returns to attract more capital and new suppliers of capital. The CVCA data can be significantly improved, but the existing data reveal that American VC funds outperform Canadian funds over one-, three- and five-year periods. While this can be partially explained by the recent market decline, the data raise significant structural challenges for the Canadian VC industry. Lower returns may send negative signals about the quality of Canadian investment opportunities and the calibre of Canadian VC fund managers.

As a result, the future of VC in Canada will depend on the industry's ability to provide investors with solid and credible risk-adjusted rate-of-return benchmarks and other industry information. Otherwise, it will be increasingly hard to raise money for VC, especially from institutional and foreign sources.

The Canadian VC industry is aware of this information challenge and its importance for the future growth of the Canadian VC industry. In fact, the CVCA published improved performance benchmarks in October 2003 and is also developing guidelines to help VC funds to value and report their investments.

The importance of industry and returns information raises critical policy issues and questions that need further consideration.

What explains the lower performance of Canadian VC funds? Is it the lack of quality investment opportunities, the poor quality and unreliability of the valuation and reporting of Canadian VC funds, the lack of expertise of Canadian VC fund managers or the lower performance of a group of VC funds such as LSVCCs?
What are the long-term impacts of these lower returns on the VC market?

What should the government do to help the VC industry develop and disseminate credible and reliable industry and returns information?

Improvements to tax system

The federal and provincial governments have recognized the VC industry's importance to the creation and development of high-growth-potential firms, to innovation, to the creation of wealth and to overall economic activities. Indeed, recent federal budgets have announced several measures to eliminate tax and regulatory barriers to the flow of VC, and measures to further encourage VC activity in Canada.

While some of these measures have yet to be legislated, the VC industry has generally lauded these developments. The CVCA predicted that these measures would make Canada's private equity market more attractive to both domestic and foreign institutional investors, which in turn would help support the continuous growth of the Canadian VC industry. See Appendix E for a summary of the recent changes and additional revisions requested by the CVCA.

However, the CVCA feels that these positive developments take too long to implement and that further improvements to the tax system are required to remove some technical bottlenecks and improve the flow of capital from both institutional and foreign investors to high-growth-potential firms in Canada.

Given the recent changes and measures announced by the Department of Finance Canada, what other improvements to the tax system might still be needed to ensure the continued growth of the Canadian VC industry?

Relatively smaller and younger VC industry and Canadian VC funds have less VC management expertise compared to the U.S.

Size and maturity of the Canadian VC industry
Despite the comparable levels of VC investment as a percentage of GDP in Canada and in the U.S. since 1990, the Canadian VC market is, overall, less mature and sophisticated than the American VC market.^{Footnote b} Canadian VC funds are younger, smaller and have showed lower growth rates.

The number of Canadian VC funds (282 in 2002) increased by 117 percent between 1996 and 2002 compared to growth of 140 percent in the U.S., for a total of 1798 VC funds in 2002.
The average capital under management per Canadian VC fund was C$79.8 million in 2002 versus C$210 million per VC fund in the U.S.^{Footnote c}
The average Canadian VC firm is 5 years old, while the American average is 11 years (with the median at 4 and 9, respectively).

While the Canadian VC industry has developed significantly since 1996, the industry's relative youth may hinder its capacity to appropriately fund Canadian SMEs. This may be particularly true for seed and start-up firms in a number of key industries, and for companies in the continuous expansion and growth phases, which typically require large capital injections.

As a result, to grow and become successful, some of these Canadian firms may have to seek VC financing in the United States.^{Footnote d} This tendency, if meaningful, may affect the continued growth of the Canadian VC industry, as viable companies needed to feed the Canadian VC industry may relocate to the United States. Not only could this limit the Canadian VC industry's growth, it could reinforce the "brain drain" and damage Canada's future innovation performance and economic growth.

Too few venture capitalists with management experience and industry knowledge
Canadian venture capitalists also find it harder to recruit skilled and experienced VC fund managers than American venture capitalists. This may be because of the relative youth of the Canadian VC market (e.g. fewer and smaller VC funds and less total capital invested), as well as the lack of serial entrepreneurs, and, thus, fewer good potential venture capitalists. It may also be that successful Canadian venture capitalists are being recruited by Americans. The Canadian private equity market is also relatively young — according to Goodman and Carr LLP and McKinsey & Company, Private Equity Canada 2002, it is mainly composed of VC (50 percent) and buyouts (41 percent).

Many Canadian private equity firms were established recently; many Canadian general partners (also referred to as VC fund managers) have shorter track records and less experience than their American counterparts. This can make it difficult to convince new and existing investors to supply capital for VC investments.

While only time and experience (e.g. several business and investment cycles) can address this lack of expertise and maturity, the key policy question is:

What should the private sector or the government do to further support the growth of Canadian VC funds and develop VC funds managers' skills and experience?

For example, improving industry information and returns data, or further streamlining of the tax system, would help Canadian VC funds raise capital from institutional and foreign investors. As well, training, mentoring and educational initiatives could be investigated as ways to develop VC skills and expertise (see Part IV).

Ensuring a strong angel investment market

Before seeking VC, most new firms secure funding through informal channels.

Business angels can impart broader visions and goals to entrepreneurs and can provide management expertise and experience. Some start-up companies remain with business angels throughout their life cycle, while others eventually turn to formal VC. Studies show that in the U.S., business angels work with the formal VC sector by seeking out and screening new projects, which stimulates start-ups and increases deal flow for VC firms. In fact, studies have found that more than half of all VC-funded high technology projects in the U.S. had business angel participation, and that this proportion was even higher among smaller and newer firms. The presence of a highly regarded and well-connected business angel in a previous financing deal may allay the fears of VC investors and promote further rounds of investment.

Considering the importance of angel investment to high-growth-potential SMEs and the lack of information about angel activities in Canada, Industry Canada's SME Financing Data Initiative has studied angel investments in Canada^{Footnote e}^{Footnote f}^{Footnote g}^{Footnote h} to improve the overall understanding of this market. In addition, a National Angel Organization study for Industry Canada^{Footnote i} revealed a number of issues and concerns common to many angel investors in Canada, such as the need for risk-adjusted tax treatment and new tax incentives, and better networking with venture capitalists. Given the important linkages among angels, VC and IPOs, these markets must be reviewed in parallel as part of an overall government approach to improve high-growth-potential SMEs' access to capital. In other words, VC should not be the only focus of government attention.

In particular, one of the key challenges facing policy makers is the lack of information on the actual and potential size of the angel investment market in Canada. Industry Canada is developing a research protocol with Statistics Canada and the Department of Finance Canada to measure the amount of actual and potential angel investment in Canada.

The results of this research should illuminate potential gaps in the market and point to possible policy actions to encourage informal investment in Canada and provide more quality investment opportunities for VC investors.

Ensuring a strong IPO market

As explained in Part I, VC financing serves as a bridge between the informal financial sector and the public capital markets. As a transitional phase in financing, VC will likely be most efficient in the presence of a strong informal capital market that screens, evaluates and finances new deals and provides good exit potentials, preferably through IPOs or mergers and acquisitions.

Due to their potential to influence the development of the VC industry, the public markets must also be evaluated. A recent Industry Canada study by Carpentier, Kooli, Suret^{Footnote j} on the performance of Canadian IPOs revealed a mixed story about the Canadian IPO market. Going public is less expensive in Canada than it is in the U.S. and, paradoxically, traditional IPOs are less expensive than junior capital pools. However, the Canadian IPO market is characterized by very small issues, averaging just $2.5 million, and in recent years small companies that have gone public have performed poorly. Companies generally have gone public too early and few survive.

In light of these findings, the authors recommend the re-evaluation of all policies, regulations and programs that encourage small businesses' access to public capital. Government policies should be as neutral as possible and should not push small businesses to IPOs until they can demonstrate a solid track record and are large enough to have reasonable chances of survival. However, to achieve this, the capital market must be able to provide the financing support required through the pre-IPO stages. See below for the weaknesses and policy issues related to improving the supply of VC in Canada.

Securities regulations reform

In Canada, there are 13 sets of rules and regulations administered by 13 different provincial and territorial regulators. Several groups, such as the TSX, the University of Toronto, the Ontario Government and the federal government, argue that this creates a red-tape nightmare for Canadian companies. The Canadian Securities Administrators (CSA) is promoting a uniform securities law for Canada, which would reduce complexity, increase protection from fraud, improve efficiency in Canada's capital markets and encourage investment. The current debate about securities regulations reform is far from resolution and some provincial regulators oppose such reform. Nonetheless, regulatory issues and burdens related to the public markets can affect all risk capital markets, including angels, the VC industry and IPOs.

However, very little research is available on the regulatory reform issue, its impact on the angel and VC markets, and how it would affect SMEs' access to risk capital. While the recent Carpentier, Kooli, Suret^{Footnote k} study did not specifically address securities regulations reform issues, it examined the regulatory environment surrounding the Canadian IPO market and studied its impact on Canadian firms and on the risk capital market.

The study explained that the direct costs of issuing an IPO are determined by regulatory costs (e.g. preparation of a prospectus, the payment of fees and the work of various professionals) and by the commission paid to an underwriter. The authors found that these direct costs in Canada were lower than the equivalent American costs and that the underwriter's commission was, on average, lower in Canada. However, because these are fixed costs, they remain very cumbersome, especially for small businesses.

Paradoxically, the authors noted that junior capital pool companies, for whom the IPO process is meant to be simplified and cheaper, actually pay a higher percentage of the transaction value to issue an IPO than do traditional IPO SMEs of comparable size (22.95 percent compared to 15.98 percent). Finally, given the relatively poor performance (measured in terms of survival rate of Canadian IPOs reviewed), the study concluded that all regulations should be reviewed so that they encourage companies to delay IPOs until they are more likely to survive and become successful.

Given the strong links between the public markets and VC, the provincial and federal governments should examine securities regulations reform, and assess current regulations governing Canadian firms' access to the IPO market.

Demand for VC

Too few investor-ready firms

Venture capitalists reported that the lack of quality investment opportunities was one of the major impediments to VC investment. In other words, while many firms may be seeking VC financing, few are ready or appropriate for such investment, at least in the eyes of venture capitalists. In fact, the literature suggests that venture capitalists are attracted by high returns and fast-growing, high-growth-potential business opportunities. Given these criteria, the growth of VC activity will require a critical mass of quality firms ready for VC investments. Unfortunately, angels and venture capitalists report that many potential investee firms are weakened by the lack of management skills and are unwilling to share ownership. The SME Attitude Survey^{Footnote l} reinforced this finding. Most business owners surveyed would not give up enough ownership of their firms to attract investment capital. The survey found that SMEs think that venture capitalists avoid risks and that their investment criteria and requirements are too stringent.

These concerns, from both venture capitalists and entrepreneurs, raise a few key policy issues and questions.

Does Canada have the infrastructure in place to build enough quality demand for more VC investment? For example, are Canadian SMEs well-supported by government programs in their quest for growth capital?
How can Canadian SMEs best be informed about the VC market? How can their expectations about VC be made more realistic?
What is the role of government (if any) in developing the management skills of Canadian SMEs?
How can government help Canadian firms become investor-ready?

Entrepreneurship by itself will not ensure a vibrant VC sector without the necessary institutional and regulatory framework (see below for more details).

However, since the SME sector is a source of economic dynamism, its development should be promoted by building the necessary program and policy framework, which means considering such issues as personal and corporate taxes, the regulatory environment and the growth of VC market support structures.

Lack of information about the demand for VC (and other types of risk capital financing)

For most firms, debt, leases, retained earnings and investments by the owners will satisfy the demand for capital. However, as explained in Part I and above, VC is limited to very young high-growth-potential firms that feature new or adapted innovative products for which there is no current market or no well-developed market. Hence, it is very difficult to collect and discuss information on SMEs' requirements for VC and on the overall rates of approval and rejection. This lack of information makes it hard to assess the VC industry's ability to provide risk capital to high-growth-potential SMEs across Canada. Part IV presents a number of options to address this information gap.

Supply of VC

Relatively low participation of domestic and foreign institutional investors^{Footnote m} in Canadian VC market compared to the U.S.

As shown in section 7, Canadian institutional investors have not played an active direct role in the VC market since 1996, although their recent increased contribution to new capital raised (about 18 percent in 2002)^{Footnote n} should lead to more investment. In terms of direct investments, institutional investments grew by only 15 percent between 1996 and 2002, which is far below the 139 percent growth of VC investment over the same period. Institutional investors' investments had the lowest growth of any investor type; foreign investments grew by 2021 percent and government funds' investments by 433 percent. Furthermore, institutional investors' share of the market has declined by 52 percent over the period, from 15 percent of total investments in 1996 to 7 percent in 2002.

The low participation of institutional investors (particularly pension funds) is probably one of the most significant differences between the Canadian and American VC markets. In the U.S., institutional investors contributed 89 percent of new capital raised in 2002 (compared to 18 percent in Canada).^{Footnote o} Given the importance and size of institutional investors, and based on the American experience, the growth and vitality of the Canadian VC industry will depend on the increased participation of institutional investors and private independent funds. For example, if institutional investors allocated a small portion (3-5 percent) of their portfolio to the VC asset class (preferably by funding Canadian private independent funds or through funds-of-funds), the impact on the Canadian VC market could be extremely positive. However, a number of barriers identified by institutional investors need to be overcome.^{Footnote p}

Investors need critical VC market information against which to measure the long-term performance and the inadequacy or unreliability of financial returns.
Problems with the tax and regulatory environment must be addressed, which raises some technical issues, particularly related to the foreign property rule.
More VC investment specialists are needed among institutional investors.
Trustees should support activity and institution-friendly infrastructures, such as gatekeepers and funds-of-funds. In the U.S., gatekeepers and funds-of-funds are used by pension funds as advisors and vehicles for private equity investments. This practice has addressed organizational barriers to investment and has given institutional investors substantial exposure to private equity. In Canada, until recently, there were no such funds-of-funds (and there are still no gatekeepers). However, in 2002, three funds-of-funds^{Footnote q} were created to help Canadian pension funds invest in VC. While this represents a positive development for the Canadian VC industry, awareness and confidence in these new instruments must be raised.
It takes too much money and time to review proposals and perform due diligence.
There is a high risk of high-profile business failures and liabilities.

Given these barriers and the increasing importance of VC financing to growing and innovative firms, Industry Canada (in partnership with the provinces of Ontario, Quebec, Alberta, Manitoba, Prince Edward Island and Nova Scotia) has asked Macdonald & Associates Limited to survey about 75 Canadian and American institutional investors. This survey will analyze institutional investors' awareness of private equity and their current investment strategies and processes, as well as the remaining barriers to private equity investment. The results of this study, to be published in fall 2003, will raise Canadian institutional investors' awareness of private equity and VC investment opportunities. The results will also help develop policy options that should make the Canadian private equity market more efficient.

Relatively low funding and participation of Canadian private independent funds compared to the U.S.

As shown in section 7, private independent investors have supported the growth of the VC industry in Canada since 1996. Private independent investors accounted for 35 percent of new capital raised in 2002, but have contributed less than other investor types, such as LSVCCs, foreign investors and government-owned funds. While private independent investors invested 58 percent more (from $198 million in 1996 to $313 million in 2002), the number of deals declined by 14 percent (from 235 to 202) and the average share of total VC investments declined by 34 percent to reach 13 percent of total investments in 2002.

To ensure the sustained development and growth of the Canadian VC industry, and to provide a significant proportion of VC investment, private independent funds must continue to grow and expand their fund-raising activities. For this to happen, these funds must be able to attract more capital from institutional and foreign investors, as is the case in the U.S. In that context, removing barriers to the participation of institutional investors would contribute indirectly to the increased participation of private independent firms. In other words, the recent creation of funds-of-funds, the publication of improved and reliable VC performance benchmarks, and the review of additional barriers to institutional investments should help private independent funds to raise money.

Furthermore, if private independent funds can establish a stable, long-term source of funding from pension plans, they could develop expertise and management skills and then undertake a larger volume of ongoing VC financings. This would provide these firms with the critical mass (in terms of size, funding and management skills) that they need to make a wider range of VC investments and to accept higher risk thresholds. These developments would allow them to become more competitive in the Canadian VC market and to provide more financing to SMEs at competitive costs.

Limited interest in new financing^{Footnote r}

As demonstrated in section 3, most VC investment since 1996 has come in the form of follow-on financing and at the expense of new investments. This trend has been even more apparent since the 2001 market downturn, which has forced venture capitalists to become more cautious in their investment decisions.

While this phenomenon appears natural in more difficult market conditions, it does raise significant concerns for young high-growth-potential firms seeking first-time VC financing. Indeed, many of these firms are at a critical stage in their development and without access to VC, they will be left with narrow financing options and limited chances of success. Since the financing of new investments is critical to developing innovative and competitive Canadian firms, the increasing preference of VC firms for follow-on financing raises key policy questions, which may be linked to the trends toward increasing deal size and later-stage financings.

What barriers (if any) face VC investors in funding new investments?
Does government have a role to play in supporting first-time financings?
Can public policy help investors overcome some of these barriers?

Limited capacity to finance very large deals

Deal size is a significant issue from a policymaking perspective, since it is the main determinant of whether a project is financed. Deal size also determines whether a company garners enough financing to support its survival and growth.

Canadians have been relatively successful in financing larger deals in recent years. Indeed, as mentioned in the previous section, large deals drove most of the VC industry's growth between 1996 and 2002. The amount invested in large deals grew more than any other deal size — by 274 percent between 1996 and 2002, compared to 28 percent for mid-sized deals, 5 percent for small deals and 26 percent for very small deals.

This tendency toward large transactions is linked to the increase in capital available for investment and the emergence of high-growth-potential firms in innovation-oriented sectors, such as information technology and life sciences, which tend to have higher capital needs and which have successfully attracted the interest of VC investors. This has increased the average deal size from $1.7 million in 1996 to $4.3 million in 2000 and to $3 million in 2002.

Nonetheless, there is still a significant deal size gap compared to the U.S., where the average deal size has consistently remained double or triple the Canadian average. In 2002, the average deal size was C$3 million in Canada and C$11.4 million in the U.S. The lower average deal size in Canada raises an important concern about the Canadian VC industry's capacit y to support and fund mid-sized and large firms that require large capital injections. In fact, the limited capacity of the Canadian VC industry may significantly affect Canadian firms trying to secure the capital they need to grow and expand.^{Footnote s} In the absence of appropriate funding, some firms may have to seek funding in the U.S. and may eventually move part of their business operations abroad. This is addressed below in the discussion of foreign VC investment.

The lower average deal size in Canada raises several policy issues and questions.

How does the average deal size fill the demand for VC by Canadian firms in different sectors and regions? Is there a real deal size gap in Canada?
What factors, if any, prevent the achievement of a higher (or optimal) deal size in Canada?
Does the Canadian VC industry have the resources to raise enough funds to sustain the continuous increase in the average deal size?
Will deal size continue to grow without increased access to institutional investment pools?
Is the average deal size only a reflection of venture capitalists' decisions or does the demand for VC play a role?
What role does conditions on access to public capital markets play in the growing focus on larger transaction sizes?

Continued challenges for seed and early-stage firms

It is often alleged that Canada's capacity to commercialize university research results and incubate high technology and biotechnology firms is constrained by a lack of seed or start-up investment capital, including angel investment and VC. But it is difficult to determine whether there is a gap in the supply of and the demand for capital.

First, it is hard to calculate the demand for seed capital in Canada. Not all VC financing requests represent commercially viable investment proposals and it is difficult for investors to identify firms seeking seed and start-up financing. In fact, VC investors may not know about seed firms looking for VC investment. University researchers face significant hurdles in developing and commercializing new ideas, but these challenges are often related to a lack of management expertise, which is a separate policy question.

Second, it may be difficult to evaluate and control challenges related to the structure of the VC industry and to the overall market environment. Venture capitalists require high-return potential, a defined market, a solid business plan and an experienced management team, so seed firms' difficulties in accessing VC are not unexpected.

Despite these difficulties, the situation does not appear to be disastrous. Indeed, the stronger focus on early-stage development in recent years can be attributed to the remarkable increase of seed and start-up investments, which grew by 546 percent and 262 percent between 1996 and 2002. This was higher than the 255 percent growth of early-stage investment as a whole and the 126 percent growth of expansion financing. In other words, the data for 1996 to 2002 reveal a significant improvement in seed and start-up firms' access to VC.

However, despite seed and start-up firms' improved access to VC, there remains a need to develop these firms' management skills and preparedness for VC investments, which will ensure the Canadian VC industry's continued support. Furthermore, current conditions in the public markets have led to fewer exit potentials and a shift in the focus of VC investments toward follow-on investments. This tendency may have a significant impact on companies seeking seed financings and first-time VC, as venture capitalists have been more conservative about due diligence and investments.

Importance, impact and future role of LSVCCs

As shown in the historical highlights in section 1.1 and in Part III, governments in Canada have used indirect and direct measures and programs to help the Canadian VC industry establish itself and grow. Key government initiatives in the VC market include tax incentives favouring individual investment in LSVCCs to fund VC activities and support job creation.

Created in 1984 during difficult economic conditions, LSVCCs have undoubtedly played a critical role in developing the VC industry in Canada, especially considering the withdrawal of pension plan funding from the VC industry in the early 1990s. This was particularly true in 2002, when LSVCCs regained their status as major players in the market (with 26 percent of total VC investments).

However, a recent study from Douglas J. Cumming and Jeffrey G. MacIntosh^{Footnote t} argued that LSVCCs limit the expansion of the aggregate pool of VC in Canada, that LSVCCs' mandates, which require that their capital be invested over a certain period, could result in companies being financed at higher valuation, potentially producing lower returns. They also found that the large pool of capital recently raised by LSVCCs may act as an overhang in the VC market and potentially limit the growth of new VC funds.

Based on these findings, Goodman and Carr LLP and McKinsey & Company, Private Equity Canada 2002, suggested that, while LSVCCs were designed to play an important role in stimulating the growth of SMEs in Canada, it may be time for industry participants to collaborate with the federal government to identify a more effective role for LSVCCs, one which would ensure that the Canadian VC market continues to attract new institutional capital.

Given the significant participation of LSVCCs and the recent opposition to them, Industry Canada is assessing the importance of LSVCCs, including their impact on and their future role in the Canadian VC industry. In particular, the study will examine the following issues and questions:

What is an LSVCC? What are their investment strategies and regulatory requirements (e.g. fund-raising, reserve, location, level of risk usually accepted, expected returns, diversification, timing of investments) and what are their average returns on investments?
What is the importance of LSVCCs' activity in the Canadian VC industry and what are their investment practices or preferences in terms of stage of firms, sectors and regions?
Does the Canadian government play a larger role in the Canadian VC industry than the American government does in its VC market? If so, can this difference be justified?
What are the impacts of LSVCCs on the Canadian VC industry? How do they compare to the impacts of SBICs in the United States?
What are the benefits (e.g. amounts invested) and costs (e.g. loss of tax revenues, impacts on VC industry) of LSVCCs?

The results of this review, expected in winter 2004, will improve analyses of LSVCCs and provide solid analytical information for the development (if necessary) of actions to improve the efficiency of the Canadian VC industry.

Importance, impacts and future role of foreign investment in Canada

The growing participation of foreign venture capitalists in the Canadian VC market since 1999 has been an important element in the ongoing growth and stability of the VC industry in Canada. Foreign investors accounted for most of the growth in overall VC investment since 1996, with an increase of 2021 percent of the amount invested in Canada (compared to 433 percent for government funds, 58 percent for private independent, 53 percent for LSVCCs and 139 percent for overall VC investments).

While foreign capital has been crucial to the relative strength of the Canadian VC industry, its benefits and drawbacks are not fully understood and these could raise significant policy issues for Canadian firms. Foreign investment is a relatively recent phenomenon and may be the result of specific market factors associated with the burst of the technology bubble or other structural dynamics.

Furthermore, foreign investors' penchant for high technology sectors has led to regional concentrations of financings, particularly in Ottawa and other clusters of high technology firms. According to a recent study from PricewaterhouseCoopers,^{Footnote u} foreign investment (which comes primarily from the U.S.) may pressure Canadian investee companies to move to the U.S., either directly or through mergers and acquisitions.

In fact, some of the Canadian companies funded by American investors, most of which depend on the American market to sell their products and to find experienced management personnel, find it easier to expand their markets by moving the entire company or some of its decision-making components to the United States. Such practices benefit American VC investors by easing the process of value-added support to their investee companies (through more active management support and recruitment) and by streamlining exit opportunities (through acquisitions of their Canadian investee companies).

With the potential loss of successful or promising companies to the U.S., Canada would lose the benefits of the longer term growth of these companies, particularly if they were to grow into world-class leaders in their industries. As a result, investment in Canadian companies by American VC firms, although beneficial to the overall strength of the Canadian VC industry, can have a downside over the longer term if these companies migrate to the U.S. This impact would be diluted if American investors, such as pension fund managers, invested in Canadian VC funds or invested as part of a syndicate in which the Canadian VC fund maintained some control.

From a policy perspective, it could be better for Canada to encourage inflows of foreign capital, from private independent or pension funds to Canadian VC funds, rather than to promote direct VC investment. To achieve this, the Canadian VC industry, particularly Canadian private independent VC firms, would have to be profiled and promoted to American pension funds and other investors. Canadian embassy and consular facilities in the U.S. could help by organizing and sponsoring trade shows and other promotional events, and in general by increasing the profile of Canadian VC investment opportunities.

However, since foreign investment is relatively new, Industry Canada has asked PriceWaterHouseCoopers to study the issue, culminating in the release of a profile of foreign investment in Canada in the fall of 2003; a second report on the impact of foreign investment on Canadian firms and on the Canadian economy is planned for 2004.

Sectoral preference and vulnerability

Importance of sectoral performance data
Performance data from the U.S. indicate that the sectors that attract the majority of VC investments (e.g. information technology and life sciences) also yield higher rates of return. While the recently published Canadian VC performance data do not provide sectoral breakdowns, VC investments generally flow to firms in sectors that offer higher rates of return. For this reason, Canadian performance benchmarks must be improved to attract VC investment in Canadian high-growth-potential firms and to increase institutional and foreign investors' participation in the Canadian risk capital market.

Sectoral vulnerability
While emerging and high technology firms have benefited greatly from VC investments in recent years, these firms are also more vulnerable to the cyclical nature of VC, to the reality of difficult public markets and to increasingly tight exit avenues. For example, it may be harder for these firms to access new VC financings, as the investment focus has favoured follow-on transactions. Moreover, some sectors may depend on declining foreign investment. Thirty percent of information technology VC came from foreign investors from 1996 to 2002, but these levels have been dropping in 2002 and 2003.

It must be determined whether these structural vulnerabilities during difficult market conditions merit long-term policy actions. While VC is critical to high-growth-potential innovative firms, some sectors may need to address structural and operational issues. However, some of these issues may be unrelated to the VC industry and some may fall outside the scope of government intervention. Below are some considerations for each sector.

Information technology — While information technology firms have been relatively well- served by the VC industry over the past seven years (compared to other sectors), past strength is an unreliable indicator of future vitality. A more detailed analysis of the demand and supply of capital to each subsector would help determine prospective vulnerabilities. A comprehensive analysis would show how to further improve the supply of capital to these high-growth-potential and innovative firms, particularly from institutional and foreign investors.

Life sciences — Life sciences firms attracted a growing amount of VC investment. They have captured a significant and relatively stable share of total VC activity from 1996 to 2002 and an average share of 19 percent of total VC investments from 1996 to 2002. However, these firms faced financing challenges, particularly given the smaller Canadian VC deals (around C$11 million in the U.S. compared to C$2.7 million in Canada). Life sciences firms also faced structural challenges; venture capitalists generally seek quick returns on investment, while life sciences firms often require more development and commercialization time before they become profitable.

A variety of factors may inhibit increased VC investment in biotechnology companies:

the structure of the biotechnology industry, which involves higher R&D costs and a longer period to profitability;
the limited managerial skills of biotechnology firms; and
the Canadian VC industry's relatively low level of specialization, which may compromise its ability to understand and assess the potential of new biotechnology products.

In that context, government programs need to reflect the shift toward developing and commercializing biotechnology. Many Canadian biotechnology companies are moving into the developmental stages of their research, some have reached the commercialization point, and many newer entrants continue to focus on the research and pre-development stages. Can government work with the private sector to help firms develop and commercialize biotechnology in Canada? What further policy actions would encourage VC investment in this sector?

Other technology — While firms in other technology sectors have not captured a significant share of total VC investments in the past, they could offer good potential investment opportunities. For example, the Kyoto Protocol may stimulate demand for new technologies, such as environmental technologies, which could lead to more investment in these sectors.

The VC industry must be made aware of these new potential opportunities to encourage venture capitalists to take on investment in new sectors. Fortunately, the past two or three years have seen VC investments to other technology sectors increase by 56 percent.

Traditional sector — The drastic growth of high technology firms and the growing interest of VC investors in these sectors have meant that companies in traditional sectors have attracted less VC investments. VC activity clearly follows the highest potential return and over the past seven years, the highest returns have come from high technology investment.

The financing of high-growth-potential traditional sector SMEs merits further study. Some of these traditional sector firms may offer high-growth potential, but because they are not in the high technology sectors, they may not attract the attention of venture capitalists. While policy options may not include reorienting VC investments toward this sector, supporting these firms to better market themselves and find appropriate forms and suppliers of risk capital could be considered. As well, there may be some connection between investment in traditional sectors and regional VC strengths. The Prairies and Atlantic Canada, as well as rural areas of some other provinces, are traditionally oriented and new technology sectors need time to evolve.

Regional concentration of VC activity in a few regions or provinces

The regional distribution of VC activity is important, but, for several reasons, is difficult to analyze.

It refers to the unresolved debate about whether the presence of VC leads to the creation of firms in specific regions or sectors, or whether the presence of the kinds of firms that secure VC results in the creation of VC funds and VC investments?
There are no measures or precise benchmarks to calculate the "optimal" or "appropriate" amount of VC investment for an economy or region.

However, several conclusions about the regional distribution of VC activity are possible.

The regional concentration of VC activity is not unique to Canada

VC activity in Canada is concentrated in three provinces. Between 1996 and 2002, Ontario, Quebec and British Columbia captured average shares of 49 percent, 31 percent and 11 percent of total VC activity.
In the U.S., the majority of VC investment is concentrated in four states. California attracted an average share of 42 percent of total VC between 1996 and 2002, followed by Massachusetts with 10 percent, and Texas and New York with 6 percent each.

The concentration of VC activity in Canada might represent VC investors' preference for certain types of firms that are concentrated in certain regions, rather than a structural issue or a gap.

Compared to all regions or provinces, the Prairies and Atlantic Canada attract relatively little VC activity
Several benchmarks can be used to examine the regional distribution of VC within Canada: VC investment as a percentage of population, economic activity (GDP), or proportion of KBI firms. While far from being a perfect measure, a strong case can be made that the appropriate benchmark is the proportion of KBI firms, as these firms are most likely to attract and make use of VC. The other benchmarks do not consider the very limited number and type of firms that can or should attract VC.

Using the proportion of GDP and KBIs, there appear to be two relative gaps in the Canadian market — the Prairies and, to a lesser extent, the Atlantic provinces^{Footnote v} — where the level of VC activity from 1996 to 2002 was lower than the proportion of KBI firms and GDP.

As discussed in section 6, in terms of growth of VC investments, the Prairies (growth of 93 percent of VC investments between 1996 and 2002) and Atlantic Canada (growth of 33 percent) have fallen short of the average growth of VC investment in Canada (139 percent) — a regional gap that is growing.

Furthermore, while in absolute terms the problem is worse in the Prairies, in terms of growth it is worse in Atlantic Canada. On the other hand, the number of funds active in the Prairies and Atlantic Canada has grown faster than the national average over the period.

Several factors explain the lower level of VC activity in these regions:

a general lack of awareness by VC investors about regional economic activities and opportunities, which is likely linked to weak networks between entrepreneurs outside central regions and VC investors;
a continued reluctance of Canadian and foreign VC investors to monitor and provide value-added assistance to remote investee firms;
a relatively lower level of KBI firms and regional activity in high technology sectors compared to central regions (despite the recent emergence of technology centres in some regions);
a lack of demand for VC or a lack of a critical mass of high-growth-potential firms in some regions; and
a lack of marketing and management skills in most SMEs, including regional firms.

While some of these weaknesses may be explained by the nature and operation of VC investment processes and by the structure of some regional economic activity, several initiatives targeted at VC firms and SMEs could mitigate some of these weaknesses and improve SMEs' access to VC in regions that have traditionally been underserved by the VC industry.

Recent improvements — changes in location preferences
Proximity continues to be a significant investment condition for most VC investors. But in recent years, an increasing number of VC fund managers no longer see location as a major impediment to VC investment, as seen in the recent trends in foreign investment and Canadian investment abroad. However, most VC fund managers still prefer to invest within a few hours of the VC fund's location or in areas that have a critical mass of high technology firms and viable investment opportunities.

As colleges, universities and research centres spawn a new generation of innovative firms, all regions can support growth. However, certain regions may lack the regional networks to discuss with venture capitalists and raise their awareness about viable regional investment opportunities.

The requirements of venture capitalists mean that VC is not appropriate for all firms in all regions. But government must remain attentive to local and regional supply conditions and to the importance of strategic partnerships between Canadian and foreign venture capitalists, who have demonstrated an increasing interest in investing abroad.

While location now means less to U.S. investors, government should try to better understand the intentions of distant venture capitalists to determine whether they anticipate that the company will remain in Canada or whether they want to relocate some or all of the company's operations. In fact, foreign VC investments in Canada are currently being reviewed and analyzed in detail by Industry Canada, PricewaterhouseCoopers and Macdonald & Associates Limited to determine the profile of foreign investors in Canada, from which Canadian firms secure foreign VC.

The study will also examine how these VC deals are structured and the short- and long-term impacts of foreign investments on Canadian firms and the national economy.

Provincial and regional access to VC
Based on the review of regional VC trends presented above, there should be a more detailed examination of the market conditions and motivations behind the concentration of VC activity in a few regions. In particular, a number of key regional factors merit further analysis: the importance of information technology in determining the regional distribution of VC investment; the weaknesses in VC investments in some regional life sciences sectors that have relatively strong research activities (e.g. government life sciences R&D spending by region; links between a region's total R&D expenditures (industry and government), management of intellectual property and product development; the number of new companies spun off by universities and hospitals; and the actual commercialization of technology transfer outcomes) as opposed to expected outcomes; the increase of foreign investment activity in only a few broad regions and sectors; institutional investors' apparent disinclination to invest in VC; and the importance, role and impacts of LSVCCs and other government programs in developing the VC market in specific regions where LSVCCs are heavily involved.

Importance and impacts of Canadian investments abroad

Despite the growth of Canadian VC activity abroad, investments made outside Canada raise several policy issues and questions. In particular, the data outlined in section 8 show that Canadian VC investments made abroad in 2002 were more oriented toward new financings (43 percent of total) than those made in Canada by both Canadian (26 percent of total) and foreign (8 percent) VC investors. While this may not be a long-term trend, the stronger focus of these Canadian investments abroad on new financings seems inconsistent with the recent difficulties faced by Canadian firms seeking first-time financing.

This may raise important questions about the quality of Canadian investment opportunities. For example, why are Canadian investors abroad more willing to finance foreign firms seeking first-time financing than they are to finance similar companies in Canada? This focus on new financings may be the result of investments in syndicates with foreign investors, which enables investors to reduce the risk of financing new deals through a more rigorous due diligence process and a sharing of the risk among investors.

Furthermore, life sciences investments made outside Canada are becoming more important, which may be related to the quality of Canadian investment opportunities.

In 2002, life sciences firms attracted 35 percent of total investments made abroad (compared to 39 percent for information technology firms). The relative importance of life sciences firms in 2002 was significantly higher than the 19 percent share of life sciences VC investments in Canada from 1996 to 2002. The impact of foreign investment on Canadian life sciences firms should be examined to determine whether this is a one-year phenomenon or a growing trend. It may be that a lack of quality life sciences investment opportunities is driving Canadian life sciences-oriented venture capitalists to look outside Canada.

^{Footnote a} Before 2002, performance data were only available for LSVCCs. However, these represent a particular subset of Canadian VC funds, one that is supported by government tax credits and has a social mandate (e.g. job creation and returns). As a result, their returns data do not necessarily represent the performance of the Canadian VC industry as a whole.

^{Footnote b} According to Goodman and Carr LLP and McKinsey & Company, Private Equity Canada 2002, compared to other major markets, the Canadian private equity market is relatively young. Many Canadian Gross Products (GPs) have short track records; investors have fewer products to select from; limited returns information exists to compare performance against the rest of the world; and gathering industry data is relatively difficult.

^{Footnote c} These were calculated as total capital under management divided by the total number of VC funds in 2002.

^{Footnote d} No solid statistics exist on the number of Canadian firms seeking foreign VC because these firms were unable to secure enough VC in Canada. However, a recent PricewaterhouseCoopers study, Foreign Investments in Canada (June 2003), for Industry Canada revealed that the distribution of investments across companies seeking investments of different sizes varied considerably between foreign investments and the average VC investment. Where the average VC investment in Canada was distributed across companies securing investments of all sizes, foreign VC investments were concentrated among firms raising over $5 million. Hence, foreign investors are a key source of financing for larger deals, accounting for about 35 percent of investments in companies of over $5 million. Conversely, domestic venture capitalists are the primary source of financing for smaller deals, accounting for over 95 percent of investments of less than $5 million. The study also explains that the concentration of foreign VC investments in larger deals probably happens because American venture capitalists, the dominant foreign investors in Canada, typically invest in larger deals than is the case in Canadian VC investments, on average.

^{Footnote e} Alan Riding, Informal Equity Capital for SMEs: A Review of Literature (Equinox Management Consultants Ltd., 2001).

^{Footnote f} A. Ellen Farrell, A Literature Review and Industry Analysis of Informal Investment in Canada: A Research Agenda (2001).

^{Footnote g} Alan Riding, Practices and Patterns of Informal Investments (Equinox Management Consultants Ltd., 2001).

^{Footnote h} Alan Riding, Value Added by Informal Investors: Findings from a Preliminary Study (Equinox Management Consultants Ltd., 2001).

^{Footnote i} National Angel Organization, Angel Investment in Canada: A Regional and National Perspective, 2003.

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

^{Footnote k} Ibid.

^{Footnote l} Université du Québec à Trois-Rivières, SME Attitude Survey (2000).

^{Footnote m} Institutional investors include private and public pension funds, insurance companies, mutual funds, endowments and charitable foundations.

^{Footnote n} In Canada, this investor type includes private and public pension funds (16 percent of new capital raised in 2002), insurance companies (1 percent), and endowments and mutual fund companies (2 percent).

^{Footnote o} In the U.S., this investor type includes private and public pension funds (42 percent of total capital committed in 2002), endowments and foundations (21 percent), and financial and insurance companies (26 percent).

^{Footnote p} Kirk Falconer, in co-operation with PIA of Canada, Prudence, Patience and Jobs (1999).

^{Footnote q} The three recently created Canadian funds-of-funds are Edgestone Venture Capital Fund of Funds, TD Capital Private Equity Investors Fund of Funds and the BDC Fund of Funds. These funds-of-funds have helped leverage some enhanced institutional participation and should exert even more influence in the future.

^{Footnote r} New financing refers to the first round of VC financing secured by an investee firm, whereas early-stage financing refers to the stage of development of the investee firm.

^{Footnote s} This deal size issue may be more significant for life sciences firms, which face particular challenges in securing appropriate financing. However, the challenges faced by life sciences firms in accessing VC may be explained by several factors, including the costs and time required to conduct research and development, challenges related to commercializing new products, a lack of knowledge by venture capitalists about the kinds of products being developed, and structural issues (e.g. size, management skills) related to the Canadian biotechnology sector in general.

^{Footnote t} Douglas J. Cumming, School of Business, University of Alberta, and Jeffrey G. MacIntosh, Toronto Stock Exchange Professor of Capital Markets, Faculty of Law, University of Toronto, Crowding Out Private Equity: Canadian Evidence (2003).

^{Footnote u} PricewaterhouseCoopers, Foreign Venture Capital Investment in Canada: A Profile of Foreign Investors and Domestic Investors (to be published in fall 2003).

^{Footnote v} Note that, as mentioned previously, the data used for this analysis do not permit a detailed review of the distribution of VC activity within the broad regions and provinces described above. As a result, some areas within the broader regions and provinces may not be reflected in this report. For example, this report does not review the issues related to the distribution of VC activity in Northern Ontario and Eastern Quebec, regions which may experience some difficulties in attracting VC investments. With better data on the demand for VC by sector and region, it would be possible to identify such areas that have the potential to attract VC investments but are not because of factors such as location (or others).

^{Footnote 85} Trends must be distinguished from the current situation. The strengths and weaknesses presented in this section are based on the VC investment trends observed from 1996 to 2002. They do not take into account the continued decline of VC activity in the first six months of 2003. As a result, current market conditions may present a less positive situation.

^{Footnote 86} According to the Goodman and Carr LLP, and McKinsey & Company Report on the Canadian Private Equity Market in 2002, the growth of the private equity market in Canada should continue because of Canada's attractive fundamentals (e.g. strong forecasted economic growth, less competition for deals, advantageous valuations and continued exit opportunities) and institutions' growing realization that private equity — as an asset class and in Canada — could offer attractive returns.

^{Footnote 87} Josée St-Pierre and Claude Mathieu, Venture Capital Financing: Evolution of Knowledge Over the Last Ten Years and Research Avenues (Laboratoire de recherche sur la performance des entreprises, Institut de recherche sur les PME, Université du Québec à Trois-Rivières, 2003).

^{Footnote 88} The Goodman and Carr LLP, and McKinsey & Company Report on Private Equity Canada 2002 argued that the U.S. market recognizes that supply exceeds demand, leading some fund managers there to return limited partnership commitments.