Growing the Businesses of Tomorrow: Challenges and Prospects of Early-Stage Venture Capital Investment in Canada

Executive Summary

Since the late 1990s, Canada's venture capital (VC) industry has witnessed growth in the volume of early-stage transactions involving new businesses in clean technology, communications, information technology (IT), life sciences and other innovative sectors. Indeed, since this time, there has been a fundamental shift in industry focus towards early-stage activity as compared to prior years.

For this reason, the period 1996 to 2004 – which reflected both up- and down-cycles in VC investment – can be regarded as formative years of much Canadian industry activity in early-stage ventures. A key feature of this period was the emergence of a new generation of VC fund managers and funds, formed to apply specialized management practices and techniques to facilitate seed, startup and other early-stage deals.

This new community of balanced/specialty funds with early-stage mandates was largely responsible for the industry's refocus, in partnership with angel investors, and domestic and foreign sources of syndicate capital. As has occurred in the longer history of the United States (US) VC industry, such funds have been pioneers of value-added, early-stage company building in a Canadian market context.

Despite their clear influence on industry trends, early-stage investors have encountered major challenges along the way, not the least of which has been a prolonged market slowdown since 2001, and a difficult fund-raising climate that threatens to undermine or erode progress made to date, and block progress down-the-road.

In addition, seasoned early-stage investors believe strongly that there are lessons to be learned from the experience of recent years. A key message was that the process of early-stage VC investment in Canada must be more strategic, and much better capitalized, going forward, and with even greater onus placed on adding value. This can be achieved, they say, through industry concentration on management skills relevant to growing fledgling firms, more and larger-sized funds, increased deal sizes, and further development of the Canadian ecosystem for venture activity as a whole. By tackling such issues, domestic industry capacity for undertaking early-stage investments can be greatly enhanced.

These are just some of major findings of Growing the Businesses of Tomorrow: Challenges and Prospects of Early-Stage Venture Capital Investment in Canada, which examined early-stage activity in Canada and Ontario since 1996, using statistics extracted from the Macdonald & Associates' database, and comparative US data (Section II of the report, Trends in Early-Stage Venture Capital Activity in Canada, 1996-2004), coupled with the insights of senior VC professionals, obtained in interviews conducted by over December 2004 – January 2005 (Section III, Results of a Survey of Canadian and US VC Professionals)

Key Findings of the Statistical Analysis

Macdonald & Associates' data show that early-stage activity in the VC industry in Canada (and Ontario) saw exceptional growth in the latter half of the 1990s, as seed, startup and other early-stage deals gained considerable traction with respect to numbers of companies financed and capital invested, and even succeeded in outstripping aggregate trends in peak years of activity.

While activity in early-stage ventures began to decline in absolute terms with the market downturn, its relative share of total VC activity was largely sustained as compared to previous years. For instance, prior to 1999, seed deals accounted for just over 1% of dollars invested annually, but have sustained over 2% since then. Similarly, in the lead-up to 2000, startups obtained just over 10% of industry cash, but have typically registered something closer to an 18% share thereafter.

This attests to the nature of market change since 1996, that the data further show to have been concurrent with greater emphasis of emerging telecommunications, IT, life sciences and other technology-intensive sectors of some critical mass, in key urban regions of the country.

The data further indicated that relatively large company financing sizes, particularly in IT sectors, have been integral to high levels of disbursements going to early-stage activity. The activity of diverse industry players, including government funds, LSVCC and other retrial funds and private-independent funds, contributed to this trend. This activity frequently involved major syndicates that tapped substantial supplementary resources from American VC funds and other foreign investors – at least since 1999 – though non-residents have tended to invest in only a fraction (5-6%) of all Canadian early-stage firms.

Private-independent funds were integral to growth in seed investment up to 2000 and have remained key to activity since then, while LSVCC/retail and government funds have steadily increased their relative shares, especially after 2001.

These trend lines notwithstanding, the data further reveal a major, and persistent gap between the average sizes of Canadian early-stage financings and those in the US. For instance, since 2000, the average capital infusion in related deals in Canada has typically been less than half of the average south-of-the-border.

Key Findings of the Interviews

Reflecting on industry trends, professional managers surveyed for the report agreed that a fundamental shift in focus towards early-stage activity has taken place since the late 1990s, which they linked with the emergence of dedicated Canadian early-stage VC funds (Macdonald & Associates data show most related fund inceptions as occurring between 1995-2001).

While stressing the central importance of this development, VC professionals also emphasized the challenges that early-stage investors now encounter following three years of a slower market, and a fund-raising environment that has become increasingly tough for industry players of all types (a fact that has also been confirmed in Macdonald & Associates' data), chiefly because of limited capital sources. This is an especially critical issue for funds that have recently become fully invested or near fully invested.

Challenges with roots in the market's down-cycle have also existed for an essential partner to venture fund managers undertaking early-stage activity – angel investors. In response, the interviews found that a new strategy being embraced by many Canadian angels was "collectivization", or the forming of groups that provide for risk mitigation and resource sharing. To this end, organizations like the Ottawa Angel Alliance and the Toronto Angel Group have recently been built on a well-established US model.

To clarify the nature and significance of specific issues confronting early-stage investors, interviewees were asked to rate a list of thirteen "challenges", identified in pre-survey consultations by Macdonald & Associates. Industry practitioner rankings of these challenges (see Figure 15, Section III, Results of a Survey of Canadian and US VC Professionals) were accompanied by commentary, based on "lessons learned" since the late 1990s. This was mixed with feedback from American fund managers who have addressed similar issues over a longer span of time.

Of the thirteen early-stage "challenges", eight attracted especially high ratings from survey respondents (on a scale of 1-5, an average rating of between 3.2 and 4.4).

The highest rated issue concerned VC professional skills sets relevant to investing in early-stage ventures. Respondents said that such activity required a unique blend of specialized skills that pertain to company creation, including operating experience. Without access to these skills, venture fund managers were unlikely to add sufficient value to assist fledgling firms in their growth.

Industry practitioners also gave some weight to the sector knowledge of early-stage investors, though this challenge was not ranked as highly as company building skills. In general, respondents saw this expertise as being most relevant to very specialized areas of innovative activity (e.g., life sciences).

Survey respondents also argued that first generations of Canadian early-stage VC funds have typically been too small, as both balanced and specialty funds must have adequate resources to handle a full cycle of new and follow-on company financings. For this reason, a goal of new early-stage fund formations must be greater capital depth. This challenge took second spot among interviewees.

Equal significance was accorded to undercapitalization of early-stage transactions in the industry. Survey respondents were not surprised by the Macdonald & Associates' data finding of a Canada-US gap, noting that this has created a major competitive disadvantage for young Canadian technology businesses, given the importance of "time-to-market" in the VC world, and particularly in certain sectors.

VC professionals also placed a great deal of emphasis on the number of active early-stage VC funds. Despite recent fund formations, and several new fund products on offer in 2005, respondents believed there are too few effective early-stage investors in Canada, generally, and in specific regions and sectors.

Among the other highest-rated challenges, the issue of too few local business managers available for company building was singled out, which survey respondents said was a result of nascent Canadian technology sectors. For much the same reason, interviewees also thought there remained too few experienced entrepreneurs to found new businesses, though this situation has improved somewhat recently.

VC professionals were also concerned about the number of co-investors necessary to take venture-backed firms through successive stages of development. With regard to this issue, respondents expressed a strong interest in increasing access to US VC funds, due to their abundant market experience and deep pockets.

Throughout their commentary, Canadian and American industry practitioners proposed various, marketed-based strategic responses for addressing the challenges discussed. They also emphasized that the formative years of early-stage activity in Canada has produced significant VC management talent that must not be squandered in the years ahead – for instance, due to capital supply shortages.

Some Public Policy Recommendations

Professional managers also reflected on the role of federal and provincial governments in the area of early-commercialization, noting that public policy would be most effective by supporting the development of the broader ecosystem in which market activity occurs.

Along these lines, several initiatives by which public policymakers could support early-stage activity in the Canadian VC industry were recommended. These include: Encouraging more institutional investor participation in the market; establishing a government role as limited partner in private funds, perhaps via funds-of-funds; investing in proof-of-principle activity at the front-end of early-stage projects; facilitating entrepreneurial skills development; assisting in the local organization of angel investors, and; removing tax and legal barriers that unnecessarily impair cross-border activity in early-stage syndicates.