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

I. Introduction

The Unique Role of Venture Capital

Multiple research studies have detailed how VC activity is capable of transforming the innovations of R&D into value, and product ideas into major corporations, through a unique combination of financing and professional management (e.g., see Gompers & Lerner, The Money of Invention, Harvard Business School Press, 2001). A vibrant VC market can – despite its relatively small size – achieve superior, risk-adjusted returns for its investors, and simultaneously have a disproportionately large impact on a nation's economic growth, employment and productivity levels.

This same research frequently discusses how VC investment takes place in a dynamic and always evolving ecosystem. One part of this ecosystem feeds demand – e.g., researchers working on inventions in hospitals, laboratories, post-secondary institutions and centres for research, technology transfer and commercialization, and entrepreneurs working independently or in business to design new technologies or new applications of existing products.

The other part of this ecosystem handles supply – e.g., angel investors, managers of VC funds, and diverse market agents that provide not just money, but also mentoring and other value-added services to activity emerging on the demand side.

A VC market's success in generating value and economic wealth depends on how its ecosystem develops over time. In the United States, VC's birthplace, several decades of activity has created a sophisticated, entrepreneurial environment matched by an investor community with deep pockets and refined practices.

Canada's Evolving Venture Capital Marketplace

In Canada, such activity has also been underway, albeit for a shorter period of time, and involving a comparatively young industry.

It has been widely acknowledged that Canada possesses a rich innovation system, based on significant R&D investments, a growing class of entrepreneurs and business managers in competitive technology sectors, and an increasingly diverse VC industry. It has been further recognized that the Canadian ecosystem for VC activity must continue to evolve if it is to thrive and prosper (e.g., see Macdonald & Associates, Finding the Key: Canadian Institutional Investors and Private Equity, 2004).

VC Focuses on Young, High-Growth Firms

As the following report will show, a key aspect of recent market development in Canada has been growth in the quantity and quality of early-stage ventures. While the Macdonald & Associates' database indicates that such activity has always been a focus of Canadian VC – helping to spawn major businesses in clean technology, information technology (IT) and life sciences – activity of particular size and scope did not occur until the late 1990s (see Section II, Trends in Early-Stage Venture Capital Activity in Canada, 1996-2004).

Challenges to Undertaking Early-Stage Activity

The importance of this trend should not be underestimated. As one professional manager interviewed for this report said, early-stage funds are the "heavy-lifters" of the VC industry. Together with angels, these funds devote time and energy to helping entrepreneurs and inventors turn their concepts into young companies. Ultimately these businesses may, over the course of their lifecycles, create new markets or market niches, or take market share away from well-established competitors.

As VC professionals said repeatedly in interviews (see Section III, Results of a Survey of Canadian and US VC Professionals), this process is risky, long-term and management-intensive. Furthermore, it requires skill and patience on the part of VC fund managers, as early-stage investing is replete with trial and error. However, industry practitioners also agreed that, with persistence, the rewards should match the effort, as such activity acts as a pipeline for future high-growth firms (see Fig. 1).

D

As this report will also show, a number of specialty early-stage VC funds, or balanced funds (i.e., funds organized to integrate a broad market focus) with significant exposure to this activity, have recently been passing through their formative years in the Canadian market. Despite some successes, these funds also face challenges, including a still-evolving ecosystem, a prolonged down-cycle in the VC marketplace in recent years, and shortages of capital supply. These issues are discussed at greater length in Section III.

This report aims to touch on the key challenges currently facing Canadian industry practitioners engaged in early-stage activity, and to reflect some of their concerns and expectations for the future.