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

III. Results of a Survey of Canadian and US VC Professionals

III.1   The Survey Process

To shed light on recent trends on early-stage activity in Canada, Macdonald & Associates conducted interviews with senior professional managers in the VC industry, as well as prominent angel investors (see Appendix A for a full listing).

To facilitate these interviews, Macdonald & Associates developed a survey questionnaire intended to elicit practitioner feedback on multiple topics of relevance. This questionnaire included a section in which angels and VC fund managers gave rankings to current challenges of importance to undertaking early-stage activity in the Canadian market.

Senior professionals representing fifteen VC management companies in Canada were interviewed over the period December 2004 – January 2005. In general, these were professionals who managed balanced or specialty early-stage VC funds with operations across the country, or in specific provinces or regions.

In addition, senior professionals representing two major angel organizations in Canada were interviewed over the same period. While these organizations have broad VC interests, they are essentially based in Ontario.

Finally, to complement Canadian survey responses, Macdonald & Associates also interviewed VC fund managers based in the United States. Using a comparable survey instrument, these interviews focused on the longer-term experience of investment in early-stage ventures south-of-the-border, to elicit feedback on lessons learned.

Senior professionals representing four VC management companies in the United States were interviewed in January 2005. In general, these were professionals who managed specialty early-stage VC funds, and had some knowledge of related activity in Canada.

The findings of the survey process are summarized in the following three sections of this report:

Section III.2 contains a brief introduction to the primary investor relationships that characterize early-stage activity in the Canadian VC industry at the present time. Much of the information in this section derives from interviews with angel investors and venture fund managers. This section also includes an overview of survey responses, using Fig. 15, "Key Challenges to Undertaking Early-Stage Activity in Canada, Professional Manager Ratings By Importance" as a focal point.

Section III.3 contains more detailed commentary on issues by professional managers, again using Fig. 15 as a guide. In general, this commentary interweaves the feedback obtained from both Canadian and American survey respondents, using examples and illustrations as necessary.

Section III.4 considers some of the public policy recommendations arising from survey responses, including some specific proposals by VC professionals relevant to their ratings of "key challenges".

III.2   Overview of Survey Responses

Today, an array of market and non-market investors is active across the early-stage investment spectrum in Canada. Among market participants, the most important are angels, balanced or specialty VC funds with early-stage mandates, and various sources of partnership capital in the Canadian industry, outside of the industry, and outside of the country.

The Role of Angels

Angels are crucial players in a successful VC market, and especially in the realms of pre-seed, seed and startup activity. Research has shown that while most can be defined as well educated individuals of high net wealth, it is those angels with entrepreneurial backgrounds in distinct technology sectors that play a catalytic role in the early days of a high-growth business (e.g., see Riding, Madill & Haines, Practices and Patterns of Informal Investors, 2001). This is because these angels often bring solid company-building skills as a companion to their risk financing.

Using these skills, angels can assess the domain expertise of prospective founding entrepreneurs, and test proprietary ideas and innovations for true commercialization potential. As such, angels are vital screeners of VC deal flow, which make them invaluable to investors that may join them in later financing rounds.

Angels are sometimes called "informal" investors. In one sense, said VC professional interviewed for this report, this term excels at describing their hands-on activity in early-stage situations, as angels frequently develop close, creative bonds with founding entrepreneurs. Indeed, at this level, the investor is commonly indistinguishable from the founder, as the former coaches and mentors entrepreneurs – instilling a market perspective, where necessary – and is otherwise involved in all aspects of the emerging business entity.

"Collectivizing" Angels

Angels work independently and in combination. In the highly evolved American VC market, many angels have embraced "collectivization", or the forming of groups with numerous individual members, such as California's Band of Angels and Tech Coast Angels. These organizations, which mirror the features of funds in the VC industry, sometimes include pools for investment purposes.

There is evidence that this trend is taking hold in the Canadian market. For instance, Band of Scoundrels and Purple Angels have become key investors in Ottawa since their establishment by local angels in 2001. In 2004, these groups determined to leverage still more angel participation through the Ottawa Angel Alliance (OAA), which to date has attracted 60 members. An analog to the OAA is the Toronto Angel Group (TAG) with a current membership of 40, which has grown in collaboration with the Toronto Venture Group (TVG).

Angel "collectivization" is a development of note, as organizations like the OAA and TAG give members a means of risk mitigation – via pooled expertise, networks and resources, access to quality deal flow, investment-cost efficiencies, and other types of strategic support. For this reason, collectivization gives members not just new opportunities, but in the words of one angel interviewed for this report, "safety in numbers".

Angels and VC Fund Managers

The phenomenon of organized angels probably also increases the effectiveness of the overall VC industry. Among its advantages is a point of reference for VC funds interested in angel activity. This includes funds with early-stage mandates, which, over time, have increasingly occupied much of the same market territory as angels.

Survey respondents commented on the topic of market participants in early-stage ventures. A widely held view was that angels and VC fund managers brought very different strengths to this activity that, in part, explains why they typically work side-by-side in seed and startup transactions.

Many of the strengths of the angel investor have already been mentioned. Indeed, it is because of their unique characteristics that some early-stage funds prefer to utilize angels as a source of pre-screened deal opportunities in which value has already been injected. On the other hand, some VC funds have organized themselves to perform the same company building tasks as angels, chiefly by locating the necessary experience and skill sets in general partner (GP) teams.

And while the "informality" of angels lends them a special dynamism in early-stage activity, it may also encourage a lack of structure and discipline, say survey respondents. Fund managers, by contrast, offer years of experience in managing the economics of VC cycles, as well as a structured approach to due diligence, investment agreements and monitoring. In these and other ways, VC funds provide value to angel partners.

Survey respondents agreed that angels are especially motivated about the success of an early-stage situation, given their substantial personal investment. Regardless, like-minded angels and VC funds believe they share a common stake when early-stage ventures develop, and receive follow-on financing rounds. At this point, more partners may enter the picture with syndicate capital, but depending on the state of the market, sometimes at a very high price (from the perspective of existing investors).

The Role of Co-Investors

Angels and early-stage funds put great stock in trustworthy co-investors that bring something to the table at all steps in the process. For instance, when looking for optimally sized capitalization of deals, lead investors tend to prefer domestic or foreign VC funds with a compatible market focus (e.g., by sector), or those with whom they have had good experiences in past.

When these are scare, or when transactions are exceptionally capital-intensive, lead investors may turn to other industry players, or approach non-industry sources, such as Canadian corporations, financial institutions, governments and institutional investors.

Co-investors are also sought out for their strategic merits. In early-stage company financings, lead investors may prefer angels and like-minded venture fund managers as partners because of their reputations for company-building and extensive networks.

In follow-on rounds, the goal may be to introduce syndicate partners with later-stage specialization, for instance, where a portfolio firm needs to be prepared for IPO. American VC funds are increasingly popular as co-investors, because of their abundant market experience, and because of their reach into broader capital and customer markets, among other things.

Rating Challenges to Undertaking Early-Stage Activity

Professional managers in the VC industry were asked to rate a list of thirteen "key challenges" to making seed, startup and other early-stage investments in Canada. These challenges were identified by a small focus group of industry practitioners and analysts prior to development of the survey questionnaire by Macdonald & Associates. Ratings of 1 to 5 pertained to how much emphasis was given to challenges as continuing factors in the Canadian market.

The results of this exercise are found in Fig. 15.

Fig. 15: Key Challenges to Undertaking Early-Stage Activity in Canada
Professional Manager Ratings by Importance
(5 = Very Important, 1 = Not important)

Source: Macdonald & Associates Ltd.
Too few venture fund managers with adequate skills, experience	4.4
Early-stage venture capital pools are too small	4.3
Early-stage firms are undercapitalized relative to competitors	4.3
Too few venture capital funds focused on early-stage	4.2
Too few experienced business managers for company-building	3.9
Too few venture fund managers with sector-specific expertise	3.5
Not enough co-investors, particularly for follow-on financings	3.2
Too few seasoned entrepreneurs	3.2
Scope of venture capital liquidity options too narrow	2.8
Early-stage investors operate with overly restrictive criteria	2.8
Insufficient government support at front-end of early-stage activity	2.5
Inadequate market infrastructure for sourcing quality deal flow	2.4
Regulatory barriers to advancing IP and prototype testing	1.7

Interestingly, VC professionals interviewed for this report gave above average ratings to most of the thirteen challenges, and especially high ratings to at least eight of these. Survey respondents made clear that their attitudes were based on direct experience since the mid-to-late 1990s, when a large number of balanced and specialty early-stage funds were formed, in many cases, for the first time.

There are apparent links between the highest rated challenges, discussed in greater detail in Section III.3, such as "Early-stage venture capital pools are too small" and "Early-stage firms are undercapitalized relative to competitors". What is perhaps most telling about these and other issues given prominence is the importance attached by professional managers to ecosystem issues relevant to the still evolving demand and supply sides of Canadian venture activity as a whole.

Many veteran industry practitioners discussed their concerns in these broader terms, noting that several challenges are rooted in fundamental market practices that will change over time, as venture fund managers engaged in early-stage activity became more aware of them, develop new strategies, and generally persevere in "learning by doing", just as their American counterparts have done. Indeed, survey respondents based in the United States industry made the same point.

The following is a brief summary of key observations made by survey respondents about their ratings:

• The highest ranked issue was: Too few venture fund managers with adequate skills and experience. Survey respondents said early-stage activity required specialized skills sets relevant to building companies, including operating experience. Without access to these skills, professional managers were unlikely to add sufficient value to assist fledgling firms in their growth and development.
• Two issues tied for second spot: Early-stage venture capital pools are too small and Early-stage firms are undercapitalized relative to competitors. These issues are probably linked, as both boutique and larger, balanced-integrated VC funds must have access to sufficient resources to handle a full cycle of new and follow-on company financings. This has not always been the case in recent years, one consequence of which has been early-stage deal sizes that are sometimes too small, a situation that can impede rapid growth of young businesses.
• Not far behind was: Too few venture capital funds focused on early-stage. 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.
• Also rated highly was: Too few experienced business managers for company building. Survey respondents argued that options for drawing on local management talent when building early-stage firms are limited in Canada, as technology sectors have yet to produce large numbers of experienced business executives, particularly in sales and marketing.
• A substantial ranking was also accorded to: Too few venture fund managers with sector-specific expertise. Most respondents saw sector knowledge as being coupled with company building skills and, consequently, of importance to early-stage ventures, particularly in highly specialized areas of innovative activity.
• A significant rating was also given to: Not enough co-investors, particularly for follow-on financings. Survey respondents said they too often lacked co-investors in early-stage transactions, or in follow-on financing rounds in later stages. This situation, which is linked to the relative sizes of early-stage funds, has sometimes led to protracted periods for assembling syndicates and undercapitalized deals.
• Too few seasoned entrepreneurs also attracted a fairly high rating. Respondents argued that while the pool of entrepreneurial managers with track records in Canada is larger today than in past, more skilled entrepreneurs are needed to increase the rate of quality, early-stage deal opportunities.
• A slightly above average ranking was given to: Scope of venture capital liquidity options too narrow. While relatively small domestic capital markets place some limits on the current range of VC liquidity events, survey respondents did not believe that this obstructed their ability to grow major innovative businesses.
• Slightly above average emphasis was also given to: Early-stage investors operate with overly restrictive criteria. However, respondents thought that this issue was essentially a function of the market slowdown, and would be addressed by increasing the diversity of balanced and specialty VC funds with early-stage mandates.
• Only moderate emphasis was given to: Insufficient government support at front-end of early-stage activity. In general, survey respondents was satisfied by the level of public expenditure on R&D and other aspects of Canada's innovation system, though several argued strongly that government should assume a greater role in proof-of-principle activity.
• A significant challenge was not perceived in relation to: Inadequate market infrastructure for sourcing quality deal flow. Respondents said that various agencies that facilitate early-stage activity and market relationships were effective where in use, though some suggested these be extended to certain underserved regions and sector clusters in Canada.
• The lowest ranked issue was: Regulatory barriers to advancing intellectual property and prototype testing. The majority of survey respondents did not regard this as a key challenge, though concerns were identified for early-stage ventures in agri-food and perhaps other life sciences activity.

In their feedback, respondents also indicated that government policy-makers had a role in addressing selected challenges (see: III.4  Public Policy Recommendations Arising from the Interviews).

III.3   Detailed Commentary on Challenges of Early-Stage VC Activity In Canada

(1)   Too few venture fund managers with adequate skills, experience.

Senior VC professionals interviewed for this report put this issue at the top of their list, with a rating of 4.4.

As discussed previously, undertaking seed, startup and other early-stage activity is hugely time-consuming, and requires application of a unique set of management skills, acquired only through years of experience in company creation.

To be successful, angels and venture fund managers must be engaged in almost every dimension of business formation. At the seed level, for example, much of the effort may involve coaching and mentoring founding entrepreneurs, advancing R&D or initial product development, and working through the details of high-growth market plans and strategies.

By the time a startup occurs, attention must be paid to corporate governance and personnel decisions, such as hiring a CEO, or populating Boards of Directors with executives who can share advice and contacts. In these and many other ways, company infrastructure gets developed, always with the aim of injecting competitive advantages relevant to future growth.

In short, early-stage investors add considerable value to VC-backed firms in their first months of life. Industry practitioners with careers in this field said they could not do otherwise, as their interests are inextricably bound to those of founders. Regardless, such activity creates a special breed of venture professional – one that is particularly adept at recognizing good prospects for commercialization, and judging the best means for achieving growth.

Survey respondents believed that it is crucial to recognize the necessity of company building skills sets in early-stage situations. This means that professional managers must be equipped with more than just extensive backgrounds in financial risk intermediation, or even experience in managing the economics of VC investing – as important as these also are.

Along these lines, respondents argued that early-stage investors must show some evidence of operational experience in their professional activity, based or several years of running first-time businesses. In their view, well-established VC funds with early-stage mandates will typically locate operating skills in GP teams, or have networks in which these skills can be readily accessed by GPs.

Where these and other company building skills are not present – in one form or another – said most survey respondents, VC investors are likely to be passive or ineffectual when faced with crucial decisions in a fast-changing early-stage environment. This can unfairly place the onus for success or failure on inexperienced entrepreneurs.

After close to a decade of increased early-stage investing, Canada has grown its stock of experienced specialty, early-stage VC managers. Survey respondents observed that it is important not to squander this talent going-forward.

In addition, some respondents felt there is merit in finding ways to leverage comparable talent among veterans in the United States industry, perhaps through cross-border strategic partnerships, or by encouraging American funds to set up shop in Canada – as New Jersey's ProQuest Investments and California's VantagePoint Venture Partners plan to do in Montreal, in partnership with CDP Capital Private Equity.

(2)   Early-stage venture capital pools are too small.

Industry practitioners also gave this issue a high ranking, with an average of 4.3.

VC funds doing seed and startup deals must be large enough to handle considerable up-front costs, especially where fledgling firms are judged to have major growth potential. In addition, once portfolio companies move into new phases of development, there must be cash available for follow-on financings. For these reasons, said survey respondents, fund size matters.

According to respondents, limited resources posed a barrier to many Canadian funds launched in the mid-to-late 1990s. In particular, so-called "boutique" fund managers often operated with pools of less $20 million, $10 million, and even $5 million. While not a handicap in all circumstances, funds of these sizes can end-up relying too heavily on co-investors. Sometimes, difficulties were compounded for funds that failed to conserve money, or have spread it too liberally over too many firms.

Survey respondents felt that all Canadian early-stage funds – both balanced and specialty – need to be larger to be more effective.

Some respondents argued that what the VC industry needs most, however, is more "big" balanced funds in which the ingredients of early-stage activity – professional management skills, sector knowledge, well developed networks – are combined in a single, integrated organization. However, others saw a shortcoming in the large-fund model, as size can create pressures to invest only large sums, and dampen the appetite for extensive early-stage activity.

For some veteran fund managers, this appears not be a problem. For instance, despite having a current fund of $US250 million, Silicon Valley-based Newbury Ventures has been described as possessing a "boutique fund personality". This is a cultural quality that Newbury achieved strategically, in part through its situation of small GP teams in local IT clusters in the United States, as well as Canada (via Eagle One Ventures), Europe and Israel.

A similar quality has been ascribed to Sanderling Venture Partners, also headquartered in California, given this fund manager's ability to combine capital depth ($US230 million in Fund VI) with a tailored approach to seed and startup investments in life sciences.

Another route is for independent boutique funds to develop strategic relationships with larger entities. For instance, SAS Investors of New York launched its $US40-million partnership in 2001 with the backing of three major VC funds – Canaan Partners, Rho Capital Partners and Sevin Rosen Funds. In this model, SAS is able to concentrate on a select number of seed and other early-stage technology deals in Northeastern states, drawing on its partners for support and potential follow-on capital, when necessary.

Some survey respondents observed that versions of the SAS model have been tested in the Canadian market, with mixed success. Where problems arose, said respondents, strategic partners tended not share an equal commitment to, or understanding of, early-stage ventures.

Irrespective of the model, one barrier to larger-sized pools in Canada is the reluctance of many pension funds and other institutional investors to participate in the private equity market (see Macdonald & Associates Ltd., Finding the Key, 2004). While several balanced and specialty early-stage fund managers raised new resources in 2004 and early 2005 – including Brightspark Ventures, Celtic House Venture Partners, MSBi Capital and Ventures West Management – in general, there has been intense industry competition over too few sources of institutional money, said respondents.

For this reason, several survey respondents recommended a heightened role for Canadian governments as a source of early-stage fund supply. It was suggested that by acting as lead limited partners, governments might help leverage institutional investors.

Despite tax incentives, LSVCC and other retail funds with an interest in early-stage activity have also encountered pitfalls in fund-raising. For example, challenges exist in Ontario, where the retail marketplace has been crowded in recent years.

Be they limited partnerships or retail funds, potential sources of capital can also be skittish about early-stage VC investment mandates due to perceptions of the inherent risk. American survey respondents said this was also an issue for them south-of-the-border.

(3)   Early-stage firms are undercapitalized relative to competitors.

With a rating of 4.3, professional managers also identified this issue as a top challenge.

As discussed in Section 1.2, Analysis of Venture Capital Statistics, the average amount invested per early-stage firm in Canada's venture industry has generally been less than half of comparable deals in the American industry (see Fig. 14). In Ontario, average capital infusions were higher due chiefly to well-syndicated IT transactions – especially in 2000 and 2001 – but nonetheless reflected a shortfall as compared to the United States.

The size of early-stage deals tells only part of the story, as the Canada-United States market gap in VC financing rounds of all types – be they early-stage, expansion or later-stage in nature – is very substantial. This fact is of relevance to the progress of fledgling firms, as growth must be adequately financed at all points of the investment continuum.

Survey respondents emphasized this issue because "time-to-market" is an essential factor in successful early-stage ventures.

For instance, when vetting deal flow, VC professionals typically seek entrepreneurial situations where intellectual property and proprietary technology can be rapidly leveraged, often ahead of known sector competitors. If significant cash reserves do not exist in a given fund, or the time taken to assemble syndicates is protracted, the growth path of a firm may be slowed. In such cases, the result can be lost market opportunities.

This also suggests a link between deal sizes and the issue of resources available to VC funds. Several survey respondents argued that young innovative businesses in Canada are put at a disadvantage in a large and extremely competitive North American market when – due to small fund sizes – the seed, startup and other early-stage transactions backing them are too small and incremental.

(4)   Too few venture capital funds focused on early-stage.

VC professionals also gave this issue a high priority, according it a rating of 4.2.

Survey respondents tended to agree that the Canadian venture marketplace functions best when there are numerous management companies and funds with diverse market strategies, and oriented to diverse sectors and regions. This includes a variety of funds with clear by-stage VC capabilities, including those positioned across the early-stage investment spectrum.

As discussed in Section 1.2, Analysis of Venture Capital Statistics, there appears to be a correlation between the size and scope of early-stage activity in recent years and multiple new balanced and specialty funds. New fund formations, most of which occurred between 1995 and 2001 (source: Macdonald & Associates), prompted intensified activity in the lead-up to 2000 and thereafter, in what appears to have been a fundamental change in industry focus. This is most graphically illustrated in the case of seed activity, beginning in the latter half of the 1990s.

Respondents to the survey saw this correlation, observing that, in the case of seed activity, a number of small boutique funds with roots in local innovation systems, sector clusters, and angel groups were originally at the forefront of trends, along with a handful of larger, balanced funds.

Respondents also spoke of the pressures placed on early-stage funds of all types since the onset of the market downturn in 2001. After a fairly brief boom cycle, many funds were forced to shift gears and concentrate on survival strategies for portfolios firms. Not surprisingly, the sudden change in climate for industry activity had a depressing impact on the returns performance for funds with vintage years immediately prior to that time.

Due to the slowdown's long duration, the universe of active balanced and specialty funds has also contracted somewhat. In keeping with market realities, some funds have closed shop, some have merged, and others have redirected their energies towards later-stage opportunities. In addition, by 2004, many early-stage industry players were either fully funded or fast approaching that status.

During the slowdown, an increasingly important role was assumed by BDC Venture Capital Group, which has since 2002 managed the $100-million BDC Technology Seed Investments (BDCTSI). Using its regional offices across the country, BDCTSI greatly ramped up its activity in pre-seed and seed investments of between $250,000 and $1.5 million in the past year. Indeed, as also discussed in Section 1.2, BDC has been central to seed activity, in both up- and down-cycles of the market (e.g., see: Seed Activity Led by Key Community of VC Funds).

As noted previously, 2004 also marked several successful closings of new early-stage funds. In addition, at the outset of 2005, other initiatives were in the offing.

Examples include the new fund offering of Primaxis Technology Ventures – one of the pioneers of seed investment in Ontario's IT sectors – in partnership with Menlo Park's Draper Fisher Jurvetson. 2005 will witness the full launch of DFJ Primaxis Limited Partnership.  A key aspect of this new Primaxis fund will be its strategic role in the international DFJ network of affiliated early-stage VC funds.

The Quebec-based GeneChem will launch its second fund in the coming months, with CDP Capital Private Equity as its lead limited partner. With this fund, GeneChem will continue to focus on groundbreaking, early-stage companies in genomics and other life sciences in Canada, the United States and other countries.

On the retail side, GrowthWorks WV Management has established a new seed fund targeted at $40 million, and directed at deal opportunities in Ottawa, Toronto, and Southwestern Ontario. The new GrowthWorks Commercialization Fund is intended in part to emulate features of an earlier provincial model for Community Small Business Investment Funds, which fostered demand-supply relationships at the local level. However, the new fund would have more substantial co-investment capacity, given its access to the larger GrowthWorks pool.

Recent growth in OAA and TAG membership also indicates that more resources might be at hand for angel investors in this space. Survey respondents believed that such "collectivization" should be encouraged, given the vital role of angels as partners to early-stage funds, and as a transactional pipeline into the broader VC market. Indeed, it was argued that such models should be replicated in other Canadian regions.

These initiatives notwithstanding, survey respondents felt that there remain too few effective early-stage investors in Canada that combine sizeable fund sizes and some of the strategic qualities already discussed – such as seasoned professional managers – generally, and in specific, underserved regions and sectors.

(5)   Too few experienced business managers for company building.

Industry practitioners also gave fairly strong emphasis to this issue, evident in the 3.9 ranking on average.

As discussed under (1) Too few venture fund managers with adequate skills, experience, a major milestone in early-stage company development is the formation of management teams around founders. For angels and VC fund managers, this may involve introducing business leadership to an original team comprised primarily of researcher and technologists. In other cases, the task may be to match the skill sets of new managers with existing ones.

For this reason, one professional manager described early-stage investors as "human resource specialists". Of course, said survey respondents, there is a challenge implicit in the search for experienced CEOs and other top managers, either in the business-world-at-large or, more particularly, in innovative sectors of relevance.

Several decades of venture activity in emerging technology sectors in the United States has, in turn, spawned successive generations of business managers. In Canada's still evolving ecosystem, this process is not nearly so advanced in key sectors, leaving industry players with fewer options for drawing on local management talent.

Survey respondents further observed that differences could be perceived between regional sector clusters, depending on the degree to which these have achieved some critical mass. For instance, in Ottawa, telecommunications and other IT sectors have already produced a batch of senior entrepreneurial managers. By contrast, the national life sciences sector is perceived as still producing its first generation.

In the short-term, said industry practitioners, a strategic solution lies in more extensive foreign activity in early-stage syndicates. Along with abundant capital, such activity facilitates greater Canadian industry access to a broad North American pool of technology managers.

Above all, cross-border partnerships have provided a fresh source of sales and marketing executives. Virtually all survey respondents identified this as an area of major deficiency in Canada, irrespective of the sector context.

Several respondents spoke of new cross-border initiatives intended in part to further open doors. For instance, the DFJ network, to which Primaxis Technology Ventures is now affiliated, comprises 16 like-minded early-stage VC funds and other partners based in 27 regions on three continents. The network allows over 70 GPs to interact strategically, by sharing contacts, resources and market intelligence, and with the capacity to search management pools in the United States and internationally for potential hires.

More than one venture professional suggested that a target group for new hires of early-stage business managers should be Canadian expatriates working in established American technology corporations. Recruiting from these now highly trained executives could lead to, in their words, a "reverse brain-drain".

(6)   Too few venture fund managers with sector-specific expertise.

Professional managers also acknowledged the importance of this issue, giving it a rating of 3.5.

Survey respondents noted that, over time, venture activity in Canada has become increasingly differentiated along sector lines, a trend evidenced by the wide variety of fund products on offer by management companies. Today, the industry reflects a growing mix of funds with GP teams specialized to invest in clean technology, communications and IT, life sciences, and sub-sectors of these broader categories.

Most respondents viewed growth in the technology domain expertise of industry players as a step forward. Furthermore, they saw this trend as being necessarily coupled with growth in company building skills in the case of early-stage ventures, given that angels and fund managers typically work in sectors familiar to them. Others said the latter of the two qualities was the more crucial, as sector knowledge can be acquired by various means.

VC professionals with a singular focus on particular sectors or sector clusters tended to feel most strongly about the application of domain expertise in early-stage activity.

A good illustration is seen in the life sciences sector, which most respondents agreed was in an infant state of development in Canada, featuring young companies with unique needs at the time of seed, startup or other early-stage financings.

For instance, VC-backed biopharmaceutical firms progress in a manner unknown to many other technology sectors, with development paths of ten years-plus, due to extended periods of R&D, several phases of clinical trials, regulatory approval procedures, etc. Such firms are likely to develop a platform of one or more products, requiring major cash infusions on an incremental basis, but little prospect of revenues in the short-term (see Norland, "First Principles", Background to Financing Canada's Biotechnology Companies, 2004).

Just as they have in the United States, a number of balanced and specialty VC funds have been formed in Canada to apply a special blend of patience and skill to life sciences businesses in their formative years. Survey respondents observed that a key challenge for professional managers is to target those in the pipeline that can truly grow to create new markets or market niches in a sector that is still emerging on a global basis.

(7)   Not enough co-investors, particularly for follow-on financings.

With a rating of 3.2, VC professionals agreed that this issue also held considerable significance.

It has already been observed that over the VC financing history of a young, high-growth business, lead investors will commonly invite co-investors to participate in rounds for various strategic reasons. In addition, as discussed under (2) Early-stage venture capital pools are too small, syndicate partners are also regularly sought out when lead investors lack sufficient resources to undertake new or follow-on deals on their own.

Survey respondents argued that the problem of relatively small fund sizes has perhaps created overdependence on co-investment in the Canadian venture industry, for the purpose of increasing deal capitalization levels (see (3) Early-stage firms are undercapitalized relative to competitors). Certainly, data from Macdonald & Associates indicate that rates of investment syndication in Canada have risen steadily over time.

For instance, in 1996, the average number of VC investors per deal in Canada was 1.4. By 2001, the average number had climbed to 2.1, and in 2004, the average was 2.4. Interestingly, these overall rates of co-investment have grown irrespective of shifts in average company financing sizes.

Over the same period, rates of co-investment in early-stage transactions have generally trended higher: 1.6 on average in 1996, 2.4 in 2001, and 2.7 in 2004.

Survey respondents believed that, by contrast, co-investment activity in the American industry was less imperative for deal capitalization than it was for obtaining strategic value. Respondents thought this general rule applies to many early-stage funds in the United States, due to their comparatively large sizes.

While co-investors may be necessary to both early-stage and late-stage VC financing rounds in the Canadian market, the experience of many respondents suggests that finding them is not a straightforward proposition. Most spoke of obstacles in the process of assembling early-stage investment syndicates in a timely fashion. Even where co-investors were located, said respondents, there were often numerous complications, born of different fund types and their different governance structures. For instance, government or government-assisted VC funds (e.g., LSVCC/retail funds) are often bound by legal stipulations that unnecessarily complicate syndicate activity.

Survey respondents also felt that some Canadian industry players were simply unsuitable as co-investors. Examples include management firms with later-stage mandates, which do not always understand or appreciate the nature and requirements of VC-backed firms emerging from earlier stages of development.

In addition, while VC professionals welcomed the increasing role of American industry players in early-stage syndicates in Canada, several noted that much of this activity is hampered by legal and tax costs – or perceptions of these costs – depending on the nature of the transaction or the fund structure of the non-resident partner.

For instance, to avoid one set of tax difficulties – including those linked to the Canada-United States Income Tax Convention – American venture investors sometimes invest in private Canadian businesses via offshore subsidiaries, which are covered by more favourable international tax treaties. Alternatively, they may insist that a given Canadian firm become a subsidiary of a Delaware holding company, through an exchangeable share arrangement. These approaches are also fraught with challenges, however, that can end up deterring cross-border activity.

Survey respondents spoke of instances in which American venture fund managers have rejected early-stage co-investment opportunities in Canada out of hand, based on their assumptions about such issues, which they believe are likely to induce legal bills, paperwork, and considerable time taken to avoid still greater costs.

Respondents indicated that, in the absence of sufficient co-investors of various types in follow-on financing rounds, some fledgling Canadian firms might not experience optimal growth on their own, but instead be exited early by VC investors through a merger or acquisition.

As discussed earlier, more opportunities for syndication might be availed by boutique VC funds through collaborative relationships with larger entities. This is the model utilized by SAS Investors, as well as within the DFJ affiliate network. In both cases, partnership capital is made available subject to the standard due diligence procedures of independent, but like-minded, funds.

(8)   Too few seasoned entrepreneurs.

Industry practitioners also accorded an above average ranking to this issue: 3.2.

Similar to the discussion under (5) Too few experienced business managers for company building, the relative experience of founding entrepreneurs is integrally linked to the demand side of Canada's still evolving ecosystem for venture activity. Survey respondents agreed that as fresh generations of entrepreneurs gain experience in innovative sectors, so too will there be growth in the quality and quantity of deal flow that prompts successful seed, startup and other early-stage ventures.

Respondents also said that the pool of entrepreneurial managers with track records in Canada is probably larger today than it was even a few short years ago, and particularly so in key IT sectors. Indeed, some respondents believed that the Canadian market is currently benefiting from the activity of a relatively new batch of IT-focused "serial" entrepreneurs located primarily in urban centers in Central Canada and on the West Coast.

To enhance entrepreneurial skills, and to tap the knowledge and energy of "serial" entrepreneurs, there appears to be growing interest among Canadian VC professionals in "entrepreneur-in-residence" (EIR) programs.

For instance, the veteran investor, Ventures West Management, sponsors one of the largest EIR programs in the industry, offering seasoned entrepreneurs access to resources and networks as they work towards their next VC-backed opportunities. The EIR program at Ventures West has spawned some major early-stage deals, including the 2002 seed investment in OctigaBay Systems Corporation, which also saw a major acquisition just two years later.

Similar programs are featured in the operations of Skypoint Capital Corporation/Venture Coaches and VenGrowth Capital Partners, among others. Other venture fund managers flagged a desire to launch EIR programs, but currently lack the resources to do so.

There are also programs geared to advancing entrepreneurial and commercialization skills situated outside of the venture industry. Some of the best established of these are found in the United States, including the Ewing Marion Kaufmann Foundation, and entrepreneurship centres at the Massachusetts Institute of Technology, Stanford University and the University of California (Berkley).

American survey respondents said they found such programs useful, but also believed that the best skills training of technology entrepreneurs was to be found in direct activity in the marketplace.

(9)   Scope of venture capital liquidity options too narrow

Professional managers gave this issue slightly above average emphasis, with a rating of 2.8.

Survey respondents said that, in the immediate-term, the primary vehicle for liquidating VC investor shares in portfolio companies was mergers and acquisitions, with established American technology corporations assuming a pre-eminent role in the case of high profile acquisitions. Respondents believed that more IPO opportunities are likely to emerge soon – a view that was also reflected in Deloitte and Touche's Canadian Private Equity Outlook Survey, conducted at the close of 2004.

However, it was acknowledged that the scope of exit avenues in the Canadian industry is currently narrower than in the United States industry, which is a fact of smaller, and less mature, domestic capital markets. While this situation impacts all companies financed with VC, including those at an early stage of development, it does not undermine the ability of the industry to generate major, high-growth innovative businesses, said respondents.

Indeed, a recent report indicates that many young Canadian firms have moved up the VC ladder to graduate from lucrative exit events. Canadian Technology Investment Returns: Comparisons of Exits (Greenstone Venture Partners, 2005) asserts that low domestic investment costs relative to liquidity values has been one of several factors in the success of a larger number of venture-backed acquisitions and IPOs.

Moreover, survey respondents felt that as venture activity in Canada continues to evolve, the variety of exit alternatives will diversify, and include greater access to American public markets, such as NASDAQ.

(10)   Early-stage investors operate with overly restrictive criteria.

At 2.8, industry practitioners participating in the survey gave this issue a slightly above average ranking.

Survey respondents argued that the perception of overly restrictive criteria on the part of balanced and specialty early-stage VC funds is probably rooted in the post-2000 market slowdown, when these funds were forced to tighten due diligence procedures, conserve resources, and focus on existing portfolio companies, usually to the exclusion of new deal activity.

This said, there was recognition among respondents that, as discussed in (4) Too few venture capital funds focused on early-stage, some VC fund managers have adjusted their investment mandates to increase exposure to later-stage market activity – also as a result of the down-cycle. In these circumstances, the nature and degree of early-stage activity have sometimes also been adjusted.

Ultimately, said survey respondents, a broader and more diversified menu of early-stage options will materialize with a larger universe of Canadian management companies and funds with capabilities in this realm.

(11)   Insufficient government support at front-end of early-stage activity.

Overall, this issue attracted only moderate emphasis from professional managers, apparent in its 2.5 rating.

In general, survey respondents felt that governments at the federal and provincial levels are responsible for investing large sums of money in Canada's innovation system. Sizeable tranches of government expenditure support R&D in various private and public sector settings, as well as programs aimed at giving ideas and inventions commercial life, such as the National Research Council's Industrial Research Assistance Program and Technology Partnerships Canada.

In other words, Canadian governments make an important contribution to world-class R&D that will, in many instances, emerge as viable early-stage deal flow of interest to the VC industry.

This being said, venture professionals also believed that government should be more deeply engaged in proof-of-principle activity at the front-end of the commercialization process. Respondents noted that many new business formations are spun out of post-secondary institutions and other research centres in a premature state, and even without adequate validation of new technologies. As a result, Canadian VC funds are too frequently working with "raw material" in seed and startup transactions.

For this reason, survey respondents recommended that governments consider increasing expenditure on proof-of-principle facilities that bridge the gap between basic R&D and early-stage commercialization in the marketplace.

(12)   Inadequate market infrastructure for sourcing quality deal flow.

With an average rating of 2.4, VC professionals did not see this issue as being a key challenge.

In the Canadian VC industry, there are a number of agents and intermediaries engaged in matching entrepreneurs with angels and venture fund managers, and otherwise facilitating deal flow and improving the fundamentals of the market's operation. For example, since 1987, Inno-centre has performed a variety of roles in this regard, including that of as a business incubator, and today has operations in Alberta, Ontario and Quebec.

Some survey respondents believed that such agency activity was important, and especially in specific regions of the country. Others said that organizations that foster market relationships at the local level, such the Ottawa Centre for Research and Innovation (OCRI) and the TVG should be emulated elsewhere in Canada to promote early-stage activity.

Several respondents emphasized that such models for relationship building at the local level might be of particular value with respect to identifying and organizing angels. For some venture fund managers, this was of special importance given a desire to more frequently engage angels as a source of deal opportunities that were pre-screened and, in many instances, rendered "investment-ready".

(13)   Regulatory barriers to advancing intellectual property and prototype testing.

Industry practitioners did not regard this issue to be of substantial concern overall, giving it an average rating of 1.7.

The only specific concern raised by survey respondents pertained to the approach of Canadian regulatory authorities to clinical trials for agri-food products. It was observed that while Canadian standards in this area are not substantially different from those in the United States, the government review procedures in this country are of unduly long duration and can consequently impede "time-to-market" for relevant early-stage ventures.

Respondents believed that other barriers posed by government regulation probably exist for certain types of business formation in the life sciences sector.

III.4 Public Policy Recommendations Arising from the Interviews

Professional managers interviewed for this report were aware of federal and provincial public policy initiatives in the area of early-commercialization. They were generally supportive of these, and other efforts on the part of government officials to increase their understanding of how the outputs of Canada's innovation system realize their full potential in the marketplace and, wherever possible, to take steps in improving this process.

Survey respondents believed that the best way for government policy-makers to support the role of venture investment was to recognize the importance of the broader ecosystem in which market activity occurs.

This means that the domestic VC industry must be encouraged on its development path, along with the essential sources of quality deal flow – an increasingly solid base of seasoned entrepreneurs and business managers, particularly in emerging sectors, as well as more effective avenues through which new technologies generated in private and public sector research settings are tapped. Survey respondents argued that as this broader ecosystem matures, and the industry continues to focus on creating value for investors, its capacity for undertaking VC activity of all types will also grow and bear fruit.

As stated previously, survey respondents observed that both the demand and supply sides of venture activity have recently passed through several formative years in the Canadian market. On the supply side, this has been especially true for a still young community of balanced and specialty funds with mandates for making early-stage investments.

During the up-and-down market cycles evident since the late 1990s, the VC industry in Canada forged a stock of early-stage investors with fresh experience as company creators, or investors that have deepened this experience. As discussed, respondents feel that such management talent must not be squandered in the years ahead – for instance, due to capital supply shortages. Instead, all industry players should learn from the lessons of recent years, and strive to build on successes.

With these thoughts in mind, respondents made a number of suggestions for government policy-makers interested in supporting the ecosystem in which activity in early-stage ventures takes place. These included:

• Encouraging institutional investor participation in the market: Survey respondents said that governments have a key role to play in encouraging more pension funds and other institutional investors to participate in VC as limited partners. To this end, it was acknowledged that federal Minister of Finance's decision to eliminate of the foreign property ceiling in the 2005 budget was a step forward. Respondents believed other initiatives might be taken, such as removal of additional tax barriers, as proposed by the Canadian Venture Capital and Private Equity Association, or the creation of new tax incentives.
• Government assuming more of a role as limited partner: Both Canadian and American industry practitioners noted that, even under the best circumstances, some traditional sources of capital might be skittish about seed and other early-stage VC funds. For this reason, and in the interest of leveraging more institutional fund participation, government VC funds should consider increasing their role as lead partners in privately managed partnerships, perhaps by taking a subordinated return. As part of this strategy, several respondents also said that governments should also actively encourage the inception of funds-of-funds.
• Advancing proof-of-principle activity in commercialization: Many VC professionals argued that governments should greatly expand their role at the front-end of the commercialization process, whereby ideas and innovations emerging from post-secondary institutions and research centres are validated through proof-of-principle tests – prior to requests for VC financing. Some survey respondents saw this as a vital "missing piece" in Canada's innovation system, the absence of which undermines early-stage activity.
• Facilitating Canadian entrepreneurial management skills: Many survey respondents pointed to EIR programs as an important means of developing or utilizing the skills of entrepreneurs. While the VC industry is a primary locus for these, said respondents, governments and other public sector organizations may have a role in supporting related programs, such as has occurred widely in the United States (e.g., Ewing Marion Kaufmann Foundation).
• Assisting identification and organization of angel investors: VC professionals view angel investors as strategic partners, both as sources of pre-screened, value-added opportunities, and as company creators alongside fund managers in early-stage activity. Respondents were positive about OAA, TAG and other initiatives whereby angels are organized and higher profile. Several thought governments might assume more of a role in advancing this process in key regions and sector clusters, by supporting OCRI- or TVG-like models, for instance, which have fostered angel-VC fund relationships.
• Removing barriers to cross-border venture activity: Professional managers interviewed for this report acknowledged the increased activity of American VC funds and other foreign investors in Canadian early-stage transactions, as well as the implicit value of this trend in terms of access to resources, expertise, markets, etc. For this reason, most respondents said governments should investigate potential legal barriers that might unnecessarily impede or impair this activity, such as been suggested when non-residents invest in private Canadian businesses through Delaware or offshore subsidiaries. Governments should also consider any unintended tax policy obstacles to the ability of American/foreign VC funds to establish permanent residence in Canada.
• Addressing regulatory obstacles to early-stage VC investment: While industry practitioners did not regard the regulatory standards of Canadian governments as a barrier to most early-stage activity, there was concern about how lengthy review procedures might unintentionally slow activity in agri-food and, perhaps, elsewhere in the life sciences sector. For this reason, some respondents recommended that governments consult with VC professionals on this topic and ensure that unnecessary delays do not occur.
• Other areas of concern: Without formulating specific proposals, survey respondents raised other issues they believed should be considered by governments, including: the potential role of Canadian expatriates in new business formations at home; geographic restrictions on government or government-assisted VC funds (e.g., LSVCC/retail funds) in an increasingly North American market, and other legal stipulations that unnecessarily complicate co-investment activity.