Innovation Canada: A Call to Action

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Innovation Canada: A Call to ActionFigure 7.1 Funding Chain by Stage of Development and Size of InvestmentPublic MarketsMergers & Acquisitions$10M +Later StageVenture Capital$1M to$10MEarly StageVenture Capital$100Kto $1MBusiness AngelsAngel GroupsUp to$200KSource: The Panel.“Friends & Family”Government / universitiesSeed Prototypes Start-up Other EarlyStageLater stage/ExpansionMatureThe nature, the causes and even the existenceof a risk capital gap in Canada are the subjectof considerable debate. The Panel’sconsultations nevertheless revealed a strongconsensus within the community of venturecapitalists and entrepreneurs in R&D-based andtechnologically advanced sectors that gaps existalong the funding chain. Some recurring themesfrom the consultations included the following:there is a need to improve access to seedcapitalangel networks in Canada are not as welldeveloped as in the USCanadian companies are not as well financedas their US counterpartsforeign funds are present in adisproportionate share of Canadian exitsCanadian firms are often forced to, or chooseto, go public too early.Interviews with managers of venture capitalfunds and entrepreneurs, conducted on behalfof the Panel, highlighted the problems causedby the relatively small size of Canadian venturecapital investment funds. Subscale size limits theability of Canadian fund managers to followfirms through to maturity as the size ofsuccessive financing rounds increases. Thisadversely affects financing opportunities forinnovative firms in Canada and hurts theperformance of Canadian venture capital funds.Moreover, in the EKOS survey conducted for thePanel (see Chapter 5), lack of access to sourcesof finance was most frequently identified as themain obstacle to firms’ R&D activities.7-12
Filling the GapsSuch concerns are identified in the BusinessDevelopment Bank of Canada’s (BDC) VentureCapital Industry Review, released in February2011. 7 That review concluded that theCanadian venture capital industry was“broken.” Low returns have caused privateinvestors to leave the venture capital marketand, according to the BDC, it will takesubstantial changes to encourage re-entry. Asshown in Figure 7.2, the report identified a“vicious” cycle in the Canadian venture capitalindustry that contributes to its poorperformance, including:a shortage of serial entrepreneurs whobecome angel investorssubscale venture capital fundslimited pool of experienced, high-qualityventure capital fund managersover-investment in early-stage andinadequate follow-on investmentweak linkages to global experts, markets andbusinesses.Others consulted by the Panel argue that theindustry is in a cyclical downturn and investorsare avoiding early-stage technology companiesbecause the risk-adjusted returns are betterelsewhere. The BDC has concluded that simplyinjecting additional capital would not improvethe industry’s performance and that the key torestoring faith in venture capital as an asset classis to bring the industry to a state of profitability.Some economists have attributed the poorperformance of the private venture capitalmarket to “crowding out” by the laboursponsoredventure capital funds (LSVCFs) (see,for example, Cumming and MacIntosh 2006; andBrander, Egan and Hellmann 2008). LSVCFs,which accounted for about 20 percent of venturecapital investments in 2010 (CVCA 2010), arefunded by small “retail” investors who receive taxincentives from the federal and some provincialgovernments. Recognizing that they vary inperformance, some LSVCFs have poormanagement incentive structures and haveexhibited poor performance, 8 perhaps due inpart to overly broad mandates encompassingmultiple objectives such as regional development.Investment activity by retail funds has beenscaled back in many provinces and restructured inothers in order to promote better outcomes.High-growth firms can also obtain fundingthrough the TSX Venture market, and this mayreduce the number of high-quality investmentsthat seek venture capital funding in Canada,contributing also to the low rate of return in theventure capital industry (Carpentier, Cummingand Suret 2010).The issues affecting the performance of the riskcapital markets in Canada are complex, and itwill take time to resolve them. Governmentintervention should be undertaken in a cautiousand carefully structured manner to yield positiveoutcomes for the industry and avoid unintendedharm — an issue that is taken up below. Thenext section reviews in more detail the issuesfacing the angel investment and later-stageventure capital segments of the risk capitalmarket.7 The BDC is a financial institution owned by the Government of Canada. Its mission is to “help create and developCanadian businesses through financing, venture capital and consulting services, with a focus on small and medium-sizedenterprises” (http://www.bdc.ca). Note that the BDC is not the federal government’s sole mechanism to supplementventure capital markets. The Export Development Corporation (EDC), in fulfilling its mandate to help Canadian exportersand investors expand their international business, manages a portfolio of equity investments focussed on next-generationexporters, with a total investment value of $298 million. Farm Credit Canada, a Crown corporation, established FCCVentures in 2002 and since then has provided over $70 million in venture capital financing to small and medium-sizedbusinesses in areas such as agricultural biotech.8 For the latest performance data for captive/evergreen funds, which consist primarily of LSVCFs, see the press release ofCanada’s Venture Capital & Private Equity Association dated May 24, 2011 (available at: http://www.cvca.ca/news/).7-13
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