Innovation Canada: A Call to Action
Innovation Canada: A Call to Action Innovation Canada: A Call to Action
Innovation Canada: A Call to ActionFigure 7.2 Many Gaps Have Resulted in a “Vicious” Cyclein the Canadian Venture Capital Industry12345Shortage of of serial serial entrepreneurs and skilled and skilledmanagement with with global global networks networksGeneral GPs arepartners subscaleare and subscale lack strong and lack capabilities strong andcapabilities experienceand compared experience to compared U.S. GPs with USgeneral partnersSignificant investments made by government andSignificantretail funds,investmentswith objectivesmade byandgovernmentconstraintsand retailfunds with objectives and constraints (e.g., region(e.g., region focus, pacing requirements) mayfocus, pacing requirements) may hurt returnshurt returnsAngel network not well developedAngel network not well developedOver-investment in in early early stage stage without without adequate adequatefollow-on capital, leading to dilution to dillutionUndercapitalized and and sometimes sometimes dysfunctional dysfunctionalsyndicatessyndicatesmakemakefollow-onfollow-oninvestmentinvestmentsdifficultdifficultGeneral partners lack experience and networks todevelop GPs lackcompanies experience to and potential networks to developcompanies to potentialForeign general partners capture a disproportionateshare Foreign of exit GPsvaluecapture a disproportionate share ofexit value6Exits have been mediocre, as as public public markets markets place placeadiscount a on on Canadian Canadian venture VC-backed capital-backed companies companiesRelativelyRelativelylowlowlistinglistingrequirementsrequirementson theonTSXtheVentureTSXExchange can be counterproductiveVenture Exchange can be counterproductiveTotal funding to to venture VC capital-eligible companies companies was wasproportionately higher in Canada in Canada than than in the the USU.S.at theturn at the of turn the decade of thebut decade has significantly but has significantly decreased inrecent decreased yearsin recent yearsCurrent capital supply crunch, as institutional limitedCurrent capital supply crunch as institutionalpartners and retail funds have significantly reducedLPs and retail funs have significantly reducedinvestmentsinvestmentsGovernment-sponsored funds made up half of allavailable Government-sponsored limited partner capital, fundswith made allocation up half ofsometimes all available driven LP capital, by public with policy allocation and misaligned sometimesincentives driven byh public policy and misalignedBottom-quartile incentives funds receive largest share of capital;the Bottom-quartile fund natural selection funds receive processlargest is broken share ofcapital; the fund natural selection process isbrokenSophisticated LPsallocate appropriatecapital to the VCindustryVIBRANT VC4Attractiveexit optionsbring strongreturns5INFRASTRUCTUREVCECOSYSTEM1Talentedentrepreneursand managementstart high-potentialcompanies2Skilled VCs/angels directfunds to best3companiesBest companiesgrow throughadditional financingand VC support6Lower level of of non-dilutive capital capital from from government andother government sources prior and other to firstsources venture prior capital toinvestmentfirstLack VC investment of commercialization focus in R&D investmentRelatively Lack of commercialization low effectiveness offocus Technology in R&DTransferOffices investmentcommercializing technologyLack of connectivity to global markets, reducingRelatively low effectiveness of Technologyopportunities for syndication, business developmentTransfer Offices in commercializing technologyand exitsLack of connectivety to global markets, reducingopportunities for syndication, businessdevelopment and exitsSource: Adapted from BDC (2011).7-14
Filling the GapsAngel InvestmentAt the earliest stage — perhaps even before acompany is formed — an entrepreneur typicallyrelies on informal sources of capital from“friends and family” and later from angelinvestors. There are two structural obstacles thatlimit the supply of angel financing: (i) the veryhigh cost of evaluating and then monitoring aprospect, relative to the size of the embryonicbusiness and (ii) the novelty and technologicalcomplexity of the new business idea, whichmakes it difficult for an outside investor toaccurately determine the potential for success.As a result, angel investors target a high rate ofreturn to compensate for the risk they face andoften require entrepreneurs to invest asubstantial fraction of their own wealth in theproject, both of which may prevent viableprojects from going forward. Knowledgeable andexperienced investors are needed for capitalmarkets to function well, but there is also a rolefor government in promoting an efficient angelinvestment market segment.There are few reliable data on the supply–demand conditions in this informal market inCanada. In the US, where the market is welldeveloped, rates of return to angel investorgroups are high. A 2007 survey by the AngelCapital Education Foundation (now called theAngel Resource Institute) found that returns toangel investors in groups averaged 27 percent(Wiltbank and Boeker 2007), which was wellabove the average 10-year return of 18.3 percenton overall venture capital investments in 2007(National Venture Capital Association 2008).Industry participants describe the angelinvestment segment as underdeveloped inCanada, reflecting in part a relatively young riskcapital industry. As a result of this shortage ofsupply of financing relative to demand, it wouldbe expected that similar rates of return to thosein the US should be available to angel investorsin Canada.Venture Capital FinancingThose high-growth businesses that survive theseed and angel-financed stage of developmentusually then turn to the venture capital market,which is an important form of financing until thebusiness goes public, is bought out or is able toaccess conventional financing.The “modern” venture capital industry cameinto being in the US in the late 1970s (Lerner2009). The Canadian venture capital industry, bycontrast, is relatively young and small, havinggotten a second start in the 1990s, just beforethe technology bubble burst. Venture capitalinvestment in Canada experienced a postbubblepeak of $2 billion in 2007; since then ithas averaged $1.2 billion a year (BDC 2011). In2010, about 350 companies in Canada receivedventure capital funding, with an averageinvestment of $3.2 million and a totalinvestment of $1.1 billion (CVCA 2011).Meanwhile, venture capital investment in the USin 2010, at $21.8 billion, was about 20 timesthe Canadian total, and the average deal sizewas about twice as large (SSTI 2011).The smaller relative scale of Canadian venturecapital funds has two main consequences. First,in order to create enough diversity in theirportfolios, fund managers must keep investmentper project relatively low. The small deal sizespreads fixed costs — for example, evaluationand monitoring of investments — over a smallerinvestment base, which hurts returns. Second,smaller-scale Canadian funds are less able toparticipate in later-stage financing, since theseinvolve a larger average deal size. Canadianfunds therefore find it difficult to adopt thetypical US strategy of financing firms from early7-15
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<strong>Innovation</strong> <strong>Canada</strong>: A <strong>Call</strong> <strong>to</strong> <strong>Action</strong>Figure 7.2 Many Gaps Have Resulted in a “Vicious” Cyclein the Canadian Venture Capital Industry12345Shortage of of serial serial entrepreneurs and skilled and skilledmanagement with with global global networks networksGeneral GPs arepartners subscaleare and subscale lack strong and lack capabilities strong andcapabilities experienceand compared experience <strong>to</strong> compared U.S. GPs with USgeneral partnersSignificant investments made by government andSignificantretail funds,investmentswith objectivesmade byandgovernmentconstraintsand retailfunds with objectives and constraints (e.g., region(e.g., region focus, pacing requirements) mayfocus, pacing requirements) may hurt returnshurt returnsAngel network not well developedAngel network not well developedOver-investment in in early early stage stage without without adequate adequatefollow-on capital, leading <strong>to</strong> dilution <strong>to</strong> dillutionUndercapitalized and and sometimes sometimes dysfunctional dysfunctionalsyndicatessyndicatesmakemakefollow-onfollow-oninvestmentinvestmentsdifficultdifficultGeneral partners lack experience and networks <strong>to</strong>develop GPs lackcompanies experience <strong>to</strong> and potential networks <strong>to</strong> developcompanies <strong>to</strong> potentialForeign general partners capture a disproportionateshare Foreign of exit GPsvaluecapture a disproportionate share ofexit value6Exits have been mediocre, as as public public markets markets place placeadiscount a on on Canadian Canadian venture VC-backed capital-backed companies companiesRelativelyRelativelylowlowlistinglistingrequirementsrequirementson theonTSXtheVentureTSXExchange can be counterproductiveVenture Exchange can be counterproductiveTotal funding <strong>to</strong> <strong>to</strong> venture VC capital-eligible companies companies was wasproportionately higher in <strong>Canada</strong> in <strong>Canada</strong> than than in the the USU.S.at theturn at the of turn the decade of thebut decade has significantly but has significantly decreased inrecent decreased yearsin recent yearsCurrent capital supply crunch, as institutional limitedCurrent capital supply crunch as institutionalpartners and retail funds have significantly reducedLPs and retail funs have significantly reducedinvestmentsinvestmentsGovernment-sponsored funds made up half of allavailable Government-sponsored limited partner capital, fundswith made allocation up half ofsometimes all available driven LP capital, by public with policy allocation and misaligned sometimesincentives driven byh public policy and misalignedBot<strong>to</strong>m-quartile incentives funds receive largest share of capital;the Bot<strong>to</strong>m-quartile fund natural selection funds receive processlargest is broken share ofcapital; the fund natural selection process isbrokenSophisticated LPsallocate appropriatecapital <strong>to</strong> the VCindustryVIBRANT VC4Attractiveexit optionsbring strongreturns5INFRASTRUCTUREVCECOSYSTEM1Talentedentrepreneursand managementstart high-potentialcompanies2Skilled VCs/angels directfunds <strong>to</strong> best3companiesBest companiesgrow throughadditional financingand VC support6Lower level of of non-dilutive capital capital from from government andother government sources prior and other <strong>to</strong> firstsources venture prior capital <strong>to</strong>investmentfirstLack VC investment of commercialization focus in R&D investmentRelatively Lack of commercialization low effectiveness offocus Technology in R&DTransferOffices investmentcommercializing technologyLack of connectivity <strong>to</strong> global markets, reducingRelatively low effectiveness of Technologyopportunities for syndication, business developmentTransfer Offices in commercializing technologyand exitsLack of connectivety <strong>to</strong> global markets, reducingopportunities for syndication, businessdevelopment and exitsSource: Adapted from BDC (2011).7-14
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