Innovation Canada: A Call to Action

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