Canada’s venture capital industry is in crisis and the country’s innovation-driven economy will suffer the consequences if we don’t find a solution.
It is a classic Catch-22 situation. Venture capital funds need capital commitments from institutional investors to make investments, generate returns and establish a track record of success. Yet, those same institutional investors are retreating from the asset class, in part because of the impact of the credit crisis but mostly because the Canadian VC industry has failed to consistently generate the type of returns expected from this asset class. As a result, we have too few institutional investors providing too little capital to a few venture funds that are, in turn, making few, if any, investments in Canadian technology start-ups.
Some think government should solve the problem by extending the life of retail VC funds that use tax incentives to attract individual investors to put money into the asset class. Some want government to put money into VC funds as well as make direct investments in start-ups. Others point to institutional investors and urge them to allocate more to the VC asset class.
Some or all of these measures may help but they, alone, are not the answer. If the VC asset class was producing consistent returns, then institutional and other investors would flock to Canadian VC funds. The problem is much greater and will take longer to fix. The problem is rooted in a systemic lack of deals, sub-par quality and a lack of investor patience.
First, VC funds need to see many more opportunities than they presently have available. A lot more. This is a numbers game of Darwinian proportions and, for a VC fund to achieve top-quartile performance, it needs to see a huge volume of opportunities from which it will choose to invest in a very few. According to the Canadian Venture Capital & Private Equity Association (CVCA), just 210 new businesses a year were financed on average by all domestic VC funds between 1996-2007. This pales to the rate of investment by VCs in most other parts of the world.
And, it is not getting any better. From 2003-2008, CVCA reports that while U.S. VC activity relative to the size of its economy (GDP) increased by 17%, VC investments in Canada dropped a startling 35%. Remove foreign investments in Canadian firms from the picture and the numbers are more dire — Canadian fund investments in domestic ventures fell a whopping 40% against GDP in the past six years.
And, as of the first quarter of 2009, Canadian VC deal activity had fallen to its lowest level in six years, with a total of $275 million invested in 102 companies — down 25% from $367 million invested in 136 companies during the same period in 2008.
There are three ways to increase deal volume:
1. Canadian universities need to graduate more students from technical sciences schools that want to work in start-ups and become entrepreneurs as opposed to just “employees.” Many of our universities and colleges fail to inspire technical sciences students to create start-ups. The best of our best computer science, engineering and other technical students should be equipped to create companies. Stanford University, for example, offers an iPhone software development course to equip grads with relevant and timely capabilities. Canadian educators must re-tool the relevance of their programs if Canadians are to compete and create globally.
2. Institutional investors should broaden the geographic scope of Canadian-based venture funds. Many restrict VC funds to the Canadian geography. VCs need to be able to pursue the best deals, regardless of location (within reason). For example, due to proximity alone, it may make more sense for some Toronto or Montreal-based VCs to invest in start-ups in Boston rather than Vancouver. Since internal rate of return (IRR) is the sole measure of success for VCs, geographic restrictions make it very difficult for them to meet return expectations. In a well-functioning market, IRRs of over 30% would be expected historically by many global VCs, yet Canadian VC funds often show only single-digit IRRs. The market in Canada is simply too small to support a captive VC industry.
3. We need successful Canadian entrepreneurs to do it again, to support the entrepreneurial eco-system, and collaborate and support the next generation of entrepreneurs. We also need to celebrate Canadian success stories to give budding entrepreneurs role models to look up to. Who are the Canadian versions of Google founders Larry Page and Sergey Brin that our entrepreneurs can look up to?
Second, we need better quality deals. Simply increasing the volume of sub-par deals won’t solve our problem. The technology industry is a global business and has no borders. Put directly, Canadians need to build world-class companies, not just “Canada-class” businesses if they are to be competitive. To do this, Canadian entrepreneurs need to make a wholesale shift in their attitude about markets, competition, ownership and opportunity.
I continue to hear from entrepreneurs that they want to expand throughout Canada before exploring opportunities in the United States. This is a fatal mistake. Canadian technology entrepreneurs need to adopt the view that Israeli entrepreneurs accepted long ago. There is no domestic market for their product or service. The sooner they recognize there is only a global market, the better off they will be.
As for competition in this global market, Canadian entrepreneurs need to operate under the assumption their competitors are better capitalized, networked and staffed than they are. As former Intel CEO Andy Grove said, only the paranoid survive. Our high standard of living in Canada sometimes shields us from the reality that somewhere out there is an entrepreneur who has nothing to lose by taking chances, making bold moves and just plain working harder than everyone else. We need more of that attitude in Canada.
Since I probably spend more time with American entrepreneurs than most other Canadian VCs, I can tell you Canadian entrepreneurs seem overly focused on owning the largest slice of what will turn out to be a very small pie. At the risk of generalizing, most American entrepreneurs would rather have a small slice of a really big pie. When it comes to financing a company with venture capital, entrepreneurs need to keep this concept in mind. It is a self-fulfilling prophecy that comes true more often than not.
Finally, too many entrepreneurs in Canada are creating “lifestyle businesses” that only aim to achieve a certain level of income or give them a “job” on their own terms. While there is nothing wrong with this, VCs are not in the business of funding these opportunities. To create the next RIM, VCs need to focus on entrepreneurs with game changing ideas who are building “companies” with large markets and high-growth potential.
Third, we need to encourage more foreign VCs to invest in Canada. This is a corollary to asking Limited Partners to stop restricting us to Canada. Foreign investors are already active and pursuing high-quality deals in Canada. It was recently reported that foreign investments in Canadian VC-backed companies are averaging $3.8 million, while domestic investments in similar companies average just $1.1 million.
These funds are helping create quality, high tech companies and jobs here. There is nothing wrong with this, even though some will argue it may lead to our best companies leaving Canada. Yes, that may happen. Companies relocate primarily because of talent, networks and access to capital. Silicon Valley is a compelling place to operate because, in the IT industry, it is the centre of the universe. Canada needs to build a competitive eco-system underpinned by a talented entrepreneurial and technical workforce that makes Canada a compelling place to do business.
Finally, we need to play the long game. Canadian VC funds need to adopt a new global perspective. The funds themselves need to be as differentiated and globally competitive as the companies they seek to fund. Desperate to show results to our Limited Partners, we tend to sell start-ups too early in their life-cycle. We need to keep feeding start-ups as they grow and attract foreign investors to provide increasing amounts of capital to fund that growth.
Canadian VCs also need to forge a new, more effective, operating model with early-stage investors, often called “angels.” Currently, the relationship between angels and VCs can be acrimonious with one pitted against the other over valuations and capital structure.
Venture capital plays a critical role in financing innovation and fewer start-ups in the nation’s pipeline is ultimately bad for the Canadian economy and its people. The U.S.-based National Venture Capital Association recently reported that VC-backed companies account for more than 20% of that country’s GDP. Canada could mirror that success.
With Canadian-based but globally-mandated VC funds, we can develop a world-class financing capacity while financing and growing the best start-ups in Canada and elsewhere in the world. This won’t happen overnight, so we must start now.
