Allan Riding explores the risks and challenges that face Canadian venture capitals. Will Canada recover?
What are the symptoms? Back in the heady three-year period of the dot-com boom, from 1999 through 2001, about $12 billion in venture capital was invested in Canada industry — much of it in early-stage financing for innovative companies. But in the most recent three-year period, from 2008 through 2010, the total was only about $3 billion—and about two-thirds of that was in the form of follow-on investment in firms that had already received initial venture capital (VC).
What are the problems? Of course, the recent global financial crisis has had an impact on Canadian industry; few would claim that the dot-com boom was sustainable. However, the malaise goes far beyond the effects of the economic downturn. Although it could be said that ten years ago there was actually too much venture capital investment, today many would argue that there is not enough. So the question remains: how much venture capital investment is an appropriate amount?
Analyzing the problem is far more complex than just trying to decide on the right level of supply. Another factor is that VC investment is inherently risky, and most investors have simply not generated rates of return that justify the high level of risk. Doug Cumming, a professor at the Schulich School of Business at York University, reports that VC returns on investment (ROI) have been nothing short of abysmal. Indeed, the most recent performance data show that ROI rates in Canada have actually been negative—that is, investors have lost money rather than making it. These results do nothing to draw new investors to venture capital.
Cumming argues that another aspect of the problem is governments’ well-intentioned interventions to stimulate the supply of venture capital. In his opinion, these have backfired. In particular, he questions the whole idea of labour-sponsored venture capital corporations, known as LSVCCs. This initiative allows individuals to contribute a portion of their savings to LSVCCs; these contributions not only receive tax credits from the provincial and federal governments, they may also qualify as RRSP contributions—giving individuals the added benefit of tax deferrals. For instance, taxpayers making over $100,000 can invest $5,000 in an LSVCC, and be only $1,180 out of pocket. Then they can cash in the investment years later for the original $5,000, plus any returns the fund may have earned. That’s pretty attractive. No wonder most of the venture capital currently available in Canada derives from LSVCCs. In fact, some early models, in Quebec, have double bottom lines: their goals go beyond a simple return on investment, and also aim to stimulate job creation and economic development.
There’s no doubt that LSVCCs have stimulated Canadian venture capital. However, the funds have some significant drawbacks. For one thing, they’re expensive to operate. They require the same high-priced talent as other VC enterprises: savvy people who can identify and nurture small but high-potential companies. But LSVCCs also require the kind of back offices that mutual funds have, including the staff and infrastructure to manage the many people whose personal savings are invested. Coupled with this high cost of operation is the fact that many have a downright poor selection of investments. Two University of British Columbia researchers, Jim Brander and Edward Egan, have shown that ROIs from government-sponsored funds such as LSVCCs perform especially poorly. In fact, they do so badly that only the tax benefits—which cost governments millions in forgone tax revenues—still tempt people to invest in LSVCCs. This has recently prompted Ontario, at least, to rethink the concept.
Other problems facing the Canadian venture capital sector are outlined by Miwako Nitani. In her PhD thesis, the Carleton University business professor has shown that the sector is relatively fragmented and poorly structured. In particular, she found that Canada has an imbalance of VC fund sizes. The vast majority holds less than $100 million, a level regarded in the industry as a bare minimum.
Consider the example of Chantry Networks, which had to raise $30 million in two years. This is not unusual: typically, VC funds need to hold eight to fifteen investments to reduce risk by diversifying their assets. In effect, the funds place multiple bets on prospective winners, hoping to achieve economies of scale and scope. But when a fund has less than $100 million, it is often forced to syndicate. Syndication may be a good thing if it brings in more experience and expertise; but when the move takes place because of a lack of capital, it weakens the fund’s strategic position.
Nitani’s research reveals that one consequence of an imbalance in fund sizes is excessive syndication. There are so few large VC funds in Canada that they are often sought out for syndication by many much smaller funds—meaning that the large funds often hold more than a hundred portfolio companies, many of which require syndicates of ten or more investors. This makes it difficult for management to make decisions or achieve consensus on strategic directions: with so many people to be consulted—managers, board members, and up to ten investors—even holding a meeting of the Board of Directors can be a challenge. And because the fund managers are responsible for so many portfolio companies, their ability to provide advice is stretched too thinly. As well, the company founders’ time and energy are often diverted from managing the firm and developing the product, and directed instead toward the tasks of seeking potential new investors and coordinating the existing ones. These are not formulas for success.
The shortage of large VC funds makes it difficult for companies to find late-stage investments in Canada, so their response is often to look south of the border—as Chantry did. Chart 2 shows that over the last decade, an increasing proportion of this country’s dwindling VC investment has come from foreign sources— typically, the U.S. Last year, 35% came from non-Canadian investors; and most was at the later stages of enterprise development. What this means, Nitani points out, is that our many small VC funds are taking on the early-stage risks of developing young firms—and offshore investors then harvest the successes.
What to do? In some ways, the problem is already being resolved, albeit slowly. Some provincial governments have indicated their intent to phase out the LSVCCs. However, other aspects are not receiving much attention. How can we make small funds bigger— especially when institutions, seeing the poor returns, are progressively less willing to allocate investment to venture capital?
Perhaps an answer can be found in the United Kingdom, where an interesting program is under way. Unlike Canada, where the government invests directly and indirectly in venture capital through the Business Development Bank (BDC) and Export Development Canada (EDC), in the UK governments lend money, at a fixed rate of interest, to the private sector.
While Canadian crown corporations have made relatively good investment decisions in the past, the direct approach requires them to hire and keep expensive talent—even though their future investment performance cannot be guaranteed. This direct approach essentially makes the BDC and EDC into VC investors into risky ventures, with taxpayers’ money.
In the UK, by contrast, this direct approach is gradually being replaced by the lending approach, which sees private VC firms competing with one another for the privilege of government financing. This does not require the crown corporations to retain as many fund managers. Government money in the form of a loan returns a set interest rate, and is somewhat secured by the assets of the investee companies. Also, VC investments made by private-sector fund managers are arguably better choices. Essentially, the UK approach seeks to leverage the successful VC firms in the private sector. It may make a lot of sense for Canada to keep a close eye on this British experiment.
Allan Riding is a professor in Telfer School of Management at the University of Ottawa. His expertise in the area of management growth enterprises enables the university to develop a better understanding of the business characteristics, strategies and environments that drive enterprise growth.
Dr. Riding’s primary research is the financing of small and medium-sized firms. His work spans bank financing, loan-guarantee programs, angel and venture capital, and initial public offerings. His current research focuses on the structure of the Canadian venture capital sector, preferences for, and access to, financing sources for knowledge-intensive small firms, and financing impediments to international trade.