The Winds of Change
Canadian Venture Capital: An Industry in need of an Overhaul
by Ted Anderson, Managing General Partner

The winds of change seem to be blowing through the venture capital industry in Canada. Industry participants are beginning to realize that we need to change our approach to the market if we are going to create globally competitive companies and generate competitive rates of return for investors. A study recently released by Canada's Venture Capital and Private Equity Association (CVCA) entitled “The Drivers of Canadian VC Performance” suggests that as an asset class the Canadian VC industry, with the exception of a few top performing funds, is not generating reasonable or acceptable rates of return. The US venture industry, on the other hand, is considered a performing asset class – delivering, on average, acceptable rates of return for their investors.

There are a number of reasons put forward by the study to explain why this is the case but the most striking is that in Canada capital allocation is inefficient and financings are too small. The report suggests that this is partially due to the fact that many Canadian VC funds are too small. Smaller funds must make lots of small investments in order to get reasonable portfolio diversification as well as focus on early stage companies in order to get a reasonable equity interest for these small investments. The 2005 data collected reveals a number of interesting facts. In terms of the number of financings, 53% of Canadian investments are early stage versus 33% in the US. In terms of dollars, 49% of the capital invested in Canada goes into early stage companies vs. 19% in the US. Exacerbating this is the fact that the size of financings in the US is substantially larger – almost twice as large in early stage investments (an average of $5.7 million in the US vs. $2.6 million in Canada) and almost four times larger in later stage investments ($11.8 million in the US vs. $3.2 million in Canada)!

How can Canadian companies compete with this disparity in capital relative to their US competitors? How do they competitively fund market growth and development? Simply, they can’t. And this, to a large degree, drives another phenomena identified in the study – Canadian companies are not, on average, achieving large exits, whether by acquisition or public market offering. Most companies are either sold too early because of lack of capital resources or, more commonly, the company has not gained market traction or penetration as quickly as some of its competitors. Venture rates of return can not be achieved without the occasional big win and Canada is not, as an industry, getting enough of them.

When we here at Ventures West talk about being successful, we talk about investing in companies that have the wherewithal to compete with any company, anywhere, while in the process generating a venture rate of return for our investors. We don’t want to invest in a company striving to be the best in Vancouver or Ottawa or Montreal; we want to invest in companies that have what it takes to compete on a global basis and become the best in the world in whatever their market segment might be. In order to be successful in this quest more than unique IP, a big market opportunity and smart, capable and enthusiastic people are required. There are a lot of other very smart, capable and enthusiastic people in labs and garages all over the world hatching ideas and building products to address the same perceived opportunities our Canadian entrepreneurs have identified. These competitors can be anywhere: Silicon Valley, Massachusetts, Texas, Israel, Europe, the Far East. So what can make the difference between becoming a market leader or becoming an ‘also ran’? What is the difference between what we as a venture industry in Canada are doing and what our competitors in other parts of the world are doing that appears to make a difference to the ultimate success of an investee? 

At Ventures West we have long held the belief that in order for our investees to go to market against US competitors, they need to be funded like their US competitors. Because of this, the average size of financings of Ventures West portfolio companies (total of VW and our syndicate partners) has been well above the Canadian average and is comparable to the size of the financings raised by companies in the US.  Too often, however, we have seen Canadian companies with great technology and market potential raise substantially less capital than their foreign competitors and go to market with fewer resources at their disposal.  Yes, we here in Canada have the reputation of being able to do more with less, but customers, suppliers, and employees are going to be more comfortable dealing with the company with the stronger balance sheet. The ability to go to global markets as quickly and effectively as possible is going to be further enhanced by having more capital and resources than by having less. If the Canadian venture industry is to generate rates of return similar to those of our US competitors (and make no mistake – they are our competitors for both investments as well as LP dollars) our investees must be competitive, and in order to be competitive they need financing on the scale of that being received by their US counterparts.

Of course this will not, by itself, solve the problem of sub-standard returns in the Canadian venture industry but it is an essential first step if we are to build successful companies and a competitive and sustainable venture industry in Canada.