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Who Killed Canadian Venture Capital? A Peculiarly Canadian Implosion

by Randall on March 15, 2009 · 11 comments

Posted in: Entrepreneurism,General,Green Technology,Investing,Public Policy,Randall Howard,Social Enterprise,Startups,Web,Wireless

“Fortes fortuna adiuvat” – “Fortune favours the bold” – Latin proverb

Where's the Venture Capital: Canadian Business

The current economic meltdown has unleashed brutal forces acting on all aspects of the business world, but certainly innovative startups in fields like software, web, wireless, green technologies and life sciences are at grave risk. In Canada, our startups have generally been world class innovators, but severely underfunded when benchmarked against US and leading European countries.

Not only has the credit crunch forced most Angel Investors to the sidelines, but the supply of Venture Capital (VC) in Canada has contracted almost to the vanishing point.

Tomorrow’s Canadian Business documents this very well in VC Financing: Cold Realities.

Having started my first software company in the mid-1980’s, I am well aware that although VC money was available and well established in the Silicon Valley, VC money for knowledge-based startups such as mine was then nonexistent in Canada. Through the 1990’s, however, Canada started to build a cadre of new funds that showed early promise of replicating a US style VC funding ecosystem

In the early millennium when Verdexus investigated raising a institutional fund to fill a gap in the Canadian market with our “hands on” model and accessing global capital sources. It gave our partners a chance to look to VC best practices on a global basis and figure out how to apply to the Canadian context. While we didn’t proceed at that time, I’ve had the good fortune to work on projects with top VCs from the US and several European countries, giving me a global perspective on how Canadian Venture Capital measures up.

Sadly, I believe that the 2000/2001 tech bubble, or dot com meltdown, stopped the maturation of our VC industry in its tracks, a body blow from which the industry has never recovered. It is to this time that the root causes of our current VC meltdown can be traced. A few of the main reasons holding the VC industry back can be summarized as follows:

  1. Impact of the Labour Sponsored Investment Fund model on our VC ecosystem.
  2. Lack of balance between financial and operational skills: The Banker Effect.
  3. Lack of International Funding discipline in our VC industry.

I will explore each of these causes in turn.

1. Labour Sponsored Investment Funds

Labour Sponsored Investment Funds (LSIFs, also known as Retail Venture Capital Funds), have been a particular sore spot, as a 2005 Globe and Mail Report on Business article “Labour-sponsored Love Lost” points out. Considered good public policy when launched in the late 1980’s, both Federal and Provincial governments gave individual (retail) investors a significant tax incentive (up to 35%)  to invest up to $5 000 with a minimum 8 year hold period. In essence, many funds totalling  hundreds of millions of dollars were raised by firms like VenGrowth, Covington and Growthworks as were numerous very small funds.

Lacking the inherent financial discipline imposed by typical venture capital structures, in which several “funds of funds” (legally dsignated as Limited Partners, or LPs) invest in a fund managed by a General Partner (or GP). The LPs in this sense have much leverage, not just in choosing their GPs, but also in ongoing oversight, not to mention the choice to re-invest in the next fund raised by the GPs. This LP/GP structure is the model employed world wide and has generally stood the test of time.

The thousands and thousands of retail investors in a typical LSIF exert no such control and hence we’ve seen Management Expense Ratios (MERs) as high as 4-6% versus the 2% private equity industry norm and Carried Interest (the portion of the investment gains shared by the fund) as high as 30% versus the 20% norm.

More importantly, although at its peak, more than half of Canadian VC money was in LSIF funds, returns were, as Doug Steiner says, “lousy.” How lousy? Studies show that average fund returns, also called Internal Rate of Return (IRR), are negative. The best fund appears to have produced a measly 1% IRR. In the US, funds aim for 30% and there is a long term track record of many funds in the 18-20% range.

Undoubtedly, individual investors didn’t have a lot at stake with those huge tax credits and it can be argued that LSIFs encouraged loads of job creation in the all important knowledge economy. All of that is true. My main concern is that the attraction of the LSIF model impaired the formation of a more mature VC ecosystem based on the normal LP/GP model mentioned above.

2. The Banker Effect

Credit: AIAlex.com

Credit: AIAlex.com

In the US, both in California’s Silicon Valley and in the Route 128 area around Boston, the VC industry has always been populated by a healthy mix of the financially oriented fund managers coupled with serial entrepreneurs who have founded and build technology startups. The composition of the partners at Canadian VC funds has always been different than this international norm, having many more banker types than operators. The experiences Jonathan Geist relates in the Canadian Business article are symptomatic of this difference. Too much focus on the numbers is like looking in the rear view mirror when startups need to be focused on the future – building market share, refining partnerships and developing strong go-to-market execution.

Again, I believe that this gap can be attributed to us being a less mature VC and startup ecosystem. In the late 1980’s and 1990’s finding seasoned technology startup operators would have been almost impossible. Most were still building their first startup. However, had things unfolded as they should have, many of the startup founders from the 1980’s and 1990’s should now be partners at Canadian VC firms. That didn’t happen because the dot com meltdown appeared to remove the ability to the industry to make changes or take risks. Ironically, this exacerbated an already more conservative VC culture here in Canada, and this more risk averse approach actually contributed to the lower IRRs seen when Canadian VCs are compared to their US or European peers.

3. Lack of International Money

The fledgling LP/GP VC industry of the 1990’s was funded by a relatively small ecosystem of LPs, such as OMERs, Caisse de Depot, Teachers, CPP, BDC, etc. Thus every VC fund was essentially not differentiated by its LP composition. In essence, a closed group of Canadian fund of funds all were chasing this same relatively small asset class. Furthermore, the relaxation of Canadian content rules coupled with these aforementioned low IRRs, sent the Canadian LPs looking elsewhere (mostly abroad).

What is the right recipe to change this situation? Quite simply, access to more global sources of money. The thousands of US, European and Gulf institutional fund of funds investors have largely ignored investments in Canadian VC funds. This is partially because of the chicken and egg of lower IRR returns. But, more fundamentally, it is primarily because the Canadian startup and VC ecosystem had low visibility to these international funds. Several years ago, I spoke to a large €6 billion LP fund at EVCA in Barcelona, that had investments in 40 tier 1 VC firms in each of the US and Europe. Ironically, that LP’s sense of the Canadian technology scene was limted to Nortel. Since Nortel hasn’t really been a star for many years. Clearly we have a long way to go market our great technology stories to the world.

The Way Forward

Going Out of BusinessUnlike this sign, I don’t want to end this piece on a note of doom and gloom. Nor do I want to leave the impression that there aren’t very talented people in the Canadian VC industry. Nothing could be further from the truth – our long term VC gap arises from long term structural challenges, such as a lack of discipline as imposed by global LPs and not having reached the proper banker/operator mix. There are other factors, including the small population and large geography unique to Canada, but all can be and should be overcome with the proper model.

We already have a few outliers in our funding ecosystem. Being optimistic and entrepreneurial, I’m convinced that many talented individuals will find ways to, little by little, to invent and rebuild a healthy network of startup financing alternatives. As I’ve argued in other blog posts, there is a role for governments. However, that role isn’t to pick winners or to enter the VC business directly, rather it is to be a catalyst to the process by streamlining (securities) regulation and taxation.

As a stakeholder in the success of knowledge-based startups, what do you think?

Please share your comments.

About Randall

Randall Howard is a serial entrepreneur and long term technologist with a passion for social innovation.

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  • Great article, Randall.

    The reputation of the Canadian VC market hasn’t had a chance to get off the ground. As start up firms in Canada looked to find ways and means to get a leg up, they were left with Canadian VC’s and Angels with very little experience. When times got tough (in their minds), the Canadian VC’s and Angels scrammbled, leaving behind carcasses of promising ideas and talent, took absurd amounts of equity in the start up (killing the spirit that drove it) or basturdized firms for the sake of some limited and measly recovery forsaking any future potential. The word on the street, amongst promising start ups, is to avoid VC’s and Angels like the plague and try to build on good business models slowly, but surely.

    You can also attribute some of this sentiment to the new world order. Social media and social networking have enabled conversations around VC’s and Angels. The ‘brand’ of Canadian VC’s and Angels is spiralling out of control and they are oblivious.

    Canadian VC’s and Angels are like the start ups they choose to partner with. Relatively new to the experience, greatly affected by errors and limited resources to adequately build.

    I have no doubt it will Canadian VC and Angels will survive, but it will take a long time for them to grow up. We’re like the toddler’s learning to walk in a global market of adults who are running.

  • Great points Bill, and thanks for contributing your perspective which I know is based on direct experience.

    On the first point, I personally want to separate my comments about the maturity and effectiveness of our particularly Canadian VC incarnation from the overall desirability of the VC model. I understand that many startup founders dislike the whole model. I’m definitely not in that camp. Many companies need the injection of capital and discipline to build a world class technology business. Of course, some do not, but those aren’t the ones that Verdexus is focused on.

    You make a good observation that many recent web, mobile or social media businesses can be built for a fraction of the cost of building, say, a full scale software business. At Verdexus, we focus on a Venture 2.0 model often focused on such businesses, and if you want to better understand our perspective, here are a few posts discussing it:
    New Playbook for Venture 2.0 – Presentation & Spreadsheet
    Business Models: Subscription vs. Freemium vs. Free in Lean Times

    Lastly, I know we are all optimistic. Brainstorming and dialogue may well help to strengthen our overall startup funding universe.

  • The problem is the question you ask. Your question assumes Canada HAD a technology venture capital industry at some point. We’ve all seen purported VC’s doing “loans” and bizarre pref share structures; those aren’t VC’s, those are money managers. Not a lot of early stage technology investors in Canada, and you can’t kill what doesn’t exist.

    We have early stage money for natural resources and old economy type start-ups, but Canada doesn’t have and never has had a technology VC industry.

  • Fair comments Peter and truly I do applaud both your candour and clarity on this as one who has worked in the financing ecosystem for quite some time.

    I know there are those on Bay Street who are uber-sensitive around this sort of talk, but it is only by laser focused clarity of analysis that we’ll learn from our mistakes and build the proper startup financing platform.

    And, as I mentioned, I don’t see this as some optional pipedream – it is mission critical for all our future prosperity.

  • I agree. The problem is the flip side; there are a lot of incompetents out there who think they know how to run a tech company and architect a project, and of course there are the inevitable scammers. The hard part, as always in any capital allocation, is defining an appropriate balance between risk and return.

  • Folks,

    Interesting article and comments about the state of venture funding in Canada. As both CEO of a software company and experienced Angel investor, I have noticed we can be great from a technical perspective but typically not very sophisticated on the business side. As a result, a lot of very promising technology litters the landscape and a lot of people have expereinced life setbacks. The main reasons for this are entrepreneurs struggle with sales, marketing, managemenet, finance, etc. In addition, investors typically aren’t sufficenetly sophisticated, skilled or empowered to pick up the slack. As an Angel, having seen 1,000’s of deals, made + 20 investments, and been on the Board of Directors of a number of ventures – I can assure you there is a huge need for all stakeholders to learn faster how to improve the probablity of venture success and better manage the high risks inherent in this industry.

    • Thanks for the observations, Ron. At Verdexus, we would share your views on the operational and managerial gaps in many Canadian startups. As a result, our Venture 2.0 methodology is a playbook aimed at, in part, filling that gap.

      The post was written primarily from the viewpoint of looking at the startup funding ecosystem in Canada when compared to what’s happening globally, primarily in US and Europe. It’s clear to me that in our current environment, an equally well-managed Canadian startup would almost certainly be less well capitalized than one in the Silicon Valley, for example.

      But, looked at the other way, I’m convinced that as we improve our operational and executional skills to turn “engineering labs” into global, market-driven companies, we will also start to see more capital enter the picture. Capital and operational excellence are certainly not independent variables in building out a healthy and globally competitive startup ecosystem.

  • Randall

    You have presented some excellent points. I think we could go one step deeper and look at the role that the startups themselves had to play in what is now a serious lack of funding. Notwithstanding the LSIF issues and the lack of operational expertise, if the startups themselves had produced reasonable returns, a few of the smarter VCs would have had acceptable rates of return. With acceptable returns at least a few of them would have been able to raise subsequent funds and contribute to a smaller, albeit still living industry.

    In Canada though, startups in the 80s, 90s and even now are typically started by technology oriented people with little background or appreciation for the need for marketing. In fact as you must have experienced, 25 years ago, it was very difficult to find a Canadian with international marketing experience in software. With less appreciation of the need for marketing, Canadian firms typically delayed their marketing spend until well along the product development path. Unlike in the US, where marketing funds start flowing as soon as product development starts, Canadians were forced to wait as they typically raised smaller rounds of VC money. On a per capita basis we financed as many firms as they did in the US but we only put in a third of the money. If you have too little money to spend then marketing will inevitably suffer as there is no point marketing if you can’t develop a product.

    Not only did we delay spending marketing dollars, we didn’t typically spend as much on marketing as US firms did. Successful US firms typically spent twice as much on sales and marketing as they did on R&D. With Canadian firms spending more typically on a one to one ratio, when a Canadian firm met a US firm in the market they were swamped by the other firm’s early access to the market and robust spending.

    The lack of experience and lack of spending meant that Canadian firms were typically slower to develop than US ones. Statistics show that the successful US firms reached $10 million in revenue in an average of 6 years. The equivalently successful Canadian ones reached the same level in 10 years. This slower growth would have resulted in returns to Canadian VCs that were much lower than those to US VCs. This inevitably resulted in a sub zero rate of return for the industry and the disappearance of most of our VCs.

    We bemoan our lack of innovation in Canada and typically look for answers to idea formation. We have forgotten that Innovation equals Idea plus Marketing and we need to improve our ability to market before we will equal the US at the innovation game.

    • Charles,
      I couldn’t agree more about some real gaps in the Canadian startup skillsets. This was massive in the 1980s and 1990s, but still exists today. Back then, we had to develop and train even product management, as the software industry version of that was still ill understood. Likewise enterprise software sales talent, relative to the US, was in short supply.

      But no area was (and I would argue still is) missing as much as the type of marketers that made the Silicon Valley startups thrive. In Canada, I believe we’ve always thought of “Marketing” as the “Marcom” set of skills: PR, advertising, promotion, etc. But the analytical marketing of product positioning, market segmentation, etc. are the real differentiator. It was for that reason that MKS brought in a US-based VP of Marketing in the 1990s which worked well and also, incidentally, helped to strengthen the skillsets north of 49.

      But, I must say, that if you go up a level, blaming the Startups themselves for the low returns is a bit like blaming the victim. Venture Capital, at its best, is hands on in helping to build teams and skillsets. And, the best people to do that are VCs who have themselves built and exited great technology businesses. It is a virtuous circle that never got completed (yet?) in Canada

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