15 Feb 20090 Comments
Getting Creative – “Yes We Can” or “Mind the Gap”?
In today’s challenging economic times, it is extra important for governments, academics and individuals to plan our future economic prosperity. Thus, it is timely that Richard Florida and Roger Martin from the Martin Prosperity Institute, Rotman School of Management, University of Toronto this month published Ontario in the Creative Age, which provides a detailed future-oriented policy blueprint.
It sets a policy agenda to help us unleash our full potential in the Twenty-first Century where economic success is increasingly coming from creatively-oriented enterprise versus our traditional strength in routine physical and routine service occupations. The report is backed by research which highlights both our existing strengths and weaknesses including those in education, income and even the gap in our creative/routine job mix compared to our peers. Starting from the base of today, the agenda suggests four main focus areas to drive future prosperity:
- “Harness the creative potential of Ontarians”, including businesses’ role in changing job mix, education and even marketing of our capabilities,
- “Broaden our talent base”, focused on significant increases to our post secondary educational levels and broadening managerial capabilities,
- “Establish new social safety nets”, including early childhood development, better utilization our key immigrant resource and retraining of older workers from declining occupational groups, and
- “Build province-wide geographic advantage” which strengthens connections (physical and otherwise) within and beyond the mega-region spanning Waterloo-Toronto-Ottawa-Hamilton-Niagara-Rochester.
Having read this paper, it is encouraging to see such a forward thinking analysis that will certainly drive future governmental, business and economic decision and policy making. With that in mind, and being of an optimistic “yes we can” mentality, I was, however, struck by how very little attention was paid to the biggest gap of all — Funding this agenda.
Without proper funding, our ability to transform our economy in these wise and necessary ways, will go unfulfilled. I’ve written about this “funding gap” numerous times and from different perspectives:
- as part of my series on government policy aimed at preparing us for the Digital Age: Digital Policy #3: Startup Investment and Taxes
- our recent Federal Budget was chock full of stimulus measures, but seemed totally blind to the creative transformation. For example, I discussed potential green technology initiatives in A Bright Green Federal Budgetary Stimulus Opportunity
- much social enterprise, particularly that most creative sector – the Arts, is hurting badly: Another One Bites the Dust – and You Thought Business Was in Crisis Mode
I’m certainly not alone in this concern. Many others in positions of thought leadership have raised the issue of funding of investment, some with very specific policy proposals and others just highlighting the gap:
- Avvey Peters from Waterloo’s Communitech blogged about Magic Words: Economic Stimulus right before the Canada’s Januaray federal budget, and her post contains some very specific policy measures.
- Dr. Ilse Treurnicht, CEO of MaRS Discovery District, a leading Ontario driver of research and commercialization, provided a well-researched analysis of the major institutional and venture funding gaps of Canada compared to other jurisdictions in their latest newsletter.
- Alec Saunders, CEO of one of Canada’s most promising web/mobile startups, Iotum, addressed the tech startup funding gap in the context of the proposed federal stimulus in his blog post Tech in Canada: Can We Do More Than Play Hockey? Also, a number of international discussions of technology competitiveness have been hosted on their innovative Calliflower service.
- Peter Childs, an Ottawa social media strategist and tech luminary, has laid out a framework Tech in Canada: Peter Child’s Framework for Stimulus
Make no mistake, having surveyed funding sources for startups and social enterprise, Ontario (and Canada) significantly lags most regions in the US and Western Europe — our primary OECD comparables. The reasons for this are numerous and will be discussed in a separate posting, but this funding gap is our extra hurdle before we can be successful in driving the Florida/Martin challenge to transform Ontario to a creative economy.
And to be clear, this transition to the creative economy needs to be driven by the competitive, market economy. That implies that it will not the primary role of governments to provide the major funding for our transformation. Fundamentally, governments should not be picking winners and losers, but simply equiping market forces to go to work. And, given our long history and culture of relying on governments for answers, it is important to clarify that point. With the right framework in place, businesses and individuals will compete to drive the path to our future.
Thus, as their primary task, it is imperative that our federal and provincial governments develop a strong and co-ordinated policy framework, dealing with taxation, security regulation, and the like, to encourage the private sector to make such investments. And, in our current times of economic stimulus, the extra icing on the cake should be to channel some of those near term stimulus dollars toward growing the creative sector that is so essential to our future economic prosperity.
15 Mar 20090 Comments
Who Killed Canadian Venture Capital? A Peculiarly Canadian Implosion
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:
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
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
Unlike 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.