CATA Venture Capital Blueprint on Federal Investment in Canadian Venture Funds
Significant growth in ‘new money’ is essential if VC Funding is to reach the levels needed for Canada to succeed as an ‘Innovation Nation’. The federal ‘Economic Action Plan 2012’ proposes to commit such funds “...to help increase private sector investments in early-stage risk capital, and to support the creation of large-scale venture capital funds led by the private sector.” Canada must not miss this opportunity to attract foreign investment and expertise. This paper examines how this objective can best be accomplished, through a review of different investment mechanisms and models. It is a Blueprint for action.
The financial ecosystem necessary to support the development of future global tech industry leaders requires a wide range of financing from ‘seed’ through ‘early stage’ through ‘later stage’ to achieve financial self sufficiency and business success, with job growth. For ‘seed’ and very ‘early stage’ requirements, Canada’s Angel investor community is playing an increasingly important role. At the next stage, the Business Development Bank of Canada (BDC) has already been allocated a further $100M and is becoming more active in supporting new tech start-ups to help them across the infamous ‘Valley of Death’.
In addition, provinces such as New Brunswick and Manitoba have already adopted the B.C. model for Venture Investment Tax Credits, which has proven to be very effective at the early stage level of the financing spectrum, and Ontario’s current government has proposed doing so as well. CATA has recommended the federal government consider a similar VITC program, modelled on B.C. but implemented on a cost sharing basis with each province prepared to implement such a program itself, or already having such provisions in place.
CATA also advocates that Canada follow the lead of the United States by reforming long standing investor protection provisions that currently make it impossible for any but a limited number of ‘qualified’ individuals of sufficient wealth and experience to make equity investments in a company. Reforming these provisions, which date back to the 1930’s, would allow the use of Internet based ‘Social Media’ tools to raise small amounts of money from large numbers of individuals to support new start-ups. As with the provincial investment tax credit schemes mentioned above, it would be helpful if such small ‘crowd funding’ investments by individuals qualified for investment tax credits.
Obviously, a proper framework for transparency and investor participation is needed but the current system is not appropriate. Unlike the United States, where ‘Crowd Funding’ can be authorized nationally by amendment to the provisions governing the U.S. Securities & Exchange Commission (SEC) and through new regulation, in Canada such regulatory responsibilities rest with the provinces. Each province will need to consider and act on this issue. The key will be ensuring that there is a common, robust model framework that can be drawn upon to promote transparency, and that the necessary balance is struck between investor protection and the encouragement of public investment in Canadian companies.
These aspects will help with the launch of a new generation of technology firms in Canada, though without further action to address the desperate need for capital at the mid and later-stage parts of the financing spectrum, few such companies will survive. It does little good to encourage new start-ups, if there is then no money to support their growth and success in international markets.
After years of steady downtrend and a major dip due to the 2008/09 recession, 2011 Canadian VC fund investments in all types of tech companies were up 34% from the 2010 year (just as they were in the U.S.), and the highest since their 2008 crash, at $1.5 B. This has led some to assume that ‘the VC crisis is over’. But unfortunately, that $1.5B compares to just short of $2.1 B in 2007. Venture capital investments in Canada have been dropping since about 2001, so even the already low level of 2007 (compared to earlier years) has not yet been regained. (All figures from the Canadian Venture Capital Association & Thompson-Reuters.)
More relevant (and worrisome) to the future of technology investment in Canada is that the amount of new money coming into VC Funds for investment was almost flat in 2011 at just over $1.0 B, compared to a 32% increase in the U.S., as opposed to the reported increase in VC money going out to companies. Early signs are that there may be some improvement in 2012, but it’s too early to be sure. And none of the new money raised for Canadian VC funds came from U.S. based investors, compared to 16% the previous year. In short, though U.S. companies and private equity firms continue to buy up Canadian technology firms at a considerable rate, there was not a single dollar of U.S. institutional money invested in a Canadian VC firm in 2011 to support the establishment and growth of new companies. There is no way a successful Canadian VC industry can occur in the face of a total Canadian inability to access the largest institutional capital pool in the world. And VC firms investing in annual amounts greater than what has been raised by such firms is obviously not sustainable. There needs to be a significant growth in new investment funding coming in 'the top of the funnel'. Not simply to help ensure a profitable Canadian VC industry, but to ensure that this service industry in turn is able to support the needs of Canada’s tech sector companies.
The currently stalled Canadian VC fund raising also means that VCs have less and less money to invest in each target company. It used to be that Canadian firms only got 40% of what a similar American firm could attract there. By 2010 that had slipped slightly to 39%, and by 2011 it fell further to 37%. Figures just released show continued slippage, to 31% in Q1 of 2012. This seriously handicaps Canadian tech companies, and consequently their investors as well. With our dollar at about parity with the U.S. it costs roughly the same to develop and build a new product or service (perhaps 10% less here), so the significant difference in funding means that Canadian companies lack the money needed for developing sales channels and marketing --- the areas in which we are already significantly less effective than American firms.
Recall that the words in the Economic Action Plan 2012 are “$400 Million to help increase private sector investment in early-stage risk capital and to support the creation of large-scale venture capital funds led by the private sector.” Clearly, contained in those words is a recognition that this funding (or at least a major portion of it) is going to be used to leverage and encourage private capital to come back into the Canadian VC market. Independent reviews by global consultants McKinsey and Co. have identified the chief problems with Canada’s VC industry as including Canadian venture funds being ‘subscale’, our limited pool of experienced, high quality venture capital fund managers, and over-investment in early-stage with inadequate follow-on investments, leading to dilution. The ‘Jenkins Panel’ similarly commented, referencing the McKinsey work. The $400 Million to be invested by the federal government should ensure that these principal issues are addressed, rather than simply extending the current situation by injection of new money into the old system.
The reality is that as long as it remains highly attractive for Canadians to invest in mineral & petroleum exploration, through instruments such as flow-through shares, it will be difficult for Canadian VC managers (who invest instead in young technology companies,) to raise sufficient funds locally to allow the creation of private sector VC funds in the range of about $200 Million each, which the industry generally considers the most appropriate scale. Some have suggested that the combination of existing available capital plus the new government commitment, plus existing ‘quasi public’ and ‘public’ funds in Canada such as Teralys (in Quebec) and the OVCF (in Ontario) will be sufficient to ensure necessary scale. However, such ‘Quasi-public’ and ‘Public’ funds usually have special restrictions, including a requirement that much of the money be invested ‘locally’, which in turn scares off private investors. And without attracting significant foreign (largely American) investment CATA believes that our VC industry will continue to be unable to see many of the companies they invest in through to ‘adulthood’, as profitable and self sustaining corporate entities from which the early investors will also profit.
In short, unless we take this opportunity to rethink Canada’s approach to attracting venture investment and build an ongoing VC capability and scale able to build and sustain Canadian technology companies through their various growth stages, we will have not achieved much more than a short-term-fix to the VC sector, perpetuating the classic ‘vicious circle’ within which both our VC industry and tech sector industries are now trapped. This is why it is so important that the opportunity created by Budget 2012 to attract foreign investment and expertise not be missed.
Several means by which the $400M funding could be applied to accomplish the objectives stated in Economic Action Plan 2012
Page 61 of the Economic Action Plan 2012 indicates that “In the coming months, the Government will consider how to structure its support in order to incent private sector investments and management of seed and large-scale venture capital funds.” The remainder of this paper therefore explores several of the mechanisms available for the Government of Canada to disperse / invest the funds committed in the Economic Action Plan 2012 against the general objectives outlined above, including in particular “... to support the creation of large-scale venture funds led by the private sector.”
A) Select an internationally respected private sector VC firm to establish and manage a ‘Fund-of-Funds’ structure which will then use its own processes and best judgement to choose the best Canadian VC managers with which it should invest the Crown monies, who will be expected to complete their fund raising from both private sources and existing ‘Quasi-public’ and ‘Public’ Funds .
B) Invest the monies through the Business Development Bank of Canada (BDC) using its existing ‘Fund-of-Funds’ operations, with BDC placing it with a number of top selected VC funds across Canada looking for investment monies, through a competitive process. Successful fund managers (GPs) would be expected to raise at least the equivalent amount to the Crown’s contribution from private investors, plus additional amounts from ‘Quasi-public’ and ‘Public’ funds.
C) Having in mind that there are reportedly about 20 existing situations where Canadian fund managers are seeking additional investment capital to complete planned new VC funds, the government could assign the $400M to Industry Canada or Finance to be ‘doled out’ directly to Canadian funds which apply, against a qualification check list, thereby assisting those presently incomplete VC funds seeking investment.
Of the three options above, it can be seen that while the most suitable implementation mechanism is likely to make use of BDC’s Fund-of-Funds expertise and experience, perhaps with some ‘adjustments’. However, the remaining significant and consistent shortcoming is the failure of these options to use the government monies to leverage foreign investment and talent to develop Canadian funds of adequate scale, with improved prospects for long term growth and viability of a Canadian based VC industry, and thereby for Canadian tech companies.
One must also ask whether it is reasonable for government to simply invest with existing Canadian VC managers unable to otherwise raise adequate funding themselves, in order to help establish more adequately sized pools of risk capital. And what happens once these government monies have been fully invested? Given the current ‘market failure, Government should move beyond temporary relief for VC managers and attempt to resolve this long standing problem so as to revitalize both the Canadian VC industry and the tech sectors it supports.
Fortunately, there is one option that has the potential to attract serious amounts of foreign investment and talent to build a lasting VC industry here and then keep foreign direct investment coming into Canada over the long term to sustain and grow our technology firms into global industry leaders. That option is often referred to as the ‘Yozma Model’, and while it originated in Israel, it is now seen as an international best practice. This approach was also specifically referred to in the ‘Jenkins Panel’ report released in the fall of 2011.
D) Implement a ‘Yozma Inspired’ approach with additional Canadian elements to carry out an international competitive process to select the top three or four proposals from partnerships of Canadian and Foreign investors that would attract significant additional international capital and talent into Canada, employing BDC as the government’s investment channel in a ‘Fund-of-Funds’ structure.
Clearly, only Option D, using the ‘Yozma Inspired Model’, provides the potential to raise significant matching foreign investment while bringing top talent into Canada in the bargain, and strengthening Canada’s VC industry in the long term. Similarly, it is clear that using the existing structures of BDC to organize the competitive process, aided by top outside experts retained for the purpose of ensuring the best possible proposals are encouraged and selected, will provide the quickest, lowest cost and most effective means of getting the monies identified in Economic Action Plan 2012 out into Canada’s technology sector companies, where it is so critically needed.
In summary, the following benefits are thus expected should the government choose to proceed with Option D, using international best practices inspired by the ‘Yozma Model’:
1. Using this model, the government money can fully fund the new VC firms and be put to work over four years.
2. A rigorous RFP process will ensure top Canadian and international GPs are selected for the new VC firms without politics entering into the equation. Moreover, the Yozma model is now regarded as an international best practice, having already inspired the adoption of similar programs in several other countries.
3. If option D above is selected for a ‘Yozma inspired’ approach, employing BDC as the government’s organizing entity, it could result in avoidance of millions of dollars in duplicative fees.
4. Under a Yozma like program, the foreign GPs will not get a free ride as to Canadian government money – a primary condition of the RFP should be the requirement that at least one-times the government’s LP investment be raised in the non-government sector, in which fundraising the foreign GPs can be expected to play a significant role. While the government could require that a portion of its investment in each VC fund be invested solely in Canada, it should keep in mind that restrictions can be a negative factor for potential foreign investors. It is expected there would be four large-scale industry-specialized VC funds optimally sized at $200 million each.
5. Having foreign GPs who bring LP money with them participate in the new VC firms should not in itself attract public criticism, given the well accepted importance and practice of attracting foreign investment within Canada. In fact, Canadian immigration policy has contained welcoming provisions to induce foreign persons with money to come to Canada, which the government is planning on updating and strengthening.
6. In 2011, there was not a single dollar of US institutional money invested in a Canadian VC firm. If the new fund of funds is not structured to induce the beginning of a major turn-around in the Canadian VC industry’s ability to access this US pool of capital, the future of the Canadian VC industry is further endangered. There is no way a successful Canadian VC industry can occur in the face of a total Canadian inability to access the largest institutional capital pool in the world.
7. In an age of globalization in all the world’s largest customer and capital markets, vibrant partnerships of Canadian and international GPs contemplated by a Yozma-like program are not the exception, but increasingly will be the rule. We see those partnerships already beginning in Canada with Merck and TVM becoming partners with Canadians in forming new Canadian-based VC firms. These early developments, while not occurring at anywhere near the scale needed, have justifiably been highly welcome by the government.
8. The existing 2012 budget language is an eloquent and compelling statement of the Yozma model. If the government, instead, should ultimately decide to put the $400 million in a fund of funds with a structure that is NOT intended “to incent private sector investments ….” (in the budget’s words) in venture capital funds, isn’t that a fundamental alteration of the 2012 budget?
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V.P. System Strategies
Senior Vice President, Tax,
Finance and Advocacy