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Canada’s Venture Capital Crisis

In Canada, we love to talk the talk when it comes to supporting the New Economy and the job creation that will stem from the high-tech sector’s growth.

But when get beyond the talk, there’s a much different story happening. Without setting off the alarm bells too loud, there’s a crisis looming that will have a major impact on the New Economy.

The problem is the sharp decline in the amount of venture capital available to start-ups in Ontario, which accounts for about 40% of VC investment in Canada. While this issue hasn’t got a lot of coverage, the reality is the money available to companies that want develop products and hire lots of people is quickly evaporating. If you look at the number of deals done in Ontario so far this year, there is a huge decline compared to historical trends.

Calling a spade a spade, Wellington Financial’s Mark McQueen described the first-half venture capital statistics as “brutal”. The numbers tell the story – and it isn’t pretty.

In Q2, total venture capital investment in Ontario dropped 57% to $131-million from Q1, and 35% from Q2 2006. In Quebec, $149-million was invested – a modest 12% drop Q1 and a 10% year-over-year increase. In B.C., $112-milion was invested – 44% higher than Q1, and only 13% less than Q2 2006. (Source: CVCA)

If you exclude Guelph, Ont.-based Geosign’s $160-million financing in the first-quarter, McQueen estimates there was just $83.8-million invested in Ontario during the first six months of 2006.

“For all of the time and effort that has gone into the MARS project, the technology industry is starving for capital in this province,” he said.

If you go further up the food chain, the funding “problem” is also evident by looking at fund raising by Canadian VCs. In Q2, VC firms raised $272-million, a 46% drop a year earlier, while fund-raising over the first half of 2007 dropped 21% to $739-million.


So what’s gone wrong?

In simple terms, there are two major issues:

1. A couple of years ago, the rules on where institutional investors could invest their capital changed. Rather than forcing them to invest 40% of their funds in Canada, institutional investors can now do whatever they want to get the best returns possible, including the vibrant U.S. private equity market. As a result, it has become more of a challenge for Canadian venture capital firms to raise money.

2. Two years ago, Ontario’s Liberal government decided to phase out the tax credits for labour-sponsored funds. While the phase-out period extends to 2011, the market has effectively dried up because investment advisors are unwilling to aggressively sell a product that has a financial cloud hanging over it.

This one-two punch has unfortunately meant there’s less and less money around for start-ups. VCs that do have capital to deploy are funneling a good chunk of their money into existing investments rather than jumping into new deals.

Another impact of the dearth of start-up financing is it could see U.S. VCs retreat form Canada. Why? U.S. VCs like to invest in “B” rounds rather than early-stage deals. But without a vibrant early-stage market, there will be fewer “B” round opportunities.

For anyone thinks you need to encourage innovation, the commercialization of R&D, and support the entrepreneurial community, this situation is very troubling.

So what’s the solution to jump-start the venture capital market in Ontario?

The Ontario government could do the high-tech industry a huge favour by reversing its tax policy about labour-sponsored funds. Bringing back investment tax credits would go a long way in encouraging retail investors to come back. It would also see Ontario have much the same approach again to labour-sponsored funds as Quebec and B.C. where the financing markets for start-ups are much healthier. With the Ontario election campaign about to kick into high gear, it would be a positive sign if tax credits became part of the discussion when the focus turns to job creation.

Getting institutional investors interested in Canada again is a more complex situation because they need to be confident there’s an opportunity to generate strong investment returns. One way to instill confidence is doing what’s needed to nurture vibrant venture capital and high-tech markets.

Truth be told, jump-starting Ontario’s venture capital landscape is going to take time. But if we truly believe in the New Economy, having a healthy amount of financial support for start-ups and entrepreneurs is crucial for success. If Ontario is really serious about creating this kind of environment, now is the time to make the necessary moves.

More: Who knows; maybe Google will rescue Ontario’s VC market given the cash-rich search engine giant has started to make investments of about $500,000 or less in promising startups as it hired a team of financial analysts to assess deals. GigaOm wonders whether the weak U.S. economy will “KO Web Startups”.

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  • Alex

    I think in addition to more capital, Ontario and other places in Canada should create an environment that is different from other startup nests like Silicon Valley and New York to prevent brain-drain and also lure international startups. Successful companies in the United States like shoeboxed.com actually had their starts somewhere else (Berlin in this case but others in London). There, these companies can set themselves apart from the dime-a-dozen variety found in California.
    The question is: how are we fostering an environment of innovation and support for these initiatives.

  • http://www.profectio.com Dave Forde – The Connector

    Maybe the “conservative” Canadian way won’t work, even if the Ontario government steps up, and it will be US VCs or companies such as you mentioned with Google who come to the rescue. I did a post on Infobright who received $8M of funding last week which was lead by a US-based VC after none of the Canadians would step up to the plate they way they needed.

  • http://stuart.blogware.com Stuart MacDonald

    Are you *seriously* suggesting a return to Labour Sponsored Funds? Yikes, Mark.

    I agree that the Canadian VC world wouldn’t be best described as vibrant (though there are some smart players out there, and we are fortunate to have them) but I can’t imagine that a return to the tax-break driven Labour Sponsored thing is the way to do goose the system.

    And, what about the Canadian startups getting funded in the US? It’s a two way street, right?

    - Stuart

  • http://www.markevanstech.com Mark Evans

    Stuart: I’m suggesting that LSF is one of many tools that could be use to jump-start the VC landscape in Ontario. There is no silver bullet but there needs to be a variety of different programs to make things happen.

  • http://colin.smillie.ca Colin Smillie

    My experience with the LSF’s was that because of the tax break fund managers seemed to think that they could just perform poor with little consequence. I think this is true with most situations where you remove the risk of the vendor, you get poor investment decisions.

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  • http://www.venturelinkfunds.com John Varghese

    Mark

    Your article is very timely and relevant. First I need to disclose that I am biased and conflicted on the topic as a Portfolio Manager and Co-Owner of the VentureLink Group of Labor sponsored funds.

    My overall proposal: fix it, don’t shoot it. Remember, If $100,000,000 is raised, the tax cost is $15,000,000 to Ontario. Assuming $75,000,000 is available to invest, that is 5 to 1 leverage. What program comes close to replicating that?

    The facts speak for themselves in terms of the decreases in early stage investing in Ontario over the past five years. In every cycle one needs to invigorate at the early stage to drive future cycles. Failing to do so will have longer term far reaching implications on our economy and productivity. Less capital available will lead to less entrepreneurial risk being taken which will then further the gap between Canada and the rest of the world. We cannot keep pace, especially in light of more and more buyouts of Canadian companies by multi-nationals if we don’t generate more made in Canada solutions.

    Ontario, as a province and country are proud that we have a world class technology hot bed in Waterloo. We are proud of the technology market in Ottawa. The Ontario LSIF market has raised over $2.7 billion, with almost 40% of that deployed in Ottawa area. The Waterloo area has also greatly benefited from LSIF investing. I would argue that we would not have attained these centres of excellence without the investments made. Perhaps lost in the shuffle is that since being formed, LSIF’s in Ontario have invested in over 600 companies that have created over 27,000 jobs.

    Ontario is the only province that has taken away the credits. Quebec has not done so. The Funds de Solidarite FTQ is well over $6 bln under management and growing by about $500 million a year. It stands to reason that Ontario in the context of venture investing will fall behind if we stay the course. Others have pointed out that the suggested replacement solutions are not doing enough….

    It has been easy to take shots at the LSIF industry. If one does a analysis of venture capital returns for LSIF’s vs. “Traditional” Venture Capital in Canada, you would be surprised to find that the returns for both over the past five years are comparable. There is room for both to exist. We are still seeing the effects of investments made in 1999 to 2001 and are just starting to make our way out of that.

    It is also important to look at the program from the investors perspectives.
    Advisors have been able to generate RRSP’s using the incremental tax credits for people who might not otherwise have done so. The after tax cost for a $5,000 investment would be less than $1,900. Now if they used the taxcredit to make further payments to mortgages etc, then the return is even more enhanced.

    VentureLink has shown that LSIF’s can be successful. We have two funds that are providing investors a good return and thus advisors are able to use us as an effective part of their tax planning with their clients. Our financial services fund has since inception been earning 18% on the invested deals. Our Diversified Income Fund is also producing double digit returns. Not all funds are the same…

    Glad to chat further if you like.

    Cheers

    John Varghese
    Managing Partner
    VentureLink Funds

    #801-1 Richmond Street West
    Toronto, Ontario, M5H 3W4
    p: 416-681-6371
    c: 416-706-2312
    f: 416-681-6661
    Regards

    http://www.venturelinkfunds.com

  • http://www.AshworthInformation.com Will Ashworth

    I am totally against the Ontario government funding tech start-ups on the backs of hard-working retail investors. I invested in a LSVCC and it’s been nothing but a major disappointment.

    What makes you think LSVCC’s can be operated profitably a second time around?

    The short answer is it can’t. This is flawed business model and those who work in the business are simply trying to save their well-paying jobs.

    My solution: do a better job selling the institutional money on the financial merits of investing in early stage financing. Retail investors should be investing in solid, profitable companies, where they have a better than 50 percent chance of making a return on their capital.

  • Robert W

    Not sure where John Varghese is getting his figures from but Professors MacIntosh and Cumming have done a series of papers that illustrate the utter uselessness of Labour-sponsored funds. I just completed a venture capital course with Prof. MacIntosh at UofT Law and there is no doubt these must cease to exist and never return. Search for their papers at SSRN. We should be cheering their demise not trying to “fix” them.