"Access to Late Stage Capital" is not Canada's key innovation hurdle

The drums are beating, and members of the venture capital ecosystem recognize the sound. 

During the global financial crisis, Jean-René Halde, the recently retired activist CEO of the Business Development Bank of Canada, convinced a naive Industry Minister of the day (Tony Clement) that the key gap in the Canadian innovation ecosystem was access to “late stage” capital.  Fix this, his pitch went, and Canada’s commercialization challenges will be addressed.  Nor will folks sell out too early.  Somehow, his solution was going to be a universal tonic to all that ailed the sector.

The Conservative government was very cognizant of the ~$17 billion being spent invested each year on early-stage R&D in Canada, and were only happy to drop some additional BDC-directed capital into the Federal Budget based upon this advice.

At the time, Mr. Halde’s recommendation was inconsistent with the stats.  VC investment in Canada actually had actually grown from $1.68B to $2.1B between 2005 and 2007 (stats from Thomson Macdonald at the time).  Capital deployment was more concentrated, though, as 2007 saw 560 different financings as compared to 411 in 2011.   Figures which might suggest that investors were backing their later-stage winners, in fact.  Something many would say is a good thing, and didn’t imply a shortage of late stage rounds.

Mr. Halde’s assessment of the key challenges facing the ecosystem was also different than that of Canada’s venture capital leaders.  In fact, the CVCA’s four top policy recommendations of the day (see prior post “CVCA letters to Messers Flaherty, Clement and Ignatief” Dec. 26-08) were as follows:

Assist in the creation of a Corporate Limited Partnership Strategy.

– In the USA, firms such as Cisco, Comcast, Intel, Motorola, T-Mobile, etc. had VC arms, while few Canadian corporations had done something similar (beyond Telus and BCE) or participated as limited partners (other than the LPs in the original BlackBerry Partners Fund or the Ontario MRI Fund).  The thought was that for some corporations, an investment in a technology, life sciences, alternative energy or clean technology venture capital fund could be a useful mechanism to stimulate research and development in their firm’s area of commercial expertise.  The irony was that a limited partnership investment wasn’t immediately tax deductible, even though a corporations’ internal R&D-related costs were. 

SR&ED Credit Enhancement

– Few government programs are better able to reward companies for their efforts in the area of research and development than the Scientific Research and Experimental Development program.  Enhancing the SR&ED program is one of the most effective tactics to stimulate the growth of a small company, as every dollar of external and internally-generated capital (gross margin) is immediately reinvested in the business.  The proposal would see that for every $1 of approved R&D expense, the refund would be $1.50.  Consideration could be given to requiring that the “50 cents” be invested in sales, marketing or other business development expenses in an effort to help commercialize the research already being done.  To ensure that only smaller firms could benefit from this enhancement, the refund could be capped at $[5] million per annum per company, and that the revenue for any applicant in this category couldn’t exceed $[50] million.

Industrial Offsets

– An Offset Investment is a tool that is often used to generate commercial benefits for Canadian industries in conjunction with a large government capital expenditure purchase.  Historically, these Offset investments have been focused on specific regions or R&D by a single domestic firm.  Although Canada technically permitted a foreign multinational to count a new limited partnership commitment as a commercial offset, the red tape was so painful that only one firm had taken advantage of the opportunity at that point.

$300 Million 3rd Party-managed Fund of Funds

– The federal government had the opportunity to play a leadership role in capitalizing seed stage, venture capital and venture debt funds.  A $300 million fund of funds, managed on normal commercial terms by a private sector third party, could provide meaningful capital to 12 different funds across Canada.  As a limited partner, the government could expect to earn a return on that initial investment, just as every other professional investor would do.  Over the life of the fund, the government could expect to see a return of their principal as well as a return on the investment, subject to market conditions.  The opportunity to leverage public capital is clear.  A $25 million commitment to a particular fund could be expected to be joined by another $100 million of private sector capital – 4 to 1 model.  The Ontario Government estimates that their $205 million MRI Fund would generate investments of three times that figure in Canadian companies as a result of investments in specific companies by syndication partners.

This was what the CVCA, representing Canada’s ~1,400 private capital investment professionals, put forward in 2008.  Nonetheless, thanks to Mr. Halde at the BDC, Ministers Jim Flaherty and Clement went off to fix a “problem” that wasn’t actually on the list the General Partners  of Canada’s VC industry had put together.

After a few more years of advocacy (see representative prior posts “Venture Capital gets on PM’s agenda” May 25-10 and “HoC Finance Committee appearance: good news/bad news” Oct. 12-10), then-Minister Flaherty took the CVCA’s advice and launched a $400 million Fund-of-Fund initiative (aka the Venture Capital Action Plan) in January 2013 (see prior post “Entrepreneurs are making steady progress in Bytown” Jan. 15-13), following an allocation in the 2012 Federal Budget.  But not before Mr. Halde had convinced Mr. Clement, in his role as Industry Minister, to send more money BDC’s way: first for his own portfolio (see prior post “Clement moves to fund BDC’s existing venture portfolio” June 15-09), and then to set up the $300 million Tandem Expansion Fund in December 2009.

For the past few months, it’s felt a bit like Groundhog Day to me.  Senior BDC representatives have been pitching the Canadian business media that Canada, once again, has a shortage of late stage funding sources.

Jérôme Nycz, Executive vice-president of BDC Capital, has been making the call this time around for more “late-stage capital.”  In July, it was to the Kitchener-Waterloo Record: “There is a gap in what Nycz calls late-stage financing for growing technology companies.”  August’s target was the National Post: “When they seek to compete on a global scale and need investment rounds of $10 million or more, will that capital be there?”  

Much has changed since 2009 when it comes to the availability of “late stage capital” in Canada, and I’m concerned the new government will be putting their eggs in the wrong basket in the upcoming budget.  You should be, too. 

Right here in Toronto, about $1.085 billion has been recently raised for three venture funds that definitely cater to growth-oriented, Canadian-based innovation companies: OMERS Ventures II (with III pending), Georgian Partners III and Wellington Financial Fund V.  Then there’s the $1.5 billion Novacap, which backed Montreal’s Stingray Digital, for example.  There’s a new debt fund in Vancouver, and CDP is putting a great deal of energy into tackling  the needs of private companies in Quebec.  And one can’t forget the billions of investment dollars under management at the various Labour-sponsored Fonds in that province.

Compare that $1-$2 billion of growth capital to the aggregate sum raised by every early stage Canadian VC fund over the past five years; sadly, a large earlier stage fund has between $120-$150 million to deploy.  And there are less than 15 of any size at all.  

With 16 years in business, I think we have a feel for the various needs of Canada’s innovation economy.  When I look across our own portfolio, access to late stage capital has never been an issue for the good stories: In Fund II, for example, Airborne and TM Bioscience were acquired not because they didn’t have big investors (Insight and MDS), but because the price was too good to ignore; Necho’s VC investors got tired of the slow growth and ongoing burn, which led to that company’s acquisition by a portfolio co. of US-based LLR Partners. 

Of our 50 Wellington Financial Fund III transactions between 2006 and 2012, I can’t say the experience was any different.  Montreal’s OZ Communications was supported by Canadian investors with very deep pockets, but Nokia made them an offer they couldn’t refuse; just as we saw with Ventus Energy and Suez or Ericsson’s acquisition of Ottawa’s Belair Technologies.  High profile tech stars from our Fund III, Real Matters and Vision Critical, have continued to stay private, and are able to raise all the late-stage private equity and debt capital they want (despite Mr. Nycz telling a journo last year that “mezzanine” capital isn’t “broadly available” in Canada).

In our 2012-vintage Fund IV, Aquam, Elastic Path and Insception Lifebank are all examples of Canadian firms with lots of debt and equity financing options.  When Montreal’s Beyond The Rack went bankrupt earlier this year, the fact that it had at least six different institutional investors were involved made no difference.  It had a business model challenge, not an inability to access “late stage” local capital.   Likewise with TSX-listed Guestlogix.  The North American equity markets are very deep, but it went into CCAA just the same.

Atlanta-based Nanolumens, another Fund IV portfolio company, has had great success selling lighting products based upon technology that was originally developed at McMaster University in Hamilton.  That business wound up in the U.S. long before it had any meaningful revenue, so one can’t lay the blame on Canada’s late stage innovation financing markets for that missed opportunity. 

One has to assume that Mr. Nycz is gearing up for BDC’s 2017 Federal Budget ask, and has been laying the groundwork in the hopes that some form of “Expansion Fund II” will get funded via a special Budget allocation.  His original 2009 partner, Tandem Expansion Fund, has a track record to fundraise against; the team has gelled and they’ve closed a dozen transactions.  Thanks to Mr. Flaherty’s VCAP, there are four obvious private sector doors to knock on to get that crucial lead investor for Fund II.  Not to mention CPP Investment Board, which is considering making direct allocations to venture capital funds for the first time since 2005 in the wake of its recent change in leadership.  Tandem will be just fine when they hit the road; it’s the early stage world that needs more help.

The Canadian ecosystem needs to make it clear to Innovation Minister Navdeep Bains what its pain points are.  Insufficient Angel and Series A capital seems to be highest on the list, as it always is.  Getting the average size of a Series A round up can only happen if there’s more Series A VC money to go around.  For more than 15 years, Canadian policy makers have noticed that the average size of a Canadian Series A round is between 30 and 50% smaller than the U.S. version. 

Fix that shortfall, and Canadian entrepreneurs will have a far better chance of building their companies into world-beaters.  As much as the B.C. Clean Tech sector would love more late stage capital, it may well be that the General Partners with the expertise to back them are already in place; they “merely” need to convince the LP community to back larger, specialized funds.  But, when it comes to Ottawa, there’s only so much money to go around at Budget time. 

It’s up to you all to make sure the new government directs our tax dollars to the key challenges.  We don’t have four years to wait.

MRM