Canada needs more aggressive venture strategy, expert says

(February 17, 2005) Canadian investors need to step up to the plate and better fund their small businesses if they are to compete with American start-ups, according to one of the country’s major venture capitalists (VCs).

“The industry in Canada is about half of what it should be,” says Dr. Robin Louis, president of Ventures West Management. While Canada’s population and overall economy are generally about 10% of the same stats in the U.S., the venture capital industry is only 6%.

Louis says Canadians need to take a hard look at the way they fund their entrepreneurs. “It is not enough to stagger along and survive. They need to be able to compete with their American rivals.”

Not only is the pool of available funding too small, but its application is far too thinly spread, Louis says. There are only about a dozen VC firms which are large enough to participate in large funding deals of $30 million or more. Because there is a shortage of capital, many small businesses are underfunded, receiving enough cash to survive, but not enough to compete with their U.S. rivals.

South of the border, there is excess capital in the VC market, with 2004 estimates ranging as high as $100 billion, according to a recently released study by the Canadian Venture Capital & Private Equity Association (CVCA). At current funding rates, it would take between three and five years to fully absorb un-deployed capital, assuming no more cash was raised.

This embarrassment of riches has caused inflation in the value on deals, as competing VC firms enter bidding wars to participate in quality start-ups. With U.S. rivals receiving more than adequate funding, Canadian small businesses tend to be bought out at earlier stages than might otherwise be desirable.

There is some evidence that Canadian capitalists are starting to focus on fewer firms, but it is too early to call it a trend. Last year saw an increase in Canadian VC disbursements, from $1.7 billion in 2003 to $1.8 billion in 2004 — the first annual increase since 2000. While the dollar value of disbursements increased by 6%, the number of businesses receiving funding contracted by 9% to 589 firms.

Canadian VC investment is more concentrated in the start-up and early stage financing, with 50% of 2004 funding occurring in these phases. In the U.S. however, early phase funding accounts for only about 20% of the total market. About 45% of funding is focused on expansion, with the remaining 35% funding later stage development.

“Even though the deal size in small, there are a tremendous number of companies funded so it sucks up a lot of money and there isn’t very much money left for later stages,” says Louis.

Another major difference between the two markets is the source of capital, which also explains the enormous size of the U.S. markets.

Pension funds and endowments, which are major players in the U.S. accounting for over 60% of funding, are much less active in Canada. Between 1999 and 2001, pension activity spiked, rising to about 45% of the total market, but when the dot-com bubble burst, pensions withdrew from the VC space and now only account for about 15%.

Among pension funds with a value over $5 billion, there is relatively no difference between Canada and the U.S. On both sides of the border, these larger funds allocate 3.2% and 3.4% of their respective portfolios to the VC market.

But among smaller pensions, Canadian participation drops off dramatically. In the $1- to -$5 billion range, only 0.5% of the portfolio is allocated to VC activity, while similar-sized funds in the U.S. devote 2.6%. Below the $1 billion mark, Canadian funds allocate just 0.1% compared to American funds’ 1.5%.

Louis says this is consistent with the stereotype of Canadian conservatism in money matters, whereas Americans tend to “swing for the fences.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com