“Hey, don’t write yourself off yet,
It’s only in your head you feel left out.
Or looked down on.” – Jimmy Eat World, In The Middle
The noise about the state of early stage investment (both angel and venture capital financing) is getting deafening here in Canada and in the US. From the entrepreneur’s point of view, there just isn’t enough capital. There never has been, nor will there ever be enough capital to fund everyone’s dream... so someone is always grumpy about the lack of capital. But in times where early stage capital investment has dropped significantly (Early 1990’s, 2002-2003 and the past 9 months) there are many who are grumpy. While I am a fervent believer in the funding cycle continuing (we are currently at the low point) and the investment climate improving over time, there is still cause for worry now, especially in Canada. How much time will pass before things improve?
Concern # 1 – Without capital, innovation dies on the vine. If we assume a significant amount of innovation in our society comes from the entrepreneur trying to commercialize innovation, as opposed to the giant corporation doing it, then we need early stage capital to fund the commercialization gap. Today's Globe & Mail celebrated Canada Day by bashing our funding of innovation, mostly from the big corporation point of view. Summary: No Nortel = Big Drop in Innovation. I would argue that a bigger part of the responsibility of improving innovation has been borne by the start-up. And the start-ups need cash.
Concern # 2 – In Canada, there aren’t enough VCs left to invest, leading to a severe shortage of early stage capital. I tried to get to this sentiment in last month’s BC Business column where I likened the Canadian VCs to the Toronto Maple Leafs (even if you hate them, you need them to be successful once in a while... you know, for the good of the game). Yes, BDC got more money recently, but the number of managers of early stage money in Canada has been dropping since 2000. Canada, it seems, is doing its pruning of venture fund managers due to years of sub-optimal returns. For once, we may be ahead of the Americans on this point. Which brings me to...
Concern #3 – Canada has relied heavily on US venture investing (as high as 40% by dollar) since the late 1990’s. What is happening down there? As former Canadian VC and massively popular blogger Paul Kedrosky pointed out in this Kaufmann study called Right-Sizing The US Venture Industry, the US venture industry is in dire need of contraction. Less managers putting money in less companies is the only way to help fix the crappy returns that are now prevalent in the US. Interestingly, about the same time as he put that study out, the NVCA (national venture capital association in the US) reported that there were 15% less VCs investing now since the end of 2007. All of this comes on the heels of mounting evidence that the US VCs can’t make money anymore. Which leads me to...
Concern #4 – If VCs (whom I previously equated to sheep) all start reading articles like this which lays out how Q2 was the worst quarter for VCs since 1999, despite 4, count ‘em, 4 IPOs, well... we are all in for harder times. The absolute last thing we need now is for further contraction of investment in new companies in the US. It’s already at catastrophically low levels in Canada. If the US joins us in even lower levels of investing, we are all in deep trouble.
What can be done to alleviate these concerns? If you listen to VC pundits like Fred Wilson of Union Ventures, he believes that the funding cycle will ultimately play itself out to the benefit of all. We need another year or two of crappy conditions for US VCs to raise their funds, thus eliminating quite a number of managers and getting the US venture industry more lean and focused. If that’s true, then the very lean Canadian VC industry should be getting healthier faster than in the US. The pruning has already happened up here.
Where does this leave the entrepreneur in Canada? If capital is a very scarce commodity, simple economics says that if you want it, you are going to have to take it at some discount. You should expect that valuations will be lower than you want. You should understand that the twitch on the VCs face is a result of he/she facing their own investors with crummy returns and dealing with the high probability that they could be out of a job. As a result, they are probably playing things “safer” and looking for opportunities that are later stage.
Bottom line: If you are offered money by a credible early stage investor and the terms stink, plug your nose and take the money. The funding cycle appears to be at a low for the foreseeable future. It may be as long as a year or two before the new lean, mean VCs emerge with fresh capital.