“If you want my future
Forget my past
If you wanna get with me
Better make it fast...
Tell you what I want, what I really, really want.” – Spice Girls, Wanna Be
Headline: August 11th 2009 - Severe Contraction in Venture Capital Levels, Worst Quarter in 14 Years
What was the state of the venture capital industry in Canada 14 years ago? In Q2 1995, there were a few VCs in Canada with capital to invest. Ventures West had a small fund, BDC was active, Working Opportunity Fund had been up and running for a few years, Working Ventures and Vengrowth were the newest players in Ontario joining Helix and the uber-angel Terry Matthews, Quebec had a few small funds... and not much else. It was before the Internet bubble (Netscape went public in August of 2005, launching that lucrative cycle) and all the technology rage was about the upcoming launch of Windows 95 (Start Me Up... remember?). Personally, I spent Q2 1995 worried about one thing... the birth of my son. So this timeline is very relevant to me. I see what 14 years looks like every day.
About $160 million was invested that quarter in 1995 in start-ups across all technology sectors across Canada. Not since those heady days of Bill Clinton and the Spice Girls have we seen that low of an amount invested by VCs in the commercialization of innovation in Canada. But we are back. Only $179 million went into Canadian companies from the coffers of VCs in Q2 2009, down 42% from Q2 2008 and, more alarmingly, down 34% from the first quarter of 2009, according to Thomson Reuters. In Western Canada, I can count three investments in Q2 (Teradici, Sustainable Energy Technology and Zymeworks).
Now we get the inevitable hand-wringing. We have talked about the issue with VC in Canada ad nauseum. You can see excellent essays here, here and here. The head of the venture capital association in Canada calls this a venture capital crisis, officially naming what most of us have seen coming for three years (to wit, here's what I thought in 2007). We can fix venture capital. We need to fix venture capital. But I think it’s time to step back to fundamentals. Capital for start-ups and growth stage companies can come from a variety of sources. It depends on what you need.
Quick history lesson: Venture capital is an outgrowth of private equity funding. In the 1970’s, new businesses were popping up in the technology world that required a substantial funding of losses. These companies could grow amazingly fast only after they had commercialized the technology. PE firms did not “get” losses. It was too risky. Banks did not give debt to companies with no assets and a forecast of negative cash flow. So Venrock and Sequoia and a few other pioneers in the new finance category of venture capital backed these companies like Apple, Sun Microsystems and Applied Materials, taking enormous risk, but getting substantial upside.
The key point here is that VC filled a funding gap that was too large for angel investment and too early for PE investment. If you think of the original technology start-ups out the Silicon Valley, and then all around North America, they were predominantly hardware, semiconductor, biotech and enterprise software companies. All required millions of funded losses before they would generate revenue and profit.
Things are different today. Why do you need VCs for Internet media companies or casual game companies? The much lower cost of entry and shorter path to revenue means that less capital is required. My hot Internet Media list from Western Canada reveals 11 companies with hundreds of millions of unique visitors/subscribers a month, en masse. Many are profitable, some wildly so. Total capital raised from VCs of all of the companies on the list combined? A little over $18 million... or $1.6 million per. Leave out the largest raise of the eleven and the total is under $10 million, or less than a million per company. This is angel level financing to a “T”.
Enterprise software has morphed to web-based applications or open source software and their recurring revenue streams. Significant capital is still required to build up the recurring revenue to the point where the company is profitable or to sustain a high revenue growth rate. VCs are useful here, but only from the point of view of how rapidly you want to grow. Talent Technologies, a SaaS recruitment software company, has become successful on the backs of angel investors.
Semiconductor start-ups, even though they are “fabless”, require tens of millions of dollars today to get to revenue and profitability (The aforementioned Teradici has raised a total of US$43 million). Hardware companies require almost as much (Local telecom hardware company Zeugma is over $50 million in VC). Biotech companies are, for the most part, massive cash sinkholes prior to getting regulatory approval. As in the 1970’s, these companies can’t be bootstrapped or rely on angels and need a vibrant VC industry
Do we need to fix VC in Canada? It depends on your point of view. Whereas almost all technology companies looked at VC 14 years ago to help them grow, there are alternatives today. Some of you will grow incredibly successful businesses without speaking to institutional money. Some of you will bootstrap to profitability and look for growth capital in traditional sources: subordinated debt, senior debt and private equity. Many of you will rely on angels and cash flow to grow, possibly on a slower trajectory, but grow nonetheless. Bottom line is that the technology industry has never been completely reliant on VCs for growth capital and it is less so today than when VC was invented as an asset class.
So fewer of us need VC, but it is still required to commercialize significant amounts of innovation. A few more thoughts on turning the VC decline around:
What is the “right” amount of VC in Canada? Certainly $179 million seems low compared to 14 years ago. But throwing more money at the problem has never, never succeeded in growing a successful sector because capital is only one of three equally important inputs (innovation and human talent being the others). Quebec demonstrated this nicely for us in the 1995 to 2004 timeframe where they invested a lot of capital in a lot of companies, effectively watering down the talent base across too many start-ups and investing in innovation that wasn’t, well, very innovative. Without sufficient follow-on capital, many of the companies had been given just enough rope to hang themselves. As a result, their exits were the lowest valued in Canada from the period of 1999 to 2005.
The right amount of VC is more at the early stage and much more at the later stages than has been available. BDC just announced the allocation for early stage investment of $350 million. Good. Tandem Capital will close in October on almost $300 million for later stages. Hallelujah. But there also needs to be more sector specific funds, like Chrysalix in clean technology. I don’t think the “right” amount of VC is significantly more than $179 million a quarter, either. Too much money sloshing around is a very bad thing.
Has the VC industry in Canada reached maturity? Fourteen years ago the VC industry in Canada was a toothless kid beside the swaggering mature US VC industry. The maturity of its managers, after 15 to 20 years of “figuring it out”, had the US VCs primed to make great hay from the coming Internet bubble. The Canadian VC industry emulated its bigger US brother in practice (but without the experience) and ended up face down in the mud, with meagre returns. The Canadian VC industry needs to grow through its adolescence and use its collective learned experience to make better returns. Small problem... there has been huge turnover in the past 5 years in Canadian VC. It takes 10-15 investments and millions of dollars before a VC is “experienced”. A real kick in the teeth to Canada would be new VC money to invest, but from new VC investors.
New expectations of VC returns are needed. We thought we could all be Benchmark Capital (which had a very good day yesterday) here in Canada. Perhaps if you don’t invest in the Silicon Valley, you shouldn’t expect Silicon Valley returns? This is a hard one because it sounds so Canadian cliché to “shoot for the bronze”, but the reality is that very good businesses can be built in Canada and sell for $20-$50 million or wait 10 to 15 years and go public, like Creo or Research in Motion, neither of which meet the IRR (internal rate of return) guidelines of a “great” VC fund. Quicker exits at the lower value range or greater patience for returns (not driven by 10 year funds life or annual reporting requirements of labour funds in order to raise money) might be more appropriate. Sounds great, but here’s the rub: If investors in VC funds were expecting 15-20% IRR (Canadian realism) vs. 25-30% IRR (Silicon Valley VC goal), would they invest at all in Canadian funds?
It will be a tough road for Canadian technology entrepreneurs coming out of this economic downturn. It will be made tougher for some without an improvement in the VC funding levels. But for those of you with a bootstrap plan or a lower funding requirement, disregard the hand wringing and go about your business.