On the Cover: The State of Venture Capital Investing in BC
Beyond Numbers · April 2009
By Tanner Philp, CA
Amid the doom and gloom of the global economic crisis, there are a few bright spots when it comes to BC’s venture capital ecosystem
Venture capital investing is the activity of providing private equity-style investment to early-stage businesses that have high growth potential. Typically, these businesses are start-ups, with no track records of success and, in some cases, no operational histories. Venture capital investing is an art (not a science) that entails the careful selection of visionary and skilled management teams to build and develop unknown or unproven business models, often centered on new or unproven technologies and products.
As we all know, British Columbia’s economy is resource-driven, primarily by forestry and mining. These industries are struggling with volatility and contracting revenues and profits in the face of structural shocks to their core businesses and well-documented, global economic woes. Most venture capital investing happens outside of the resource sector, in what is commonly referred to as the “new economy.” This new economy consists primarily of know-ledge-based small businesses, which are the backbone of growth in most developed nations. Investment in the new economy is an investment in innovation that creates opportunity for future growth, often in emerging businesses and sectors. Ultimately, in order to maintain the overall high quality of life in our province, we must strike an optimal balance between the new economy and the resource-driven economy with which BC has traditionally been associated.
Recognizing the importance of knowledge-based small businesses, both Canada and British Columbia have instituted active programs to promote their development. The chart on page 11 provides some metrics on the magnitude of the new economy in BC. In total, BC’s new economy comprises roughly 9,200 companies, which employ 100,000 people and generate annual revenues of $15.75 billion. This represents a significant portion of the province’s output and employment base.
The probability of an entrepreneur successfully building a business and making millions is very low, and as any real entrepreneur will tell you, building a successful business is a soul-searching, life-consuming, and invigorating rollercoaster ride. But without one key ingredient—cash—the ride will be over before it has even begun. Without cash, even an entrepreneur with the best ideas and the best management team in the world can’t get into the game.
This is where venture investors come in. Most western economies have a fully developed venture capital ecosystem that includes academic institutes, business savvy entrepreneurs, and investors. When working optimally, this ecosystem efficiently matches entrepreneurs with technology, team members, and investors to take an idea from concept to product to profits. Google and Facebook are two of the highest-profile examples of this process working as desired. There are also many local examples of companies that were seeded with some form of venture capital investment: SAP Business Objects, Sierra Wireless, Angiotech Pharmaceuticals, Electronic Arts, and Ballard Power are just a few examples.
So how is British Columbia’s ecosystem doing in providing capital to these high-growth, high-return companies that are creating large numbers of high-paying jobs? Unfortunately, despite some well-intentioned efforts and a few bright spots, the net conclusion is: not very well.
Understanding BC’s venture capital ecosystem
Today there are seven venture capital funds in British Columbia, with more than $10 million of capital under management (meaning that they have scale of investments and operations). These funds are, in alphabetical order: BC Advantage Funds, managed by Lions Capital; the BC Discovery Fund, managed by Discovery Capital; the Business Development Bank of Canada (BDC); the Pender Growth Fund,
managed by Pender Capital; Ventures West Limited Partnership, managed by Ventures West; the Working Opportunity Fund, managed by GrowthWorks, and Yaletown Ventures Limited Partnership, managed by Yaletown Venture
Partners. In total, these funds manage approximately $885 million dedicated to investment in early-stage, high-growth companies.
While that might seem like a large amount of capital, there are some disturbing trends under the surface. The first is that (at the time of this writing) not all of the seven funds listed above are actively investing in new opportunities. Most funds have the capital needed to continue supporting their existing portfolio companies, but when it comes to investing in new companies, only the very best opportunities are warranting attention. Venture funds are having a difficult time attracting new capital due to market conditions and a reduction in the number of willing retail and institutional venture investors. As a result, most local venture funds are focusing on using what capital they do have to nurture and sell existing investments, and are doing few or no new deals while waiting for the climate to improve.
Ventures West falls into the “no new deals” category. The oldest venture fund in BC tested the waters to raise money for a new fund in 2008 but did not receive enough commitments to proceed, according to Private Equity Insider. The firm subsequently closed a number of offices and reduced its team size, and is currently focusing on cultivating its existing portfolio companies and hoping for a better fundraising climate in the future.
Other funds, including BDC (a government organization), are experiencing internal disruption, and the unofficial word on the street is that new investments are constrained. BDC is undergoing a restructuring of its venture capital division; in Vancouver, this has meant dropping from seven investment professionals to five. As documented in a May 2008 article in the Globe and Mail, BDC made a lot of early-stage investments, but did not kill poor performers quickly enough to keep returns from suffering.
But venture capital funds are not the only game in town. Before these institutions see an investment opportunity they will typically garner the attention of local “angel investors” (high-net-worth individuals who invest in start-ups). Because these wealthy individuals tend to fly under the radar and don’t report their investment activity, formal statistics are not available.
Anecdotally, however, most angel investors have been hit hard by the stock market meltdown, are now squeezed for liquidity, and, as such, are tightening their purse strings just like the rest of us. If you had a $30-million net worth before the stock market meltdown, and now have a $15-million net worth, you may still be able to live a pretty lavish lifestyle, but that $15-million loss is, nonetheless, a tough pill to swallow. This reality is giving angel investors added pause as they critically evaluate all new opportunities, and many are focusing their efforts on maturing existing investments before seeking new ones.
Some disturbing data
The data on venture capital activity supports the shrinking venture capital firm theory. The 2008 data recently published by Thomson Reuters revealed the following stats:
- Canadian deal activity in 2008 was at its lowest level in 12 years;
- Across Canada, $1.3 billion was invested last year—a drop of 36% from $2.1 billion in 2007. In addition, only 371 companies were financed in 2008, versus 412 in 2007;
- Activity in Canada in the fourth fiscal quarter of 2008 was especially slow, with $302 million invested versus $526 million during the same quarter in 2007; this marks a 43% decrease and, in this author’s view, indicates a worsening trend;
- A key variable in the Canadian slowdown was greatly reduced US and other foreign investor activity; $371 million was invested in Canada in 2008 versus $845 million in 2007—a 56% decrease; and
- In British Columbia, $259 million was
invested in 51 companies in 2008 versus $316 million in 2007—an 18% decrease.
The most troubling bit of data above is the fact that foreign, mostly US, investment seems to have fallen off a cliff. Canada does not have a fully mature venture capital ecosystem, and, in the past, our country has relied heavily on US investors to provide capital. Historically, US investors willing to leave their own backyards have been able to cherry-pick Canadian deals at advantageous valuations because local syndicates lacked the financial means to see them through. Relying on our counterparts to the south to fill in for local financing syndicates may not be an option much longer.
Not shown in the above data are the disconcerting facts that public markets are currently closed to venture-backed IPOs, and M&A activity is generally stalling in North America and globally, despite some buoyant sectors such as life sciences.
So where are the bright spots?
The first is the Venture Capital Corporation (VCC) program, administered by the British Columbia Ministry of Small Business, Technology and Economic Development. The VCC program provides a 30% refundable tax credit incentive to investors for investing in early-stage, knowledge-based companies. The program is split into a managed funds model, of which BC Advantage Funds, BC Discovery Fund, and Pender Growth Fund are constituents, and a direct investment model whereby angel investors deploy funds directly into eligible small businesses. Each year, the BC government provides $30 million in tax credits, thereby enabling $100 million of capital to be raised.
The VCC fundraising season extends until the end of RRSP season, so the final tally for 2008 is not yet in. But we can expect it to be roughly 30-50% lower than in previous years, and that many tax credits will go unused due to market conditions. The VCC funds are required to invest monies raised into eligible small businesses within two years of receipt. This means that for every dollar raised, $0.80 will be put to work building the new economy, employing knowledge-based workers, which will expand the taxpayer base within two years—a pretty good return to British Columbia.
What’s less obvious is the impact the Renaissance Capital Fund, formally launched in April 2008, will have on the local venture investment community in the long run. The Renaissance Fund is a $90-million BC crown corporation fund designed to attract venture capital fund managers from outside British Columbia by matching the capital raised by these fund managers with provincial money. It’s essentially an economic incentive to do deals in British Columbia. However, of the six firms selected to receive money from the Renaissance Fund to date, it is now looking as though two or three may not raise a new fund at all. As a result, the Renaissance Fund may soon re-open the tender process.
Moreover, because the firms selected are larger venture capital fund managers with existing investors, the Renaissance Fund cannot legally require fund managers to do deals in BC in exchange for incentive funds. Instead, the arrangement amounts to “moral-suasion,” whereby fund managers make a soft commitment to use best efforts to invest in BC companies. A case in point: Since the launching of the Renaissance Capital Fund in April 2008, only one participating firm—VantagePoint Venture Partners—has made an investment in British Columbia (by investing in two clean tech companies). By contrast, VCC funds are required to be invested in BC companies within two years, and VCC fund managers are required to comply with related provincial legislation—otherwise the tax credit incentives will be clawed back. BC’s Liberal government should be commended for recognizing the lack of knowledge-based business funding in this province, but only time will tell whether the Renaissance Capital Fund will be part of the solution.
The other bright spot locally is the fact that Yaletown Venture Partners closed a $65-million fund (with an additional $35 million still in progress) in October 2008, and is now actively seeking new investments in the clean technology and information technology sectors. This fund is the first new venture capital fund in British Columbia since the VCC funds were launched in 2003, and the only venture fund raised in all of Canada in 2008. But while this success is commendable, it is hardly enough to offset the contraction in venture investment activity overall.
If you add up the cash balances of BC Advantage Funds, BC Discovery Fund, Pender Growth Fund, and Yaletown Ventures, and presume that the other three institutional venture funds are making limited new investments and that the fruits of the Renaissance Fund have not yet ripened, you arrive at $90 million of capital in British Columbia currently available for new investment in high-growth, knowledge-based businesses. Admittedly this number is only a rough estimate, as cash balances are somewhat protected intelligence, but it’s in the ballpark. Keeping in mind that the average British Columbia-based venture fund investment company will burn through anywhere from $5-$50 million before becoming the next Sierra Wireless or SAP Business Objects, it’s clear that $90 million is simply not enough money to make these businesses successful. Ultimately, a lack of funding for knowledge-based, high-growth businesses will not bode well for any resident of British Columbia.
Where do we go from here?
This question is difficult to answer in the face of declining global economic conditions, and definitely merits a stand-alone discussion. To start, however, we need to focus on the bright spots. The VCC program has been very successful so far, and the provincial government should look to expand on this success by maintaining and streamlining the existing program, and allocating more tax credits to investors willing to fund the new economy. The Renaissance Fund program may be a good idea, but it might be more effective if the funds were deposited directly with local fund managers that have track records of transactions in British Columbia. Venture capitalists need to do their part by selling investments and generating returns for investors to reinvigorate the local scene.
Both 2009 and 2010 are expected to be very bleak years for any entrepreneur seeking venture capital investment. With that awareness in mind, entrepreneurs can help themselves by using capital more efficiently, reducing costs, and growing more organically on the back of internally generated cash flow.
Tanner Philp, CA, is the CFO and a partner of Lions Capital Corp. in Vancouver, the fund manager of BC Advantage Funds (VCC) Ltd. and Lions Fund I Limited Partnership. He specializes in early-stage public and private company investment and providing guidance on business strategy, transaction structuring, regulatory compliance, exchange listing, capital sourcing, mergers & acquisitions, and corporate partnering.
- Dean Deeby, “Development Bank Too Patient With Portfolio Losers, Consultants Said,” Globe and Mail, May 5, 2008.