Venture gap

Entrepreneurs say there's not enough money here, but there's no shortage of ideas to fix that.

Albert Lai is the kind of entrepreneur Canada should be fortunate to have. The 29-year-old has been involved in dozens of startups since leaving university during his first year to work for himself. He founded MyDesktop at 18 and sold the network of technology websites a few years later to Jupitermedia; he started, a comparison-shopping site in 2000; and sold his photo-networking company, BubbleShare, to Kaboose Inc. for US$3 million last year. Canadian Business last June put Lai on its cover, trumpeting him as a “whiz kid” on the cutting edge of the Internet.

But Lai’s next project — and his most ambitious — will not be based in Canada. “As a purely business decision, you’d be an idiot to start a company in Canada,” he says, unless you can get some capital from the U.S. Lai is setting up shop in California, and though he’s reluctant to get into specifics, he says his new company will have a social networking focus and is poised to take advantage of the convergence of mobile devices and the web — something pundits like to call Web 3.0. Such a venture sounds worthy of national interest, but for Lai and his peers, securing funding in Canada is a deflating experience. “It’s been very challenging to get the level of support necessary from the venture community,” Lai says. The lack of interested and well-heeled financiers is particularly acute for companies in the business-to-consumer space. “There is a complete lack of experienced or interested investors,” he says.

Many Canadian venture capitalists agree; some say the industry is in crisis. But a robust venture capital market is crucial if Canada is to build and keep the kinds of innovative companies that ensure this country remains competitive. “I wouldn’t put it on life support yet, but there’s fluid in the lungs,” says Rick Segal, a partner with JLA Ventures in Toronto. The amount of venture capital invested last year was $2.1 billion, up from $1.7 billion in 2006, according to Canada’s Venture Capital & Private Equity Association (CVCA). But the money raised by Canadian VC firms, declined to $1.2 billion from $1.64 billion, a downward trend that began in ’01. That’s causing concern about where next-gen companies are going to find funding.

Even more worrisome is that American funds accounted for 41% of the invested capital last year, the highest level to date. While certainly welcomed by entrepreneurs, the increased presence of American money stokes fears that our brightest companies will hightail it to the U.S. to be closer to their investors. But Segal sees at least one reason why Canada remains a good place to start a company: when there is a problem, such as the lack of financing, it gets dealt with more quickly than in other places. “Canadians might not think so, but from an outsider’s perspective, the government is more accessible,” says Segal, who left the U.S. more than 10 years ago. “That alone gives me cause to believe that people will, at some point, dive in there and fix it.”

Now would be that time. Canada’s federal tax rules, the government’s role in funding, and, in some ways, the entire approach to venture capital investing have to change in order to create a healthier funding ecosystem. As Lai says, “The options right now basically lead most entrepreneurs like myself to look south of the border.”

The easiest thing to start fixing is Canada’s tax policy surrounding foreign investment. The weak domestic market means early-stage companies have to rely on American money in order to grow. Just how much American money is desirable is debatable, but Canadian entrepreneurs have little choice in taking what they can get. Unfortunately, “The Americans are pissed off because of our tax laws,” says John Ruffolo, national leader of Deloitte’s technology, media and telecommunications group. Deloitte found that 40% of U.S. firms and 28% of global firms cited Canada’s cumbersome tax system as a key reason for not investing here — a number five times greater than any other country in the global survey of 528 venture capital firms in December.

The main problem? A system that requires reams of costly and unnecessary paperwork. The typical scenario works like this. An American firm invests in a Canadian company, which is sold a few years later. The VC is subject to a withholding tax of 25% on the gross proceeds. However, it can file a “request for certificate” with the Canada Revenue Agency, a form that essentially says the VC is not obligated to pay any tax on the sale under the Canada-U.S. tax treaty. But once the CRA has verified the VC is legit and not taxable in this instance, the process isn’t over. The “ultimate kick in the ass,” says Ruffolo, comes when the CRA still requires every single partner to file a Canadian tax return reporting the sale, even though no tax is paid. Some funds are made up of hundreds of investors spread across the world, meaning the paperwork is time-consuming, costly and pointless. “Canada is the only country in the world that does this,” Ruffolo says.

But even if this barrier was removed to stimulate foreign investment, a strong domestic market is still crucial. “If you think a U.S. venture capitalist is going to pick up the slack, you’re dreaming,” Ruffolo says. American VCs usually come in late during the investment process, leaving Canadians to fund the startup phases. Americans also rarely invest alone and generally prefer a domestic firm to lead a financing round. At a more fundamental level, it just makes sense for Canadians to be able to fund their own startups. “If there are good companies to invest in here in Canada, why can’t we invest in them ourselves?” asks Mark McQueen, CEO of Toronto’s Wellington Financial LP, which provides venture debt financing.

It’s a good question and one that, sadly, has plenty of answers. Canada is a small country with a relatively young venture capital industry, and a conservative society by nature — which runs counter to the entire venture philosophy. In Ontario, the popularity of labour-sponsored investment funds (LSIFs), which do the bulk of venture capital financing, make it difficult for private VCs to raise money. That’s because Ontario gives a 15% tax credit to retail investors who put money into these funds. The province in 2005 decided to phase out the credit, but not until 2012.

Ted Anderson, managing general partner with Ventures West Capital Ltd. in Toronto, has been active in the Canadian industry for more than 20 years, and he says institutional investors are reluctant to contribute to private VCs when the tax incentives afforded to LSIFs allow them to raise capital at a lower cost, and, therefore, participate in more deals. “The labour funds have this massive lake of money that has to be invested,” Anderson says. “So the institutional guys ask us, ‘How are you guys supposed to compete again?’”

These funds have been roundly criticized for many other reasons, with dismal returns being a primary complaint. LSIFs don’t even perform better than risk-free, 30-day treasury bills, the most conservative investment one can make. The program is also structured so fund managers typically have one to three years to reinvest fixed percentages of capital, regardless of the opportunities at the time. “They make bad decisions for how that money gets invested just by virtue of the lack of time to do due diligence,” says Douglas Cumming, an associate professor of finance and entrepreneurship at York University’s Schulich School of Business in Toronto. As a result, labour funds have a greater number of portfolio companies per manager than private venture capital firms, and managers are not as actively involved in their companies. “It’s not really like venture capital investing,” Cumming says. “It’s more like mutual fund investing.”

There is a belief in the industry that if the tax credit for LSIFs were eliminated, institutional investors would start directing more money to private VCs. But institutional investors have yet to show up in Ontario. “It’s been almost three years, and the market is shrinking,” McQueen says. “Whatever the intended benefits of the cancellation of that program were intended to be, no one can find that in the data.” Private VCs only managed to raise $447 million last year, compared to $666 million in 2005. Retail funds, meanwhile, raised $1.2 billion in 2005, but had just $741 million in capital committed in 2007. The effect on Ontario has been severe, where a paltry $267 million was raised last year, compared to $772 million in 2005.

Quebec is better off, in large part because the province still offers a tax credit to individuals who invest in LSIFs. Institutional investors there are also more active in supporting early-stage companies through VC. Desjardins Venture Capital in Montreal, for example, operates nine funds — eight that invest exclusively in Quebec, and another that invests mainly in the province. As a result, fundraising in Quebec is still relatively healthy. More than $816 million was raised last year, although even that amount is down from the $1.1 billion raised in 2005.

JLA Ventures’ Rick Segal is somewhat of a fan of LSIFs, putting him in the minority among private venture capitalists. “While capitalists and Darwinian theorists will tell you survival of the fittest is better, I believe that, because of the country’s size, its culture, and the need to keep the pipeline full of young companies, any place to get capital is good,” he says. LSIFs are part of an ecosystem that encourages entrepreneurs to do business in Canada. “When you start taking those things away, you just wiped out your competitive advantage,” argues Segal.

Indeed, there is now a huge chunk of capital missing from the Ontario market, and a slowdown in the province does not bode well for the rest of Canada. It takes time to raise and distribute money. The longer it takes for fundraising to pick up, the farther Canada falls behind.

Government-led VC investing, which the Quebec government already does, could help stimulate investment in Ontario and, indeed, across Canada. In November, the Ontario Venture Capital Fund, a $165-million fund of funds, was created by the province’s Ministry of Research and Innovation. The government is kicking in $90 million with institutional investors — OMERS pension plan, RBC Capital Partners, Manulife Financial and the Business Development Bank of Canada — supplying the rest. The fund is similar to the Innovation Investment Fund program launched in Australia in 1997, in that the government acts as the lead investor in order to attract other institutions. The Australian program consists of nine funds and the ratio of government to private capital is as much as two to one. Cumming at York analyzed the performance of the Australian funds and found they operate on par with private venture capital funds, and have filled the void for startup and early-stage financing in that country. For Cumming, the Australian program demonstrates the tremendous potential of public subsidization of venture capital.

While the new Ontario fund is a step forward, its size is almost laughable. The four institutional investors are contributing only $75 million combined, though the government plans to increase the size of the fund over time. It’s hard to blame institutions for not wanting to invest in Canadian VC — returns stink. From 1996 to 2006, Canadian VC funds’ net annual internal return was only 1.8%, according to the CVCA. Institutions are better off investing in American funds, where they can chase the next Google or Facebook. Ultimately, the best way to attract institutional money is to demonstrate better performance, and Canadian VCs know they have a lot of work to do.

The typical Canadian VC spreads its money around and, as a result, invests too thinly, making it difficult for budding companies to grow. That strategy is now changing. The average investment size increased to $5 million last year, up 19% from 2006. Even so, that’s still only half the average investment for a U.S. company. But Canadian VCs also don’t stick very long with their investments. “People have been happy to sell out early,” says Anderson at Ventures West. “You have to have the wherewithal to stay with it to allow big wins to happen.”

Such a strategy also means Canadian VCs don’t allow big losses to happen, either — or at least they’re so afraid of losses as to be immobilized. Segal, for one, is struck by Canada’s attitude toward failure. “You have to be able to embrace failure as a way to get to where you’re going,” he says. American VCs will try a bunch of ideas with a portfolio company, fail at most, go back to their investors to explain what went wrong and ask for more money. Canadian VCs can’t do that, Segal says, because institutional investors here equate failure with a lack of skill, rather than a learning process of trial and error. “What happens is you get very, very conservative venture capitalists, which is an oxymoron,” he says.

That leaves VCs caught in a bind. Risk-taking and long-term funding are necessary to improve performance. But having the luxury to take risks and stick with investments requires capital. And the best way to get capital? Improve performance.

Tax incentives could encourage pension funds to invest in venture capital, but that would be politically unpopular considering the wealth of tax breaks already afforded to the likes of Ontario Teachers’ Pension Plan and its peers. Ruffolo at Deloitte says federal and provincial governments could use those same tax advantages to encourage pension funds into bolstering venture capital investments. Pension funds certainly wouldn’t like that idea, although Ruffolo says it wouldn’t take a lot of money to make such a plan work. “As a percentage of their total assets, it’s a rounding error for these guys,” he says. Venture capital is such a small part of the Ontario Teachers’ Pension Plan’s overall operations that the giant doesn’t even bother to discuss its VC strategy publicly. Michael Nobrega, CEO of OMERS, says that because pension funds are legally obligated to pay a steady income stream to pensioners, venture capital is simply too risky to undertake. He adds pension funds give back to the economy in other ways, such as investing in established technology companies such as Research in Motion, which, in turn, spend heavily on research and development.

But even if tax incentives for pension plans aren’t brought in, there are plenty of other ideas. McQueen supports creating a lifetime capital loss exemption, allowing angel investors and VCs to write off losses as a way to encourage more risk-taking. Albert Lai would like venture capitalists to show more interest in and support to university students. Facebook and Napster were hatched by students, and Lai believes dorm rooms can be great incubators of innovation. When he attends technology-related conferences or networking events for students in the U.S., the venture community turns out in full force. Not so in Canada. “You get a tiny representation of venture capitalists in the audience,” Lai says. “And that’s sad, because not only are they not sharing their knowledge and encouraging students, they’re also missing out on a lot of opportunities that could be there.”

Lai does see a few faint glimmers of hope — the new Ontario fund, the relatively stable market in Quebec, and a burgeoning video game technology scene out West. More angel investors are also coming out of the woodwork to finance and mentor entrepreneurs. He cites Patrick Lor, who sold iStockphoto to Getty Images in 2006 for US$50 million, and Austin Hill, co-founder of Montreal Internet services company Radialpoint, both of whom are now angel investors. “That’s really how the Valley got started,” Lai says. It was created by successful entrepreneurs sharing their hard-won lessons — and cash — with others.

Anderson at Ventures West posits another idea: VC is cyclical, and we’re just at the bottom of the cycle. A lot of money poured into VC more than a decade ago, causing valuations to increase and returns to diminish. Funding from institutional investors dried up, creating attractive opportunities for those VCs still around. In time, those VCs should generate decent returns, and that will draw money back. And, don’t forget, investors are still recovering from the tech crash, and Canadian institutions move slowly and cautiously. “We’re back to a reset kind of zone,” Anderson says. “We’ve just gotta be able to prove that we as managers deserve the money and that we know what we’re doing,” he says.

They had better hurry. Entrepreneurs such as Lai aren’t waiting around.