Why Canada’s tech startups need to prepare for a funding slowdown

Venture capital investors are flush with cash but getting more cautious with their money. Here’s how startups can survive a drought

Big VC machine doling out tiny amounts of cash

(Illustration by Josh Holinaty)

Ever since it launched in 2011, Payfirma Corp. has been on an upward trajectory. Until recently, anyway.

The company was formed during the heady infancy of mobile payment systems. Square Inc., which launched a couple of years earlier, was a rapidly growing darling of investors. And there was nothing like it in Canada. Michael Gokturk, an entrepreneur who had just ushered a payment processing company he co-founded through a successful IPO, decided to jump on the trend and turn his attention to mobile.

He co-founded Payfirma in Vancouver and raised an initial seed round of $13 million to bring mobile payment systems to Canada. The company expanded quickly, building a multi-channel platform that allowed businesses to collect payments through mobile and websites, and in-store, all on the same account. IDC Canada estimated Payfirma’s 2013 revenue at $20 million. In May 2015, the company announced a $13-million Series A funding round (the stage that follows a seed investment, which gets the company off the ground), along with plans for hypergrowth that included a push into the American market and a possible IPO as early as 2016. “We decided—let’s raise, let’s pour more fuel on the fire, let’s grow more quickly,” says Gokturk. “We started hiring and hiring and hiring.” Payfirma brought in a senior leadership team that included veteran growth manager Yves Millette, formerly of Intuit, as chief operating officer, and Robin Jones from QuickMobile as chief marketing officer. Overall, the company nearly doubled its workforce to about 80 employees, scaled its sales and marketing teams, and grew and diversified each department.

But by last fall, things were starting to look a little different. The Canadian IPO market was cooling off. Oil prices were rock-bottom. Markets were at levels that hadn’t been seen since the 2008 recession. “Everything was at an all-time low,” says Gokturk. South of the border, Square’s November 2015 IPO appraised the company at less than half the $6-billion valuation ascribed to it a year earlier. “We started realizing that the financing market in 2016 might be a little bit slow,” says Gokturk. But even a tepid funding climate can carry big consequences for startups: Payfirma decided it would be prudent cut 30 positions, more than a third of its employees.

Payfirma isn’t the only Canadian startup to have altered course. In January, Toronto-based Craigslist rival VarageSale laid off 26 of its nearly 90 employees after a stretch of rapid growth. Smartwatch maker Pebble, which is Canadian-founded though based in Silicon Valley, cut about a quarter of its workforce in the face of a chilly investment climate. And in March, Vancouver-based Hootsuite, one of only two Canadian companies to have been valued at $1 billion, was kicked out of the “unicorn club” when Fidelity Investments, which led its 2014 $60-million funding round, wrote down its investment by 18%.

Venture capital dollars are still flowing, and in some ways, the funding ecosystem is the healthiest it’s been in years. But there’s a growing consensus that sobriety is kicking in. Valuations are coming down, and venture capitalists are getting more careful about where they put their money. “There’s a new sort of economic reality that’s hitting home,” says startup consultant Mark Evans. Startups are going to have to up their games to lure investment dollars—and play it safe with what they’ve already got.

This tightening of the purse strings has been a long time coming, says Owen Matthews, a general partner at Wesley Clover. The 2008 recession ground fundraising to a near-halt, which in turn led to a surfeit of funds closing a couple of years later when markets picked up again. “There was a glut of money during that period, and investors have to put that money to work,” says Matthews. “[Investors] start competing with one another, which drives up the value of the deals that are closing.” Now that glut has largely moved through the system. Canada’s venture capital industry had a banner year in 2015. Canadian companies saw $2.3 billion invested (up 12% over the previous year) in 536 deals (an increase of 24%). Fundraising was up too, with 30 funds garnering $2 billion, up from $1.2 billion in 2014. In the U.S., however, the last quarter of 2015 saw a drop of almost US$6 billion in investment over the previous quarter, while the total number of deals fell 13%. The average deal size went down by nearly US$4 million.

Canadian startups aren’t immune to a crunch coming from the south, warns Janet Bannister, general partner at Real Ventures, the most active early-stage venture capital firm in Canada last year. While seed and early-stage investments in Canadian companies have steadily increased over the past three years, later-stage financings have dropped. In 2014, there were 78 deals worth $931 million; in 2015, 64 deals totalled just $530 million. “A lot of Canadian startups, particularly when they get to Series A and onward, are funded by U.S. venture capital,” says Bannister. “As the market gets soft in the U.S., it affects Canadian companies.”

Bannister says venture capital firms on both sides of the border are taking more time to make investment decisions, adopting a wait-and-see approach before diving in. “They’re being much more cautious in terms of how they deploy capital,” she says. Part of that is due to uncertainty in the markets, Bannister says, and firms are holding back more reserves in case companies already in their portfolios need more capital to get to the next fundraising round. And, because competition for startups isn’t as hot, there is simply less pressure to make a deal.

To survive the funding drought, entrepreneurs need to do a few key things. First, they should strive to raise money now before the picture deteriorates further. “You want to get fuel in the tank so you’ve got lots of runway,” says Brad Johns, general partner at Yaletown Partners. Second, in the heady days of yore, a lot of money went into growing the top line at all costs, but entrepreneurs need to shift toward the bottom line, he says. “You still want to have top-line growth, but you’ve got to start figuring out how you can show that you’ve got a profitable business at some point.”

The standards of VCs are going to rise as startups must compete for more limited funds, says Bannister. For example, a company peddling services with monthly recurring fees may have needed around $100,000 in monthly revenues to get to a Series A round eight months ago, she says. Now that figure is more likely between $150,000 and $300,000. Ben Zlotnick, founder and CEO of Toronto-based startup accelerator INcubes, says startups need to prove three things to investors: that they have a market, a product that fits it and the team to pull it all together. Without those three points, it’s going to be a tough slog to find investors in the coming months. “It cannot just be a pipe dream—you actually have to prove it,” Zlotnick says.

Entrepreneurs need to be exceedingly cautious about how they spend money too, says Barry Gekiere, managing director of the MaRS Investment Accelerator Fund. “Be very frugal with spending so that it’s really focused on the key items of product development and [a] go-to-market strategy. Nothing that’s frivolous,” he says.

That may entail making some tough decisions, as VarageSale discovered. Since its 2012 launch, the Toronto-based “virtual garage sale” site had raised more than US$34 million, including from heavyweight American funds such as Sequoia Capital and Lightspeed Venture Partners. But its managers knew fundraising was going to get tougher, says VarageSale CEO Andrew Sider. Many high-growth companies fuelled by investment dollars were spending as if they were about to raise another big round, he says. “The problem is, when you continue spending like that but then the market falls apart, you find yourself running into a wall at an unbelievable rate. It does scary things to companies.”

VarageSale made an early move to avoid that fate, according to Sider. In addition to axing 26 employees, the company restructured—founder Carl Mercier, who had been serving as CEO, stepped down in March to take over the chief product officer job. The move signals VarageSale’s intent to focus heavily on its core product: an online platform that connects users with others in their communities to buy and sell goods. Rather than spending on marketing and advertising, VarageSale is betting satisfied users will recommend the service to others and drive growth. Recommendations pay dividends month after month, Sider says, whereas a marketing campaign has a shorter-term effect.

He recommends other startups do the same and resist the urge to get distracted by “the latest and greatest shiny things you could be doing” or by investing in expensive, unsustainable marketing. “I think we need to echo these sentiments a little bit louder to our Canadian peers,” says Sider. “We just need to be aware that we’re in touch with the challenges that are taking place.”

Payfirma cut 30 positions, though it managed to connect about 75% of its departing employees with new jobs through its networks. The business adjusted some plans and revisited its strategy to “make sure we were focused on the right opportunities and the right strategies for growth,” Gokturk says. He insists, adding that things are actually looking up. The company has monitored its performance metrics aggressively and, over the past six months, managed to improve the effectiveness of its sales representatives by more than 100%. Payfirma is even hiring again, albeit at a slower pace than before.

Perhaps the good news is that even though it’s tougher to secure funding, Canadian startups are used to it, says Johns with Yaletown Partners. “We always get beat up for not being as aggressive and thinking as big,” he says. “Maybe things slowing down might actually be a positive. We tend to be more cautious and have a culture of using our scarce cash more efficiently, and that may help us actually get through this.” Even if some fledging firms don’t survive a downturn, that could actually benefit the startup landscape, says Marc-David Seidel, director of the W. Maurice Young Centre for Entrepreneurship and Venture Capital Research at UBC’s Sauder School of Business. When companies lay off large numbers of staff or fail completely, a fresh wave of talent is free to launch new startups that are more relevant to current markets and consumer needs. “It’s not death and gloom—it’s just part of the natural process,” Seidel says. “It’s an opportunity to kind of shake out the stuff that doesn’t make sense anymore, and it allows the new stuff to flourish.”

Historically, companies founded during leaner times do better over the long term, he adds. Those that grow during boom times aren’t forced to develop the kind of discipline and organizational routines that ensure survival during downturns. Consequently, they’re more likely to fail. The companies that get going while the going is tough, says Seidel, “have to really up their game, which is a good thing for them. It makes them strong.”