With fund raising in the United States and Canada soaring to record heights, venture capitalists are teaming up to share deal flow in each other’s backyard. And with the number of technology and telecommunications companies still growing in both countries, there’s certainly no shortage of deals to go around.
As a result, VCs on both sides of the border have joined forces to source and back deals, a development that has brought mutual benefits to general and limited partners alike. U.S. venture firms, for example, can bring credibility to a Canadian deal and increase a company’s valuation, while Canadian firms can add insight to local business practices and trends.
“There is a significant valuation gap between a company that gets U.S. attention and one that does not,” says Steve Masson, an assistant vice president of equities at Altamira Financial Services Ltd., a mutual fund company in Toronto. “The market cap [of a company] doubles and triples once there is U.S. exposure.”
So far this year, four of the largest Canadian high-tech and communications deals in terms of dollars invested – Catena Networks Inc., Chrysalis-ITS Inc., Hyperchip and Solect Technology Group – included venture financing from American firms such as Goldman, Sachs & Co., Advent International, Weiss, Peck & Greer Venture Partners LP, Morgan Stanley Venture Partners and Technology Crossover Ventures, according to Macdonald & Associates Ltd., a Toronto-based organization that tracks venture capital activity in Canada. And while there is no blanket rule, it’s not uncommon for a U.S. venture firm to back a big Canadian deal, says Mary Macdonald, president of Macdonald & Associates.
Like the U.S., Canada has seen a surge in the number of high-tech and communications deals, with 43.8% of all deals in the first nine months of last year going into such companies. That figure is an increase from 37.8% of the $1.7 billion venture capital garnered in 1998 and 39.2% of the $1.8 billion raised in 1997 that went into those sectors, according to Macdonald & Associates. Internet and communications deals in the U.S. last year ranked first and second, respectively, in terms of venture dollars devoted to their sectors.
Unlike the U.S., however, Canadian VCs and their limited partners are less willing to take risks. At the same time, Canada’s venture industry is still recovering from a withdrawal by institutional investors who pulled out of the market following the 1987 stock market crash amid concerns that the venture market was not large enough to support their need for diversification, Macdonald says.
Indeed, Canadian venture investing operates on the same premise as it does here – institutional investors pour capital into funds that back start-up to late-stage companies in a range of industries. One must keep in mind, however, that the Canadian venture industry has not matured to the extent of its American counterpart, and as a result, VCs there have less investment expertise and fewer quality deals to choose from. Another major difference was the creation in 1989 of government-backed labor-sponsored funds – investment pools that resemble mutual funds in the U.S. and attract individual Canadian investors by offering them large tax breaks. Labor funds are known for investing large amounts of capital, but their investment staffs are often criticized for lacking the entrepreneurial expertise that private venture firms tend to have.
Of the total C$1.9 billion ($1.3 billion) venture financing raised in 1998, labor funds accounted for some 50%, corporate funds for 30% and private independent funds for the remaining 20%, says Ron Begg, president of the Canadian Venture Capital Association. Last year’s figures were not available at press time, but the CVCA expects an increase in the numbers for private and corporate funds.
Evolving Over Time
With U.S. venture capital activity increasing in Canada over the last few years, so have the valuations of Canadian companies. After seeing some first generation start-ups based in Toronto, Ottawa, Montreal and Vancouver cash out, and having observed the success of the U.S. venture market, Canadian institutional investors are ready to reenter the marketplace. Their willingness is illustrated by the record six or seven Canadian funds that have been oversubscribed in the past four to five months, at times exceeding C$100 million ($69.1 million), says Rick Nathan, a founding partner at Canadian incubator and venture capital firm Brightspark Inc.
BCE Capital, the venture capital subsidiary of BCE Inc., a Toronto-based telecommunications company, is just one of a handful of Canadian venture firms to form strategic partnerships with American firms. Its relationship with Palo Alto, Calif.-based Crescendo Venture Management LLC has resulted in higher returns on their investments, as well as helped diversify its portfolio and build lasting relationships with southern counterparts, says Paul Cataford, a managing director at the firm. BCE Capital and Crescendo hold quarterly meetings to share ideas and discuss deal flow.
Crescendo, on the other hand, partnered with BCE Capital to utilize the Canadian firm’s connections to its parent company, telecommunications service provider Nortel Networks Corp., Jeff Tollefson, a general partner at Crescendo says. Such a relationship can be of great help when conducting due diligence on emerging technologies in the communications sector. Crescendo has not invested in any Canadian companies sourced from BCE Capital, but feels comfortable that its expertise could lead to potential Canadian investments, he adds.
The firm just launched Crescendo IV, targeted at between $500 million to $750 million and expects to invest some 20% of its new fund in companies based outside the U.S., generally in Canada, Western Europe and Israel, Tollefson says. The firm’s previous fund, the $250 million Crescendo III, devoted 70% to communications infrastructure and services companies and the remainder to e-business companies.
Meanwhile, the competitive U.S. venture market has not managed to shut out Canadian VCs. Created in 1993, BCE Capital conducted all of its business at home until 1997, when it decided to completely source American deals. Since its move across the border, BCE Capital has closed 12 deals, three of which were Canadian companies.
The firm chooses to co-invest with American partners because they act as role models, teaching them how to contribute to companies as a member of its board of directors, how to conduct due diligence and best utilize a network of connections, Cataford says.
With no laws governing international co-investing, VCs from both sides can offer each other their expertise and connections. BCE Capital can compete with American venture capitalists for communications deals in the U.S., Cataford says, because of the firm’s connection with Nortel.
BCE has developed relationships with about 15 venture capital firms, including Palo Alto, Calif.-based Communications Ventures and Chicago-based JK&B Capital, along with high-net-worth individuals in the U.S., Cataford says. Strategic alliances with American firms have also given BCE insight into leveraging its portfolio companies. For example, BCE portfolio company CoSine Communications Inc., which is based in Redwood City, Calif., and develops network-based carrier class IP switching platforms, eventually will be able to use the services of Daleen Technologies Inc., a company in the BCE portfolio that develops software products and services for the billing and customer care industry.
With investment opportunities picking up in the Canadian IT and communications market about six months ago, BCE Capital decided to change its business model once again, and now evenly splits its capital between U.S. and Canadian companies. The firm offers its U.S. counterparts the knowledge and expertise of a local investment partner.
BCE is still investing its inaugural fund, BCE Capital Inc., which is currently valued at C$137 million ($94.6 million). The evergreen fund has backed some 25 to 30 communications and technology-related companies and has continued to reinvest profits. The firm will close the fund this year and raise a second, more traditional venture fund with corporate limited partners, including its parent and sister company. The vehicle is targeted to reach between C$108.3 million ($75 million) and C$144.4 million ($100 million), Cataford says.
Another example of this cross-border phenomen is Toronto-based Mosaic Venture Partners, which divides its deals between the U.S. and Canada, says David Lawee, a managing director at the firm. “We think it is strategic for us to invest on both sides of the border,” he says. “Canada is not big enough for us to build a sustainable business model on its own.”
Lawee and the firm’s two other Managing Directors, Vernon Lobo and David Samuel, all worked at U.S.-based consulting firm McKinsey & Co. and attended business school in the states. Building relationships and maintaining an understanding of the U.S. marketplace is pivotal, Lawee says. “Unless we have U.S. experience” of going through the process in a mature market, “we can’t really help these [Canadian] companies.” In return, Mosaic offers its U.S. partners a screening process to Canadian investments.
Mosiac has made investments with major American venture players, and each has brought a significant lesson to the table, Lawee says. For example, the firm co-invested with Draper Fisher Jurvetson in backing Natick, Mass.-based Direct Hit Technologies Inc., a search engine company that was sold to Ask Jeeves Inc. in January. When Mosaic invested in Zefer Corp., a Boston-based Internet professional services firm that needed capital for acquisitions, it partnered with the Chicago-based buyout firm Thoma Cressy Equity Partners.
Mosaic is now investing its second fund, the C$110 million ($76.2 million) Mosaic Venture Partners LP II, which closed in November 1999 and will back about 10 to 15 seed- and early-stage Internet and digital technology companies, with a focus on the business-to-business e-commerce and broadband spaces. At press time, the fund was invested in five companies. Mosaic’s limited partners include the Ontario Teachers’ Pension Plan Board, Caisse de Depot et Placement du Quebec, Manulife Capital Insurance Co. and the Bronfman Family of Montreal.
Begg, also president and chief executive officer at Working Ventures Canadian Fund, one of the nation’s first labor funds, believes in partnering with U.S. investors for three reasons: They have the capital to provide additional rounds of financing, they have good business contacts and they tend to be industry-specific investors. “When we are looking at an investment opportunity in a specialized field, we might see two, three or four of that type of transaction a year,” Begg says. “We will seek out a U.S. venture capitalist who might see 30 of those [same types of deals] in a year.”
Working Ventures has invested with U.S. firms on a deal-by-deal basis, but is open to the idea of formalizing such relationships. Some of those include co-investments between RoweCom Inc. and Highland Capital Partners; Stream Intelligent Network Corp. and Patricof & Co. Ventures Inc.; NovAtel Wireless Technologies Ltd. and Advent International; and Ironside Technologies Inc. and GE Capital Equity Capital Group.
In short, any connection a Canadian firm can secure with an experienced or well-known American venture firm or individual in the field enhances its reputation. “We want the credibility [a U.S. venture capitalist] provides, and they will be first to see e-commerce deals coming out of Canada,” says Tim Diamond, executive vice-president at Triax Capital Holdings Inc., which manages labor-sponsored funds out of Toronto. Triax has an existing relationship with Elijah Asset Management, an investment-consulting firm, and William Easterbrook, a portfolio manager at investment bank Chase H&Q, both of which are based in San Francisco. Triax also has plans to work with another six to 10 U.S. firms in upcoming months.
Of course, establishing ties with foreign partnership is not without its risks. When partnering with U.S. firms, Canadian VCs are sometimes rejected by entrepreneurs and venture capitalists at home who subscribe to a tribalism theory, which says that American investors are stealing all the worthy Canadian deals, BCE’s Cataford says. That myth, as he calls it, only does harm to Canadian VCs, by robbing them of the chance to reap the financial benefits of their American counterparts and spur domestic entrepreneurial growth.