Cover Story: Canadian VC Market’s Coming of Age –

While the dotcom feeding frenzy of the past two years was occurring in the U.S., its neighbor to the north – the Canadian VC market – largely avoided the fever by focusing its attention on information technology deals. As a result of that focus, coupled with increasing foreign investment and the activity of labor-sponsored VC funds uniquely Canadian investment pools that raise capital from individual investors and consequently resemble mutual funds in the U.S. – the Canadian market has grown considerably, without taking as big a hit of late, Canadian VCs say. However, despite its impressive strides, the market is still striving for a maturity level equal to that of the U.S.

“We didn’t have the same speculative exuberance in Canada that there was in the U.S. We have focused on Internet infrastructure and telecom deals far more than dotcoms,” says John Eckert, president of the Canadian Venture Capital Association (CVCA) and managing partner of McLean Watson Capital Inc. This focus has been possible as a result of entrepreneurs and engineers coming out of Canadian technology companies, like Newbridge Networks Corp., now a part of Alcatel, a number of Canadian VCs say. “Because of companies like Nortel Networks Corp. and JDS Uniphase Corp. there is an enormous talent pool in telecom and optics,” adds Ron McKenzie, managing director of the newly created Whitecap Venture Partners, the venture division of Toronto-based Whitecastle Investments Ltd. “In the last 10 years, Canada has produced world-class tech companies that have created a community from which you can build out businesses and talent.” Other Canadian high-tech successes include Research in Motion Ltd., the developer of BlackBerry handhelds, the must have wireless email device for any self-respecting VC and entrepreneur.

These successes are beginning to be noticed by the larger venture community, too. “Fully one-quarter of 2000’s venture disbursements came from foreign investors,” notes Mary Macdonald, president of Macdonald & Associates Ltd., a Toronto-based organization that tracks the Canadian VC industry. Foreign institutional investors are also getting in on the act, as they begin to put their capital to work in Canadian venture vehicles. “We felt it was appropriate to have some representation in the Canadian market,” explains Clinton Harris, managing partner at Grove Street Advisors. “There have been some good companies coming out of Canada and there are signs in place that Canada has what we think is an interesting market.” Grove Street, which manages a $1.7 billion dedicated fund-of-funds vehicle for CalPERS, committed $5 million to Canadian VC-firm Ventures West’s newest vehicle, the C$235 million ($150 million) Ventures West 7 fund.

“Over the last five years there has been an enormous increase in the amount of capital available to Canadian entrepreneurs,” adds Whitecap’s McKenzie. Whitecap’s parent, Whitecastle, is a family-funded private equity investment vehicle founded in 1959 that has been focusing on high-tech deals since 1989. Whitecastle launched Whitecap in February of this year because of its strategic decision to build out its venture investing team, McKenzie explains. Sensing a buying opportunity in the midst of the current public market correction, which has driven down valuations in the private markets, Whitecastle has decided to increase the amount of capital it devotes to its venture program by 50% for the coming year.

The increase in the amount of venture funding available in Canada has triggered a corresponding increase in disbursements over the last several years, Canadian VCs say. According to Macdonald & Associates, VCs invested C$6.31 billion last year in Canada, compared with C$2.72 billion in 1999 and just C$1.09 billion in 1996. Some 66% of 2000’s total VC disbursements in Canada went toward IT deals, up from 59% of disbursements in 1999 and towering over the 37% in 1996. “In terms of disbursements the growth in Canada has been remarkable. The curve, while starting from a smaller base, is not unlike that of the U.S.,” says Macdonald. “What is notable is that the Canadian venture industry has thrived in what is a harder environment than the U.S.”

Still Lagging Behind

What makes the Canadian venture environment more challenging and less mature than the U.S. marketplace is the fact that local institutional investors, for the most part, have stayed away from the asset class since the late 1980s, Canadian VCs say. “We have far less institutional support than VC firms in the U.S. Only about 4% of the venture capital deployed in Canada is institutional in origin,” says McLean Watson’s Eckert. McLean Watson, a traditional venture firm, is in the process of raising a new C$250 million-targeted fund, McLean Watson Ventures III. The vehicle will focus on early-stage IT companies in Internet infrastructure, wireless, software and semiconductor industry sectors, he adds.

“There are five or six pension funds in Canada that are active in this space, and these guys are the exception to the rule. There are 30 or 40 pension funds that just don’t do anything at all with VC,” comments Rick Nathan, a managing director at the Brightspark Group, an incubator and VC firm based in Toronto that primarily backs software and, in particular, infrastructure software companies. Brightspark counts two of Canada’s active VC investing pension funds – including the Ontario Municipal Employees Retirement System (OMERS) – among the limited partners in its freshman venture vehicle, the C$80 million Brightspark Ventures LP, he adds. Nathan declined to name the other pension fund.

Besides its spotty institutional support, VCs say the Canadian venture market also demonstrates its relative lack of maturity when it comes to finding experienced management teams for portfolio companies. “The U.S. is more mature than Canada in terms of getting together management teams that have experience,” says Robin Louis, president of Ventures West, a backer of early-stage technology companies in the IT, telecommunications, biotech and energy and industrial technology industries.

Mike Cohen, a managing director at VenGrowth Capital in Toronto, agrees. “One major difference between Canada and the U.S. is the depth of management,” he says. “In Canada, there are fewer management teams who have done it before, whereas in the States over the last five years, VCs have been backing people who know the game.” VenGrowth, which has $1 billion under management in two labor-sponsored vehicles, backs IT companies at all stages of development.

Another area where the Canadian venture market still needs development is in VCs’ ability to produce successful stand-alone companies, a number of Canadian VCs say. “Canada develops a lot of outstanding IT companies, but usually we fall down on building organizations. We are less successful in selling and marketing abroad,” McLean Watson’s Eckert says, “so typically you see Canadian companies built to a certain space and then sold to a bigger U.S. competitor.”

Brightspark’s Nathan concurs, saying simply “it’s tough for non-Americans to market to Americans, but there are 250 Canadian companies traded on the Nasdaq, so maybe it’s not so black and white that Canadians cannot sell to Americans.”

While the majority of Canadian VCs believe their marketplace lags behind the U.S. venture industry, Jim Hall, a senior vice president and chief investment officer at Working Ventures, seems to be the lone dissenter among Canadian VCs. “I don’t think the Canadian market is any less mature now than the U.S. The quality of our companies, our deal flow and the entrepreneurs are there. I believe we have caught up,” he says. Working Ventures, a Toronto-based labor-sponsored fund, recently announced the formation of its second vehicle, the C$200 million-targeted Working Ventures II, a technology-focused fund.

Pushing Forward

Going forward there’s no question one of the most important factors in ensuring the Canadian venture market continues to grow and develop is increasing its level of institutional support. “Pension funds need to be more active in our market,” says Doug Hewson, chief executive officer of technology incubator StartingStartups, which is in the process of raising a C$20 million seed-stage fund.

Vernon Lobo, a managing director at Mosaic Venture Partners, believes the best way to bring Canadian institutional investors back to the asset class is success. “The funds from the last four to five years have to perform,” he says, “and as they perform, you should see more allocations to VC.” Located in Toronto, Mosaic focuses on backing early-stage Internet businesses, software companies, broadband ventures and digital communications plays.

Beyond simply posting solid returns, another imperative for Canadian VCs is working harder to get capital from foreign investors, Hewson says. Relatively recent changes in Canadian tax laws have made this a more feasible option, adds Ventures West’s Louis, whose firm turned to a few U.S. institutional investors for capital while raising its newest vehicle. In addition to Grove Street’s investment of CalPERS’ capital, Fund 7’s U.S.-based LPs include BancBoston Capital Inc. and IBM World Trade Corp.

The CVCA has been working to increase Canada’s status in the eyes of foreign investors, Eckert comments. The tax law changes have helped to begin accomplishing this. “Up until the middle of last year, if a foreign investor invested in a Canadian limited partnership that foreign investor would be deemed by Canadian tax authorities as carrying on business in Canada, and would be taxed at a high Canadian tax rate. So no one would invest, really,” he explains. “Now they have changed this, so just investing in a Canadian limited partnership does not mean a foreign investor is seen as doing business in Canada and there is a more favorable tax rate in place.” However, Eckert says there are still regulatory stumbling blocks in the way of more widespread foreign investment, because the process of declaring a foreign investor as one that does not conduct business in Canada is still cumbersome. “A big step forward would be to get the Canadian government to remove investment barriers. That would help,” he adds.

Elsewhere, Canadian VCs are working on dispelling the notion that they can’t always build successful stand-alone companies by splitting up their portfolio companies and basing research and development offices in Canada, while sales and marketing efforts end up in the U.S. Employing this model has a number of benefits, Ventures West’s Louis says. “Basing sales and marketing in the U.S. makes sense, because that’s the market where most Canadian companies are selling to, and you can find experienced sales and marketing people who already know the marketplace,” he says. Moreover, by keeping R&D efforts in Canada, portfolio companies get an added economic boost, since their revenue stream is in U.S. dollars, while a large portion of their costs are in Canadian dollars, he adds. Pivotal Corp., a Ventures West portfolio company listed on the Nasdaq, successfully employed this strategy when the e-customer relationship management solutions provider, which was founded in North Vancouver, British Columbia, opened up a Seattle office, Louis said.

VenGrowth opened an office in Boston, in part to help its portfolio companies expand to the U.S., Cohen notes. “We house our portfolio companies that want a U.S, presence in our Boston office, and then when they get big enough, they find their own space.”

The Immediate Future

While Canadian VCs think about ways to help their industry mature, they are also getting ready for their marketplace to slow down a bit in the near future as it mirrors what’s now happening in the U.S. venture universe, says Andrew Waitman, a managing general partner at Celtic House International Corp. “When the elephant sneezes, we do catch a cold,” he says.

“I don’t think the market is going to stay on the same path it has been on the last few years,” adds Ventures West’s Louis. With the change in public market conditions, exits are getting tougher and this, in turn, is driving down valuations, which should lead to a decrease in the number of large deals done by Canadian VCs, he notes. Like their U.S. brethren, many of whom are already working to ensure the health of their existing portfolio companies, many Canadian VCs will probably begin to focus more on follow-on investing, he adds.

“I think 2000 will be remembered as a time with a lot of money chasing a lot of deals,” Louis says, “and I think 2001 will probably see less money disbursed.” But while Canada may not see an increase in overall investments this year, VCs remain optimistic about its long-term prospects. Even allowing for this adjustment in what has clearly been a stellar ramp-up in the Canadian VC industry, Louis believes the Canadian venture market will continue on its path to full maturity.

Indeed, while a shakeout in the Canadian venture market seems inevitable, a number of Canadian VCs are betting their emphasis on behind-the-scenes infrastructure deals combined with strong knowledge base provided by Canadian technology companies, should prevent their market from bottoming out in a way similar to how U.S. dotcoms have crashed. “I still see a wealth of deal flow and young entrepreneurs,” says Whitecap’s McKenzie. “I don’t see any level of mass discouragement. I think it is a good time to be investing in Canada.”