Special Report: Canadian VC Market Ready For Rebound: Region Still Undercapitalized, But U.S. Firms Are Looking North For Cost –

If the Canadian VC market were taking a long drive, the worst thing it could do is look in the rearview mirror. Venture investing was down for the third straight year in 2003, while new capital commitments dropped as well. And while the U.S. market suffered the same downward trend last year, Canada’s experience was much more painful.

Canadian companies raised $1.5 billion of venture capital in 2003, down 40% from the $2.5 billion they raised in 2002. By comparison, the U.S. take of $18.2 billion was down just 15% from 2002. And while market cyclicality clearly hurt both countries, VCs say the degree of decrease in Canada is stark evidence of its biggest problem: Domestic investors aren’t giving startups enough money, and they’re not committing for the long haul.

“In Canada we’re funding a lot of companies at an early stage, but the industry isn’t big enough to provide follow-on funding for those companies at a decent level,” says Robin Louis, president of Vancouver-based Ventures West and current president of the Canadian Venture Capital and Private Equity Association. “Companies in Canada, as a general statement, aren’t raising enough money.”

Adding insult to injury, less money flowed into VC funds last year. New capital commitments finished 2003 at $2 billion, down 39% from the $3.2 billion raised in 2002, according to Macdonald & Associates, as both private institutions and the Labour Sponsored Fund Provincial Venture Capital Corporations made fewer commitments.

But with 2004 in full swing, things are clearly looking up. For one, VCs from the U.S. and Europe are increasingly stepping in to fill the funding gap that Louis refers to, especially during series B and C rounds. And while statistics for Q1 2004 weren’t available by press time, a quick look at some of last quarter’s transactions hints that this year will be more active. Last March saw the closing of a $57 million Series A round-$53 million in equity-for Aspreva Pharmaceuticals, a Victoria, B.C.-based company that works with pharmaceutical companies to develop new applications for on-the-market medicines. During the same month, MEG Energy Corp., a Calgary-based oil exploration and production company, received a $44 million investment from Warburg Pincus. (That deal followed a 26 million Canadian dollar investment from unnamed Boston-area investors.)

Not surprisingly, some of the largest deals in the past six months have been in life sciences, which has been a point of focus for both investment and government organizations in Canada. All told, 110 life sciences companies raised $392 million last year, which accounted for 26% of overall investment, compared with 18% of activity in the previous year. VCs stress that the focus on this area is no temporary fad. “Places like Vancouver and Montreal… these are not Johnny-come-lately biotech centers,” says Louis. “There are big, established biotech companies in Canada….and the biotech centers here have been established for a long time.”

Sector and Stage Preferences

The next-largest single sector last year was software, where 97 companies raised $258 million for a 17% share. One of the big winners in this area was Q1 Labs, a New Brunswick-based network security software company that raised $14.4 million in a Series B deal. (The company is moving its headquarters to Boston but will keep development efforts in New Brunswick). By comparison, software startups received $360 million in funding in 2002.

The category that recorded the biggest drop was communications and networking, where just 55 companies raised $187 million, compared with the $632 million that 60 companies received in 2002. Telecom, in particular, accounted for just 13% of the overall pie, representing a sharp reversal from its dominance in 2000-2002.

Meanwhile, companies in consumer products, manufacturing, retail and retail-related sectors saw only a slight decrease in investment from 2002. All told, 219 companies raised $288 million in 2003, compared with $297 million in 2002.

Unlike the U.S., where late-stage investing has dominated over the past few years, Canada continues to favor early-stage opportunities. Specifically, 319 early-stage companies secured $758 million, or 51% of all disbursements, according to Macdonald & Associates. That represents a jump from 2002, when young startups accounted for 44% of all financings.

“The two countries are pretty different,” says Louis. “If you look at the fraction of VC investment that goes into seed and early stage in Canada, it’s been increasing.”

In fact, some of the country’s largest deals last year were for early-stage companies: Xanthus Life Sciences, a Montreal and Cambridge, Mass.-based company which develops personalized anticancer drugs, raised $30.8 million in a Series B deal; and BelAir Networks, a Kanata, Ontario-based wireless infrastructure supplier, raised $15 million of Series B funding. The Aspreva deal, mentioned previously in this story, was a Series A transaction.

Labour Sponsored Funds

If there’s one topic that gets Canada’s private funds a little animated, it’s the government’s LSFVCC program. Created after a mass exodus of institutional investors in the 1980s, this tax-advantaged, mutual-fund-like program has helped bring in billions to Canada’s venture market. Investors in the fund get a 30% tax credit-15% is federal and 15% is provincial-and are required to hold their investments for eight years.

Last year, LSFVCCs accounted for $458 million of all venture investments, while their portion of the pie jumped to 31% from 25%, according to Macdonald. There’s no question that the program has been hugely important in fueling Canada’s VC market. The problem is, these funds have performed terribly in recent years. VCs who raise money from private institutions complain that LSFVCCs are bringing down the country’s aggregate fund performance numbers, which makes it particularly difficult to market funds to foreign investors and even new domestic investors.

“The returns have been horrible,” says Andrew Waitman, managing partner of Kanata, Ontario-based Celtic House. “If you go to an American LP and look at European, U.S. and Canadian returns in aggregate, why would he look at Canada?” Adds Samuel Duboc, president and managing partner of EdgeStone Capital Partners: “When foreign limited partners look at the macro data, they say it’s no good’.”

One factor that brings down LSFVCC returns before even the first investment is made is the cost of running these funds. “Since they’re selling to individuals in $5,000 chunks, they have very big marketing costs…and big back-office operations,” Louis says.

Another complaint is that some of the LSFVCCs, which need to deploy capital within a short time frame, are not prudent enough with their investments. “They do enough bad deals that it creates bad noise in the marketplace,” says Randy Thompson, president of the Alberta California Venture Channel matchmaking service in Alberta, which is one of only two provinces that doesn’t offer the LSFVCC program (Newfoundland is the other).

“You get a supply-side pressure to invest. Their cost of capital is lower [than that of private funds], so their valuation sensitivity is lower,” says Rick Osborn, partner with Greenstone Venture Partners in Vancouver. “At the end of the day you’ve got this relative insensitivity to performance.”

Others defend the program, in part because its intent and objectives are undeniably positive. And even critics concede that the program has done much to develop Canada’s entrepreneurial culture. “One of the positives is there are far more people with start-up experience and people who call themselves venture capitalists because of it,” says Waitman.

And at least for the time being, it behooves private funds to find common ground with their LSFVCC brethren, as there are still plenty of deals where both parties participate. But there’s no question that going forward, private funds will push for more differentiation, since the returns are much more comparable with European and U.S. funds when the LSFVCC vehicles are taken out of the equation. “We’re competing [with U.S. firms] in the sense that when an LP is looking at venture returns, he’s looking to get into the top quartile,” Waitman says. “You need to be in that range.”

Northern Exposure

During a year when global VC activity was down, foreign investment into Canada dropped as well, to $257 million in 2003 from $682 million in the previous year. As a group, its share of the overall pie shrunk to 17% from 27% in 2002.

But the winds are clearly shifting. It’s worth noting that foreign investors were much more active in the second half of 2003 than the first half, contributing three-fourths of their money in the third and fourth quarters. And unlike previous years, when the U.S.-into-Canada play was dominated by investments in Ottawa-based telecom companies, last year’s investments were spread across more sectors, with life sciences being the most popular.

In many ways, life sciences is where U.S. participation seems most natural-and most advantageous for Canada. Given the tremendous capital overhang in the States, plus the fact that biotech companies, in particular, have high funding requirements but typically take a long road to exit, an increasing number of U.S. VCs are funding the large B and C rounds that Canadian VCs lack the capacity or appetite for.

But whatever the sector, one of the reasons why U.S. firms invest in Canada is the cost differential. Not only does the greenback go further in Canada, but the lower cost of living and government incentives help rein in valuations. “Businesses have always traded at a slight discount in Canada…and that continues to be maintained,” says Duboc. Adds Osborn: “We’re like the U.S. in every substantial way, we’re just a hell of a lot cheaper.”

Cheaper Than India?

Oddly enough, Canada’s low-cost advantage is still one of its best-kept secrets. Most American VCs are aware of the currency arbitrage, but those in the know say too few VCs realize how cheap it is to hire engineers and fund research there.

Dan Gatti is one of the chief advocates of Canada’s economical attributes, particularly in the western part of the country. A U.S. citizen who commutes to his job as CEO of Big Bangwidth in Edmonton, Alberta, from his home in Silicon Valley, Gatti has become one of the country’s most prolific promoters. “Canadians are just not very aggressive in marketing themselves,” says Gatti, also the president of Gatti Group, a consulting firm. “They’re generally conservative.”

But Gatti doesn’t just talk a good game. According to an article he wrote for Ernst & Young, a C++ programmer with five years experience could be hired in Edmonton for $45,000-about $35,000 less than the U.S. salary. Then factor in R&D tax credits (detailed later in this story), grants from the Canadian government and National Research Council, and the cost for that one programmer could be as low as $5,000, making it more cost effective than India or China.

Some U.S. investors have already caught on. John Dunning, general partner with San Jose, Calif.-based Crossfire Ventures, is currently working with a U.S. alternative energy startup that’s considering building a 50,000-square foot manufacturing facility in Alberta. “Costs [in the Valley] are so high, and the Canadian market is so reasonable,” he says.

Inkra, an Internet infrastructure company based in Fremont, Calif., looked at Israel and India before settling on Vancouver to staff its development team. “From a cost basis we can make the argument that within a few thousand dollars we have cost parity on an engineering level with India,” says Osborn, whose firm is an Inkra investor. “On top of that, we’re in the same time zone, which is a huge project management saver.”

Another factor that keeps startup costs down is the government’s Scientific Research and Experimental Development program, which offers tax credits of up to 35% for research and development expenditures up to $2 million. To take advantage of this benefit, an increasing number of companies are housing their development teams in Canada and maintaining their sales, marketing and corporate headquarters in the U.S. “We have something to add when we land in the Valley,” says Thompson.

In the majority of cases, it’s south-to-north investing that’s most easily pitched to U.S. investors, as opposed to east-to-west or vice versa-and that goes for investment within Canada as well. For example, while Greenstone counts East Coast VCs like Battery Ventures and Norwest among its co-investment partners, the relationship is with their West Coast offices. “One of the reasons we’re in Vancouver is because the north-south flow is easier [for Silicon Valley],” says Osborn. “Conversely, in places like Ottawa and Toronto you see a lot of Boston VCs.”

“One of the challenges is that venture folks want to stay close to home…and you need to have the management team close to where the investors are,” says Gatti. “But it’s just a one-hour flight from Boston to New Brunswick….and a two-hour flight from San Francisco to Vancouver.”

Looking Ahead

Not unlike their U.S. counterparts, Canadian pros say it’s going to take a few high-profile exits to really advance the country’s culture of entrepreneurship. “We don’t currently have a class of people who have been there, done that…in terms of building companies,” says Thompson. Adds Waitman: “We need to demonstrate that we can build real world-class companies.”

One high-profile way of doing that is through successful exits. Market pros point to Ciena Corp.’s $487 million purchase of Catena, a Kanata,, Ont.-based telecom equipment company; and the $115 million sale of Vancouver-based OctigaBay Systems, a high-performance computing company, to Seattle-based Cray Inc. Improving market conditions this year should spur further exit activity. “One of the nice things about being up here is ….that when it comes time to find a buyer, usually the buyer comes from the U.S.,” says Louis.

As a rule, Canadian startups are much more likely to exit via a merger than by going public, and sources say that isn’t likely to change anytime soon. They add that the Income Trust vehicle that’s become so popular in Canada is better suited for private equity-backed control investments where the company has been around for awhile and is already profitable.

However, in order to create a exit market that can be sustained, the Canadian market simply needs more funding. “We need more big funds in Canada so we have people who can make big investments and can fund companies,” says Louis. “Average fundings are way smaller than they are in the U.S.”

But until that growth happens internally, Canadian VCs will continue to seek U.S. relationships. “If you think about the saturation level of VCs in Silicon Valley and Boston…..Canada is relatively virgin territory and is relatively unsaturated [with investors],” says Waitman. Adds Osborn: “The market is still wildly underinvested in Canada……you almost have to be there.”