Every successful innovative company has navigated the task of early-stage funding. A review of the history of fast-growing innovators often features a prominent role for venture capital. The reason is that venture capitalists bring both money and commercialization skills to a business. Venture capital, therefore, helps with one of the key innovation challenges—commercialization skills. As Josh Lerner, one of the world’s pre-eminent venture capital experts points out, a single dollar of venture capital funding is as effective at boosting new ideas as $3 of corporate investment in research and development.1 Many countries want to host start-ups that have the potential to be the next Google or Facebook because these businesses generate billions in corporate revenue, thousands of jobs, and millions in taxes.
There is a clear connection between early-stage funding and the creation of fast-growing innovative companies. This explains the Canadian federal government’s recent $400-million commitment to venture capital. Yet if funding guaranteed success, then it would be an easy decision for many governments to lavish funds on start-ups. However, the reality is that start-up finance is exceptionally risky. Many things need to go well to generate the sizable returns commensurate with the underlying risk. In the words of Canadian venture capitalist Roger Chabra, “In order to deliver the returns that investors in venture capital funds demand, only the companies that have the potential to reach a billion-dollar enterprise value relatively quickly” are considered.2
Canada has over 1.3 million businesses. However, only 0.1 per cent have operating revenues over $75 million. The majority of these are established businesses, such as financial institutions, Crown corporations, resource companies, and manufacturers.3 In 2010, the average operating income for large enterprises in Canada was less than $600 million. Every year, around 140,000 new businesses start up and 130,000 close their doors.4 That makes the odds of finding the next billion-dollar Canadian company exceptionally high. Canadian venture capital, as an asset class, has had indifferent performance over the years. Simply put, venture capital is no guarantee of innovation success. Early-stage funding, of which venture capital is one form, is merely one piece of a much larger innovation puzzle.
There is, nonetheless, reason for optimism. The historic weak performance of Canada’s venture capital can be ascribed to bad timing, as many Canadian venture capital funds were established in the 1990s and were hurt by the popping of the tech bubble in the early 2000s. The 2008 credit crisis dealt the industry another blow. A recent survey by Ernst and Young found that early-stage finance has improved somewhat (albeit while showing it is still a key weakness for Canada).5 In 2012, new capital commitments to venture capital funds in Canada recovered and are now proportionately in line with venture capital commitments in the United States.6 Thomson Reuters reports that Canadian buyout private equity partnerships raised $6.1 billion in the first three quarters of 2013, up 27 per cent from a year earlier.7 Six of the 25 largest venture capital deals in North America involved Canadian companies.
Among these deals was Kitchener-based learning management system (LMS) company Desire2Learn, which successfully raised $80 million in venture capital. The unique thing about the Desire2Learn deal was the partnership between Canadian institutional funding (OMERs Ventures) and US-based NEA, the world’s largest venture capital fund. As we will argue, Canadian institutional and foreign venture capital involvement in early-stage finance is key to a revival of Canadian venture capital. Atlantic Canada is also seeing a revival of start-up financing. Early-stage investors in Radian6 and Q1 Labs, recently acquired by Salesforce.com and IBM, respectively, show that early-stage Canadian investors can do very well when investing in innovative new firms.
About This Report
This report is one of several Centre for Business Innovation (CBI) reports that consider capital markets and business innovation finance.8 An earlier report examined innovation finance for established businesses. Start Me Up focuses on the unique challenges of financing innovative start-ups.
The report seeks to address the following questions:
- Which capital market issues are encountered at each stage of innovation, from early-stage invention through full commercialization?
- What are the barriers to accessing capital at each stage of the innovation cycle?
- How can these barriers be overcome through financial market innovation or government intervention?
The report targets four audiences. One is Canada’s innovative companies seeking to fund their businesses. A second is the finance community, looking for funding opportunities that balance risk and return. Third is the group of intermediaries that are either seeking to improve the capacity of start-ups or broker deals between start-up entrepreneurs and financiers. Finally, government policy-makers seeking to understand their role will find the report of interest.
We drew on a variety of sources to substantiate the report’s arguments. We interviewed 10 experts on innovation finance, drawn from innovative companies and financiers. We thoroughly reviewed the relevant literature and secondary data sources. We also used proprietary data from the Centre for Business Innovation Survey on Innovation Metrics and Management.
The report moves from theory to evidence. Chapter 2 considers innovative start-ups’ need for capital. Chapter 3 goes on to explore the supply side of innovation finance. The report then considers strengths and weaknesses in Canada’s start-up finance market (Chapter 4). We conclude, in Chapter 5, with an analysis of funding gaps and make suggestions for improving Canada’s innovation finance system.