Improving risk capital funding in Canada

Make a decision. Achieving the goal. Photo courtesy of TU-KA/iStock/Getty Images

Canadian entrepreneurs regularly cite a lack of financing options as a reason for Canada’s mediocre innovation performance.

Certainly part of the problem has to do with the organization of risk capital markets. Canada’s public venture exchange (TSX-V) is biased toward junior resource listings. Canadian venture capital firms often lack the scale and expertise to fund the later-stage growth of tech companies. Canada has many angel investors, but they are not especially well-organized.

But Canadian entrepreneurs have to take some responsibility too.

According to PwC, about three-quarters of Canadian tech entrepreneurs set out to sell their companies at an early-stage of development. We call these companies “built-to-flip.” Given the nature of Canadian public markets, most of these entrepreneurs exit through strategic acquisition to (usually U.S.-based) foreign companies.

Another part of the problem is that many entrepreneurs are poorly prepared for risk capital financing. It is common for them to look for the wrong kind of funding from the wrong place. Even if they find the right place, they don’t always present their business in a way that appeals to the funder.

Canadian entrepreneurs as a group are also unaware of venture capital investment criteria and specialization. Good business ideas, poorly articulated, go unfunded while bad business ideas, well presented, may get funding. This affects the efficiency of Canada’s risk capital market and is ultimately reflected in VC returns.

Improving risk capital funding is critical to both innovators and investors. In our recently-published report, Inside the Labyrinth: Connecting Innovators to Risk Capital, we set out to educate both groups.

We elaborate the particulars of deal identification, vetting, pitching, due diligence, term sheets and closing, and point to weaknesses in the current approaches. We analyze the process from the perspectives of both entrepreneurs and risk capital providers.

Risk capital providers invest in the future of the business. By their nature, new ventures have little history upon which to draw. The number one investment criterion, used by both Canadian and U.S. investors, is the quality of the lead management team.

Investors need to trust that the management team can deliver on a company’s potential. Progressive VCs and angels understand that innovators are not finance professionals. The best ones mentor entrepreneurs throughout the investment process.

Innovators need to position themselves to approach risk capital providers on level terms. Many sometimes put themselves in a weak negotiating position if they bring in funding too early.

Such entrepreneurs are well-advised to instead make use of the generous innovation financing sources of Canadian governments (e.g. SR&ED credits) to gain initial traction. When a business has some track record, it is easier for innovators and risk capital providers to agree on valuation, a major sticking point in many deals.

Clearly, there is room for improvement in Canada’s risk capital market. Any initiative that gets entrepreneurs and investors on the same page will improve deal flow, funding, returns and ultimately innovation performance.

Michael Grant is the director of research, capital markets, at the Centre for Business Innovation, a division of the Conference Board of Canada. In recent years, he has focused his work on financial aspects of business and public policy innovations.

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