Venture Capital Monitor - Q3 2006

The Canadian venture capital (VC) industry is a key contributor to the growth of innovative firms that commercialize research. For this reason, the health of this industry is an ongoing concern. The goal ofthis series is to provide current information about this key enabling industry. To this end, the series will track trends in investment activity, report on topical VC-related research and look at key technology clusters where VC investment is taking place.

Introduction

This issue, in addition to reporting on Canada's VC trends for the third quarter of 2006,^{Footnote 1} examines VC syndication and its impact on firms receiving such investment. This quarter's "In Focus" article will look at VC in the Ottawa area, where there has been a sharp decline in the number of new companies that have received VC — the focus instead being placed on "follow-on" investment in firms that have already received financing.

VC activity overview

Investment and fundraising^{Footnote 2}

VC investment during the third quarter of 2006 increased 13 percent over the same period in 2005, rising to $330M from $291M. However, overall activity for the year to date is down 9 percent from last year, falling to $1.19B from $1.3B. If this trend continues through the fourth quarter, VC investments will decline for the second consecutive year.

Fundraising in the third quarter of 2006 totalled $330M, up from $229M in the same quarter last year. Total year-to-date fundraising is $1.21B, down from $1.43B last year (Table 1).

The declining trend of fundraising is a concern as it suggests a decline in future domestic investment as funds raised today are the basis for investment in subsequent years.

Average deal size^{Footnote 3}

For the 122 deals that occurred in Q3 of 2006, the average deal size was $2.70M (Table 2), down 29 percent from the $3.80M observed in Q2 of 2006, but up 56 percent from Q3 of last year. Foreign investors have a significant impact on deal size. When foreign investors' deals are excluded, the average deal size in Q3 of 2006 was $2.26M, up 52 percent from Q3 of last year. In contrast, the average deal size for foreign investors was $5.63M in Q3 of 2006, down slightly from $6.05M in Q3 of 2005.

For the year to date, the average deal size was $3.1M, up 34 percent from $2.3M during the same period last year, and consistent with the historical annual average deal size.

Increasing share of follow-on and later-stage investment

In the first three quarters of 2006, follow-on^{Footnote 4} investment accounted for more than 80 percent of total investment, with an average deal size of close to $5M. New portfolio companies^{Footnote 5} received the remaining 20 percent with an average deal size of $1.8M. The proportion of investment in new companies is much lower than its historical level of 40 percent. This pattern often occurs when fundraising is constrained as VC funds conserve resources needed to support the growth of their existing portfolio firms. Table 3 provides a breakdown of new and follow-on investment by stage.^{Footnote 6} It is noteworthy that 71 percent of follow-on investments were in later-stage companies, well above the 10-year historical average of 55 percent.

All foreign investment in Q3 of 2006 was in follow-on deals, with 96 percent allocated to the expansion stage, which is in line with historical trends.

Regional focus

Ontario and Quebec accounted for 40 percent and 32 percent of total VC investment, respectively, during the third quarter of 2006. The main source of investment in Ontario was foreign VC, whereas investment in Quebec was led by Labour Sponsored Venture Capital Corporations (LSVCCs).^{Footnote 7} Figure 1 shows each region's share of year-to-date VC investment in comparison to gross domestic product (GDP) and the number of firms in knowledge-based industries (KBIs). The distribution of VC investment so far this year is consistent with the historical average. The proportion of VC investment is roughly equal to the proportion of KBI firms except in Quebec, where it is much higher, and in the Prairies, where it is much lower. The discrepancy in the Prairies may be caused by VC activity in Alberta being underreported. Atlantic Canada represents only 2 percent of VC investment and 3 percent of KBIs while representing 6 percent and 7 percent of Canada's GDP and population, respectively. All of that region's investments were in Nova Scotia, where the two main investors are government and LSVCCs. Foreign and private independent investors have a weak presence in Atlantic Canada.

Figure 1
Regional distribution of VC investment, knowledge-based industry firms and GDP

Source: Thomson Financial Canada 2006, Statistics Canada 2006, Industry Canada 2003.
Note * of Figure 1: Most recent data available.

Share of foreign VC rises as LSVCC investment declines

Over the last decade, the Canadian VC market has seen increasing activity led by foreign investors. In the third quarter of 2006, they represented 27 percent of VC investments, and they have accounted for a third of investments so far this year, surpassing the historical average of 25 percent. Participation in VC investment by LSVCCs is reported to be about 20 percent, which is below the historical average of 28 percent.

Government activities^{Footnote 8}

In the third quarter of 2006, the Business Development Bank of Canada (BDC) authorized VC investments worth a total of $26.8M in 20 companies. In November, the BDC launched GO Capital, a co-investment fund that will provide $50M for business creation and start-up in Quebec's technology sector. The BDC will act as the fund's manager and will invest $10M in the fund along with four Quebecbased funds. It will also match the fund's investments, bringing the available capital to $100M.

Export Development Canada (EDC) provides equity investments in Canadian SMEs to expand their export operations. It also invests in foreign projects that involve Canadian goods and services. EDC did not report any VC deals in the third quarter of 2006.

Canada Economic Development for Quebec Regions has launched "The Venture Capital Fund for Business Start-ups." It has committed $5M and will raise more than $15M from other VC firms and entrepreneurs.

Provincial government funds were behind six deals in the third quarter. These funds invested alone, as lead investors with other partners or alongside the BDC. The largest deal led by these funds was a $4M investment in Medusa Medical Technologies. This was led by Nova Scotia First Fund and backed by VC funds based in the U.S. and the U.K.

Syndication and the cost of VC

Syndication^{Footnote 9} is a prevalent phenomenon in Canada's VC landscape. Since 1999, half of the VC deals in Canada have been made in syndication and the trend is on the rise. Syndicated deals account for about 80 percent of VC funds invested. Syndication of angel investors in Canada is also on the rise. Research indicates that investors syndicate to share risk, expertise and skills, or in cases where single investors do not have sufficient funds on their own.

A recent study^{Footnote 10} on the costs of VC financing suggests that deals made in syndication may impose greater costs on the portfolio firm, especially when each round of financing involves new syndicate members. These costs include longer negotiation periods and repetition of due diligence activities when new investors join the syndicate during follow-on rounds. The study indicates that syndication may make the VC market less competitive by reducing the number of alternative VC funds that a technology firm can approach for funding. It suggested that this may negatively affect the firm's negotiating power and therefore its valuation.

A crucial effect of a less competitive VC market is that technology firms may be forced to accept deals that do not provide enough capital to grow the firm, reducing its potential for success.

The aforementioned research has only scratched the surface of the issues related to how syndication impacts the firm.

In Focus: Ottawa-Carleton

Between 1999 and 2006, there were 169 VC-backed technology firms in Ottawa, of which more than 80 percent were in the IT sector. The predominance of the IT sector, particularly telecommunications and networking, is mainly due to the presence in the late nineties of world-class public research centres and communications and networking giants such as Nortel, JDS Uniphase, Mitel, MOSAID and Tundra.^{Footnote 11} Outsourcing by these companies and spinoffs created by ex-employees of these giants nurtured the current cluster of technology companies.

Today, five years after the tech-bubble, Ottawa has seen some recovery, but progress is slow. The IT and communication sectors continue to dominate, which continues to make the technology cluster vulnerable to cyclical shocks in this sector.

Figure 2
Number of Ottawa firms receiving first-round VC versus number of firms receiving follow-on VC, 2000–2006

Source: Thomson Financial Canada 2006.
Note * of Figure 2: Only data for the first three quarters of 2006 are included. The number of new companies might be underestimated given that Thomson Financial does not disclose information on certain deals.

Figure 2 shows that, consistent with national trends mentioned above, VC investment in Ottawa is focused on firms that have previously received VC. The number of Ottawa-based technology firms receiving their first round of VC has sharply declined since its peak of 41 companies during the "technology bubble" in 2000 to only eight new companies in 2005. With six new companies receiving VC financing during the first three quarters of 2006, it is likely that the total number of new VC-backed companies this year will be similar to 2005.

The total number of companies receiving VC dropped after the technology bubble, but recovered in 2004 and 2005 with 40 and 41 companies being financed respectively (Figure 3).

Figure 3
VC investment in Ottawa, 1999–2006

Source: Thomson Financial Canada 2006.
Note * of Figure 3: Only data for the first three quarters of 2006 are included.

The Ottawa Centre for Research and Innovation's (OCRI's) Entrepreneurship Centre notes that although there are many start-ups in Ottawa with solid potential, they often find it difficult to secure VC. This is consistent with OCRI's 2005 report, which states that Ottawa entrepreneurs are increasingly funding their firms using their own resources instead of relying on VC investment. OCRI also notes that the focus on existing portfolio companies is part of a natural investment cycle. VC firms that began funding new portfolio companies during the tech-bubble are bringing their companies toward exit. Once they realize their investments, they will start again with new companies. Moreover, positive developments include plans by VC firm Ventures West to open an office in Ottawa, and formation of the Ottawa Angel Alliance. These developments will likely lead to increased VC investment in the city.

References

• Carpentier, Cécile and Jean-Marc Suret. 2005. "The Indirect Costs of Venture Capital in Canada" (296 KB, 32 pages). CIRANO Research Centre.
• Carpentier, Cécile and Jean-Marc Suret. 2006. "Some Evidence of the External Financing Costs of New Technology-Based Firms in Canada." Venture Capital, July–September 2006, Vol. 8, Issue 3, 227–252.
• Industry Canada. 2003. "Canadian Venture Capital Activity: An Analysis of Trends and Gaps 1996–2002".
• Mallett, Jocelyn. 2002. "Silicon Valley North: The Formation of the Ottawa Innovation Cluster." ITAC.
• Ottawa Centre for Research and Innovation. 2006. "The OCRI Report 2005."
• Statistics Canada. 2006. "Summary Table: Gross Domestic Product, Expenditure-Based, by Province and Territory."
• Thomson Financial Canada. 2006. "VC Reporter."

Notes

This publication is part of a series prepared by the Small Business Branch. The branch analyses the financial marketplace and how trends in this market impact small businesses' access to financing. Current research is focused on high-growth firms, the aspects of both Canada's VC and general business environment that affect the success of these firms, and the key players in the risk capital market (for example, VC firms and angels).

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