A strategic co-investor for OMERS Ventures recently asked why on earth they should invest in Canadian venture capital when, on average, U.S. venture capital has provided better returns. Why Canada and why now?
The question is not uncommon. Every Canadian VC knows that institutional investors (in Canada, the United States or elsewhere) do not have a burning need to increase their exposure to the Canadian venture capital asset class.
The historical venture returns in Canada support their skepticism. Over the last 10 years, the median Canadian VC firm has delivered a 4 percent internal rate-of-return (IRR) versus comparable U.S. returns at 12 percent, and the five-year numbers are 11 percent and 20 percent, respectively.
The gap is closing though, with three-year IRRs at 21 percent versus 27 percent.
And the good news is that systemic factors are surfacing that should lead to a permanent and self-sustaining ecosystem in Canada with comparable long-term returns. Here’s why:
1. Canadian entrepreneurs staying home
I don’t believe there has ever been a greater number of individuals who have started and built venture-backed businesses, generated returns for their investors (via an IPO or sale to a big-name tech incumbent), remained with the business in a senior role, and are now back again building new startups here in Canada.
We have seven such companies in our own OMERS Ventures portfolio, and there are several others throughout the country. This time around, these repeat entrepreneurs want to go even bigger, faster and farther.
Beyond that though, an increasing number of individuals consider it desirable to join an existing startup or even form their own company. Canadian tech students and recent graduates consider local startups to be highly desirable places to work. Those who would once have sought work in larger enterprises, or made their way to Silicon Valley, now consider home just as interesting (and more financially rewarding).
The lifeblood of the startup world is the entrepreneur and it’s great to see the increasing activity in this area.
2. Local accelerators and incubators
To succeed, venture-backed startups need new and differentiated technologies and approaches.
A source of these technologies is often university and government labs. Stanford is well understood to be the seed of many Silicon Valley successes, and the numerous academia-affiliated commercialization engines across Canada have smoothed the way for valuable intellectual property to be unlocked from our world-class universities.
There is nothing more exciting as an early-stage VC than to interact with the people and companies in Communitech, CDL, DMZ, MaRS Discovery District, OneEleven and all the other accelerators and incubators that are helping young companies get off-the-ground and grow to the next level.
3. Federal and regional government support
The federal government led by Minister Bains (Innovation, Science, and Economic Development), Minister Freeland (International Trade), Minister McAllum (Immigration) and Minister Morneau (Finance) have all recently announced programs favourable to the ecosystem. The government has reacted well to the Council of Canadian Innovators’ work in helping to shape the industry. Rumour has it that Ottawa might re-orient the next phase of their Venture Capital Action Plan (VCAP) capital directly into startups; let’s see.
Provincial governments are likewise showing that they are innovation-savvy.
And locally, I was fortunate enough to join Mayor Tory of Toronto and Mayor Coderre of Montréal on a technology trade mission to Israel, and having met Mayor Vrbanovic of Kitchener recently, I know first-hand that they all definitely “get it.” It is great to see such wonderful support at all levels of government.
(You can read more about our Israel mission here).
4. Increased availability of risk capital
The amount of risk capital available to Canadian startups has been growing steadily over the last several years.
In 2016, several new venture firms were announced, including Leaders Fund and ScaleUp Ventures; a few U.S. firms established a Canadian presence, including 500 Startups and Azure Capital; several established Canadian firms announced new funds, such as BDC Capital, Georgian Partners, iNovia Capital, VanEdge Capital and Yaletown Partners; another pension fund beyond OMERS, the Caisse de dépôt et placement du Québec, has become directly active in the market; and successful Canadian entrepreneurs are actively and vocally backing other Canadian entrepreneurs.
CVCA data show that venture investment in Canada has been steadily growing of late. By my rough estimate, 2016 venture capital funding looks to have had a 15 percent increase over 2015. Investment by non-Canadian firms has remained at about half of all capital deployed for the last few years, showing that U.S. investors continue to view our Canadian startups as world-class.
Deal sizes have steadily grown, meaning that companies can go faster and further to successfully compete against their well-funded competitors south-of-the-border. This includes the all-important later-stage rounds, as 2016 saw over a dozen $30 million-plus “scale-up” rounds. Risk capital is increasingly recognizing that Canadian startups are world-class investment opportunities.
5. Exit opportunities are emerging
Risk capital will only take the risks if it is able to generate returns. While Canadian IRRs are improving, so too is the actual cash-on-cash return-on-investment (ROI).
As it relates to exit opportunities, the obvious story over the last few years has been the Shopify IPO and its continued strong performance as a public company. Building on this and some successful IPOs in the United States, a tech IPO revival might emerge here in Canada in the next 18 months.
It is worth noting that many lower-profile exits have occurred in the last several years as startup management and investors determine that they’re a better fit as part of a larger company. An important piece of the exit landscape is the degree to which tech “incumbents” have set up meaningful offices in Canada, and hence can be acquirers of Canadian startups with the people remaining in Canada.
Tech companies such as Amazon, Apple, Facebook, Google, Intel, Salesforce, Snap and Trend Micro all fit this mold and several of these companies’ Canadian R&D centres began as acquisitions of Canadian companies that they then grew. (I note that each one of these companies’ Canadian careers section have many job openings.)
As more add-on acquisitions happen in the future, hopefully more technology beachheads are established here at home. And to complete the cycle, when exits happen, some of that capital then recycles itself back into the ecosystem.
Each one of these elements has to grow in lock step with one another. Any “over performance” in a single area is wasted as the other elements in the ecosystem are not “ready.”
For example, if a large capital injection were to emerge (via, say, a government stimulus), many more startups would get funded at unnaturally high prices. Eventually returns would lower, a conventional wisdom would take hold that “you can’t generate returns in Canadian venture,” and a nuclear winter of funding (from private and public sources) would ensue similar to that of the 2000s.
The same applies if too many companies are started that don’t get funding. In this case, entrepreneurs would move to the United States, others would follow without even trying to start in Canada, and the exodus floodgates would open.
So why Canada and why now?
A self-sustaining ecosystem requires the right balance of risk-taking entrepreneurs with risk capital who commercialize unique technologies that address new market opportunities to eventually generate venture returns. It certainly appears that Canada is progressing in a balanced fashion in all of these areas, and returns in Canadian VC are beginning to show the results.
I look forward to the day when investors demand more Canada now.
Jim Orlando is a managing director at OMERS Ventures, the venture arm of the Ontario Municipal Employees Retirement System (OMERS). He is responsible for leading investment activities in the North American market focusing on high-growth companies in the technology, media and telecom sectors.
Photo of Jim Orlando courtesy of OMERS Ventures
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