Tuesday, May 01, 2007

Venture Capital in Canada: Ending the Silent Death Spiral?

My clients are fed by angel and venture capital. I therefore care about how much financial food they have; it's a good economic indicator for whether or not I will be able to pay for both of my kids to get braces.

While there's been a VC famine here for several quarters, public discussion of the issue has been tepid at best. Thank goodness, some of our most prominent players are finally speaking out. In the last few weeks, Terry Matthews and Pat DiPietro have become the Bono and Angelina Jolie of the venture capital scene, using their celebrity to sound the alarm.

What's the nature of the crisis? Here's a sketch of what's being said:

Venture capital is fed by the limited partners ("LPs") who invest in VC funds. Historically, the pool of Canadian LPs who are attracted to high risk capital has been discrete. To bolster the industry(and the startup community), the Canadian government therefore has from time to time created vehicles such as labour sponsored funds to attract additional capital.

When there is an irrational market (1998-2000), the usual pool of LPs expands to include new players such as US LPs and institutional equity funds. The number of VCs and the amount of venture capital available to Canadian entrepreneurs skyrockets. When the market cools, those LPS retreat to later stage investing, leaving too many funds competing for fewer LPs. A consolidation of the number of venture capital investors results, until the next irrational market heats up the investing cycle all over again.

Which is where we find ourselves today. However, a growing number of people believe that this current retrenchment is not simply part of the venture capital cycle, but a death spiral for venture capital in Canada. They point to a few developments:

- LPs are now attracted by the more robust US market and are less interested in re-investing in Canadian VCs' next funds. Our best VCs are therefore finding themselves with little support for new funds for IT, software and telecom investments. This means there could be a 5-7 year gap in funding for those industries.

- US VCs continue to stay out of the Canadian market, in part because of Canadian tax rules that prevent US VCs from investing in a cost effective way. This is continuing at a time when the US VC industry is again overheating, thanks to the Web 2.0 bubble. There is a tremendous capital overhang south of the border, but Canada is not effectively accessing those extra dollars.

- There is no agreement on the right way for the government to support our own venture capital industry. At this point in the cycle, I would expect to see another legislative initiative to incent new LP activity. There are no signs of it. There is a concern that the government will instead legislate more seed investing programs of its own, which will compete with the few remaining VCs, instead of supporting them.

- There are not enough resources - tax incentives, support infrastructure,etc - to foster the development of startups into superstars.

These concerns aren't new, but the efforts to elevate discourse beyond the venture capital community are coming just in time. We may no longer be riding a market correction.

As a nation of entrepreneurs, we are failing to capitalize on the next cycle of investing currently being played out south of the border. The issue isn't going to get solved just by a small number of VCs rallying Industry Canada. It's a start, but it's also time for the investee side to the equation to join the discourse.