Canada has a venture finance problem

Far from being a catalyst for growth, venture capital contributes to the decline of the tech sector

Robert McGarveyOntario Premier Kathleen Wynne, searching for ways to kick-start Ontario’s tech sector, has regrettably chosen to invest public funds into the Northleaf Venture Catalyst Fund, a high profile venture capital (VC) initiative.

But based on past performance, far from being a catalyst for growth, this fund of funds will continue the decline of Canada’s technology sector.

So, what’s wrong with Canadian venture capital?

Plenty in fact. It’s hard to find good things to say about a financial services industry that consistently disappoints its investors, cruelly manipulates the technology companies it’s supposed to be supporting and has simply become a feeder channel for larger U.S. funds that have no interest in developing a technology industry in Canada.

According to tech specialist Michael Arrington “(VCs) are easy targets for criticism: they make up numbers about how many jobs they create, deliver awful 10-year returns to investors, and have higher failure rates among companies they fund than among the ones they don’t . . .”

Ouch!

But let’s review the reality. While venture financing of technology start-ups is growing in all markets, it is unfortunately dwarfed by the financial needs of the tech sector. More significantly, venture financing is concentrated geographically. In 2012, 40 per cent of venture funding was generated in California’s Silicon Valley, leaving the rest of the market, particularly Canada, vastly underserved.

Investor returns in venture capital have been falling for the past decade and, although there are many reasons for this, the incentive structure in the venture capital industry is a principal cause of the problem.

Venture funds make money in three ways: they charge fees and commissions on managed funds; they earn all the interest on parked funds and; they retain up to 80 per cent of profits from any equity gains. Far from being risk takers, a venture fund manager’s most profitable strategy can often be simply parking capital in fixed interest investments like T-bills. After all, they get paid regardless of the returns.

I can see why you’d want to be fund manager, but for the life of me I can’t see why a sensible investor would go anywhere near venture capital.

There are also structural flaws in how VCs interact with their clients. VCs have a financial return mind-set, which often conflicts with the longer term best interests of the company’s they invest in. For instance, VCs will often agree to finance a new software start-up but demand the company outsource their software development to India or China in order to save money.

Although this is a cost effective strategy, it carries a variety of risks. Outsourcing software development undermines the company’s intellectual property and opens the door to copycatting that often degrades the business opportunity.

But the problems go deeper than that. Presuming a new venture qualifies for financing (and very few do), the terms imposed by VCs are onerous: VCs play hardball with their technology partners on valuations, generally undercapitalize the venture and put the organization on unrealistically short runways to payout.

VCs are notoriously unsympathetic to original technology developers and early stage investors. Most immediately force changes in the management teams, dumping the original R&D teams in favour of sales and marketing specialists. They then often have to replace these commercialization specialists with public company management teams. Needless to say, this breeds conflict between the VCs and company management at each transition.

Iain Klugman, CEO of Communitech, the Waterloo Region’s hub for the commercialization of innovative technologies, has high hopes for Wynne’s initiative. He believes it will help U.S. firms focus on Canada’s technology and spur investment.

But what will be the consequence of that increased ‘investment’?

The bigger U.S. venture firms will use their powerful financial resources and market connections to siphon yet more technology from Canada into the tech mills in the U.S. The plan generally is to acquire Canadian companies and their innovative technology, move them all to the U.S., then fire the local staff and close the Canadian operation.

No doubt another good payday for Canadian venture fund managers, but a loss of opportunity for Canada, its technology innovators and local investors.

Clearly, given the enormous challenge of creating a vibrant technology sector in Canada, venture capital is a poor choice. Not only are the VC mind-set and incentives wrong, but they could not begin to handle the volume of financing necessary to get the job done for Canada.

Robert McGarvey is chief strategist for Troy Media Digital Solutions Ltd., an economic historian and former managing director of Merlin Consulting, a London, U.K.-based consulting firm. Robert’s most recent book is Futuromics: A Guide to Thriving in Capitalism’s Third Wave.

© Troy Media


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