Despite the noise around Canada’s tech market over the past few years, an objective assessment reveals that Canada is still a developing, not a developed, tech venture capital ecosystem. While markets like Israel and the Valley proudly cite the annual value of their exits, Canada still uses dollars invested as the proof point of the ecosystem’s evolution. The good news, however, is that, the market is poised for change; a unique period of investment opportunity as Canada moves rapidly from developing to maturity.
It is clear that the Canadian tech ecosystem is at an inflection point. In the 1st quarter of 2018, recent data shows that total venture capital funding to Canadian tech beat its previous recent high-water mark (Q3 2015) and that the number of deals completed was a more than 60% increase vs that same quarter. Total venture capital funding of Canadian tech hit nearly $1.3B in Q1 2018[i]. In fact, the total value of venture capital funding has increased every year since 2012; an increase of 113% from 2012 to 2017[ii]. On top of this, the market has seen the emergence of incubators, accelerators and mentors. Organizations such as MaRS and the DMZ are viewed as leaders on the global stage. Several Canadian funds have emerged as prominent. Angel investors are both sophisticated and available. Importantly talent and funding is clustering and, as a result, the dynamic competition, collaboration and creativity normally associated with more mature markets is starting to emerge. Of the Canadian Q1 tech funding, nearly 90% of it was concentrated in Ontario and Quebec[iii]. The Toronto-Waterloo tech corridor alone has 15,000 tech companies; 200,000 tech workers and 5,200 tech startups[iv]. Finally, the government has recognized both the importance and opportunity represented by Canada’s strength in tech overall and certain key areas (AI, health, fintech) and has introduced funding programs both at the policy level (introduction of an IP strategy), funding (VCCI and VCAP – managed by the BDC) and arm’s length direct investing through structures such as the BDC.
Despite the tremendous progress, however, important gaps and risks remain.
An important funding gap is beginning to emerge. While there is a strong flow of venture capital in support of early stage and seed opportunities and a few well-established players for late stage, proven companies, current investment is lower at the point of $5M-$10M rounds. In fact, while Canadian investors represent more than 60% of early and late funding rounds, it is under-represented in the critical “Series A” funding stage; ceding the ground to international money[v]. In 2016, early stage deals accounted for 50% of funding and $50M+ deals another 32%[vi]. Viewed through another lens, there are many funds and organizations focused on pre-seed/seed and early venture. There are also a few well known, established players at the stage of late venture / growth equity. There is a dearth of players at the middle stage. There is both need and opportunity to support Canadian tech at that critical time when they need to scale, have some evidence of success but do not yet have the track record to support traditional due diligence processes.
Investors looking to take advantage of this opportunity, however, need to tread carefully. Given the scale and stage of the Canadian tech ecosystem it would be simple to fall prey to any or all of three key challenges: adverse selection; inappropriate due diligence; and/or operational inadequacies.
Too narrow a focus, both by geography (e.g., Ontario) or sector (e.g., AI) will result in investments that should not be made. When there is too much money chasing too few deals, valuations will become over-heated or, even more problematically, funds will be driven to invest in poorer quality deals. There are only so many deals that have the potential to hit 10-30x returns available on an annual basis. With too narrow a lens, the risk of adverse selection in order to get funds deployed is the natural outcome.
Companies at this stage are difficult to evaluate. At earlier stages, investors can place a bet on the founder and/or the idea. At later stages companies have scaled and have well established business models that can be taken to the next level. At this stage, the company is scaling. Investing in staff. Increasing its burn. Aggressively pursuing commercial validation and growth. In that environment, traditional due diligence approaches break down. The companies do not have the historical data to easily support forecasts. The senior leadership team and organizational capability is just beginning to take form. Important gaps in capability typically are priority items to close. This requires a more sophisticated approach to due diligence. One that combines hard analytics with the ability to assess strategy and markets. A view that takes weeks, months or even years of close working relationships with the prospective company to allow for a more creative and nuanced view of both opportunity and capability.
Finally, companies at this stage often face significant operational risk. Scaling is challenging. The company will make some of their most important hiring decisions; without the benefit of sophisticated HR support. They need to build sales pipelines and make marketing decisions. The precarious balance of energy and discipline in sales and marketing can make or break success. Yet, most founders are first and foremost engineers. The discipline to say “no” to some opportunities and focus activity on others is very challenging. Investment, cash management and overall financial acumen can make or break a plan. In short, the companies need operational expertise that is, too often, not available, given sufficient priority and/or well developed. Great ideas hitting the barrier of operational realities.
Encouragingly, these risks are known. While the risk presented by adverse selection, inappropriate due diligence and operational inadequacies are real, they can also be assessed and mitigated. There is significant opportunity for investors to focus on the emerging funding gap, adopt a business model that acknowledges and mitigates the primary risk factors and supports and accelerates Canada’s rapidly maturing ecosystem. The time is now and the recipe is clear for sophisticated investors to benefit from Canada’s inflection point.
[i] PWC | CB Insights Money Tree Canada Report Q1 2018
[ii] BDC | Canada’s Venture Capital Landscape: Challenges and Opportunities – 2017
[iii] PWC | CB Insights Money Tree Canada Report Q1 2018
[v] PWC | CB Insights Money Tree Canada Report Q1 2018
[vi] CVCA: VC & PE Canadian Market Overview - 2016