Helge Seetzen is general partner & CEO, TandemLaunch
Ottawa’s recent announcement that it will allocate funds from its Venture Capital Catalyst Initiative (VCCI) to seven innovative investment firms sent a clear signal: Canada is stepping up its game in the venture capital world.
TandemLaunch was fortunate to receive $5-million under this program, which we will use to build more deep technology companies in collaboration with the best universities in the world. With the support of VCCI, new funds, new business models and a much more diverse group of fund managers will help expand our startup economy. But more will be needed. Beyond reinforcing seed and growth financing, Canada must improve mechanisms for liquidity – how and when we return capital to investors, founders and employees.
But let’s start at the beginning. The past decade has seen unprecedented growth in new startup creation in Canada and the venture funding that goes with it. The quantity and quality of these young companies are such that many of our cities can boast world-class startup clusters in artificial intelligence, biotechnologies, fintech and other exciting fields.
These young startups travel through a cycle of life from founding to early funding to growth financing and finally, to liquidity. A robust ecosystem needs all these aspects. And Canada has much to celebrate here: With government support and the emergence of new fund managers, company creators and other contributors, seed funding is at a record high.
While corporate investing remains low, programs such as the federal government’s venture capital action program (VCAP) and rising private capital contributions have helped to bring more growth capital to our startup community. (Think of VCAP as a bigger version of VCCI – focused on larger new-business models and aiming to fill the void of low corporate investment.) At the same time, many late-stage foreign investors have discovered the Canadian startup scene and are investing heavily in our market. All this combined means more companies are being funded and scaled in Canada than ever.
This leaves a final fundamental hurdle for our ecosystem: liquidity. Startups eventually need to return capital to its investors, founders and employees. These payouts are a key reward for all contributors and in most cases will be reinvested to support more young companies. Without liquidity, the startup wheel doesn’t turn. And therein lies a major problem for Canada.
The vast majority of startup liquidity comes from acquisitions. Going public is rare and requires a level of scale that few Canadian companies attain. As a small country, we just don’t have enough viable acquirers and thus the buyer market is predominantly foreign. This creates an unfortunate trade-off where we gain local liquidity – creating more young companies through reinvestment – but also often lose that company completely to foreign interests.
To break out of this dilemma, we should consider a solution that the U.S. venture capital economy has turned to in recent years. The U.S. economy has plenty of potential acquirers, but struggles with a different liquidity challenge: its startups are staying private longer than ever. Companies such as Uber, Twitter and Facebook far exceeded the traditional liquidity timeline of four to six years to going public. The U.S. answer to this liquidity challenge has been a thriving secondary market.
A “secondary” financing refers to an investment in which new investors purchase shares from existing shareholders rather than providing capital to the company itself (a “primary” financing). The new investors gain a significant stake in a more mature company. At the same time, this provides partial liquidity to participating early investors, founders and employees without stopping the company in the way that an acquisition would. This allows the company to bring in more patient investors and align the team on the long term by resolving their immediate financial worries. Everybody wins and the wheel keeps on turning.
Secondaries are starting to find their way into the Canadian market but, like acquisitions, are dominated by foreign capital. Transferring partial ownership to foreign owners is clearly a lot better than transferring the entire company in an acquisition, but still not ideal. For example, Canadian startups that have more than 51 per cent in foreign ownership lose many of the tax credit benefits despite still operating here. That can create a tipping point where the loss of tax credits increases the effective cost of operating in Canada and thus encourages a move to other jurisdictions.
More importantly, unlike acquisitions, Canada has a chance to use secondaries as a stimulus of our growing startup economy. Neither the government nor the funds that it supports can acquire companies outright. That role is reserved for our large corporations and will remain a weak spot owing to the size of our economy compared with our American neighbours. But secondaries are a different beast. Because they don’t alter the operations of the companies, it would be possible for Canadian funds or government programs to pro-actively provide secondary financings to our startups.
With VCCI and VCAP stimulating the creation and scaling of our startups, Canada has an opportunity for an innovative solution for the last mile of the startup race. Public or private secondary buyout funds would yield all the benefits of secondaries – local liquidity, emboldened founders and investor patience – while structurally anchoring our companies in Canada for the long term. Let’s scale, Canada!