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The Globe and Mail

Canada's venture-capital taps slow to trickle

Roy Pereira, taking the search for VC to NYC

Tom Feiler

It's early October in New York City and Roy Pereira is standing in the NHL Powered by Reebok store on 6th Avenue at 47th Street, just below a fairly low-tech sign scrolling updated preseason news about the Winnipeg Jets. On this night, the store is closed for a private party sponsored by the Maple Leaf Digital Lounge, an industry-led initiative founded last year and dedicated to helping Canadian entrepreneurs promote their businesses outside of Canada.

The event is part of New York's sprawling Advertising Week conference, billed by its organizers as "the world's premier annual gathering of marketing and communications leaders." So it's the perfect place, really, for digital start-ups and their founders to rub shoulders with potential clients, and perhaps even potential investors, here among pricey NHL jerseys, hats and other merchandise. Imagine a gathering of the world's best salespeople, marketers and idea generators in a single place, each one aggressively pitching his or her best idea, and you can get a sense of the atmosphere. At one point, a very pleasant but slightly overenthusiastic pitchman nearly bodychecks me into a rack of Sidney Crosby jerseys. For a novice salesperson – a reporter, say – it can be intimidating.

Like nearly all the attendees at tonight's party – the usual mix of digital publishers, online advertising executives and junior associates attracted by the promise of free beer and wine – Pereira is in full-on pitch mode, which for him manifests as an enthusiastic serenity. Casually dressed in a dark suit and blue- and yellow-striped open-necked shirt, he is friendly and engaging without being obsequious. He's clearly done this before.

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Pereira, an Ottawa native, is a veteran of five start-ups dating back to 1992, including TimeStep, which was acquired by Newbridge Networks for "close to $200-million," and Snipe Networks. Tonight he is here to talk about his latest venture, Shiny Ads, a Toronto-based advertising technology company focused on helping large online publishers maximize their revenue on ad buys of less than $5,000 – the kinds of smaller orders that, though vital for companies with limited ad campaigns and budgets, can be time-consuming and not even worth a publisher's effort. Shiny Ads wants to help both sides. "It's a niche we discovered, a market that's underserved," says Pereira.

The reason Pereira is in New York is actually twofold. There is the Maple Leaf Digital event, of course, and the chance to pitch directly to people in Shiny Ads' target market. But he's also looking for expansion capital. Shiny Ads closed a seed round of capital in late 2010, raising $500,000. "We used those funds to accelerate growth and I always knew we'd get to a point where that money would run out; it's what the life of a start-up is all about," he says. Pereira has spoken to three New York-based venture capital firms and will continue to shuttle back and forth between Toronto and New York with the hope of securing more cash. He is one of many Canadian entrepreneurs now making trips to places like Silicon Valley, Boston and NYC for VC funding that's increasingly hard to find at home.

Go south, young start-up

Traditionally, a start-up company goes through a distinct life cycle. First comes the idea. If the idea is good enough, then the next step is raising what is called "seed capital," typically a relatively small amount of money ponied up by family and friends and so-called angel investors that simply helps an entrepreneur get the doors open and turn the lights on. Once the seed money gets things rolling, entrepreneurs who want to accelerate their growth and expand often need to raise a larger amount of capital called a "Series A round." Then, after growth is achieved, the entrepreneurs and early-stage investors look for an "exit." That exit could be a larger company coming in and buying the start-up outright or making a significant investment in it, allowing earlier funders to take out their initial investment plus a reasonable return. It could also be an initial public offering, where the public buys shares in the company.

The lack of returns for those early investors is frequently cited as a major roadblock for Canadian entrepreneurs trying to raise capital. According to Jevon MacDonald, co-founder of Halifax's GoInstant and co-founder of StartupNorth, which tracks Canadian start-up activity, the declines in returns for early investors in all types of new enterprises is something that began long ago. "We're now reaping what we've sown in terms of capital availability," he says. "At the end of the day, very few funds in Canada have capital to deploy." The remaining venture capitalists in Canada are "way better than the guys who were doing venture capital before," the ones who "squandered the money" during the last tech boom, as MacDonald puts it.

In other words, the venture capitalists left in Canada are the survivors: They made it through the severe downturn. Unfortunately, the number of survivors is few, and the dollars available small. In 1998, 807 Canadian companies obtained venture capital financing at home in Canada; by 2010, that figure had plunged to 357. In absolute dollar terms, the capital invested fell 25 per cent, from $1,511,000 in 1998 to $1,129,000 last year, according to data from Thomson Reuters Canada. Since the global economic crisis began in 2007, exacerbated by the collapse of Bear Stearns and then Lehman Brothers, the decline in capital available to start-ups has been even more stunning: It's down nearly 50 per cent.

Chad Bayne, a partner in the Toronto office of law firm Osler, Hoskin & Harcourt LLP, whose practice is focused on the technology sector and whose clients include IBM and Google, says the Canadian VC market has changed dramatically over the past decade. "There's been a general hollowing out in the number of institutional investors," explains Bayne. "Quite a few years ago, there were a large number of VC players, labour-sponsored investment funds and attractive tax breaks for individuals." But recent tax law changes in Ontario (where the majority of tech activity takes place), including the phasing out of tax credits connected to LSIFs, have meant that those funds are slowly but surely becoming extinct.

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The decline in VC market activity in Canada explains why homegrown entrepreneurs such as Roy Pereira are now looking south – and why U.S. venture capitalists, from San Francisco to Boston, are looking north. "I've talked to two lawyers in Toronto who say more than 50 per cent of their funding deals are from the U.S.," Pereira says, "and I think it comes back to there being a lack of A-round funding availability here. So you're seeing U.S. VCs take notice – like sharks circling in the water, smelling blood."

Indeed, in September New York-based Union Square Ventures, a pre-eminent venture capital firm founded by Fred Wilson and Brad Burnham that invests primarily in early-stage companies, was part of a group that invested $3.5-million in a Series A round for Toronto-based Wattpad. Union Square is also an investor in Kik, based in Waterloo, Ontario, which in March completed a Series A round capital raise of $8-million. According to Union Square's Wilson, however, the firm's investments in the two digital media start-ups were solely based on the individual companies, not a result of geographic targeting. "We're not experts in what's going on in Canada," Wilson says. "Those are two companies that are working, building on solid ideas, and we found them. We don't have a geographic focus. We invest in markets we're interested in, and the fact they were in Canada was of no interest to us."

While Union Square Ventures was attracted to Wattpad because of the idea, not the location, Wattpad CEO and co-founder Allen Lau, like Roy Pereira, spent a significant amount of time travelling to San Francisco, New York and Boston in search of Series A round expansion capital. "Compared to 10 years ago, there are definitely fewer venture capital firms in Canada," Lau says. "We're not in Silicon Valley where there are 50 VC firms to talk to, so you have to get out there and be more aggressive finding investors who are right for you."

In search of the exits

Since 2008, the main issue confronting the industry has been the difficulty venture capitalists have in recouping their investments through successful exits, be it initial public offerings or acquisitions by larger firms.

"There just haven't been a lot of notable exits in Canada in the past few years," Chad Bayne says. "There have been very limited IPOs, so a lot of funds have been waiting to get out of their investments...(social gaming company) Zynga did their first deal up here, so there is activity, but in terms of public markets we're just not seeing a lot of public companies created."

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In fact, according to Dealogic, 2011 has seen the highest number of global IPOs postponed or withdrawn in history, surpassing the record set in 2008. As of Sept. 15, 215 initial public offerings had either been withdrawn or postponed. Instead of public companies being created in Canada and the U.S., cash-rich companies such as Google, Research In Motion and IBM have this year embarked on a buying spree; through the first nine months of 2011, 26 Canadian start-ups were acquired, according to

While the lack of high-profile IPOs may have eliminated one avenue for venture capitalists to realize a return on their investments, it's not necessarily a bad thing for the entrepreneur. Increased regulations and higher investment banking fees make the process of taking a start-up public more difficult. "To be honest," Allen Lau says, "I'm not sure that's the path most entrepreneurs should take anyway. Ten years ago, Facebook and Zynga would have gone public long ago, but today they've chosen, so far, not to because all the regulations and the overall environment is different."

Attorney Rubsun Ho, a partner in the Toronto-based "virtual" law firm Cognition LLP, which does extensive work with start-up technology companies, has seen a significant increase in the number of companies exiting at an earlier stage. "There are a lot of companies selling out in the $20-to-$25-million range," he says. "Instead of pursuing a [later stage] round of funding, a buyer comes along and the company takes the offer."

Ho remembers a far different environment for raising capital in 1999 and 2000. "At one of the companies I was involved in, we did a raise of $50-million and all we had was a PowerPoint presentation," he says with a slight, almost embarrassed, chuckle, noting that at the time the company barely had any revenue but that the deal was still "oversubscribed" (with more people willing to fund it than was required). A $50-million raise? Today a start-up would make headlines for even exiting at that level.

"We don't want to compare anything to '99 or 2000," Union Square's Wilson cautions. "Those two years were an aberration." Of course, Wilson is in the enviable position of helming a U.S.-based VC fund with a sterling track record, with investments in Foursquare, Tumblr, Twitter and Zynga, among others. The U.S. VC industry may not be as impaired as Canada's, but the ability of funds that don't boast Union Square's portfolio to raise new capital has not fully recovered to pre-crash levels. In fact, numbers recently released by the National Venture Capital Association and Thomson Reuters show 52 U.S.-based VC funds raised $1.72-billion (U.S.) in the third quarter of this year, down 53 per cent year-over-year and the lowest amount raised in the third quarter of any year since 2003. More worrisome, the decline in the third quarter comes after two impressive prior quarters (year-to-date, U.S. VC fundraising is still up 26 per cent year-over-year, by dollars), suggesting that start-ups on both sides of the border may be about to face renewed risk aversion from both VC firms and their investors.

Risk aversion: The new normal

Given the perilous state of the global economy, it should come as little surprise that today's investor is more interested in safety and return of principal, as opposed to risk and return on principal.

Peter Atwater, president of U.S.-based Financial Insyghts, a macroeconomics consulting firm, and author of an upcoming book on social mood, decision-making and financial markets, points to the market's current preference for dividend stocks, particularly of the world's largest corporations. "These are the antithesis of the 'concept' stocks of the late 1990s," he says. "Today everything requires a proven track record rather than the prospect of opportunity. It's all very rear-view- mirror focused."

To make his point, Atwater notes the reaction to Apple co-founder Steve Jobs's recent death. Media column after column lamented the fact that there was no other Steve Jobs out there waiting to assume the mantle of tech visionary, and, to be clear, stepping into the stratospheric airspace Jobs occupied as a tech leader and innovator is hardly an easy task. Still, it's as if his death marked the end of innovation itself. "No wonder people aren't putting money into venture capital," Atwater says. "It's the perception that there are no new opportunities, people or ideas worth investing in."

According to Atwater, at the top of what he calls the social mood cycle, investors have a tendency to put the cart before the horse. "They put ideas ahead of revenues," he says. Today, it's the reverse. "Not only does the market want the horse in front of the cart, they want to make sure that the cart is filled with gold."

In other words, the downturn has brought with it, as downturns always do, an increased level of scrutiny. It's no longer enough for an entrepreneur to approach potential investors with little more than a PowerPoint presentation and a dream. More discipline is demanded, as well as stronger execution.

Although this can prove painful for the start-up entrepreneur working out of his or her garage, it's not necessarily a bad thing in the end. "I think we kind of went into the trough in Canada, but we really did shake off a lot of the chaff," says GoInstant's MacDonald. "There's still a marketplace for good ideas, though."

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