Venture Capital Funding Outlook In Canada

April 23, 2009

Stephen Hurwitz, a partner at Choate Hall & Stewart LLP in Boston, recently wrote a great article on why venture funding outlook for Canadian startups is bleak and what needs to be done to improve the situation. Read the full article here (via Mike Middleton of Q1 Capital Partners). Stephen’s key points include:

Venture funding in Canada is in serious trouble

2008 was the worst year for VC investment in Canada in the past twelve years. (See Techvibes’ previous coverage about it here).
Venture-backed companies in Canada are not getting enough relative funding compared to their US counterparts.
Under-financed Canadian companies have to compete in the same North American market against much better financed US companies. As a result, they are often forced to be sold early in their lifecycle.
Early acquisitions of Canada’s most promising technology startups by US firms and their subsequent complete relocation to the US is “hollowing out” Canadian innovation.
Canada’s extensive R&D tax credits have thus essentially become a subsidy to US businesses which buy these Canadian startups for cheap.
Canadian venture funds are under-funded and can’t invest enough in their startups. As a result, returns are very low. To sum up the situation in Canada:

The less funding Canadian venture capital firms receive, the less they have to invest in Canadian emerging companies. The more these emerging companies are underfunded, the less competitive they are. The less they succeed in their marketplace, the worse the resulting performance of the venture capital firms that fund them. The worse the performance of those venture firms, the greater their difficulty in securing their own funding from institutional and other investors. And so this toxic downward cycle goes, continuously reinforcing underperformance for Canadian entrepreneurs and venture capitalists alike.

…and Canadian red tape deters US venture capitalists from investing in Canadian startups

When selling shares in a private Canadian corporation, US investors have to go through various legal and administrative hurdles which are unnecessary and make the process very time-consuming and costly. As a result, they just say no to investing in Canadian startups.
According to a major international venture study by Deloitte in 2007, 40% of US venture capital respondents and 28% of global venture capital respondents cited Canada’s unfavorable tax environment as a key reason for not investing in Canadian companies. This concern as to investing in Canada was at a level five times higher than for any other country in the survey.
Such circumstances force many of Canada’s most promising startups to become Delaware corporations instead.

Things need to start changing in Canada or budding entrepreneurs will increasingly head south. BackType and Kontagent are examples of startups founded by (ex) Toronto-based entrepreneurs but which are now based in Silicon Valley. Some amazing startups which remain here, it is unfortunate to see them being severely undervalued and underfunded. David Crow wrote a great post on StartupNorth recently about exploring the possibility of creating a Canadian YCombinator-like startup school and seed fund. But with the dismal venture funding outlook in Canada, where will these startups go beyond the seed stage ?

For starters, altering some specific laws to facilitate venture capital investment from the US is something the Canadian government can do, as Stephen suggested in his brilliant article, or Canada will increasingly lose out in the innovation space.