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Nov 20, 2015

What exactly is Venture Capital & where does it hide?

Venture Capital is a critical part of the Canadian economy because it provides the funding that enables innovative, early-stage technology companies to survive and grow.

These fast growing firms represent just 5 per cent of the companies in Canada but they have a huge impact on our ability to innovate and on our prosperity, accounting for 45 per cent of new job creation.

Designing policies to support and stimulate entrepreneurial ventures is a challenge; there is no single sector they occupy, nor do they have common business strategies. But one problem is common and acute among these unusual enterprises—almost all have difficulty finding the capital they need to realize their business plans.

Improving and growing the venture capital industry is one strategy government can pursue that could significantly benefit most fast-growing entrepreneurial firms. Such a strategy has the potential to transform Canada—to make it more innovative—by creating new businesses, technologies and jobs. It is particularly timely to consider such a strategy.

The Canadian economy is challenged by headwinds that will reduce the rate of GDP growth and job creation in the coming years. The natural resources and commodities that were so central to business investment could be facing many years of price weakness. If Canada’s traditional sources of growth are ebbing, then it needs to increase productivity and innovation in order to expand its economy into new services and technologies.

More importantly, a study by Deloitte shows that many Canadian companies are not ready for “disruptive innovation”—the huge leaps of technology that will put our traditional businesses at risk. Canada must accelerate its own innovation and develop new technologies here at home to avoid getting left behind. What can government do? Canada has already invested massively in R&D. In fact, public spending on research and development, at 0.81 per cent of GDP places Canada ahead of countries like the U.S., the U.K. and Japan (but still behind countries like Germany, Sweden and Finland.) The trouble is that Canada lags on the commercialization of products. How do we get our great ideas developed and into markets? By helping entrepreneurs to build new innovative companies.

A critical ingredient is having a vibrant, thriving venture capital industry that can provide the investment and expertise to turn ideas into innovation.

Venture capital is a form of equity financing for innovation-based early-stage technology firms. These types of start-ups are creating brand new products, so the growth potential is enormous, but the risk of failure is also very high. That is why traditional forms of funding, such as bank loans and asset-based lending, are not appropriate. Firstly, these companies have little, if any, of the tangible assets that are normally used as security in conventional financing. Most of their assets are intangible (software, R&D results, intellectual property and people). Lenders find it difficult to collateralize debt with products that have not yet demonstrated any market success. There is a high level of uncertainty linked to R&D activities and the development of unproven new technologies.

Many companies are seeking to create new needs and new products in markets where it is difficult to foresee what the demand might be. Particularly with technology companies, new solutions and business models emerge all the time and many of these might not work. There is also a high level of information asymmetry between the entrepreneur and the investor for technology start-ups. It is not enough to review the financial statements and business plan. In brand new companies where there are no revenues or profits, the investor needs a detailed understanding of what is going on inside the company to judge whether it is headed for success. Again this illustrates why conventional lenders such as chartered banks, have little incentive to target these clients.

Finally, it often takes a long time, up to seven years or more, to develop, commercialize, market and start generating revenues—the stage where companies can launch an initial public offering (IPO) or are acquired. Venture capital investors do not lend money. Instead, they buy shares of a firm, which gives them products.

The Canadian Chamber of Commerce offers a variety of proposals, supported by the Kelowna Chamber of Commerce, that we will take to government to help transform the venture capital industry in Canada.