Nothing Ventured Nothing Gained

Small Victories: With massive buyouts becoming increasingly rare, angel fund manager Basil Peters says the traditional VC model is dying.

It’s been a dreadful few years for the 
venture capital field, a situation made markedly worse by the recession and a growing aversion to risk. Can things be turned around? Or is a new funding model in order for B.C.’s startups?


The venture capital world, while not exactly dead, has clearly seen better days. Last year, according­­ to analysis by Thomson Reuters and Canada’s Venture Capital & Private Equity Association, venture capital (VC) deal activity in Canada fell to its lowest level since the mid-’90s, down to $1 billion from $1.4 billion the year previous. In B.C. – where there are roughly 10 active VC funds with $1.8 billion in assets under management, accounting for 20 per cent of all VC deal flow in Canada – the experience mirrors national trends: in 2005 roughly $225 million of venture capital was invested by these funds; last year saw just $141 million.


A lack of market liquidity has resulted in a dearth of initial public offerings (IPOs) and mergers and acquisitions (M&A), leading to poor fund performance. Institutional investors with fiduciary responsibilities have fled VC for safer investments, and once-bedrock local VC funds are struggling. GrowthWorks, for example, is posting three-year returns in the negative seven-to-10 per cent range – what one Vancouver financier politely describes as “nothing to write home about.” In December 2009, the B.C. Discovery Fund ceased redemptions after paying out $5.2 million to investors, and in January managers of the $23-million Pender Growth Fund informed shareholders that they could only meet 55 per cent of share-redemption requests for the time being, blaming “reduced opportunities for near-term liquidity in the fund’s portfolio.” In early May, the B.C. Advantage Fund temporarily suspended redemptions of its two VC funds, also citing a lack of cash. 


Venture capital belongs to a rather esoteric realm of finance not that well understood by the general public. It thrives on word-of-mouth tips rather than public financial statements, so getting fund managers to discuss strategy candidly is at times like trying to crack military code. (Then there’s the somewhat blurry line between venture capitalists and so-called angel investors, who, rather than entrust their investments to a VC fund manager, prefer to do the investing themselves or pool with other angels. Both offer a combination of equity and business experience to help entrepreneurs bring their prototypes to commercial stage or inject a boost of capital to early-stage companies enabling them to grow to the next level.) If they bet on a winner, venture capitalists can expect to realize a return on investment (in the form of an IPO or an acquisition) within a five-year horizon for IT or within 10 to 15 years for the more capital-intensive clean-tech sector. But, as indicated by the litany of stumbling VC funds, shareholders have had little to cheer about recently. And according to a June 2009 report from the U.S.-based Kauffman Foundation, things could soon get worse: it predicts a monumental rightsizing that could see annual VC investment contracting by 50 per cent in North America in the coming years. Which raises the question, Is venture capital in Vancouver a barely flickering, soon-to-be-extinguished flame of high-risk finance, or does it remain a going concern? BCBusiness talked with a handful of the province’s VC specialists to find out. 


A light in the dark: A tax on U.S. investments in Canadian ventures is coming down, and venture capitalists such as Steve Hnatiuk are looking up.

Basil Peters believes that if the VC sector is to survive, it must emerge from the current meltdown leaner and more tightly focused, ruled by smaller funds whose managers’ remuneration is more closely tied to the success of their investments. Peters heads Fundamental Technologies II, which he calls an early-stage angel fund specializing in high-tech. As a UBC engineering grad student in 1982, Peters and some associates started Nexus Engineering Corp. Ten years later, it was a leading manufacturer of cablevision infrastructure equipment, with annual sales of more than $30 million. The board decided it was time to sell. When Peters was stickhandling the $20-million sale of Nexus as CEO, he recalls fighting off a hostile takeover from one of the company’s VC investors. These days Peters believes angel investors will play a more prominent role in fostering B.C. startups and growth firms, and statistics from the B.C. government seemingly support this thesis: while VC investment in B.C. fell by almost 40 per cent between 2005 and 2009, angel investment over the same time frame grew by 80 per cent.


The stats aren’t surprising to Peters, but what happened to venture capital? The thinking goes that, starting in the 1980s and continuing through the 2000s, venture funds exploded into multi-
hundred-million-dollar beasts optimized around staggeringly huge exits, few of which actually materialized. According to one VC critic, 97 per cent of exits happen below $50 million, but the industry was structured around exits of greater than $200 million – one per cent of all VC deals. In addition, these funds were administered by managers who charged fees based on a percentage – often two per cent – of the fund value, so managers were intrinsically motivated to grow the fund into ever-larger financial animals out of touch with market realities.


“Fund managers have done well by this model, but the gig is now up,” says Peters, who as one of the founders of the B.C. Advantage Fund had direct experience with this broken model. “I stood up and told a lot of investors that they were going to get their money back in five years. That’s not going to happen. Liquidity is a huge problem.”


With his new angel fund, Peters charges no management fee. Management only gets paid if there’s a successful exit – through an IPO or an acquisition involving one of the fund’s portfolio companies. So the fund will either deliver returns to shareholders in a timely manner or be relegated to the trash heap. Rather than focusing on huge investments and equally huge exits, Peters says, new funds need to be attuned to the fact that entrepreneurs are developing IT companies for tens of thousands instead of tens of millions of dollars, and those generally aren’t the kind of investments that excite large VC fund managers. 


Bob Chaworth-Musters, founder of the B.C. Angel Forum, is another evangelist for the angel approach. Since 1997 he has been gathering as many as 60 investors semi-annually to hear pitches from between 20 and 30 entrepreneurs seeking anywhere from $100,000 to $1 million in equity financing. On May 18, Chaworth-Musters hosted the 27th Angel Forum, the latest in a series that has so far resulted in $28-
million worth of investment. He says angel and small-VC investment has been boosted by provisions in B.C.’s Small Business Venture Capital Act, passed into law in 2003. The act allows B.C. residents to claim a 30 per cent tax credit, up to $60,000, on money invested in approved venture capital corporations, usually managed by venture capitalists or angels and formed solely to invest in startup, emerging and expanding small businesses. 


“The 30 per cent tax credit has helped substantially. It’s a good program and I think equity is a lot easier to come by in B.C. than it is in other jurisdictions because of it,” Chaworth-Musters says, adding that VC fund managers will come to a forum to scout for up-and-comers but are angling for investments that will net 10- or 15-times exits. “A lot of companies in B.C. won’t get big enough to interest VC.”


In several ways, B.C. is ahead of the curve with its tax credits and support of VC funds, something Canada’s Venture Capital and Private Equity Association says is crucial for rescuing a VC sector experiencing a “severe” crisis in investor recruitment and shareholder returns. In addition to its venture capital corporation tax credit program, the province in 2008 introduced the $90-million B.C. Renaissance Capital Fund (BCRCF). The fund is seeded with money collected by the feds from economic immigrants, with a percentage of these proceeds handed to the provinces. B.C., through the BCRCF, uses a portion of its share to invest in VC funds to boost local tech startups. Since its inception, the BCRCF has doled out $13 million into various funds. Todd Tessier, executive director of B.C.’s Investment Capital Branch, which is responsible for the BCRCF, says these allocations have translated into $60 million in investment to date – a leverage factor of four to one – in Vancouver firms such as Angstrom Power Inc., Indicee Inc., Cooledge Lighting Inc. and Ostara Nutrient Recovery Technologies Inc. 


A tall order: Raising money gets harder as investors get more demanding, says former EA president and current venture capitalist Paul Lee.

“I like to think of the venture capital marketplace as an ecosystem. We need sources of private capital, including venture funds, to build our next wave of anchor technology companies,” Tessier says. “Their pools of capital and expertise are needed, and their hard times are often systemic of poor market conditions or other market opportunities of the day such as real estate and commodities.” 


In 2007, when Richmond’s Cellex Power Products Inc. and TIR Systems of Vancouver Inc. were bought for $75 million and $45 million, respectively – the former by fuel cell maker Plug Power Inc. and the latter by Royal Philips Electronics – they represented successful exits for local VC heavyweight Ventures West Capital Ltd. But it also meant that B.C.-grown technology with multibillion-dollar potential would not get commercialized locally. Examples such as these are why the province jumped into the VC game, according to Tessier: to not only bring innovative goods and services in B.C. to full-scale commercialization but also to lure more institutional investment and prevent homegrown companies from floundering or being snapped up mid-stride by foreign enterprises. While angel proponents such as Basil Peters fear that the province may simply be propping up the tired VC beast, Tessier disagrees. 


“We believe that our world-class technology opportunities in this province, combined with our local venture capital community, is enough to convince fund managers to invest here,” he says. 


Over at Yaletown Venture Partners, there are tentative signs of a VC resurgence. Despite market illiquidity (several Yaletown-backed startups such as Vancouver’s NxtGen Emission Controls Inc. remain in fund portfolios awaiting a public offering or acquisition), Yaletown co-founder Steve Hnatiuk and his partners have still managed to attract $162 million to their clean-tech and IT-focused funds, Yaletown Ventures I LP and Yaletown Ventures II LP (the latter was launched in 2008 and includes an injection of equity from the BCRCF). 


“Our job is to get in early, grow an enterprise and then get out through either an IPO or M&A,” Hnatiuk says. “However, it has been a very difficult environment for venture capital to operate in, and there’s a snowball effect. Reductions in allocations from financial institutions to venture funds mean less money for innovative companies that are significant drivers in the economy.”


That said, Hnatiuk’s hopes are buoyed by a recent change to federal tax regulations that he believes will make it much easier to attract American investment to VC funds as well as give a boost to local startup tech companies. The often-
maligned Section 116 of the Canadian Income Tax Act required foreign investors to pay a 25 per cent withholding tax on capital gains earned when a Canadian investment was sold. (Alternatively, they could fill out paperwork proving residency to receive an exemption.) For deal makers such as Hnatiuk trying to partner with foreign fund managers, the rule was an onerous administrative burden requiring the disclosure of investors’ personal information, something most are loathe to do in the secretive world of VC financing. In March’s federal budget, Section 116 was stripped down, with non-resident investors now free from both bureaucratic paperwork and the obligation to pay withholding tax (so long as the value of that sale doesn’t come principally from real estate). 


“The regulation created unnecessary impediments for U.S. venture investors coming into Canada,” says Hnatiuk (who left his management position at Yaletown shortly before this article went to press). “With this final barrier to the free flow of capital falling, investing in Canadian companies will now be no different for American venture funds than investing in U.S. companies.” 


The full impact of revising Section 116 remains to be seen. While it should lead to more investment in Canadian funds by U.S. investors, it could also lead to more competition for local VC firms. Paul Lee, former president of Electronic Arts Inc. and now a senior partner at Vancouver’s Vanedge Capital, isn’t worried.


“While it will mean more U.S. venture funds coming up to invest in Canada, they will generally look for local co-investment partners,” says Lee. “We believe the 
additional capital and enhanced contacts will provide more opportunities for Canadian companies to grow internationally, which will enhance the returns from our portfolio companies.”


As woeful as returns have been of late, believers say that VC funds remain a critical component in sustaining what is, in Vancouver, one of the largest clean-tech sectors in the world and the largest digital-media workforce in Canada. Still, successful fund managers go where the good investment prospects are, and that doesn’t necessarily always lead to B.C. Paul Lee’s new firm, for instance – with a focus on social media and new media gaming apps for devices such as iPhone, iPad and Android – announced in May that its first fund, Vanedge Capital I LP, closed at $100 million, with expected exit time horizons in the three- to five-year range. Lee says Vanedge is not a regionally focused fund, which is another way of saying it’s not married to investing in B.C.; hence its first play last September was for a stake in Toronto online advertising specialist NeoEdge.


Lee, a former co-chair of the Premier’s Technology Council, says his partners at Vanedge bring a wealth of experience in new media, giving the fund a competitive advantage. But he admits that today’s investor remains wary. “Investors are doing much more thorough due diligence and demanding that venture fund managers have proven operating and investment expertise and success in the areas of focus for their funds. That is going to make it much more difficult for a lot of funds and prospective fund managers to raise capital,” he observes. “So I think fundraising – that is, actually making it through the diligence process – is likely to be the biggest challenge. For the investors, that is a good thing.” 


Wal van Lierop, former vice-president of strategic planning for Westcoast Energy, Inc. is now CEO of Chrysalix Energy Venture Capital. Although he agrees that the old model of huge unsustainable funds is dead, he isn’t tossing in the towel on venture capital. Van Lierop’s Chrysalix Energy LP III fund, which topped US$120 million this spring, boasts one B.C. company, Burnaby’s General Fusion Inc., and four American tech firms in its portfolio. Both General Fusion, which is developing a utility-scale fusion engine, and Primus Power, a California innovator in low-cost energy storage technology, are cogs in the wheel of van Lierop’s utopian vision of a green energy revolution in North America.


While van Lierop is excited about the future of green energy in B.C., he believes investors and innovators need to become savvier when it comes to recognizing the province’s strengths. Venture capital will play a key role, he says, simply because the largely commercially unproven clean-tech sector – which in B.C. is a crowded carnival of some 200 different firms – requires huge amounts of risky upfront capital. But VC investors will also require the stomach to endure long return time horizons with energy innovators that, in some cases, can soak up hundreds of millions of dollars before technology goes commercial. According to van Lierop, B.C. can plan for the future by learning lessons from the past, namely the domestic pulp and paper sector. Thanks to an abundance of cheap energy, B.C.’s pulp and paper producers have languished for decades, becoming increasingly antiquated and inefficient by failing to invest in new technologies. The industry went from being a world leader to a moribund second-rate player while other countries that innovated, such as Sweden, stole market share. 


Lest our energy advantage go the way of pulp and paper, van Lierop says, B.C.’s venture capitalists need to view the clean-tech sector, despite the inherent risks, as a tremendous opportunity for their industry. “However, if we don’t take advantage of our energy position,” he cautions, “there are companies in the U.S. and elsewhere that will fill the void, and we’ll be left behind. Silicon Valley is moving away from IT and into clean tech in a big way.”