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Innovation Canada: A Call to Action

7. Filling the Gaps (continued)

Recommendation 4

Transform the institutes of the National Research Council (NRC) into a constellation of large-scale, sectoral collaborative R&D centres involving business, the university sector and the provinces, while transferring NRC public policy-related research activity to the appropriate federal agencies.

The Vision of the Panel

Canada needs a fundamentally new approach to building public–private research collaborations in areas of strategic importance and opportunity for the economy. Over the next five years, several of the NRC institutes must evolve to become a core constellation of research and technology centres, mandated to collaborate closely with business in key sectors and focussed on achieving measurable progress in this mission. Individual institutes should become focal points for the development of R&D and innovation strategies for key sectors, for major enabling technologies and for regional clusters.

Getting There

To realize this vision, the Panel recommends the following.

  • 4.1 Evolution of the NRC – Charge the NRC to develop a plan for each of its existing institutes and major business units that would require their evolution over the next five years into one of the following:
    1. an industry-oriented non-profit research organization mandated to undertake collaborative R&D and commercialization projects and services, funded by amounts drawn against existing NRC appropriations together with revenue earned from collaborative activities
    2. an institute engaged in basic research to be affiliated with one or more universities and funded by an amount drawn against existing NRC appropriations together with contributions from university and/or provincial partners
    3. a part of a non-profit organization mandated to manage what are currently NRC major science initiatives and potentially other such research infrastructure in Canada
    4. an institute or unit providing services in support of a public policy mandate and to be incorporated within the relevant federal department or agency.
  • 4.2 IRAP – Transfer the Industrial Research Assistance Program to the proposed Industrial Research and Innovation Council (IRIC).
  • 4.3 Structure and oversight – Institutes could be established as independent non-profit corporations, with the federal government's share of funding managed and overseen by the proposed IRIC for industry-oriented institutes in category (a) above, and by the Natural Sciences and Engineering Research Council (NSERC) or Canadian Institutes of Health Research (CIHR) for categories (b) and (c) above. (Apart from functions in category (d), any residual activities of NRC, or institutes that are unable to secure adequate funding, would be wound down according to an appropriate transition plan.)

The model of arm's-length, non-profit research institutes is key to putting in place appropriate incentives to develop high-quality R&D programs that would compete for required funding (beyond federal core funding) from industry and from government programs. The Panel envisions institutes of sufficient scale to have significant long-term impact on business innovation capacity. Some of these institutes – by virtue of their expertise in specific sectors and integration with related local partners – could play an important role as focal points for the development and implementation of sectoral research and innovation strategies. Such strategies are paramount to addressing Canada's innovation deficit, since different sectors face different challenges across an array of issues such as access to financing, regulatory restrictions and intellectual property rules, among others (Box 7.5).

The Panel's proposal would allow for the redeployment of institutes that are not actively engaged in business-related research to universities whose research capacity has vastly improved in recent years. It is not proposed that the separate industry-facing institutes should be grouped organizationally under the proposed IRIC, but it would be logical and appropriate for IRIC to have financial authority over the federal contributions to the institutes by managing the funding agreements between the institutes and the Government of Canada. Moreover, it would also be appropriate for NSERC or CIHR to manage any needed funding agreements with institutes fitting in categories (b) and (c) in Recommendation 4.1. 6 Those institutes that provide services in support of a public policy mandate – for example, activities such as those concerned with public health and safety – should be transferred to appropriate federal departments and agencies, with no reduction in current resources.

The budgetary implications of the proposed model permit considerable flexibility regarding cost sharing between the federal government and the external partners. That said, the institutes proposed here would have to develop robust transition plans to ensure initially that each individual institute is achieving fiscal balance. These plans would also outline appropriate metrics of success, the ongoing realization of which would be a necessary condition for continued federal contributions to their operation. The key to success would be requirements that

  1. the governance of the business-facing institutes be dominated by the industry they are intended to serve,
  2. the core federal support be long term and sufficient to ensure dependability and quality and
  3. the funding contributed by business be a sufficiently large proportion of the total budget of each institute to ensure business buy-in and commitment.

The devolution of certain of the NRC's basic research activities to the university sector would need to be accompanied by ongoing federal support, but presumably not significantly different from the current and anticipated amounts. There would also be significant one-time costs associated with the transition to the new structure. But these costs should be viewed as a necessary long-term investment in much-improved outcomes for business innovation, driven by more leveraged financing of commercially relevant R&D.

Box 7.5 Sectoral Research and Innovation Strategies

The collaborative R&D institutes proposed in Recommendation 4 would have the potential to play important roles for tailored, industry-led sector strategies. The CCA's report on innovation and business strategy (CCA 2009) underscores that no Canadian sector in Canada is "average." Each sector is characterized by a wide array of features stemming from a multiplicity of social, economic, cultural, historical and other factors. To illustrate, the report includes case studies of four sectors that highlight the great diversity of circumstances. Each of the case studies can be summarized in a phrase as follows.

  • Auto sector – "weak R&D, but strong productivity"
  • Life sciences – "great promise, but mixed results"
  • Banking – "balancing stability versus radical innovation"
  • Information and communication technologies – "a catalytic role for government."

Just as there is no average sector in Canada, there is no "one size fits all" remedy to Canada's innovation challenges. Sector-specific expertise and initiatives are paramount, and the Panel's proposed large-scale, industry-directed and co-funded institutes could potentially serve as a catalyst in that respect.

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The Risk Capital Gap

The term "risk capital" as used in this review refers to funding of innovation-focussed businesses from start-up through to maturity, when the company is ready to access public financial markets or is acquired by another firm (Figure 7.1).

Figure 7.1 Funding Chain by Stage of Development and Size of Investment
Figure 7.1  Funding Chain by Stage of Development and Size of Investment

The nature, the causes and even the existence of a risk capital gap in Canada are the subject of considerable debate. The Panel's consultations nevertheless revealed a strong consensus within the community of venture capitalists and entrepreneurs in R&D-based and technologically advanced sectors that gaps exist along the funding chain. Some recurring themes from the consultations included the following:

  • there is a need to improve access to seed capital
  • angel networks in Canada are not as well developed as in the US
  • Canadian companies are not as well financed as their US counterparts
  • foreign funds are present in a disproportionate share of Canadian exits
  • Canadian firms are often forced to, or choose to, go public too early.

Interviews with managers of venture capital funds and entrepreneurs, conducted on behalf of the Panel, highlighted the problems caused by the relatively small size of Canadian venture capital investment funds. Subscale size limits the ability of Canadian fund managers to follow firms through to maturity as the size of successive financing rounds increases. This adversely affects financing opportunities for innovative firms in Canada and hurts the performance of Canadian venture capital funds. Moreover, in the EKOS survey conducted for the Panel (see Chapter 5), lack of access to sources of finance was most frequently identified as the main obstacle to firms' R&D activities.

Such concerns are identified in the Business Development Bank of Canada's (BDC) Venture Capital Industry Review, released in February 2011. 7 That review concluded that the Canadian venture capital industry was "broken." Low returns have caused private investors to leave the venture capital market and, according to the BDC, it will take substantial changes to encourage re-entry. As shown in Figure 7.2, the report identified a "vicious" cycle in the Canadian venture capital industry that contributes to its poor performance, including:

  • a shortage of serial entrepreneurs who become angel investors
  • subscale venture capital funds
  • limited pool of experienced, high-quality venture capital fund managers
  • over-investment in early-stage and inadequate follow-on investment
  • weak linkages to global experts, markets and businesses.

Others consulted by the Panel argue that the industry is in a cyclical downturn and investors are avoiding early-stage technology companies because the risk-adjusted returns are better elsewhere. The BDC has concluded that simply injecting additional capital would not improve the industry's performance and that the key to restoring faith in venture capital as an asset class is to bring the industry to a state of profitability.

Some economists have attributed the poor performance of the private venture capital market to "crowding out" by the labour-sponsored venture capital funds (LSVCFs) (see, for example, Cumming and MacIntosh 2006; and Brander, Egan and Hellmann 2008). LSVCFs, which accounted for about 20 percent of venture capital investments in 2010 (CVCA 2010), are funded by small "retail" investors who receive tax incentives from the federal and some provincial governments. Recognizing that they vary in performance, some LSVCFs have poor management incentive structures and have exhibited poor performance, 8 perhaps due in part to overly broad mandates encompassing multiple objectives such as regional development. Investment activity by retail funds has been scaled back in many provinces and restructured in others in order to promote better outcomes. High-growth firms can also obtain funding through the TSX Venture market, and this may reduce the number of high-quality investments that seek venture capital funding in Canada, contributing also to the low rate of return in the venture capital industry (Carpentier, Cumming and Suret 2010).

The issues affecting the performance of the risk capital markets in Canada are complex, and it will take time to resolve them. Government intervention should be undertaken in a cautious and carefully structured manner to yield positive outcomes for the industry and avoid unintended harm – an issue that is taken up below. The next section reviews in more detail the issues facing the angel investment and later-stage venture capital segments of the risk capital market.

Figure 7.2 Many Gaps Have Resulted in a "Vicious" Cycle in the Canadian Venture Capital Industry
Figure 7.2  Many Gaps Have Resulted in a 'Vicious' Cycle in the Canadian Venture  Capital Industry
  • Shortage of serial entrepreneurs and skilled management with global networks
  • General partners are subscale and lack strong capabilities and experience compared with US general partners
  • Significant investments made by government and retail funds with objectives and constraints (e.g., region focus, pacing requirements) may hurt returns
  • Angel network not well developed
  • Over-investment in early stage without adequate follow-on capital, leading to dilution
  • Undercapitalized and sometimes dysfunctional syndicates make follow-on investment difficult
  • General partners lack experience and networks to develop companies to potential
  • Foreign general partners capture a disproportionate share of exit value
  • Exits have been mediocre, as public markets place a discount on Canadian venture capital-backed companies
  • Relatively low listing requirements on the TSX Venture Exchange can be counterproductive
  • Total funding to venture capital-eligible companies was proportionately higher in Canada than in the US at the turn of the decade but has significantly decreased in recent years
  • Current capital supply crunch, as institutional limited partners and retail funds have significantly reduced investments
  • Government-sponsored funds made up half of all available limited partner capital, with allocation sometimes driven by public policy and misaligned incentives
  • Bottom-quartile funds receive largest share of capital; the fund natural selection process is broken
  • Lower level of non-dilutive capital from government and other sources prior to first venture capital investment
  • Lack of commercialization focus in R&D investment
  • Relatively low effectiveness of Technology Transfer Offices in commercializing technology
  • Lack of connectivity to global markets, reducing opportunities for syndication, business development and exits

Angel Investment

At the earliest stage – perhaps even before a company is formed – an entrepreneur typically relies on informal sources of capital from "friends and family" and later from angel investors. There are two structural obstacles that limit the supply of angel financing:

  1. the very high cost of evaluating and then monitoring a prospect, relative to the size of the embryonic business and
  2. the novelty and technological complexity of the new business idea, which makes it difficult for an outside investor to accurately determine the potential for success.

As a result, angel investors target a high rate of return to compensate for the risk they face and often require entrepreneurs to invest a substantial fraction of their own wealth in the project, both of which may prevent viable projects from going forward. Knowledgeable and experienced investors are needed for capital markets to function well, but there is also a role for government in promoting an efficient angel investment market segment.

There are few reliable data on the supply– demand conditions in this informal market in Canada. In the US, where the market is well developed, rates of return to angel investor groups are high. A 2007 survey by the Angel Capital Education Foundation (now called the Angel Resource Institute) found that returns to angel investors in groups averaged 27 percent (Wiltbank and Boeker 2007), which was well above the average 10-year return of 18.3 percent on overall venture capital investments in 2007 (National Venture Capital Association 2008). Industry participants describe the angel investment segment as underdeveloped in Canada, reflecting in part a relatively young risk capital industry. As a result of this shortage of supply of financing relative to demand, it would be expected that similar rates of return to those in the US should be available to angel investors in Canada.

Venture Capital Financing

Those high-growth businesses that survive the seed and angel-financed stage of development usually then turn to the venture capital market, which is an important form of financing until the business goes public, is bought out or is able to access conventional financing.

The "modern" venture capital industry came into being in the US in the late 1970s (Lerner 2009). The Canadian venture capital industry, by contrast, is relatively young and small, having gotten a second start in the 1990s, just before the technology bubble burst. Venture capital investment in Canada experienced a post-bubble peak of $2 billion in 2007; since then it has averaged $1.2 billion a year (BDC 2011). In 2010, about 350 companies in Canada received venture capital funding, with an average investment of $3.2 million and a total investment of $1.1 billion (CVCA 2011). Meanwhile, venture capital investment in the US in 2010, at $21.8 billion, was about 20 times the Canadian total, and the average deal size was about twice as large (SSTI 2011).

The smaller relative scale of Canadian venture capital funds has two main consequences. First, in order to create enough diversity in their portfolios, fund managers must keep investment per project relatively low. The small deal size spreads fixed costs – for example, evaluation and monitoring of investments – over a smaller investment base, which hurts returns. Second, smaller-scale Canadian funds are less able to participate in later-stage financing, since these involve a larger average deal size. Canadian funds therefore find it difficult to adopt the typical US strategy of financing firms from early stage to exit. As a result, foreign funds, particularly from the US, are often dominant in later-stage financing in Canada – for example, over the 2004–09 period the average venture capital investment by foreigners in Canadian firms was $3.8 million, compared with $1.0 million on average by Canadian investors. 9 Although foreign partners invest in only about 10 percent of Canadian venture capital deals, they account for about 30 percent of exits and almost 45 percent of exit proceeds (BDC 2011). This situation appears to be hurting returns of Canadian funds and is contributing to a financing gap in later-stage investments.

Interviews with managers of venture capital and growth equity funds indicate that access to financing for firms that have revenues but are not yet profitable is particularly difficult. The typical deal size here is $10–20 million, with fewer than 10 percent of deals greater than $40 million. Canadian participation in this segment is limited. From 2003 to 2011, private venture capital funds disclosed 255 technology-related deals over $10 million. 10 About a quarter of these deals were undertaken by purely Canadian funds, and foreign participants dominated all of the funding syndicates. Canadian-only funds accounted for about a third of the deals in the $10–20 million range and none of the deals above $40 million. Fund managers indicated that, since there are very few Canadian funds actively investing, there are many examples of good Canadian companies struggling to obtain financing.

The relative lack of participation from Canadian funds at the critical late stage of development of a business can have a number of adverse effects. First, either too many worthy firms are not getting financing, or they are being financed by US funds, which can affect where the intellectual property developed by the firm is ultimately exploited. While financing by US funds is preferable to no financing, overcoming barriers to full participation by Canadian private equity funds would result in greater benefits for Canada.

Second, in downturns, US funds will tend to invest closer to home, which amplifies the decline in "peripheral" markets like Canada. Third, the required return on a foreign investment may be higher than that on domestic investments, especially if the investment is not in a current "hot spot" and the company is further away from breakeven. This increases the probability that a good Canadian company will not be properly financed.

On the other hand, US funds bring not only capital but also expertise and networks, which result in higher exit values. Technology companies that obtain quick access to global markets and meet international standards attract the attention of global acquirers or are able to make an initial public offering on foreign stock exchanges. Foreign funds appear to prefer to co-invest with a local investor but, given the small size of Canadian funds, this is not always possible. This observation reinforces the point made earlier that small fund sizes are hurting returns in Canada.

Such considerations were the motivation for funding – with the support of BDC, Teralys Capital and others – the Tandem Expansion Fund, a $300-million private equity fund specializing in late-stage investments over $10 million. This fund was established in recognition of the fact that "many Canadian venture-backed companies are unable to access later-stage funding from any private source, which causes them to seek out foreign funds, strategic buyers or public market alternatives earlier than they should" (BDC 2009).

With the foregoing in mind, the Panel is recommending programs to facilitate investment in the two parts of the risk capital market where the most crucial gaps exist: angel investment and late-stage venture capital and growth equity.

6 Scientists in the academic-facing institutes would be able to apply for granting agency funding in line with others at the universities. (Return to reference 6)

7 The BDC is a financial institution owned by the Government of Canada. Its mission is to "help create and develop Canadian businesses through financing, venture capital and consulting services, with a focus on small and medium-sized enterprises" (BDC). Note that the BDC is not the federal government's sole mechanism to supplement venture capital markets. The Export Development Corporation (EDC), in fulfilling its mandate to help Canadian exporters and investors expand their international business, manages a portfolio of equity investments focussed on next-generation exporters, with a total investment value of $298 million. Farm Credit Canada, a Crown corporation, established FCC Ventures in 2002 and since then has provided over $70 million in venture capital financing to small and medium-sized businesses in areas such as agricultural biotech. (Return to reference 7)

8 For the latest performance data for captive/evergreen funds, which consist primarily of LSVCFs, see the press release of Canada's Venture Capital & Private Equity Association dated May 24, 2011 (available at: CVCA) (Canadian Venture Capital & Private Equity Industry Performance Data – Captive/Evergreen Funds). (Return to reference 8)

9 The data in this paragraph and the following paragraph were compiled using the Thomson Reuters venture capital database (except as noted). (Return to reference 9)

10 There is no requirement to disclose deals. (Return to reference 10)