Help high-growth innovative firms access the risk capital they need through the establishment of new funds where gaps exist.
The Vision of the Panel
Innovative, growing firms require risk capital, yet too many innovative Canadian firms that have the potential for high growth are unable to access the funding needed to realize their potential. The Government of Canada can play an important role by facilitating access by such firms to an increased supply of risk capital.
To realize this vision, the Panel recommends the following.
5.1 Start-up stage – Direct the Business Development Bank of Canada (BDC) to allocate a larger proportion of its portfolio to start-up stage financing, preferably in the form of a "sidecar" fund with angel investor groups.
5.2 Late stage – Provide the BDC with new capital to support the development of larger-scale, later-stage venture capital funds and growth equity funds in support of the private venture capital and equity industry. These funds would specialize in deal sizes of $10 million and above that are managed by the private sector and subject to appropriate governance practices.
The foregoing recommendations, depicted in Figure 7.3, reflect the Panel's views on where the weaknesses in the financing chain are found. However, as pointed out by Josh Lerner, a respected US analyst of the venture capital market, government intervention has to be carefully structured in order to be effective (Lerner 2009). 11 The recommendations are therefore developed with the following considerations in mind.
Bearing this in mind, the Panel recommends that the BDC set up a national angel investment "sidecar" fund – that is, a pool of committed capital that "rides along with" or invests following the lead of an investment group. Working with groups (instead of individuals) results in economies of scale and promotes higher-quality investments through access to a broader range of expertise. BDC's contribution to the fund would come from its existing resources, with each dollar of BDC funding matched by at least 50 cents in funding from angel groups, although the appropriate funding ratio is likely to vary by sector. In order to encourage adequate participation, it may be necessary to provide an attractive financial structure to secure private/institutional partners and to induce private sector fund managers to invest in high-growth, innovative Canadian firms. One option is for the government to offer its partners a leveraged return in exchange for taking on more risk. This approach has been adopted by a number of countries.
To improve access to later-stage venture capital, the Panel recommends having the government invest in private sector funds on terms that encourage larger fund sizes. The current state of the risk capital market suggests that the government may have to adopt a financial structure that encourages private/institutional co-investment by improving the risk–reward trade-off these investors face, as discussed above. The government should establish funds with the intention of leveraging private funds on at least a dollar-for-dollar basis.
The intention is not to create one large fund; rather, it is to encourage more and larger private funds supporting late-stage venture capital. Interviews with fund managers indicate that, while the optimal fund size varies by sector, larger fund sizes are more efficient because firms can be financed through early and late stages while a diversified portfolio is still being built. But these economies of scale and scope appear to be exhausted relatively quickly: the best returns in the US are obtained on funds in the $200–300 million range (BDC 2011, p. 13). The Panel's interviews with pension fund managers further indicated that it is more efficient to focus funds on particular sectors. The government should deploy the additional funding in stages in order to assess periodically the effectiveness of support.
11 The title of Lerner's recent book on venture capital is highly revealing – Boulevard of Broken Dreams – and the subtitle even more so – Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed and What to Do about It. (Return to reference 11)