Industry Committee on May 15th, 2008

[The Chair, Conservative, James Rajotte]

We'll call the 39th meeting of the Standing Committee on Industry, Science, and Technology to order. Pursuant to Standing Order 108.(2), we will be continuing our study of Canadian science and technology policy.

First of all, I do want to apologize to the witnesses for the delay. We did have a vote in the House and all members had to be there. The government lost that vote, so we may be into an election later this afternoon; I'm not sure. We'll see what the opposition decides to do with that. Anyway, it looks like we will have almost an hour and a half for presentations and for questions from members.

We have with us here today four organizations.

From the National Angel Organization, we have the president, W. Daniel Mothersill. We have the chairman of the board of directors, Andrew Wilkes. Welcome.

We have joining us again from Precarn Incorporated Mr. Paul Johnston, president and CEO, who was with us on Tuesday.

From VenGrowth Asset Management Incorporated, we have a general partner, Jay Heller. Welcome.

Fourthly, from the Business Development Bank of Canada we have the executive vice-president, investments, Jacques Simoneau.

Perhaps we could have presentations in that order, except Mr. Johnston, because he made a presentation on Tuesday. We'll have three presentations. So we'll do that in that order.

We'll start with the National Angel Organization. You have up to five minutes for your opening presentation, and then we will go to questions from members.

Mr. Mothersill, will you be starting?

[W. Daniel Mothersill, President, National Angel Organization]

Yes, Mr. Chairman, thank you very much.

To the committee, thank you for including us in today's discussion.

Today I'm going to actually split the presentation between Andy and me. So with that, what I would like to do today is explain the role of angel investors in Canada's commercialization ecosystem--and yes, there will be a test.

Angel investors, individually and via formal angel groups, invest approximately $3 billion annually in seed and early stage companies. Those are Industry Canada statistics.

The National Angel Organization, of which I am president, is the industry association that represents angel investors throughout Canada, including over 30 formal angel groups, representing about 4,000 angels and angel investors. We are a grassroots, non-profit organization that runs from coast to coast, whose mission is to promote best practices in angel investing, to facilitate the formation of angel groups as a means of overcoming the barriers to investment in early stage companies by accredited investors, to facilitate deal co-investment and syndication via increased investor communications and networking, both nationally and internationally, and to facilitate and organize channels of communication with government researchers, entrepreneurs, and the capital markets.

As the industry association for angels and angel groups in Canada, NAO is also partnered with other angel groups in the U.S., Europe, and Asia, to promote foreign direct investment into Canadian companies.

We--that is, business angels--are the oldest, largest, and most-often-used sources of funds for entrepreneurial firms. Most Canadian start-up companies have been funded in some form by angel investors. Most angel investors—this is not family money—are entrepreneurs, often serial entrepreneurs who have successfully founded and/or operated one or more companies. They typically invest in and mentor several start-up companies at the same time. Angel investments in Canada facilitate the transformation of R and D into successful businesses that public institutions, venture capital funds, public investors, and banks can then finance.

The bottleneck holding back the benefit of the government's large investments in research has been a shortage of coordinated angel investments. According to Sustainable Development Technology Canada, Canada faces an estimated $5-billion annual funding gap, sometimes known as “the valley of death”, in financing early stage companies.

Interestingly, as the venture capital industry has come under some pressure, they are not investing as much in early-stage companies and certainly in seed rounds. This has increasingly fallen to angel investors in terms of supporting. The emphasis by all levels of government in Canada has been on the funding of research and development. Proportionately few resources have been allocated to commercialization of innovation. However, this commercialization is one of Canada's only true sustainable natural resources.

With that, I'm going to turn it over to my colleague and chairman, Andy Wilkes.

[Andrew Wilkes, Chairman, Board of Directors, National Angel Organization]

Good morning.

I'd like to say a few words about investing, a program that is working effectively in an industry, and two or three quick recommendations to put out to the committee for review.

The first thing is about the first principle of investing, that being that investment flows to businesses or sectors with the highest returns in relation to the inherent risk of the venture. So that's relevant in harvesting our science and technology resources, which are primarily, as Dan Mothersill mentioned, invested by the government to develop a commercialization of our knowledge-based industries. So a good example of an industry that attracts commercialization capital is the resource industry.

In 2006, over $1.1 billion was invested in new publicly listed mining and oil and gas resources through flow-through shares on the TSX Venture Exchange. That amount is only on the Venture Exchange. These flow-through shares enable taxpayers to reduce their income through the deduction of Canadian exploration expenses, Canadian development expenses, and Canadian renewable and conservation expenses. This program helps attract capital by mitigating the risk of drilling or mining a dry hole.

So it's interesting that this flow-through share program, the $1 billion in investment capital, is primarily going to the provinces of British Columbia, at 48%, and Alberta, at 28%. Provinces like Ontario receive less than 16% of the investment funds. It should be noted that eastern Canadian provincial treasuries are indirectly subsidizing other provinces, often in sectors that may actually be less friendly to sustainable development.

One reaction to this example would be to question the need for the program in the resource industry. I would argue that this very successful program is a best practice that should be used to mitigate risk and attract private capital in the knowledge-based industries, and further that $1 billion a year times five would go a long way to dealing with the valley-of-death stage Dan mentioned that Sustainable Development Technology Canada has identified.

We have learned some lessons from this resource example: strong investment returns attract large capital flows, tax incentives that reduce risk and improve return on capital attract capital, and strong sector food chains attract early-stage capital as investors know there will be a well-defined exit.

The significance of the resource example ties into the following three recommendations for the standing committee, to attract capital for the knowledge-based businesses. There are many ways of doing this, but here are three successful programs:

Establish an angel co-investment fund. We put a number at it in our report, but the principle is that we need this if it's important for public policy to commercialize. We give an example of the State of Ohio very effectively using this program.

We also talk about the innovation and productivity tax credit, which is successful in eighteen U.S. states and five provinces in Canada, soon to be six. The federal government should join in this program.

The third thing is to help establish angel groups across the country. We list in the appendix some groups that support these recommendations, like the Conference Board of Canada, the Canadian Federation of Independent Business, etc.

On that, Mr. Chair, I guess I've said my words.

[The Chair, Conservative, James Rajotte]

Thank you very much, gentlemen.

I do want to point out that there is a very substantive presentation with some very specific recommendations, which we want to encourage members to look at. I want to thank you for that.

We will now turn to Mr. Heller, please, to make your presentation.

[Jay Heller, General Partner, VenGrowth Asset Management Inc.]

Thank you, Mr. Chair and members of the committee, for inviting me here this morning.

I'm with VenGrowth, Ontario's largest venture capital firm. Since our inception in 1982, VenGrowth has invested over $1.1 billion in more than 180 small and medium-size Canadian businesses, mainly in the high tech and life sciences sectors.

I'd like to speak to you this morning about the state of Canada's venture capital market, but first I think it's important to point out why venture capital is so critical. The answer, simply, is jobs. Venture capital builds knowledge-based businesses that create high-paying jobs in cutting-edge sectors such as software, semiconductors, therapeutics, and clean energy. The biggest challenge that companies in these sectors face is access to capital.

Knowledge-based businesses create jobs by turning ideas into businesses. This involves three stages.

First, a researcher conceives and tests the idea. Often this occurs in a public institution such as a hospital or a university that, obviously, is largely publicly funded. This is what we call the primary research stage.

Second, an entrepreneur starts a company around the idea. He or she continues research and development, develops a business plan, and starts talking to customers. We call this the early growth stage. Companies at this stage rely on funding from angel investors and from early-stage venture capital firms. This is what our colleagues from NAO call the valley of death. As I'll discuss further, this type of venture capital is rapidly declining in Canada, particularly in Ontario.

Finally, a company reaches the expansion stage. Business ramps up, sales and marketing and productive capacity expand, and a product is completed. These types of companies are funded by expansion-stage venture capital, and sometimes by going public. Canada's domestic supply of expansion-stage venture capital is, like early-stage venture capital, also in decline, but foreign investors have taken up some of the slack.

To continually create knowledge-based businesses, we need the pipeline to be full at all three stages all the time. It requires ongoing funding for basic research, for early-stage start-up companies, and for expanding firms. Unfortunately, Canada is experiencing a significant decline in financing for the second stage, the early growth stage. As I mentioned, this is when basic research is first taken out of the lab and put into a company. It's also generally when a company first raises outside capital.

In the past four years, the number of companies receiving first-time venture capital investment has declined by 25% in Quebec and by 50% in Ontario. Over the same period, the U.S. grew by 100%. Ontario saw fewer new companies funded in 2007 than at any time in the past 10 years.

Why is early stage venture capital in such decline, especially in Ontario? The answer is that all four sources of money for the industry have contracted concurrently.

The first source of capital of the four is institutions, such as banks and pension funds. Except in Quebec, these institutions have in recent years cut back their allocations for venture capital in favour of other sectors.

The second source of capital is retail investors, largely through the labour-sponsored venture capital, or LSVC program. Fund-raising in this program has fallen dramatically in recent years, particularly in Ontario, where the provincial government is phasing out its support for the program.

The third source of capital is government. The federal government remains a critical supplier of venture capital funding, largely through BDC and to a lesser extent EDC, but federal spending on the LSVC program has declined in recent years to less than half the level of eight years ago.

The fourth and final source of venture capital is foreign investors, mainly from the U.S. This source of capital is actually growing in Canada, but it's focused largely on later-stage expansion companies. Foreign investors generally will not fund early-stage Canadian companies. In 2007, there were only four disclosed early-stage venture investments in Canada that did not have Canadian investors.

The lack of early-stage venture capital in Canada has reached serious, perhaps crisis proportions. Entrepreneurs are already leaving Canada for the U.S. to get their companies funded. I invite you to look at the last page of my written material, which contains quotes from a number of leaders of Canada's venture capital industry attesting to the enormity of the problem.

The federal government simply must devote more resources to facilitating early-stage venture capital or the inevitable result will be fewer high-paying jobs in knowledge-based industries.

Thank you for your time. I would welcome any questions.

[The Chair, Conservative, James Rajotte]

Thank you very much for your presentation, Mr. Heller, as well.

We'll go now to Monsieur Simoneau, for your presentation, please.

[Jacques Simoneau, Exectutive Vice-President, Investments, Business Development Bank of Canada]

Thank you, Mr. Chair.

Honorable members of the committee, ladies and gentlemen, it is a privilege to be here today. I thank you very much for your invitation

As you know, BDC is Canada's business development bank. We offer tailored financial services, information, and advice. These services include, of course, venture capital investment. Parliament and the government have instructed us to facilitate the commercialization of R and D, and we dedicate considerable money and energy to this task.

Commercializing R and D is not for the faint of heart, the impatient, or the poor. Turning an idea into a successful company is very risky, complex, and expensive. It takes patience, specialized knowledge, superior management skills, and lots of money.

As a nation, we have made impressive public investments in R and D, but we have yet to see this investment trigger a sufficient creation of globally successful technology firms such as RIM. We must do a better job of commercializing and fostering a greater commercial focus for our R and D. The government's role in helping catalyze these changes is as crucial as its support for the original R and D.

Fundraising for venture capital has been declining for several years, a predictable result of the industry's bad returns of the past several years. Large financial institutions such as pension funds--which have a fiduciary duty to maximize returns--have abandoned the field for more lucrative, less risky investments. And because up-front tax incentives for labour-sponsored funds have disappeared from large parts of the country, retail investors are also shunning it. This disappearance of institutional and retail money has happened at a time when, to succeed, technology firms need larger investments, for longer periods of time.

Canadian venture capital funds--which are not performing well--are too young, too small, and too many. Compared to their American peers, they lack scale, sophistication, experience, and capital. The average Canadian venture capital investment is usually only half that of an equivalent American investment.

The results are predictable. Canadian technology firms are deprived of money they need. Managers spend more time hunting for money than developing their businesses. Because there is still no late-stage Canadian investment fund, foreign investors are free to cherry-pick the most promising late-stage firms, dictating financial terms that are detrimental to the firm and its initial Canadian investors, as well as to the national economy.

In Canada, we oblige our new technology firms--at a very early point in their lives--to live without grant support and immediately capture investor support. This cliff-like step is a fundamental feature of our market, and it has great consequence for all parties. If the young firm's idea fails to attract investment dollars, it dies. If the investment is enough for continued existence, but not much more--as is often the case--the firm has little latitude to learn from error. Many fail at this stage, destroying venture capital value. Venture capitalists must put their money in very early, and leave it there much longer. At this early point in any firm's life, the range and scale of the risks are daunting, even for hardened venture capitalists. And even if the firm succeeds, the value of investor's return is lessened by the longer period of time it took to generate it. What this means is that our returns tend to be much lower.

I believe this fundamental point is worth repeating. For new Canadian technology firms, the transition from grants to private sector investments is a sudden, do-or-die affair. It is not a gradual or scaled decline in grants accompanied by a corresponding rise in venture capital investments.

Entrepreneurs and venture capitalists face another hurdle when they try to acquire clear ownership of intellectual property. In universities across Canada--the fonts of the R and D---there is no consistent approach to technology transfer. For the most part, despite best intentions, the people who work in university technology transfer offices lack the authority to make the quick, firm decisions that the business world needs, or to structure deals that benefit both parties.

Finally, Canada lacks a sufficient number of a particular breed of entrepreneur--serial entrepreneurs--with enough experience and management expertise to take small companies global. Simply put, we need more of these people. Our economy is fundamentally constrained by our shortage of them.

I'll now describe what we at BDC do to facilitate commercialization in this generally sobering environment. We are and continue to be a crucial contributor to commercialization and technology adoption by Canadian companies.

Since 2001 we've focused on very early-stage investment to help entrepreneurs cope with the capital shortage I have described. We also invest in venture capital funds across Canada, to stimulate the market. In an independent report of last year, which we commissioned at the request of the government, Dr. Gilles Duruflé, a Canadian venture capital expert, found that we are fulfilling our role in the marketplace in accordance with our mandate and best industry practices and meeting many market needs, and that stakeholders perceive our presence as essential.

I will be candid. We have done a good job of seeding and building more than 400 technology companies since we started, but in recent years our financial returns in venture capital have been negative. This is true even when we set aside the impact of the new, obligatory, and purposely cautious accounting method called fair-value accounting, which is further depressing our results. When I compare our results with those of the private sector funds in which we've invested, I note that their results are similarly uninspiring. I'd invite you to regard BDC as a barometer of the industry at large.

Please allow me to offer a few observations and suggestions.

Broadly speaking, I believe we should take a more holistic approach to building a vibrant venture capital industry. We should act to improve its attractiveness to institutional and retail investors. We have to help our entrepreneurs improve their ability to take Canadian companies onto the global stage and to succeed. This is a question of management skill. So the challenge is clear: We must increase the number of people who master this skill.

With regard to the shortage of early-stage funding, we may wish to look at the different durations of time for which other countries allow new technology companies to be eligible for grants. Here in Canada we stop them at a relatively early stage. It may be that prolonging their eligibility for grants, grants made contingent on the company's potential commercial viability and proven ability to also attract investors, would spare them the travails of multiple financing rounds begun too early, with the consequential lower rate of return for investors.

As for the scarcity of late-stage funding, the government's recent decision to give BDC $75 million with which to create a new $500 million private sector later-stage venture capital fund is a decisive, practical way to help remedy this problem and help reduce the number of too-soon exits through sales to strategic buyers or initial public offerings. As you can imagine, attracting this kind of private sector money will be a challenge.

We might also wish to examine our tax incentives. We know that upfront tax credits often attract the wrong types of investors. Tax-free exits might attract more sophisticated investors.

Other incentives to reward successful investments at exit, a concept that several countries have applied, may have more meaningful impact. Israel is notable in this regard.

With regard to the transfer of intellectual property at universities, the University of Waterloo is a striking example of success. Its policies and practices merit close study, and perhaps emulation.

In conclusion, I believe that fixing this industry will take money, patience, expertise, and the combined efforts of legislators, policy-makers, and practitioners. BDC welcomes any opportunity to help. We are collaborating with NRC and NSERC, looking at how to integrate fundamental research into the creation of economic value. This fall we plan to host a round table of industry players to ensure we have a thorough understanding of the industry's problems, as well as ideas on how to improve things.

I thank you for your time and look forward to questions in English or French.

[The Chair, Conservative, James Rajotte]

Thank you very much, Mr. Simoneau.

We will start with questions from members with Mr. McTeague, for six minutes.

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

Thank you, Chair.

I thank the witnesses for being here today. I think you gave us a fairly accurate, apt--if not grim--picture of the problems that are facing innovation and new technologies.

It seems to me that in summation, it would be fair to say that not only do you have to be smart, innovative, and ahead of most in terms of new ideas, but you also have to be rich in order to get your products into market.

I will begin with Mr. Wilkes and Mr. Mothersill.

The National Angel Organization would put together groups that would ultimately provide funding for new ideas if those new ideas were worthy and had merit. In terms of the extent of the investment you would make, do you hear some concerns about how much is required up front, the percentage of ownership of the patent or the new idea? Is this a bit of a barrier?

In other words, if you were putting together a group that demands, for example, 75% ownership in order to get through the early seeding, the early, past-the-bootstrap level, how much of a disincentive would that be to someone who just says, “Well, I'm going to lose that anyway”?

[W. Daniel Mothersill]

No angel group that I know of in this country would ask for 75% of the company in the early-stage financing or in any other tranche that angels may do.

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

What percentage would they ask?

[W. Daniel Mothersill]

Depending on whether there's going to be a follow-on VC round, in which angels are typically diluted, you're looking at probably something in the neighbourhood of between 20% and 30%, because we want to keep entrepreneurs motivated to show up. Over the last ten years that I have been involved in angel investing, there have been too many times when I've had entrepreneurs come to me and say “Look, I just need another $200,000 to get me over the next tranche. The problem is I've raised $1 million in $100,000 tranches, and I'm now down to 7% ownership of my company.” At that point I've turned to individuals like these and asked why they bother showing up. There's nothing in it for them.

Besides, one of the things that angels do, one of the characteristics of angels, is that they not only provide early-stage financing--and they're about the only people who are doing that right now in this country in any volume--but they also mentor companies, because most are serial entrepreneurs who have built successful businesses. Sometimes, the more you get outside of large cities like Ottawa, Toronto, Montreal, Calgary, or whatever, you find that there's an added component to it.

I spent a lot of time this year in places like Thunder Bay, North Bay, and the Soo. Angel investors, of course, want to make money, but they also have a real desire to give back to the community. That may sound a little like motherhood, but it is really part and parcel of the role that angels are playing. What we really have to do--which is why this year alone, the National Angel Organization will build ten new angel groups in Ontario alone--is provide discipline around investing and have term sheets that make sense and exit strategies that people can all adopt and feel good about to keep these entrepreneurs alive so they can go on to the next stage of investing. Without angel investors they never get to the VC landscape.

That's a very long answer, but it's so fantastic.

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

It's important, because it gives us a perspective on the challenges you face and some of the good work you're doing at a time when it becomes extremely critical. There is obviously concern among many that what is happening in Canada in terms of innovation, technology, and any new type of industry that creates opportunities, investments, and employment is in fact controlled by companies that operate and whose interests may lie outside of Canada, save and except for the commercial or consumer side of what Canadians may consume, given that it is a fairly wealthy nation.

I want to turn to a current reality that I think any of you can give us a bit of perspective on.

The liquidity in commercial lending as a result of what's happened in the United States and around the world has obviously put an even greater crimp on the ability to provide risk venture capital. At the same time, we have very lucrative options in commodities like oil.

Mr. Heller, how challenging is it for you to get these groups to come together with your organization to at least try to prod people and say you have to look to the future? Obviously, it is de rigueur to put money in potash or in oil, but not back into the economy that produces the kinds of jobs and outcomes that make us successful down the road.

[Jay Heller]

It's a real challenge right now.

In the first part of your question you alluded to banks. Probably venture-backed companies or angel-backed companies have been somewhat less hurt by the credit crunch than the economy at large because they don't qualify for bank loans to begin with. Most of these are loss-making companies. In our portfolio, some of the later-stage or more advanced companies do have bank loans, and certainly the banks are tightening their lending up and down our portfolio. We feel that every day.

With respect to getting capital, the answer is yes. I don't know if it's unique for this committee to hear three different witnesses from three different organizations come and basically say the same thing--

[Dan McTeague, Liberal, Pickering—Scarborough East, ON]

Yes, we noticed.

[Jay Heller]

--but there is not a lot of capital available for this industry right now. In part it's because lots of other sectors have done fabulously well and in part it's because technology has been, frankly, a very difficult place to make money for the last decade, as Mr. Simoneau mentioned a couple of times. Venture capital returns have been poor for a decade in this country; frankly, all technology returns have been poor for a decade in this country, and with that kind of track record it's tough to go cap in hand and raise money when the alternatives look good.

[The Chair, Conservative, James Rajotte]

Go ahead, Mr. Mothersill.

[W. Daniel Mothersill]

I'll mention one of the interesting differences between VC returns and angel returns. Recognizing that we are both in a very high-risk space, we just conducted a survey in partnership with our angel organization in the U.S., the Angel Capital Association of America. We went out and surveyed a lot of the members to discover that right now formal angel groups--angels who are banding together with some discipline and doing due diligence and whatever--are enjoying about a 27.5% IRR, internal rate of return, which is one the things encouraging people to come together in forming formal angel groups to take some benefit in terms of this. The trick that we face from an angel perspective is in the actual formation of these groups and the disciplines around it.

One of the things we have done, partly through getting a small grant from Ontario and a small grant from Western Economic Diversification Office, is to put together the first unified best practices on how we are going to do investing. They have been adopted by all angel groups across the country. We have a common agreement on that. We're absolutely....

I'm sorry.

[The Chair, Conservative, James Rajotte]

We're running over time. It's very good, but we are running over time. I know you'll get many more questions to expand on that.

Thank you, Mr. McTeague.

We'll go to Madame Brunelle.

[Paule Brunelle, Bloc, Trois-Rivières, QC]

Good morning and thank you for being here. Mr. Simoneau, in an article published last May I read the following:

BDC should abandon investments that have no return and focus on its best opportunities, according to a study commissioned by the Conservative Government after years of poor performance from its Venture Capital Division.

You have been accused of funding lame-duck companies and, according to that study, of investing too much money in them. I would like to know how you react to that comment. What can you tell us about it?

You stated earlier that, very early in their life, new technology companies become ineligible to grants. Is there a link between those two factors? Are those companies becoming lame-duck because of that?

[Jacques Simoneau]

I want to start with that article in the Globe and Mail. The reporter stated that we provide our support too long to companies that have no hope of success. It is easy to say after the fact that a given company could not succeed. When you are working in that company, it is much more difficult to see if it will succeed or not. The report published on our portfolio underlined, with reason, that we might have provided our support too long to some companies. However, another mistake would have been to cut our support much too early to good companies. To correct that situation and to improve our decisions, we have improved our selection of the companies and have implemented very rigorous methods of reviewing their chances of success in order to focus our dollars as much as possible on those companies that are the most likely to succeed.

You are asking me if there is a link between those two things. Canadian venture capital must be invested very early in companies whose technology is not yet proven and which may not be even sure that it will work. It may happen that we invest venture capital too early in a project that will fail, which leads to a loss of capital. This appears in the statistics and adds to the poor performance of Canadian funds. If grants had been cut off more progressively, we would have lost less venture capital. The danger is that this will have an impact on the results of Canadian venture capital generally and that big investors will lose interest in this type of investment. The space we operate in is not appropriate to their performance expectations. We have to rebalance risk and performance in order to make sure that this sector will be attractive for investors.

[Paule Brunelle, Bloc, Trois-Rivières, QC]

In 2003, BDC negotiated an important agreement of $300 million with the Caisse de dépôt et placement du Québec. This had allowed you to improve your position. What is your assessment of that initiative today?

[Jacques Simoneau]

It is working very well. These are not investments that we would call venture capital. They are investments of subordinated debt in order to loan money to companies that have no assets to provide as collateral but have good results and will have good cashflow in the future. The agreement is working very well and investments are increasing. We renewed the agreement a year and a half ago for another $330 million and we are very pleased with it.

[Paule Brunelle, Bloc, Trois-Rivières, QC]

I am very interested in one of your initiatives. You have set up a $25 million fund for women entrepreneurs. We know that it is always difficult for women to borrow from banks.

Do you think this situation is improving?

In the past, we used onto say that women entrepreneurs were more timid and had more difficulties but that their companies survived longer. I wonder if it is still true.

[Jacques Simoneau]

I believe that this situation is improving. We deal with more and more female entrepreneurs and female CEOs. Many of them have very good results and are very successful in business.