28, March 2023

The siren song of venture capital.

The idea of investing in  a promising but risky venture in hopes of making a substantial return in the future is nothing new. This was the business model that funded Christopher Columbus,  Venetian spice traders, nineteenth century whalers and the early days of the Hudson’s Bay company.

This model provides an incentive for investors to channel capital to promising new areas of activity that could benefit society. Without a big incentive those projects would go unfunded. Venture capitalists today inherit that tradition.

In Canada venture capitalists have invested $253 billion since 2013 in promising early stage companies, according to the CVCA1. Globally VC investment in 2021 was $US613 billion, according to BDC2, having risen from $US10 billion ten years ago. The reason for this huge increase was the very high returns, reportedly 20% in the period 2017-20212.These investments are celebrated in the press, by elected officials and economic developers.

The business model

VC’s assemble  a pool of capital from individuals and companies, who are passive investpors (the Limited Partners). The General Partner then screens companies and decides which companies to invest in. The General Partner usually has a seat on the Board and provides intensive coaching, mentoring and access to their networks for the CEOs of the companies they invest in.  After around five years, and several rounds of investing, comes the exit. This can be an Initial Public Offering or, more likely nowadays, a sale to another company.  The VCs take a portfolio approach, which makes sense as the companies they invest in are very risky early stage companies. Most of the companies they invest in fail, and they rely on 1 in 10 investments making a very large return to cover the losses of the others.

Although VC-backed companies represent less than 0.5% of American companies created every year, they make up nearly 76% of the total public-market capitalization of companies started since 19953.

But is Venture capital always a good thing for the local community?

There is no doubt that the VC model is a very effective way of advancing innovation. Seven out of ten of the world’s largest companies, including Apple and Amazon, were venture capital-backed.3

However, what is good for the economy as a whole isn’t always good for the local community.  The basic reason is that the goals of the VC and economic developers do not align at all. The sole purpose of the VC is to make money. The aim of local economic development is to create good local jobs and build the community.  However successful founders can play a key role in community building if they stay and act as mentors and investors for others.

The downsides of VC for the local community are:

  • The company often moves away after the exit. If the acquiring company is based in the US or Europe the company may be moved to the new location. There are relatively few big companies in Canada capable of acquiring VC backed companies. Dan Breznitz, A University of Toronto professor, has noted this4.
  • The profits often leave Canada. Just to take a recent example, in Calgary there have been five unicorns in the last couple of years. These are companies with a market capitalization of $1 billion. All five were funded by VCs (or private equity) from the US or UK. When the exit happens all the profits will accrue to the funders in the US or UK.
  • They don’t build the local innovation ecosystem. The companies receive intensive mentoring and coaching the from the VC, so they don’t have a large need to engage with the local ecosystem.
  • The entrepreneur gives up some ownership. This is in common with all forms of equity investing.
  • It leads to a very unequal society. Dan Breznitz describes Israel, whose economy has grown substantially due to VC investing. Israel is now one of the most unequal societies in the world. A small group of entrepreneurs has become very wealthy but their gain has not penetrated to the rest of the economy, where 20% live below the poverty line4.
  • There is little spin off to the local economy. The experience from Israel shows that the “VC economy” can coexist with the “other economy” with very little interaction between them.

Alternative sources of funding.

It’s worth remembering that not all growth companies require external funding. For example, Smart Technologies, which grew to revenue of almost $1 billion in Calgary, received no external funding.  Their CEO described the model to me as “make  a few, sell a few, make a few more, sell a few more, and so on.”

Taiwan has a VC model that removes many of the downsides of the North American VC model. It is based on local capital and requires an IPO on the Taiwan stock exchange, so profits remain in the country.

Conclusion.

  1. Venture capital is a powerful force driving innovation. However it is not a reliable way of building a local community as many VC backed companies leave after their exit.
  2. We badly need some innovative thinking to come up with other business models to channel capital to high growth companies that benefit local communities.

Peter Josty
www.thecis.ca

  1. Canadin Venture Capital Association https://www.cvca.ca/?gclid=CjwKCAiAmJGgBhAZEiwA1JZolmSlFD43_AXhwbv5HtkLjKxrpbdNbFme9pCONz3nPUNrpopPk3rBexoCU5UQAvD_BwE
  2. Canada’s Venture Capital landscape https://www.bdc.ca/globalassets/digizuite/36181-report-canada-venture-capital-landscape-2022.pdf
  3. The Economist (November 25, 2021). The bright new age of venture capital.
  4. “Innovation in Real Places” by Dan Breznitz, Oxford University Press, 2021.