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Dwindling local venture capital helps U.S. VCs get foot in door

Ottawa's startups saw venture capital dwindle by 26.4 per cent to $264.65 million in 2006, forcing them to look elsewhere for funding, according to a new report.

In its annual tally of VC activity, the Ottawa Centre for Research and Innovation attributed the large decline to the lack of returns to support new fund creation, the relatively young age of the Canadian venture capital industry, and constant changes in government regulations.

However, the life sciences sector continued to grow, grabbing a 31-per-cent share of disclosed venture capital investments flowing into Ottawa.

"Ottawa's life sciences industry is bucking the national trend, and has shown a 49-per-cent annually compounded growth since 2001," said OCRI Life Science Program vice-president Ken Lawless. "And 60 per cent of all Ontario life sciences deals this year were for Ottawa companies. We've done well in a tough market."

As the venture capital market continues to shrink at home, an interesting - and sometimes problematic - trend which has cropped up is the increasing number of lead foreign investors, especially in the life sciences industry.

OCRI chief executive Jeffrey Dale noted that most of the deals made in 2006 had some kind of foreign investment, with the usual arrangement being co-investment by Canadian and international venture capital firms.

"Well over 50 per cent of foreign venture capital coming into Canada flows into Ottawa," said Mr. Dale. "Foreign firms are comfortable with Ottawa because of the telecommunications and semiconductor markets here."

However, he said that the life sciences market was seeing more deals where U.S. venture capital firms, in particular, have come in as the key investors. This is both positive and worrying, for while there is more interest in Ottawa companies and more money coming in, it means Canadian VC firms are strapped for cash, he said.

"I don't see Canadian venture capital drying up, but it's certainly not a healthy market," said Mr. Dale.

He explained that there have been no new funds created because of slow returns to the VC market, while the phasing-out of labour-sponsored fund tax credits has caused some firms to conserve their capital for fear of running out when the phase-out is completed. The smaller number of lead local investors would also mean there would be fewer matching dollars from foreign venture capitalists.

In the life sciences market, the story is a slightly more positive one, as deals such as the recent $41.9-million financing round received by Gatineau-based Variation Biotechnologies - which involved only U.S. investors - show that the U.S. is interested in the Ottawa biotech market, Mr. Lawless said.

"The story that's at play is that there's a weakness in Canadian venture capital firms, with most of the funds flowing into energy, but that's not the case in the U.S.," he said. "The opportunity is to ensure that Canadian companies access that capital ... and get U.S. VCs to invest in Canadian venture capital firms as well."

Variation's director of corporate development, Adam Buckley, said the company hadn't noticed any particular difficulty in obtaining local funding, as it had received offers from both sides of the border.

"I think it's the same challenge everywhere (in obtaining funding)," he said. "It's an involved process."

However, he noted that it was possible that U.S. venture capital firms could be getting more action in the Canadian market because they are quicker in getting through due diligence.

"They are quicker to assess the opportunities and act upon them because they often have in-house analysts to look at each deal," said Mr. Buckley, adding that it had likely been the case in Variation's own recent financing deal.

"We did have to go through more questions and answers with the Canadian venture capitalists, perhaps because they didn't have the same amount of industry knowledge and expertise and needed to get more comfortable with the technology," he added.

What's the outlook for the local venture capital market?

Mr. Lawless noted that the number of VC deals is going down, but they are also becoming larger, with the average size of the 17 deals in 2006 having nearly doubled to $15.57 million from 2004's average of $8.4 million.

Nonetheless, the VC market is likely to be flat for the next year because of the lack of new funds, said Mr. Dale.

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