Does Canada Have Enough Venture Capital?

In Canada, access to venture capital (VC) is cited as a persistent barrier to the creation of world-class firms, prompting the development of programs and funds to overcome it. Policy is operating under the assumption that availability of VC funding is as much a problem today as it was years ago. But what is the current state of VC funds in Canada? Is there a gap? If so, why?

To help us answer these questions, we took a closer look at: the availability of VC funding in Canada in international comparison; the sources and availability of funds by VC stage within Canada; the structure of the Canadian VC system; and the sources of VC flowing into Canada’s leading tech companies.

 

Contrary to popular belief, Canada performs exceptionally well globally, ranking among the top countries in the world for availability of capital in both absolute and relative terms. Internationally, Canada ranks third in absolute VC dollars invested, behind the United States and China and far ahead of more populous countries such as the United Kingdom, France, Germany, and South Korea. Canada also ranks third on a gross domestic product-basis in VC invested per year, lagging only the United States and Israel.

For a long time, it has been thought that investments from international sources have propped up overall VC funds in Canada, particularly at later stages of growth. But the evidence suggests that this may hold true for earliest rounds of investing as well. In fact, there were 22% more Series A investments made by foreign firms than by Canadian VCs in Canada and more than twice as many foreign firms investing in Canada than Canadian firms making investments. This implies sufficiency of capital for Series A rounds and potentially even later rounds.

The data also helped uncover a major issue with Canadian investors who are less likely to put forward competitive and significant sums of money. Among the companies we analyzed, only 18% financed were exclusively supported by VC firms based in Canada, and nearly 30% had no Canadian investors. In addition, businesses with no Canadian investors received 2.7 times as much money as those with Canadian investors only.

When it comes to leading Canadian technology companies, businesses that relied exclusively on US and other foreign funding in their Series A round eventually raised more money than Canadian-financed firms and were positioned better to become Unicorns.

Perhaps one of the main factors shaping our perception of capital in Canada is the lack of results on the scaling front. Canada ranks last among Unicorn-creating Organisation for Economic Co-operation and Development (OECD) countries. Although Canada ranks third in the world for the amount of VC invested annually, we place last in the world at turning this investment into Unicorns. The situation is so bad that even if we were to create four times as many Unicorns, we would still be in last place.

The structure of the Canadian VC system also poses some challenges:

  1. We have too many VC firms with too little capital, potentially causing competition for deals and smaller investments, far less than the companies need to grow fully.
  2. With smaller investments, these companies have less capital to support losses and important business functions (e.g. marketing and sales) that would help them grow faster.

Our current report has put forward evidence that there is, in fact, sufficient capital for Canadian companies, especially when international flows of monies are considered. Certainly, there is some disconnect between data and the general VC insufficiency narrative commonly heard in Canada. Overall, we believe that significantly more effort should be focused on exploring the underlying causes of the capital (in)sufficiency problem. Only then will we be equipped to design and deliver meaningful solutions that get at the underlying “disease”, rather than the symptoms alone.

Why WeWork Blinked

I met with someone yesterday who has an office at WeWork and was pleased to see the relaxed atmosphere, posters advertising Meditation Hour, and beer on tap. (It was morning so I couldn’t have any beer.) That visit reminded me that I wanted to look at their prospectus and check out issues relating to their valuation as it had been under attack recently. Lo and behold, yesterday happened to be the day that WeWork delayed their IPO. After looking at their prospectus, I understand why.

In total, the company has raised $5.6 billion of equity and has revenue last year of $1.8 billion. That’s a ratio of 3.1 times which isn’t far above the ratio of 2.3 times for software industry IPOs over the last six years. (Check out our recent report on IPOs for data.) The problem is that WeWork isn’t a software company but it looks like they tried to value themselves like one.

The average software company going public has a gross margin (Gross Profit/Revenue) of 65% whereas WeWork has one of 16%. (Bear with me here, I’m about to get even more boring.) That means the Capital to Gross Margin ratio is 18.7 times, way more that that of the software industry’s recent IPO ratio of 2.59 times. 

WeWork has a great growth rate, 105% in the last year which puts them well above software industry IPOs of 55% over the last six years. They were initially looking for a valuation of about $47 billion and this would imply a revenue multiple of about 26 times. Even this would be high compared with Shopify’s which was worth a revenue multiple of 20 times for an equivalent growth rate. 

The problem is that you can’t use a revenue multiple similar to software companies when the gross margin is so low. WeWork is a high cost operation so a better way to look at it would be to look at a Gross Margin Multiple. Software industry IPOs over the last six years averaged revenue multiples of 8 times. This would be equivalent to a Gross Margin Multiple of 12.3 times. WeWork was looking for a Gross Margin Multiple of 157 times. 

Even if you factor in their high growth rate, they might have deserved a gross margin multiple of 30 times. This would have valued the company at under $10 billion. They had already reduced expectations to a valuation of $20 billion. The problem was that with a valuation of below $10 billion, it was less than half their valuation at the beginning of the year. Someone was about to get a haircut.

Overall, I think they are in a great market with a very needed product that users love. There may be a problem though with unit economics. The average software company is losing 60% of revenue or 100% or so of gross margin. WeWork is losing 89% of revenue which is not out of line. What is out of line is losing 536% of gross margin. Overall, something has got to change in their business model as these numbers do not point to a company that can ever make money and whose valuation was justifiably questioned.