Reposted from Venture Law Lines25 Mar 2009
By Suzanne Dingwall

As budget day approaches, the usual flurry of press releases is trickling out, including one in which the Ontario’s Fund of Funds (the OVCF) at long last announces an investment in a investment fund. You can read Mark McQueen’s take on it over here. 

The principals behind Georgian Capital are the former operators of DWL, a Toronto software firm that was backed by local VCs and New York’s Insight Venture Partners. Mark speculates that Georgian Capital may also be receiving backing from Insight in the future, (welcome news; Insight has been a long time shopper here in Canada – in Eftia, Airborne, Platespin among others), in which case OVCF’s commitment to invest “up to $15 million” may be one that never closes, unless Insight or some other LPs also invests in Georgian. No reason to get too excited, although the fact that Georgian Capital has now leased out space in a Rosedale office building (Patachou croissant, anyone?) likely means it is here to stay, regardless.

The issue I have with all of this is about the press releases which OVCF has not issued. As Mark points out, those of us in the industry are well aware of the rumoured deals being considered by OVCF. (Ordinarily, the fund of funds world is a private one whose managers operate outside of the public disclosure light. Which funds they support, and the terms of their investments, are rarely announced.) 

Many private FOFs are sitting out the current market, and in one sense, it’s hard to fault OVCF’s managers for taking the same prudent approach as they appear to be doing. But this is not a private fund of funds, and the Ontario government did not form it for the sole purpose of generating capital gains. The OVCF exists to support the Ontario venture capital industry and to create Ontario jobs. Don’t listen to me – check out John Wikinson’s 2007 press release if you’re uncertain.

Given the mandate of the OVCF, is waiting out the market appropriate? And when our tax dollars are being managed, should there not be greater transparency? 

Why should we care? In the current market, with few options for limited partners, the OVCF in effect holds a monopoly over the venture capital industry in Ontario and, in turn, over the future of Ontario’s venture-backed companies. The decisions OVCF’s managers make in the near term will determine whether any local venture capital funds survive, and who will receive the lion’s share of the profits resulting from any Ontario innovation. 

If the majority of OVCF funds go to foreign VCs, then investing in Ontario’s future becomes a one-cycle event. The amount of capital gains that recycles into our economy from successful start-ups will be significantly diminished. If that is a decision that is being made by OVCF, we are entitled to understand why it’s the right tradeoff for Ontario.(Me, I think it’s a question of proportion – equal parts local and foreign, in case you’re asking.)

Of course, announcing investments in US funds just before delivering a budget would not be the most popular public relations move by a government. But was this press release an improvement? It underscores the fact that, more than a year after our tax dollars were handed over to OVCF’s managers, the chance of any Ontario company receiving funds is likely still months away. (Investment funds still need to be deployed to VCS before they can trickle down to investees.) Which is perhaps why John Wilkinson has created the recently announced investment matching program for “qualified” investors. 

There needs to be some kind of oversight or audit of this kind of government investing activity – call it an ombudsmen function if you want to make it catchy, I don’t care. But there is clearly a misalignment between public policy and private sector implementation of that policy and the two need to be reconciled. I am one of those who believes that in the current economy, careful government support of the venture ecosystem is absolutely necessary. How that support is provided needs to be monitored and adjusted.

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Repost from Flow Ventures

by Raymond Luk

This is a great time to be building startups in Canada. Ontario and Quebec have recently announced over a $1 billion in funding for new ventures through matching funds and fund-of-funds. There may be more good news when Ontario tables its budget on March 26.

Here’s a quick summary:

Ontario:

• $250 million Emerging Technologies Fund which will match private investments in IT, cleantech and life sciences startups

Quebec (link to budget):

• $825 million for a fund-of-funds to invest in 15-20 VC funds ($700 million from the government, $125 million from the private sector)
• $125 million for the creation of 3 seed funds ($100 from the government, $25 from the private sector)
• 10-year provincial tax holiday for new ventures that commercialize research from a Quebec university or research centre

So how does this trickle down to startups?

1. If you’re raising your first round it means there will be more seed funding sources and more money in existing funding sources. Private investors may be more willing to invest since the government is matching their dollars 1 to 1 or 2 to 1 in some cases.
2. If you already have investment it means your investors may be more likely to top-up if they are on the receiving end of these funds.
3. If you’re commercializing research, which Canada does a poor job of, you look a lot more attractive to investors. Not paying provincial corporate tax for 10 years has a huge effect on investor returns (assuming you’re planning on profitability).

The best part of these initiatives is that they support the existing investment ecosystem rather than trying to replace it with something government run. We already have the pleasure, privilege and intestinal fortitude to deal with the government for SRED and other subsidies. Best leave investment to experienced managers.

So is there any bad news? Timing will be an issue as nobody can deploy this much money quickly. It’ll be awhile before funds actually trickle down to companies. I personally don’t like any initiative with a geographical limitation. I understand the desire to create jobs in a particular place but technology companies can be spread out. In Canada, where we don’t have the density of markets and talent, an Ontario-only company doesn’t make sense.

But enough complaining. Does this mean that we at Flow are more likely to make investments in the near future? You bet!

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 March 16, 2009

Premier Dalton McGuinty

Government of Ontario

Legislative Building, Queen’s Park

Toronto, Ontario

M7A 1A1

Dear Mr. Premier,

On behalf of Canada’s Venture Capital and Private Equity Association (CVCA), I would like to draw your attention to the critical situation facing Ontario’s venture capital industry.  The current severe economic downturn is further exacerbating an already difficult fund raising and investing environment and risks compromising our collective ability to fund the industries of tomorrow.

Venture capital (VC) firms generally focus on entrepreneurial and fast growing small businesses in the technology arena, including information and communications technology, life sciences and biotechnology, alternative energy and clean tech.  Perhaps the best known Canadian VC success story is Research in Motion, which has fundamentally changed the way we work and communicate while at once creating tens of thousands of jobs and serving as an engine for Canada’s economy.

The CVCA has recently released a study on the economic impacts of venture capital.  This study has been led by the CVCA with the financial support of Ontario, several other provincial governments and the federal government.  This study clearly shows that venture capital in Canada has resulted in the creation of close to 150,000 jobs and an additional 1% to Canada’s GDP.  In addition, according to the Information Technology Association of Canada (ITAC), 700,000 Canadians work in the broader information technology and communications technology sectors.

This record reflects the specialized business-building skills that Canada’s venture capital firms bring to their portfolio companies.  It is also a measure of our long-term focus, astute risk management and strong sense of corporate responsibility and accountability to stakeholders.

While the venture capital industry has been a key driver of Ontario’s prosperity, our members are currently facing significant challenges that we believe require government action.  At a time when our economy urgently needs new success stories like RIM, ATI, Open Text, Cognos and Corel, we believe that it is vital for the government to address the: 

● Current lack of funding available to bridge the gap between research and development and the commercialization of promising technologies;

● Existing obstacles to foreign investment

Each of these challenges is presented below along with a proposed approach to form the basis for a more detailed discussion.

Access to Funding

Given the current economic environment, fundraising in our sector reached new lows in 2008.  The ability of funds to raise new capital impacts their capacity as financial intermediaries to make investments into promising companies.  Because of the increasing difficulties in fundraising, between 2003 and 2008, venture capital investment in Ontario dropped to $99 million in Q 4, 2008, down precipitously from $177 million in Q 3, 2008 and from $217 million in Q 4, 2007.

The lack of capital available to venture capital investors reflects the broader market volatility and the new market realities.  Institutional investors such as pension funds have incurred considerable losses in their public equity portfolios, which in turn has resulted in a corresponding lower allocation to venture capital and private equity.  Additionally, individual investors are increasingly reticent to invest in publicly-traded vehicles such as Labour-Sponsored Venture Capital Corporations, for a variety of reasons, including the gradual withdrawal of tax incentives for investing in the asset class.

Simply, the lack of capital is putting Ontario’s innovation at risk.  Without funding, there is an increasing and very real risk that Ontario will not be able to fully capitalize on and benefit from its multi-billion dollar investment in research and development.

We note that the federal government has already taken significant steps towards improving SMEs’ access to credit.  However, the fastest-growing, most export intensive Canadian SMEs are disproportionately backed by equity infusions from venture capital funds.  The current economic environment is depriving venture capital funds of their ability to raise capital, thereby robbing our most promising SMEs of the opportunity to grow.

A practical commercialization support program will ensure that more of Ontario’s enterprising companies are able to realize their full potential, which will help to strengthen Ontario’s competitiveness in the global, knowledge-based economy of the 21^st century.  The CVCA recommends the following initiatives: 

• Setting up a federal $300-million, third-party managed fund of funds similar to the fund recently-established by Ontario to help fuel the growth of vibrant, leading-edge companies;
• Doubling the size of the Ontario venture fund through a direct injection of $200 million in government funding;
• Improving the federal Scientific Research and Experimental Development program (SR&ED) so that for every $1 of approved claims,$1.50 is returned to the company, thereby stimulating its growth and development; Ontario’s support on this score would be welcome;
• Enabling greater use of government procurement/offsets to encourage domestic as well as foreign multinational investment in domestic venture capital funds; and
• Creating an incentive for large Ontario corporations to invest in domestic VC funds, where an investment in a VC fund would receive the same tax treatment that is currently available for in-house research and development.

 These measures would benefit Ontario’s technology firms as well as its venture capital funds in both the short and medium term and would improve our collective ability to achieve the longer-term innovation and productivity goals that are necessary to maintain the province’s competitiveness in the global economy.

Removing Remaining Obstacles to Foreign Investment

Foreign venture capital investment has historically been an important contributor to the success of emerging Canadian companies.   However, at the end of the fourth quarter of 2008, foreign venture capital investment in Canada fell 56% in 2008 relative to 2007, the lowest level in five years.  Moreover, this trend appears to be accelerating.

We encourage the government to examine ways to improve Ontario’s and Canada’s investment appeal.  The CVCA shares the analysis of the situation put forth by the recently-released federal Advisory Panel on Canada’s System of International Taxation, namely that the current Section 116 process “may negatively affect Canada’s ability to access foreign capital, particularly by private companies.” (p.91). The Advisory Panel’s Recommendation 7.4 that deals with this matter is, regrettably, insufficient to deal with the problems encountered by our members and by the foreign investors with whom they deal.

Canada currently defines taxable Canadian property to include shares of a private corporation resident in Canada.  At the same time, Canada’s tax treaties cede taxing jurisdiction to the country where the non-resident vendor is resident, provided the shares do not derive their value principally from real property.  Based on the large number of tax treaties Canada has concluded, it appears that Canada is prepared to exempt from taxation all gains realized by non-residents, other than the gains from the disposition of real property.

In light of this treaty policy, we believe that Canada should adopt a broader exemption in its domestic law to exempt gains realized by non-residents other than those arising from the disposition of real property.

We see little benefit in providing the exemption only on a bilateral basis.  The benefit of a broader exemption is that it would make Canada a more attractive destination for equity investments by non-residents and, in particular, venture capital and private equity funds.  A broader exemption would also reduce a significant compliance burden that acts as an impediment to foreign direct investment in Canada.  Unfortunately, recently enacted changes regarding the Section 116 clearance certificate process did not address the issue and are unlikely to reduce the number of situations involving arm’s length transactions in which clearance certificates are obtained.  We recommend amending the definition of taxable Canadian property so as not to include the shares of a private corporation resident in Canada other than when such shares derive their value principally from real property in Canada.

This proposed solution would put an end to the onerous Section 116 compliance requirements (except for real property), should not result in any significant tax revenue loss and would mirror the practices of most leading international jurisdictions.

We would strongly urge Ontario to continue to press the federal government to remove the Section 116 obstacles to foreign investment.

Encouraging Angel Investing

Although it is not within the CVCA’s mandate, we recognize the important role that Angel Investors play in our ecosystem.  Although the CVCA has not taken a formal position on the topic, I will note that one half of U.S. State governments have adopted some sort of “Angel Tax Credit” to stimulate the creation of start-ups.

In closing, the strength of our venture capital industry has a direct impact on Canada’s economic health as well as the financial well-being of millions of Ontarians.  At the CVCA, we take this responsibility very seriously. 

We would welcome the opportunity to meet with you to further discuss the opportunities and challenges that are outlined in this letter. I can be reached at 416-607-5150 while the CVCA’s Executive Director, Richard Rémillard, can be contacted at 613-744-8969.

Yours sincerely,

Gregory Smith

President

CVCA

http://www.cvca.ca

cc. Dwight Duncan

      Minister of Finance

     John Wilkinson

     Minister of Research and Innovation

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Original post on 20 February, 2009

http://venturelaw.blogspot.com/2009/02/bridgewater-systems-challenges-of.html

By Suzanne Dingwall 

I’ve been fascinated by the recent press surrounding Ottawa-based Bridgewater Systems, whose current circumstances illustrate well the challenges of a public start-up. 

Bridgewater is one of the last Ottawa telecom start-ups to attract significant venture capital, from Vengrowth, EagleOne/Newbury, Terry Matthews’ Wesley Clover and even from strategic investor Alcatel-Lucent, among others. The company had been publicly contemplating an IPO since the early 2000s, before finally biting the bullet in 2007, driven in part by the desire of some of its VCs to generate some cash from their investment. 

Here’s where things get interesting. Despite becoming a public company, Bridgewater’s board post-IPO looks more like a private board – comprised of VC nominees, management and in one case a strategic consultant to the business. Great set of board members, but their strengths all appear to lie on the operational side. Which perhaps explains why the Company appears to have left itself without any defensive mechanisms to stave off the overtures of hedge funds such as Crescendo Partners.

Why is being a target an issue? It’s not, if you think your company’s stock is trading at a reasonable value. But whose is at the moment? Even in the best of cases, boards today who have received attractive offers from hedge funds find themselves unable to make a recommendation to their shareholders, due to the reluctance of advisors to give fairness opinions in support of that recommendation. 

Public company boards often have in place tools that allow them to slow down or discourage proxy fights to ensure that the best price is obtained in these kinds of circumstances. At our firm, we try to ensure that our public clients understand the kinds of shareholder defenses that can be put in place from day one following an IPO – from the simplest (staggered board terms, which make it hard to replace the entire board in a proxy fight) to a shareholder rights plan and beyond.

As more and more start-ups making the transition to the public markets to accommodate the liquidity needs of their VCs, shareholder defenses are becoming a start-up issue, too. Public company boards differ from those of private ones in that they must split their focus between (a) oversight of operations and (b) awareness of stock market dynamics and how they might affect shareholder value. It’s important to expand the skill set of any company as it transitions from private to public to include someone who understands proxy fights and market dynamics. 

The irony here is that companies like Bridgewater, who spent their formative years working towards an exit for their first backers, may well find themselves on the liquidity merry-go-round once more. Hedge Funds generally seek the same return on investment within the same time frame as VCs. Stay tuned.

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