Seed Series Part 1

Seed Series Part I: 

Canada’s Early-Stage Founders are Being Neglected

Bryan Slauko, CFA, April 2020

OVERVIEW

Recent headlines in the media, like the ones below, indicate that the technology sector is thriving and that record amounts of capital are being invested in our entrepreneurs.

“Record Breaking CAD $6.2B Invested in 2019” – Financial Post, March 11, 2020.

“Canadian VC Investments Set Record in 2019 as Tech Sector Dominates” – Startup Toronto, March 10, 2020.

“Canada Is Having A Record Year for VC Funding” – Crunchbase News, November 2019.

On the surface this certainly seems to be the case given $6.2 billion of investment in 2019 is a massive increase over the $3.7 billion invested in 2018. But where is all this money going? What parts of the ecosystem really are dominating? In Part 1 of our Seed Series, we’ll use published Canadian Venture Capital Association data to show how the Canadian venture capital industry has undergone significant changes over the past 10 years.

The Rise of the Megadeal

  • Annual venture capital investment in Canada has grown by a factor of 4 over the past 8 years and by 69% in 2019 alone.

  • Growth in megadeals, defined by CVCA as $50 million and larger investments, accounted for 85% of $2.5 billion increase in total venture capital investment in 2019.

  • The average venture capital deal size has more than tripled from $3.5 million in 2011 to $11.6 million in 2019, demonstrating a clear shift to investment in larger transactions.

A Seed-Stage Funding Gap Persists

  • According to CVCA data, the amount of capital invested in deals under $5 million, critical to seed-stage founders fell by 24% in 2019. Investment activity in deals under $1 million fell by 49%. A large seed-stage funding gap persists and has worsened for smaller deal sizes.

  • Seed-stage founders are the future job and wealth creators needed to diversify and revitalize our economy. But they’re stranded without access to the capital and expertise they need when they need it the most.

$500,000 is the new $5 million

  • The focus on larger and later-stage deals comes at a time when the cost to launch a startup is dramatically less and early-stage companies need much smaller investment rounds, not larger.

  • Smaller investment rounds have become critical in enabling early-stage companies to grow, create jobs and wealth, and become the portfolio companies traditional venture capital funds are looking for.

  • The traditional venture capital fund model doesn’t allow a focus on this critical range of investment.

Seed Needs to Become the New Series A

  • 10 years ago, traditional Series A venture capital funds provided funding to help early-stage companies build an initial team, complete version 1.0 of their product, and achieve initial traction in the market.

  • Today, companies need to reach these milestones before most traditional venture capital funds will consider an investment. Seed capital needs to become the new Series A to enable this to happen.

The Traditional VC Fund Model Must be Disrupted

  • Early-stage capital needs to be treated as a distinct asset class from venture capital. We need new, smaller funds to emerge,  structured to allow a singular focus on making smaller $250,000 to $5 million investments.

  • These funds must have the unique expertise needed to understand and evaluate earlier stage companies when traditional revenue metrics don’t exist.

  • It is critical for early-stage funds to be willing and able to carry the additional burden of being lead investors. A strong lead investor sends a needed positive signal to the market. This helps unlock additional investment capital from the sidelines that is critical to ecosystem growth.


GLOBAL INFLUX OF PRIVATE INVESTMENT CAPITAL

Private capital has become very central to large, institutional investment portfolios over the past 10 years. According to Bain & Company:

“Since the start of the current economic cycle in 2009, investors have allocated a staggering $5.8 trillion globally to private equity”.

The chart below demonstrates significant and continued growth in allocations made by institutional investors to long-term private equity in their investment portfolios.

Private Capital Growth

The impact of this trend is easily demonstrated by looking at initial public offering activity on the Toronto Stock Exchange. The total value of IPO financings decreased from $6.1 billion in 2017 to $2.7 billion in 2018 and $1.6 billion in 2019. Companies are using the new private capital sources available to them to stay private instead of going public to raise capital.

This growth in private equity has been great news for later-stage businesses, but it’s had a significant negative impact on the availability of traditional venture capital funding to seed-stage companies. As the demand for private equity has grown, venture capital has seen an influx of capital, as large investors look for sources of growth and diversification in their portfolios. With larger fund sizes and growing portfolios to manage, most traditional venture capital funds have shifted their focus to pursue larger, and therefore later-stage investments. It’s the only real way these funds can execute efficiently when they have hundreds of millions of dollars to invest.

Unfortunately, this leaves them with less time to focus on earlier-stage companies that traditional venture capital used to focus on 10 years ago.

Annual Venture Capital Investment in Canada Has Grown by 4x

Total venture capital investment in Canada reflects this influx of private capital. Canadian Venture Capital Association (“CVCA”) data shows that total annual venture capital investment has grown by a factor of 4 over the past 8 years, reaching $6.2 billion in 2019. This is illustrated below.

2 - Total VC $ Investment Activity

The Rise of the Megadeal

While this growth is significant, it’s important to understand where this money is going and who it is helping. The influx of private equity capital has contributed to a global trend in venture capital investing known as the ‘megadeal’. The Canadian Venture Capital Association defines megadeals as those that are $50 million and larger in size. CVCA data, illustrated below, shows an almost 3 times increase in the value of megadeals in 2019 compared to 2018.

3 - Mega Deals vs all others
  • The $2.2 billion increase in megadeals in 2019 accounted for 85% of the $2.5 billion annual increase in total venture capital investment in 2019.

  • Megadeals accounted for 54% of the total capital invested in Canada in 2019. In comparison, they averaged 33% of total capital invested between 2016 and 2019.

  • Capital invested in all other deals also grew in 2019 but by a much more conservative 15% over 2018 levels.

So what impact is this growing supply of venture capital having on average deal sizes in Canada?

Average VC Deal Size Has Tripled

With an influx of private capital, venture capital funds investing in Canada have shifted their focus to larger investments, as demonstrated below. The average deal size has more than tripled from $3.5 million in 2011 to $11.6 million in 2019.

4 - Average Deal Size

The emergence of megadeals in 2019 has driven the average deal size up 90% higher than the 2018 average of $6.1 million. But this broad average hides the true story. If we separate megadeals from an analysis of recent data, we see two very different venture capital markets emerge.

  1. A ‘traditional venture capital’ market with a $5.6 million average investment size, and

  2. A ‘growth equity’, or ‘private IPO’ market with a $121 million average investment size.

Average deal sizes in these two markets are growing, as highlighted below.

  • In 2019, 28 megadeals represented only 5% of the total deals completed but accounted for 54% of total investment activity.

  • These ‘private IPO’ type deals are of a size that they likely would have been candidates to raise capital through an initial public offering if not for the prevalence of private capital today.

What does all of this mean for the ability of our early-stage founders to access much needed growth capital??

Let’s take a closer look at how much of the $2.9 billion invested in Canada’s traditional venture capital market in 2019 supported early-stage founders.

Early-Stage Founders are Being Neglected

The cost of launching a startup today is tremendously lower due to the availability of open source technology and cloud-based tools that allow entrepreneurs to get started quickly and cheaply. This makes the availability of early-stage risk capital, particularly in deals under $1 million in size, critical to the health of our innovation ecosystem. For founders, $500,000 is the new $5.0 million.

Early-stage founders need access to smaller amounts of capital to validate product-market fit, hire a team and start to build their business. They’re on the cusp of significant growth and ready to commercialize their product or service but can’t find the help they need when they need it the most. The paradox founders face is familiar – they need capital to get revenue but can’t get capital until they have revenue.

Let’s examine investment activity in two deal range sizes that are vital to seed-stage founders.

$100,000 to $1 Million Deals Down 50%

CVCA data shows a downward trend in total traditional venture capital investment in deals between $100,000 and $1 million in size, and a 50% reduction in 2019 alone. As a percentage of total traditional venture capital investment, the amount of investment has declined significantly. This is illustrated below.

  • This range of investment is vital to early-stage founders who are often pre-revenue, or, are showing strong signs of validation through early annual revenue typically less than $500,000.

  • The declining allocation of capital to this investment size leaves a fragmented, fragile capital market that is painful for founders to navigate. It leaves many feeling desperate and stranded. Many more run out of time and see their opportunity pass them by.

$1 Million to $5 Million Deals Down 20%

CVCA data shows the same downward trend for investment in deals between $1 million and $5 million in size, as illustrated below. While there was much more capital available for these deals, the total invested dropped by 20% in 2019.

  • This level of investment is vital to early-stage founders who have typically achieved greater levels of market validation and revenue and built a larger team to support their growth.

  • Annual revenue is often below $1 million and certainly below $2 million, which is the revenue traditional Series A venture capital investors typically look for to consider an investment.

Both deal size ranges are small in the context of the billions of dollars invested in Canada in 2019. But the availability of capital for these deals is critical to thousands of early-stage companies across the country who are the innovators and future job and wealth creators that our economy needs to grow and prosper. Unfortunately, the data clearly shows they are being neglected by the venture capital industry that used to serve them.

An Early-Stage Funding Gap Persists

CVCA data also breaks out the average deal size by stage of investment. The chart below demonstrates how the average Series A investment in Canada has grown in size much more than the average seed-stage investment has. A large early-stage funding gap exists between the $2 million average seed deal size in 2019 and the $10.9 million average Series A investment. Nobody is making the $4.9 million average investments that Series A funds used to make.

11 - Avg VC Invest by Stage

If the market were operating efficiently, early-stage funds would have started investing in larger deals and moved into the space vacated by Series A investors. They would have reached average deal sizes closer to $5 million and closed the funding gap. The U.S. has experienced similar venture capital trends, as illustrated in the chart below (Source: Wing VC). But we can see that U.S. seed capital has moved a lot further towards closing the funding gap than Canada has.

12 - Avg VC Invest by Stage US

Canada’s Early Stage Funding Market Needs to Evolve

Many early-stage companies in Canada are struggling to find the funding they need to grow to the next level.  The number of early-stage focused investment funds is very limited. The number that will consider pre-revenue or very early revenue companies is inadequate. Angel investor networks have their own challenges in filling the gap. The challenges our founders have been facing have been magnified by the COVID-19 crisis. But it’s not a new problem. Canada’s early-stage funding market needs to catch up and close the gap.

$500,000 is the new $5 million

The VC industry’s focus on larger and later-stage deals comes at a time when early-stage startups need much smaller investment rounds, not larger. $500,000 is a game changer today for companies that are finalizing a minimum viable product and have early signs of customer traction. This size of investment is often enough to allow companies to add to their team, continue product development and earn more traction in their markets.

These smaller investment rounds are critical today in enabling early-stage startups to grow, create jobs and wealth, and become the portfolio companies traditional venture capital funds are looking for. $500,000 really is the new $5 million.

Seed needs to become the new Series A

10 years ago, traditional venture capital used to provide funding to help companies reach significant milestones including building out a team, completing version 1.0 of their product, and achieving traction in the market. This isn’t the case today. Companies need to understand they need to reach these milestones before most traditional venture capital funds will consider an investment. This is illustrated in the image below (Source: Unusual Ventures). Early-stage seed capital needs to become the new Series A and fill the role that Series A funds have moved out of.

Most Series A venture capital funds won’t consider an investment until a company is generating $2 million in annual revenue. Early-stage startups need access to professional capital to keep building their business and get to the other side of the funding gap. We’re in critical need of new sources of capital active in deal sizes from $250,000 to $5.0 million.

The Traditional Fund Model Must be Disrupted

We need to disrupt the traditional venture capital fund model that’s operating in Canada today. Our ecosystem needs professional early-stage, seed capital investors to play a major role in filling the gap left behind by the evolution of traditional venture capital. To be successful these funds need to focus on 3 critical areas:

1) Structure Funds to Focus on Smaller Investments

Investment management firms need to be structured to be able to focus on making $250,000 to $5 million investments. This requires firms to manage smaller funds of $10 million to $50 million in size. It also means that firms need to re-design the traditional revenue model as the traditional 2% management fee may not work.

2) Secure Unique Expertise 

Investing at these earlier stages is not like buying a lottery ticket. It’s not a simple win or lose situation, as is sometimes perceived. The expertise required to complete effective due diligence on pre-revenue and early-revenue companies is unique given traditional revenue metrics aren’t there to evaluate. But with the right amount and type of diligence, investors can build the same amount of confidence needed to make later-stage investments.

3) Act as Lead Investors

Much of our investment community is not experienced with the type of early-stage investing discussed above. Many investors don’t have the confidence required to be active investors in this space. Even the angel investor community has been focusing more on revenue generating companies in recent years. Unlocking additional investment from the sidelines is critical for our ecosystem. This requires early-stage funds to be willing and able to carry the additional burden as lead investors so others can confidently follow them into investments.


Part 2 of our Seed Series, ‘Grave Consequences for Alberta’s Ecosystem’, focuses on what all of this means here in our Province. Alberta’s innovation ecosystem is younger and a majority of our companies are in the seed stages of development. They desperately need the smaller investments highlighted above. We’ll look at this in more detail.

Part 3 of our Seed Series, ‘What the Funding Gap Means for Founders‘, looks at the impact of the changes in venture capital on founders, the challenges they are facing, and how they need to adjust their plans to attract the funding that’s actually available to them.

METIQUITY VENTURES

Metiquity Ventures is a Calgary-based early-stage growth equity fund partnering with innovators to modernize the regional funding ecosystem, unlock emerging growth potential and protect our families’ futures.

We partner with innovators in emerging innovation hubs who are creating long-term, systemic business value and are on the cusp of commercialization and significant growth, regardless of industry. We focus on early-stage investments where we can amplify the impact of our expertise and help partner companies accelerate growth by implementing the efficient use of systems, processes, and a well-defined purpose. We make meaningful lead investments in up-and-coming companies using technology to digitally transform and fundamentally disrupt the way traditional industries operate.

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