Great Expectations? The Future of VC in Canada

An article appearing in the Financial Post earlier this week about new venture capital initiatives in Quebec and Ontario got me thinking about current expectations for future performance of venture capital in Canada.

After reading much of the press this past year surrounding the new $300 million Tandem Expansion fund launched here in Quebec and some thoughts on growing fund sizes South of the Border, I did some very quick, back-of-the-envelope, fuzzy calculations to gauge how high the bar is currently being set.

Not being familiar with the terms or structure of the new fund, I have assumed:

  • the new $300M fund will aim for a return of at least 20% over 7 years;
  • the management fee is 2% (I suspect it is actually lower given recent comments on fees by Jacques Bernier, managing partner of Teralys Capital, an investor in the new fund) with a carry of 20%; and
  • the fund will have an average 30% equity stake on exits.

In order to return 20% to LPs in seven years, the managers would have to turn that $300 million into just under $1.4 billion, after annual management fees and carry are factored in. If the fund holds a 30% stake on each exit, then they will need to create nearly $4.7 billion in market value.

While I don’t have any recent numbers on value creation by later-stage Canadian VC firms to contextualize my fuzzy math, those are some quite impressive numbers.

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Investors as Source of Risk: Sometimes it is Better to Just Get out of the Way

At its most basic level, the business of investing is about managing risk. In order to reflect the risk in the terms of a deal, most investors know the basics risks to look at (e.g. market, management, operational risks, etc.) and engage in intensive due diligence processes to discover what the extent of those risks are.

One source of risk that is rarely considered in the investment process, however, is sometimes readily discoverable if investors simply look in the mirror.

Fred Destin at Atlas Ventures has put together an interesting post on the topic of investors behaving badly after the money goes in, but an investor can also unintentionally notch up the risk BEFORE investing a single cent.

I once had the opportunity to see this happen first hand. Briefly, the company had an exceptional management team, proven technology, good track record, full order book and a slew of potential customers in their pipeline. A large round of financing was needed to scale the company rapidly to seize a market opportunity that would have given any first mover a significant sustainable competitive advantage. In other words, the company had to move quickly and needed the financing to do it. After much negotiation and due diligence, we were ready to close with the material issues having been reasonably addressed in the terms of the deal…

…then some of us decided that even bigger belts might look good with our already hefty suspenders.

Initially, this was not necessarily a bad thing. But as weeks turned into months, the value-add of the negotiation process began to decline exponentially. As some insisted on debating what colour costumes the angels dancing on the pin should be wearing, the company’s window of opportunity was shrinking. The absurdity of the situation was brought home when a particularly combative member of the investor syndicate suggested now not doing the deal because company management had failed to achieve their projections for that year – projections that had been based on the assumption that the financing would have been in place several months earlier on the initial expected closing date (in fact the performance numbers showed the management were still making remarkable progress despite funding capital expenditures from a relative dribble of internally generated cash).

Although the deal eventually closed, and on terms that made some sense, the business plan ended up being riskier than it had been at the start of the process. It had nothing to do with the entrepreneurs involved, however, and everything to do with some investors trying just a little too hard to justify their existence.