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by Wayne Lilley
National Post, Sunday, April 1st, 2001.
VCs are used to market collapses. So far, no amount of dot-com doom and gloom has been able to put a lid on their spending.
Venture capitalists aren't by nature worriers. But Robin Louis, CEO of Vancouver-based Ventures West, admits to feeling a growing anxiety when the Nasdaq ended 1999 with an 89% gain. His concern only increased when the bull market turned into a dot-com stampede in early 2000. But unlike many investors, Louis' chief worry wasn't the market's nuttiness. Rather, it was the behaviour of his fellow VCs, many of whom had developed the knack of feeding the herd even while being carried away by it, acquiring oracular status and Croesus-like wealth along the way. Louis feared that he'd made a mistake by not running with the bulls. "We never jumped on the dot-com craze because we didn't understand the business model,Ó he says. "But we wondered for a while if we were just dumb and everybody else saw something we didn't."
Louis' misgivings, of course, disappeared last April - along with a lot of investors' paper gains - when the tech stampede turned toward the exits. "We don't feel so dumb now," he acknowledges, though some of his counterparts probably do. At the very least, they're feeling chastened - and with good reason. Even those who missed the bulk of the trampling spent most of 2000 watching dust settle on investments in companies they had hoped would by now be sold at a profit.
"Since there aren't many new ventures that are profitable, and not many that can point specifically to when they will be, the venture capital business has been off since the market downturn," says John Eckert, managing partner of the Toronto-based McLean Watson Capital, and president of the 91-member Canadian Venture Capital Association.
Despite bruises on their portfolios, however, VCs' investment in new ventures reflects a remarkable buoyancy considering that the technology market they specialize in has continued to languish. At the end of 1999, the total amount of venture capital money under management in Canada was $12.1 billion. But in 2000, VCs had increased that figure by $6.3 billion through a record-setting 1,441 deals.
Robin Louis is a key player. His firm, Ventures West, is Canada's biggest private, independent VC, with $400 million under management. "We did 15 new deals [in 2000], which is a lot for us," he says. "We invested $100 million, which is also a lot for us." Included among the 15 new financings was participation in six of Canada's 50 biggest venture capital deals. "As long as there are entrepreneurs that want to build companies," he adds, "there are opportunities for us."
Another bouyant VC is Andrew Waitman, managing partner of the Kanata, Ontario-based Celtic House International, which is backed by billionaire entrepreneur Terry Matthews, who co-founded and sold Mitel Corp., then repeated that success by creating Newbridge Networks Corp., which he sold in February 2000 for US$7.1 billion. Celtic House, which has $1 billion under management, recently added five new partners and opened two new offices. "We're expanding to deploy more capital than we had three years ago," Waitman says. "In our case, that's US$250 million that we've targeted for new start-ups."
Those on the retail end of the venture-capital spectrum, where few billionaires lurk, are also seeing rays of sun through the pall of dust. Labour-sponsored investment funds (LSIFs), for instance, account for more than half the Canadian venture capital currently under management. What attracts small, individual investors to these funds, which are mandated to finance small- to medium-sized companies, is not the average return, which has been unspectacular, but the federal and provincial tax credits that are offered to make the higher risk more palatable. For instance, Working Ventures Canadian Fund, the country's biggest LSIF and the only one operating in all provinces, has returned an average of 5.4% since its 1990 inception, and only 2.7% last year. But thanks to attractive tax credits, Working Ventures and other LSIFs have reinvested $6.5 billion of fund holders' money into businesses ranging from automobile exhaust pipes to biotech development. Working Ventures II, a fund launched just prior to this year's RRSP selling season, will focus on Ontario-based IT companies. "It's more aggressive, but with higher risk and higher potential for bigger returns," says CEO Ron Begg, an industry veteran who has run Working Ventures from its start. "It's not for everyone, but there's an appetite in the market."
All of which should be good news for entrepreneurs seeking funding from venture capitalists. Capital is the lifeblood of business and the more available, the more it contributes to economic growth. But as those making pitches have already discovered, touching up venture capitalists for a financial transfusion means dealing with an industry that is a lot more disciplined than it was a year ago.
The VC business is simple on the surface. While there are variations on the theme, venture capital companies typically set up limited partnerships in which investors buy shares. The VC firm acts as managing partner, filtering entrepreneurs' pitches - often 1,000 or more a year at a large-sized firm. When a proposal looks good, the VC negotiates to purchase equity from the entrepreneur. Whether supplying startup funding or financing to goose a company to its next level of development, the object is the same: spot an opportunity early, when it's relatively inexpensive, support the company while it grows and realize a profit in a so-called "liquidity event," such as a sale to the public through an IPO or sale to another company.
That elemental model, however, got skewed a couple of ways in the dot-com drunkenness of early 2000. Entrepreneurs who saw the inflated prices buyers paid for companies naturally attached similarly inflated prices to their own companies. VCs, too, got sucked in by the high exit prices and overpaid for many investments. Although Canadian VCs maintain they weren't as giddy as their bigger U.S. counterparts (mainly because they're smaller), they suffered a collateral hangover when the market collapsed.
The industry still hasn't slept all of it off. Teetotalling perhaps overstates the industry's sobriety these days, but it's safe to say it's no longer imbibing indiscriminately. "We're kind of relieved that the bubble has burst and there's a bit more reality in the market," says Andrew Waitman, who admits that his portfolio has suffered. "We had to say no to a lot of deals last year because valuations were crazy. But the sobering is good for the industry from multiple perspectives."
One result of the new sobriety is the increased rigour VCs have adopted to assess prospective investments. Dot-coms, for instance, no longer command a lot of VCs' time. "There are still entrepreneurs presenting ideas that only work in the online world, which means we'll take a pass," says John Albright, head of Toronto-based J.L. Albright Venture Partners.
Another result is that VCs now more closely assess the value entrepreneurs place on their companies. "If the idea works in both the on-line and off-line worlds," says Albright, "we might be interested, but the valuations they're demanding have to represent today's world." Albright empathizes with entrepreneurs struggling with the message from him and other VCs. "It's hard to be told your company is worth 70% less than you thought," he says. "But we're now more focussed on fundamentals versus 'What's the idea? What's the story?' We're interested in getting profitability within the next nine or 12 months and won't fund losses for three years - or indefinitely - as they did prior to the implosion."
While VCs try to hasten profitability, markets are forcing them to rethink exit strategies. "What's changed is the receptiveness of public markets to early-stage, unproven companies," says Robin Louis. "In the last couple of years, it's been possible to take companies public at a very early stage in their lives, and that's gone away."
Nor is the alternative of selling an enterprise at a profit to a third party, often for stock, the option it once was. "Companies aren't buying as they once were when inflated stock value meant they would buy anything because they had valuable currency," says Albright.
What does matter these days? For starters, sales that produce revenues for a company that's a leader in a fast-growing technology sector. "The world has gone back to what it always was when you had to prove your business and demonstrate you had customers and some way to make money before you could go public," observes Louis.
Another element that venture capitalists have been paying more attention to is the management at portfolio companies. It isn't at all surprising today to see VCs become involved at the executive level. John Albright's partner, Osama Arafat, for example, who once founded and ran an Internet service provider, has taken over as president and CEO of Q9 Networks Inc., an Internet infrastructure company in Albright's portfolio. "All my partners are operating guys," Albright says. "The Q9 entrepreneur hadn't done a business before, but he's very smart technically. So we gave him money and a body."
Though the move stretches human resources at Albright's firm, it's still better to have someone on the ground in the fast-moving technology business than to follow the more common VC practice of taking a seat or two on a company's board: "We know what's going on by the second, as opposed to two months later," Albright says.
VCs helping their portfolio companies recruit outside management note that the collapse of the tech market, though unwelcome, has made talent searches easier. "Last year it was hard to hire people [for investee companies] because good CEOs and good VPs of sales or marketing had 10 offers of big money and big options," says Andrew Waitman. "It's not that we want to be cheap. But before there was so much noise in the market that it was hard for people to determine one deal from another."
The noise may diminish still further. Most VCs anticipate doing fewer but bigger deals now that technology companies need to grow quickly to global scale to survive and compete. But to have any chance of doing so, they need large infusions of cash, which has led to an increase in syndication involving a number of VCs as co-investors.
Diversification of VCs' risk is one benefit of syndication. It also adds value to their involvement. Introducing investment partners with different networks increases the investee company's access to potential alliance partners, contacts and customers, notes Barrie Laver, managing director of Toronto-based CastleHill Ventures Partners. And when secondary financing is required, Laver adds, "you can often do two or three rounds with the same in vestment group rather than slow things down looking for a new investor."
That efficiency is no small matter. Follow-on financing, which accounted for almost two-thirds of the 50 biggest venture capital deals last year, is a trend that is expected to continue as young companies discover their usual sources of capital are closed. Ron Begg, for one, can hardly wait for that to sink in, and for companies to bring more realistic valuations to the deal table. "I don't want to sound like a ghoul," he says, "but we're rubbing our hands now. We're seeing some excellent companies that don't have the option of the public market coming back to traditional sources like Working Ventures."
Perhaps the best indication of VCs' buoyancy is that most claim to have kept enough powder dry during last year's tech downturn to have money to deploy when they spot the right deal. So in addi-tion to Celtic House's fresh US$250 million and Ventures West's new $235-million fund, for instance, John Albright says he's "sitting on $100 million in cash," and Barrie Laver, whose company runs a $20-million venture fund specializing in start-ups, is looking for promising deals. "When we talk about the collapse of the technology market, we have to segment our view," he says. "There are still a lot of good companies out there and their stock prices have come down substantially."
As optimistic as the industry is toward investing for future profit, it still has some nagging issues to attend to now. Except for labour funds, most VCs don't make their returns public, so it's difficult to determine the state of their portfolios. Waitman, who has had a couple of big winners in the last year, admits the value of Celtic House's portfolio has declined. "There are always what I call 'hairballs,'" he says.
An example is the Cisco Systems stock Celtic House received last August when it sold Pixstream Inc., one of its investments, for US$369 million. The Cisco stock, worth about US$60 a share when the sale went through, has been held by Celtic House under a lock-up agreement. But Cisco shares have since dropped in price to about US$23.
Waitman insists the deal will pan out for Celtic House when it sells, and dismisses the situation as a "burden of success." A similar situation, though, might be a flat-out burden for VCs stuck with lesser-quality stocks. Determining which hairballs to cut loose and which to support can distract them from evaluating new business. "It's become harder for entrepreneurs to get a hearing from VCs," allows Cindy Gordon, an associate partner in the private, Toronto-based venture firm XDL Intervest Capital Corp. "We're busy looking after our own nest."
Another nagging issue centres on finding investors for VCs' limited partnerships. Canadian companies note that the usual sources of limited partners - high net-worth individuals, corporations and institutions - are more supportive of the industry in the U.S. than in Canada. Which is why, says John Eckert, the amount of foreign capital in Canadian limited partnerships only "ebbs and flows" despite efforts to showcase our technology successes and venture capital expertise.
One welcome development that helps limited partners in VC funds, says Ron Begg of Working Ventures, whose fund benefits from tax rules, are recent changes in the way Ottawa treats capital gains. But support from private-sector, corporate pension plans would be even more welcome. "Air Canada, Canadian Pacific and Canadian National for the most part have stayed away for the last 10 years," observes Barrie Laver. "They didn't like the returns in the late '80s and wrote the asset class off."
Robin Louis, who stayed healthy by avoiding the dot-com stampede, says the private pension funds should consider following the example being set by their public counterparts, who are increasingly regarding venture capital as both vital to the Canadian economy and a good investment. Partners in his new $235-million VC fund include the California Public Employees' Retirement System (CALPERS), "the biggest pension fund there is anywhere," he says, plus three of Canada's biggest pension funds: Ontario Teachers' Pension Plan, OMERs (Ontario Municipal Employees' Retirement System) and the B.C. Investment Management Corp.
"They're beginning to look at venture capital as we have all along," says Louis, "as a legitimate asset class."
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