Presentation to Canada-United States Law Institute Conference Session 8 - The Importance of Venture Capital in Promoting Entrepreneurship Saturday, April

Presentation to Canada-United States Law Institute Conference

Session 8 - The Importance of Venture Capital in Promoting EntrepreneurshipSaturday, April 14, 2007

Canada-U.S. Law Institute - April 14, 2007

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Agenda

The Players: Venture Capitalists, Entrepreneurs

State of Venture Capital Canada vs. U.S. Cross-Border Initiatives/Concerns Conclusion Q & A


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Venture Capitalists

Common “beefs”:

“Why are their term sheets so aggressive?” Always looking for upper hand. Blame the lawyers? May be new trend toward simplicity and trust.

“Why are they such jerks?” Nature of the business. Lack of time; spread too thin. Success breeds overconfidence/arrogance.

Chicken or egg? Stop recognizing own limitations. Fail to value the entrepreneur. Lose sight of seed value.


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Venture Capitalists (Cont’d)

“Do deal terms limit their relationships with investee companies and the entrepreneurs that own and run them?”

Venture capital business highly reliant on personal chemistry between entrepreneur and venture capitalist. One-on-one relationship despite all the money and the institutional names and

reputations.

Most critical aspect of venture capital—and the least scientific and most prone to luck-of-the-draw. Two moving targets.

With over-reaching deal terms in place, entrepreneurs keep venture capitalist at greatest distance possible. Entrepreneur feels violated, defensive and at risk.


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Entrepreneurs

Common “knocks”:

See venture capitalists as the enemy, not an ally. “Take-it-or-leave-it” negotiating styles of VCs. “Scary” term sheets. Cautionary tales seem to be told louder than win-win stories.

Love ‘em or hate ‘em, often nothing in between. Who do you listen to?

Real trust never established. Relationship poisoned even before negotiations completed.

Negotiations take too long – blame on both sides. No real strategic value delivered.

Carefully choosing a VC critical element.


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Entrepreneurs (Cont’d)

“Penny-wise, pound foolish” on giving up equity. Leads to bad deals. Sets up failure down the road. Can end up gutting the entrepreneur.

Leaving financings until too late. Reduces chances of successful transaction. Hurts valuation. Increases chances of business failure even before getting funding. Put themselves into take-it-or-leave-it play mode.


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State of Venture Capital

It’s NOT SO BAD! Plus, there are investors with a NEW ATTITUDE.


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State of Venture Capital (Cont’d)

When it works, the value-add is huge:

VCs fill in blind spots for entrepreneurs.

Help them pick the low-hanging fruit. Focus, focus, focus. Set, enforce and amend goals over life of investment. Create the right governance/oversight structures for the business.

Go deep, but not too deep. Recognizing entrepreneur’s value-add, industry knowledge & operating style.

Industry & customer connections critical. Can be biggest value-add from VCs. Industry specialization, deal track record keys. Talk to investees.


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Sense of people equally critical. Horse-sense and experience reduce big mistakes in building team.

Entrepreneurs face a series of “deals” to negotiate and decisions that VCs can help guide. Key hires, partnerships, new strategies, new customers, acquisitions,

divestitures, follow-on financings, business/plant expansion. Entrepreneurs often out of their element in negotiating and documenting

these deals in conjunction with running their businesses.

VC works at all stages, from start-up to exit. Not a truism to say that entrepreneurs need to build their businesses with

the exit in mind. VCs can be critical here.


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Use of syndicates reduces risk to entrepreneurs and adds more value:

More imposing for entrepreneurs to negotiate and institute. Can be harder to manage. Tend to force entrepreneurs to take more funding. Some VCs oppose the idea.

But:

No single VC has all the answers or ideas. Can enhance relationships. Needs to be a “good cop” somewhere. Good cop can lead the round and be an advocate. VCs can keep each other in line.


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Canada vs. U.S.

Significant convergence in recent years, with Canada moving toward U.S. practices generally. Term sheets, due diligence, deal processes & practices have become very

similar. General trend broader than venture capital.

Borders retain little practical effect in VC industry. VC’s geographic and industry “pods” tend to ignore borders. Geographic isolation still an issue outside small number of Canadian

markets. For better cross-border engagement, industry-based funds should syndicate

and share opportunities/spread risks.


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Canada vs. U.S. (Cont’d)

Still some major impediments to U.S. VCs investing in Canada:

Tax treatment of LLCs (protocol to Canada-US Tax Treaty).

Labour-Sponsored Investment Funds (LSIFs) were well-intentioned tax-advantaged “retail” fund structures which ultimately damaged VC industry in Canada, especially early-stage segment. Gap they left not yet filled, partly in fear caused by government intervention.

Canadian markets still too small for real economies of scale and sufficient “clustering”. The global VC industry has been characterized by “spikes” or clusters of VC

activity.* Of the 16 “spikes” identified globally, 5 are in the U.S., 6 in the Far East, 3 in

Europe, 2 in the Central East—there are none in Canada.

*2007 Index of Silicon Valley – Joint Venture: Silicon Valley Network.


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Cross-Border Initiatives/Concerns

The U.S. remains by far the dominant area Canadian VCs are looking to as they expand their attention beyond Canada’s borders.*

U.S. funds listed the following as their top reasons for not investing in Canada*: Travel Time & Effort; and Lack of Deals that Fit Their Profile.

Although encouraging from a legal/structural standpoint, C.D. Howe Institute, a renowned Canadian think-tank recently issued a report** indicating that there are, indeed, significant legal/regulatory roadblocks to institutional equity capital moving into Canada:

*Deloitte – 2005 Global Venture Capital Survey.**Financing Canadian Innovation: Why Canada Should End Roadblocks to Foreign Private Equity, Feb. 2007.


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Cross-Border Initiatives/Concerns (Cont’d)

Their report suggests:

Promising Canadian ventures attract only 1/3 the capital of their U.S. competitors. Many Canadian companies are sold early in their life cycles, before they achieve

market leadership, and at low prices.

with the end result being a 10-year, net horizon return of Canadian venture capital firms of only 2.5% versus 20.7% for U.S. venture capital firms. U.S. money demands bigger returns than can be reached on the Canadian market.

They argue that Canadian tax rules block the inflow of hundreds of millions of dollars of foreign (mostly U.S.) capital from institutional investors and private equity firms.


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Report’s key recommendations:

End the tax-clearance process that foreign private equity investors must follow when selling shares of a private Canadian company.

Extend Canada-US tax treaty relief for capital gains to U.S. limited liability companies.

Permit tax-free rollover of shares of a Canadian company into shares of a foreign company.


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The following table from their report is telling of a structural issue in the Canadian market:


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Goodman & Carr recently carried out an extensive poll on the factors influencing private equity market growth, with tax/regulatory issues near the top of the list:


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Ontario Teachers Pension Plan, a major Canadian pension fund at the leading edge of private equity investment, reported recently that there is “genuine momentum towards developing a standardized LP agreement in North America”. This was their own initiative adopted by Institutional Limited Partners

Association (ILPA) and now driven by Dartmouth University, supported by a committee with LP’s and GP’s and other industry practitioners, including leading law firms.

There are a number of other initiatives which look to facilitate cross-border venture capital—everyone has a role in facilitating needed changes.

Economic development initiatives in Canada should be shared with relevant U.S. VC firms that might affect development of clusters and the furthering of favorable tax laws.

Small steps might be taken to share angel opportunities that offer higher ROI for American dollars.


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Conclusion

Overall, the relationship between entrepreneurs and VCs is a critical one to our economic health, and despite the challenges, it is always evolving--and working pretty well so far!

According to a recent Global Insight/NVCA study, U.S. venture-backed companies account for 17% of U.S. GDP and 10 million jobs on a total capital investment of only 0.2% of GDP.

Venture-backed companies have consistently outperformed non-ventured counterparts in sales and employment growth across all industries. And cyclical downturns are less severe in the venture-backed segment.

Success is attributed to factors prevalent under, but not exclusive to, VCs such as: Avoiding under-financing of growing businesses; Hands-on Boards of Directors; Open disclosure policies; and Access to highly qualified personnel.

Q & A

Documents

Presentation to Canada-United States Law Institute Conference Session 8 - The Importance of Venture Capital in Promoting Entrepreneurship Saturday, April