Let the Sparks Fly!

Government programs need to stimulate an industry, not become the industry

The largest contrast between the Israeli and Canadian technology company programs is focus – the Israeli model is focused on supporting a software industry driven by private, professionally managed VC funds while the Canadian model tries to simulate the software industry in a general unfocused manner. I believe that, if there is one MAJOR difference in approach between government programs, it is this underlying issue. And, as you’ve probably gathered, I strongly believe this is the focus that we need in Canada.

The fundamental aim of government VC programs in Israel is focused - to establish professionally managed VC funds. The Yozma program was a $100m program started to try and create an industry of seed and early stage VC funds. The program offered $8m to ANY fund that met various objective criteria in terms of other funds raised, professional management and focus. The funds had a 5 year option to buy out the $8m at predetermined conditions. They quickly established 10 such funds (of which 8 exercised their option and bought out the government). Yozma made direct investments according to a fixed formula with the single aim to create a VC industry. At the end, more than $100m was returned to Yozma, and Yozma was taken private. The Chief scientist incentives, incubator programs, R&D and Investments grants, tax exemptions to foreign investors are all designed with one thing in mind – creating a strong, independent VC industry run by professional investors.

Contrast that with Canadian programs. The fundamental aim of government VC programs is to try and stimulate the industry at every level in a very unfocused way. Some Canadian examples:
- The “SRED” program which helps pay for R&D with tax credits (and often cash).
- The BDC (Business Development Corporation) which as its opening page on its web site says “supports the needs of entrepreneurs at every stage of growth”. At this level, BDC competes with the VC industry. BDC is a Canadian crown corporation that has a group called BDC Venture Capital that describes itself on its web site as “a major venture capital investor”.
- BDC also has a “fund of funds” where it selectively invests in Canadian Venture Funds. These funds are not given to any commercial fund that meets fixed criteria, but are completely subjectively chosen.

Other generalized programs are in place in Canada.  For example, at a provincial level, in Ontario there has been huge impetus behind the MARS discovery district. This is a huge real estate facility which acts as a “facilitator and enabler”. The government of Canada and government of Ontario each donated $20m to the project. And almost $100m has been raised for the project. MARS is undertaking a number of other projects and is trying to directly help young companies.

I am not trying to be negative about the Canadian programs such as BDC and its efforts, or MARS and its efforts. I think that they stimulate the industry in a general way and help companies to become established.

However, the Canadian model has failed to create a software industry. I believe that Canadian government programs could go a long way to help create a software industry if they would become focused. The general approach of government programs should be to motivate professional, independent fund managers to be successful. The model in Israel speaks for itself. In Israel, we find a mature VC industry with more that 60 Venture Capital firms, weekly exits and a thriving industry. In Canada, we have a struggling VC industry. The reason for the difference is that the Israeli model is focused on creating a software industry and the Canadian model is focused on helping individual companies.

Ten years later, we now see that the Israeli model works and the Canadian model is broken. The Quebec programs have taken the first steps to fix this. Let’s learn from this. Let’s stop spending our tax dollars on real estate and government run programs. Let’s create an industry.

Contrasting the funding of a seed VC startup in Israel and Canada

Coming back to Canada from our trip to Israel, I wanted to highlight some programs that I think could make a huge difference to the Canadian VC market. I am not making these suggestions as criticism of existing or past programs, but rather as a constructive way of trying to help the Canadian VC market catch up with the Israeli VC market.

 

At Brightspark, as one of the only private seed VC funds in Canada, we OFTEN see really interesting ideas presented to us. The challenge we have is to try and select the companies that we think are going to be able to flourish and become successful as a “VC investment”.
 

One problem we often encounter is the very high risk of trying to evaluate extremely early stage technology companies. Sometimes it makes sense to invest in a marketplace with huge potential (meaning where LOTS of money is being spent, such as wireless), and we often do just that. But at other times, we are presented with ideas that need to worked on before we know how successful they can be, and very often we need to turn down these investment opportunities because they are too risky. 

An example case in point: We were presented by a small software company which was creating software to improve productivity in an existing market. The concept was developed by very knowledgeable domain experts, including professors at one of Canada’s leading universities, and recognized leaders in the field. The company was self-funded, along with a few Angel investors, and they had created some prototypes and concepts that “demo’d really well”. Our challenge at Brightspark was trying to evaluate how much better than the existing products would this new product be? We consulted with experts in the field, potential customers, and evaluated competitive existing products. Our eventual conclusion was that the company would need to spend in excess of $1 million dollars to get the product to the point where we would be able to start answering these questions. It would still have “VC-type” risk at the end of that process. As a result, we turned down the investment. We were not willing to invest up to $1m of our investors' monies to get that answer – the risk was simply too high.

In Israel, we met VCs and incubators that are undertaking quite a number of these early trials. How do they do that? They have access to risk capital from the “Incubator Program” and Chief Scientist office. In the above example, the startup would have received two thirds - about $650k in the form of a non-recourse loan which would be matched with $350k from the early stage VC/incubator. These loans are given according to a formula – if the company and VC/incubator meet the formula, they get the loan. 

This is not theory, but linked to REAL examples. I know of many startups that have not been able to be launched in Canada because it was too risky without these types of programs. And, we met a number of later stage startups that grew with these programs.

It’s not hard to set up or to run programs like this in Canada. It just needs the government programs to realize that their role is to stimulate the industry and grow it. And the way to stimulate the industry is not to compete with the private VC professionals but by fostering a healthy private VC driven market like in the US and Israel. The focus for government programs needs to be the creation of a software industry.

VC Industry Lessons

I have recently returned from a 10 day trip to Israel with my partners at Brightspark. We were busy the entire trip with meetings every day including some touring as well. It was a wonderful opportunity to see the Israeli VC industry “in action”. We met with a number of VCs, especially early stage VCs, software companies – early and later stage, angel investors, operating companies, incubators, and investment bankers. We were treated very well, and we learned a lot – now to get rid of the jet lag...
Instead of composing a long blog post, I am composing a few smaller entries with some thoughts and ideas after our travels.

Trying to compare the Canadian and Israeli VC software markets – not much to compare

I have been fortunate to participate in the Israeli and Canadian software industries over the last twenty five years. My first programming jobs were on Data General computers in Israel in the early 80’s when hardware was so expensive that we battled to squeeze business software on to underpowered hardware. Soon thereafter, I came into contact with the software publishing industry when Ontario, Canada led the market (with Atari and Commodore software). By the early 90’s, we had some major software companies in Canada when Delrina, Corel and other led their marketplaces.

Ten years ago, the Canadian and Israeli VC marketplaces were poised to take off from a leveled starting point. The Internet was emerging; both markets had some of the best computer science universities in the world; governments were trying to figure out how to help. When I founded a software company called Balisoft in 1997, we created a software company that had early leading VCs from both countries - Sofinov (CDP) and J.L. Albright from Canada, and Gemini from Israel with government assistance via CIIRDF.

Fast-forward 10 years to 2006. Canada has a VC based software industry that I would describe as quite unhealthy, and the Israeli industry has created huge momentum that seems to be driving an entire economy. The contrasts are amazing. During our trip to Israel, we spent four days traveling from hi-tech area to hi-tech area. We kept saying to each other that we could easily have been in Silicon Valley. And we never even got close to visiting any meaningful proportion of the industry – we mainly visited just the North Tel Aviv Area. We found an industry with more than 60 private VC firms, with exits taking place regularly on a weekly basis, established government programs in place that are driving innovation, and a new presence from the major US VC firms.

Contrast that with the Canadian industry. We seem to have fewer VC’s in existence each year. At the seed and early stage, outside of Quebec we have very, very few funds. It seems to me that the Quebec government is doing something right because they are attracting outside VCs and new activity. But outside of that one glimmer, we seem to have an industry where the best talent moves quickly to the USA, we have very few repeat entrepreneurs, very little momentum in creating success stories; and while we keep hearing about new potential new government programs, there seems to be almost no visible success from these programs.

Sadly for the Canadian software industry, we find that if Israel and Canada were at the same place in the VC industry 10 years ago, we now find Canada very far behind.

We can find excuses and explanations, and there are no simple solutions, but it is interesting to look at what I think are some of the reasons for the difference and what can be done about it. This will be the topic of other blogs posts, but I believe that well focused government programs have been a huge contributing factor to the success of the Israeli industry, and that Canada should learn from this success.

Fortunately, it’s not too late to fix...

Capital Efficiency

There has been lots of talk lately about whether the venture capital model is “broken”. It is quite a complicated question (with no obvious answer) that I will leave to others more adept at statistical analysis than me to try and answer. I have been watching and listening though.

I was at an early stage investor’s conference in the Valley a couple weeks ago where this very question was asked to a panel of well-established, Sand Hill Road-based, VCs. These investors ran the gamut of pure early-stage $150M funds, to $1B+ plus funds who also claim they do early stage. Their answers?  Well, it’s been two weeks of racking my brain and I’m still not sure that what they said makes sense.

Basically they said the model is not broken if you invest properly, and of course, they all invest properly. It must only be the guys at Sevin Rosen funds that are stupid investors I guess!

All sarcasm aside, there were a few very important issues that came up during this panel (and conference) that are worth discussing further. By far, the greatest recurring theme was CAPITAL EFFICIENCY. The tech IPO market is still on life support, and even though the M&A market is strong and providing liquidity opportunities, without a strong IPO market to goose up valuations, the average M&A valuation of less than $50M is a big problem.

Some high-level stats from the U.S. for 2006 YTD:

• $23B paid over 311 M&A deals for an average of $73M per exit, BUT the median exit is actually closer to $25M
• The median amount invested in these 311 companies - $50M
  

For a $250M fund, the math doesn’t work if portfolio companies continue to get funded with $50M when the exits average what they do...something has to change.

Hence, Capital Efficiency. Companies need to do more with less. Not exactly a novel idea here in Canada, but one that VCs in the Valley are (finally) talking about more and more. No more over-funding of companies – this is where the current VC market falls apart and appears broken. Whereas software and internet companies were being funded to the tune of $40-50M prior to an exit, the new reality is that they must be able to reach the same end-game with as little as $10-15M. The popularity of blogs, open source, the continual increase in powerful computing chips provides start-ups with a lot of options to appear much bigger, and move much faster, than previously with less capital.

So, I see two challenges with this new-found approach to the VC market:

1. While you still have less money going into companies, you still have way too many “me too” companies all chasing a limited number of exit opportunities
2. The balance between “Capital Efficiency” and being “Penny Wise, Pound Foolish”.

This second point is especially important, and one that separates the successful companies (and VCs) from those that could be, but aren’t successful. The recurring argument in Canada as to why the VC community has not posted the same positive results as the US is that we don’t fund our companies to reach $1B+ in value and are happy to settle for the $50M exits – not the “go big or go home” attitude.

How to balance this with the new realities of Capital Efficiency will separate the truly successful VCs from the rest of the pack.

Angels and VCs

I have attended a number of early-stage investment conferences over the past month and I've taken note of some common themes and controversial comments that I thought I would share over the coming days. 

The most controversial comment I heard was from a prominent U.S.based angel investor who said during his presentation (and I paraphrase) that “Angels and VCs should never co-invest”. His rationale? The interests between the groups are not aligned. Angels are investing their own money as opposed to VCs who invest the money of other people and institutions. Angels are not interested in or motivated by raising their “next fund” and therefore are much more patient investors, are not motivated by IRR (which has a time to exit aspect to it) but rather cash on cash return. Therefore time is the angel’s most valuable resource and the strategic decisions to be made by the Company are very different.

I personally don’t buy this, and neither do many of the angels I have spoken to, both locally and in the U.S. We at Brightspark have been developing a strong relationship with the angel community because we believe that our vision of early-stage investing is very much aligned with angels, and have co-invested with angels on occasion. Angels investing their own money are motivated by the same end-game as early stage VC funds – creating tremendous value for the shareholders and founders and positioning the company for the appropriate exit at the appropriate time. Angels I have spoken to are not interested in tying up their own money for 10-15 years in a single investment and while I agree that cash on cash returns are important to VCs as well, the time aspect to an exit has an absolute bearing on investment decisions for any investor. A 5x multiple on an exit within 5 years is much more motivating to an angel than a 5x multiple in 15 years. There is always a time value to money. In the latter case, they may as well buy a 15 year bond and there is much less risk.

At a Early stage investing conference in the Valley, there was a whole panel on how angel organizations presently work together with the VC community – and to a man, they all expounded on the importance of bringing the VCs into the process early on.

In my mind, this was one angel trying to motivate the angel community and give them a feeling of self-importance that they don’t need – the VC community already values the important services they provide to the start-up ecosystem.