The venture capital sector is the financing engine for the technology sector in Canada, and it has been troubled for most of the last decade.
This has severely limited the growth of our technology-based economy, which in turn is vitally needed to drive innovation and productivity.
So what is troubling the venture capital industry? In a word: exits.
The venture investment cycle is, in theory, a simple one. Invest in promising startups, add value to these fast-growing companies over a few years and then exit the investments, either through an IPO or sale to a large strategic partner. Give the profits back to investors or re-invest in new startups. Repeat.
The secret to successful exits during the 40 years that the venture industry has been around in North America has been the strategic valuation. Using conventional financial metrics, a business is valued at a multiple of its earnings. If this method is used to value an early-stage business that’s not yet profitable but has consumed a lot of development investment, the outcome on a sale is a loss for its shareholders.
There are classic examples of strategic valuations. Some worked and some didn’t in hindsight, but strategic valuations were nevertheless paid, creating great returns for shareholders.
Broadcom paid US$280 million in stock in 1999 for Hothaus, a B.C.-based startup in the digital signal processing space, to block its competitors from acquiring this strategic technology for the telephony sector. Broadcom’s share price subsequently tripled, improving returns for Hothaus shareholders.
McKesson paid US$340 million in cash for B.C.-based A.L.I. Technologies in 2002, or about nine times revenue. McKesson, the health information products and services giant, wanted A.L.I.’s top-ranked image management business.
eBay paid $2.6 billion for Skype in 2005 to help eBay move into new business areas. Five years later, in the first six months of 2010, Skype generated just $13.1 million in earnings. It’s now planning an IPO.
The past decade has been difficult. First, the bursting of the Internet bubble in 2000 created massive damage. That was followed by 2007’s crude oil bubble and 2008’s worldwide financial meltdown. The investment world has been pummelled, and previously successful investment formulas aren’t trusted any more. Even top hedge funds got hammered.
Because of this lack of trust in what to do, many investors are paralyzed in a holding pattern. There is a record percentage of cash parked on the sidelines in individual and institutional accounts and in corporate treasuries. Investors don’t like most equities – especially new equities (except mining) and don’t like minuscule fixed-income product returns. They don’t like real estate, don’t like derivatives and don’t like technology plays. Stock exchange trading volumes are going through the roof everywhere, but much of this is not real long-term buying. It’s high-frequency electronic gaming designed to shave some easy profit out of the price spreads. Large-cap corporations have lots of cash and can’t figure out where to invest it.
Looking at the state of the markets over the past decade, many observers are saying that the venture capital model and the high-value strategic exit are dead. I don’t share this view.
There has never been a time when innovation and productivity improvement – mostly created by technology – is more vital to North America. As economic competition from China, India, Brazil, Vietnam and other countries increases, the standard of living in the U.S. and Canada can only be maintained by technological leadership. And where technological leadership is recognized again, strategic valuations will come back again.
And when strategic valuations are paid again, venture capital investors will profit. New innovations will be funded, and tomorrow’s technologies will be developed. The venture capital cycle will be repaired.
