Learning to love risk

Deirdre McMurdy February 14 2000

Learning to love risk

Deirdre McMurdy February 14 2000

Learning to love risk

Deirdre McMurdy

These days, breathless media accounts of the latest hightech success story seem almost commonplace. Recently, those tales have been supplemented by reports of Internet “incubators,” angel investors and other groups formed to finance the next wave of Wunderkinder.

Last month, Mosaic Venture Partners made headlines with a 1,328-per-cent return on its 14-month investment in a startup search-engine software firm called Direct Hit. MM Venture Partners of Montreal announced a $3-million financing of e-commerce company Logibro. And the Royal Bank of Canada and Toronto Dominion Bank are both forming new lending divisions to back junior high-growth companies. On Jan. 18, Michael Bregman, better known as chairman of the Second Cup coffee-shop chain, announced the launch of a $ 130-million Internet investment fund called XDL Intervest Capital Corp., and was due this week to name Bob Young, cofounder of high-flying Linux marketer Red Hat Software, as an investor. That initiative mirrored other recendy formed “incubators” such as EcomPark and Brightspark.

Despite perennial griping about its inadequacy, venture capital has unquestionably become hot. In the United States, an estimated $60 billion was spent last year by investors anxious to get in on the ground floor of The Next Big Thing.com. Although the size of the Canadian market lags behind the U.S. significantly, it’s estimated that there is now $10 billion in venture capital under management and that about $2 billion in new funds were invested here last year.

For Mary Macdonald, the sudden surge of interest in venture capital is gratifying—and amusing. Affer 16 years in the trenches, she’s become an overnight success. Her research firm, Macdonald & Associates, gathers and sells venturecapital market data to investors. “It’s weird and exciting that the business has suddenly become so trendy,” she says. “We’ve been quietly turning the sod since 1984.”

That’s the year Macdonald left a management consulting job with Currie, Coopers & Lybrand and formed her own company. Her first major contract was from an Ontario government agency, IDEA Corp., which wanted her to complete a study on pension funds and venture capitalization. “I had no notion what venture capital really was,” Macdonald admits. “But I found out fast.”

What she discovered was that in the 1980s, pension funds were the main wellspring for the venture-capital funds investing in small, start-up companies. Rather than high technology—which was regarded with deep suspicion and nominal understanding—most ventures were in traditional areas like manufacturing.

After the meltdown of financial markets in October, 1987,

most of that pension money dried up. Given minimal returns, pension funds avoided the venture-capital sector. Between 1987 and 1997, according to Macdonald, their largest annual investment in venture capital in Canada was $100 million. For the most part, any deals done were conducted through labour-sponsored funds, which were encouraged by generous government tax breaks for investors.

Macdonald says the recent resurgence in venture capitalization is accompanied by some profound changes. “We’re now dealing with second-generation venture capitalists who understand they have to do more than contribute money: they have to add value in various other ways,” she observes. These can range from offering management expertise to finding synergies with other entrepreneurs. “There’s also,” she adds, “a second generation of entrepreneurs that understand the game better as well.”

Macdonald says the development of start-up “clusters”— in areas like Waterloo and Ottawa, as well as Toronto, Vancouver and Montreal—helps the cross-fertilization process between companies and their backers. She also notes that Canadians have become less risk-averse in their approach to junior companies, and more competitive also.

One advantage Canadian venture capitalists have, according to Macdonald, is that they are much smaller in size than their American counterparts. That allows them to invest earlier, to make a bigger difference—and a bigger profit. While the average Canadian investment is $2 million, it is $12 million south of the border. “It’s uneconomic for U.S. capital pools to administer any smaller amount,” Macdonald says. “But that’s a barrier to really early-stage players.”

Still, she warns that two in every 10 ventures fail in that early stage. She also says the Canadian market is hampered by the absence of “gatekeepers.” In the United States, these are the professional managers who assemble and monitor investments in venture-capital portfolios on behalf of large pension funds and other major investors. “Without that structural layer, it’s just easier for Canadians to load up on more Nortel shares,” she observes.

And while many critics complain that Canada does too little to nurture high-tech talent, Macdonald’s experience provides a brighter perspective. Five years ago, when she launched her semi-annual financing conferences, where entrepreneurs pitch potential backers, she says she couldn’t even find a slate of 12 strong start-ups. Last June, she chose 38 from about 100 applicants. Those sessions have resulted in several new partnerships, like Siemens’s recent multimillion-dollar investment in Hyperchip of Montreal. When it comes to high-tech bonanzas, there’s a simple lesson: nothing ventured, nothing gained.