Four years ago The Review of Federal Support to Research & Development reported that part of the reason for the poor success rate of early-stage tech companies is a lack of venture capital (VC) funds. In response, in 2013 the Feds announced a program to dole out $400 million to boost the VC community over the next seven to 10 years, called the Venture Capital Action Plan.
Now, two years on, Startup Grind Toronto host Michael Cayley is following the money. He is asking local VCs these questions: How have things changed as a result of the plan? If not, why not?
Alex Baker a Relay Ventures partner, was first up. If you missed him… too bad. Cayley will chat with Matt Golden February 26 and Robert Antoniades March 26.
Big respect to Baker. It takes guts to get up in front of people that you know you may have to negotiate with in the future and open your kimono. It takes even more guts to say that opportunities slipped through your fingers. This is the honesty we need on both sides of the table, from founders and financiers, to boost our hit rate on early-stage companies.
Baker noted some positive signs. More funds are forming. There is an uptick in incubator formation and activity. On the other hand, Relay had opportunities to invest in both Waze and Siri, and passed. Baker didn’t elaborate on the rationale. But these are two of the bigger opportunities in mobile, and Relay specializes in mobile. We’re seeing good pitches, but not swinging. Why?
One big assumption behind the FedDev hand out is that bigger funds will lead to bigger exits. Baker noted that three separate funds of $250 million to $350 million each have appeared in the last two years. He suggested that we needed to get to the $1 billion range, common in the U.S.
Size seems important. The U.S. boasts the most billion-dollar funds, the biggest Series A investments, and the biggest exits. The U.S. is to VC what George Steinbrenner was to baseball. The late Yankees owner boasted the biggest payroll. He spent more for top talent and seemed to win more championships than any other owner.
But, consider Israel. It started from zero venture capital in the early 1990s, spawned a large number of small funds and set them into fierce competition with each other for the best ideas and talent. Israel and Ontario’s Golden Horseshoe are very similar in area, population, education, and infrastructure. So the level of the VC Investment should be the same in both areas, right?
Wrong. In 2013 VCs in Israel invested three to four times as much in local early stage companies as Golden Horseshoe VCs did in their territory.
What can we conclude? Size is not the key factor. Size is a symptom, not a cause.
Two other factors are more important.
- Learn-by-doing. Startups are rife with contradiction. For example, for a startup to succeed it must grow exponentially. Yet the early days of some of the biggest successes are marked by go-to market strategies that could not scale. How do you know when to make rules and when to break them? A big part of the know-how can only be learned by doing.
- Competition. It’s fierce in Israel and in the U.S. Look at Y Combinator. Paul Graham created Demo Day to force investors into bidding wars for the equity of Y Combinator companies. Baker’s view that “we’re not in the business of jacking up valuations for founders” is common in the GTA.
We need to focus on different KPIs (key performance indicators). Research shows that companies tend to take root and grow where they land after their Series A round. We need to increase the number of startups that stay in Canada after their A round. This has two attractive knock-on benefits.
It will improve the pool of go-to-market talent. Sorry engineers, sales and marketing gals and guys are as important as you, are hard to produce and are in much shorter supply. Marketing and sales has a larger learn-by-doing component especially in the category we seem to have a knack for: B2B tech for enterprise-scale companies.
Enterprise B2B marketing and sales tends to have a steeper learning curve than other market verticals. The critical learning goes into high gear after the Series A round. So if you have more Series A companies you can attract and hold a higher concentration of marketing and sales talent with the specialized skills we need.
Baker complains that it’s hard to find VP/SVP level product management and marketing talent in Canada, and he’s right. It’s because too few Series A rounds are lead here.
It will deepen the talent pool of VCs. Leading Series A rounds is another learn-by-doing discipline. I don’t underestimate just how tough it is. With the best due diligence in the world, every company that wins Series A financing is better than even odds to fail.
To many people, this sounds like bad stewardship.
But it is the mindset of successful funds in Israel and in the U.S. They know two secrets:
- Early-stage companies that achieve exponential success return more than the value of all of the other companies in the fund, combined.
- Companies starved of cash on exit from an incubator and at the Series A round are far less likely to hit the growth spurt.
Have we embraced this mindset? Baker is among those who believe there is a shortage of cash for investments in early-stage companies from $2 – $5 million. That range includes Series A raises. From a VC’s point of view it’s hard to see why this is bad. They get more equity for less cash. But cash and equity are the oxygen and nutrients early-stage companies need to hit the growth spurt later. Starve them of oxygen and nutrients when they’re just out of the cradle and you stunt growth in the long term.
Bottom line: a $1 billion fund is no guarantee of a large number of exponentially successful companies, without a change in approach. To continue as we are means a future of diminishing returns. That is unacceptable. We need to explore the third way.