department of economic and rural development and...

Department of Economic and Rural Development and Tourism

Government of Nova Scotia

Fuelling Entrepreneurship & Innovation:

A Review of the Nova Scotia Government’s

Role in Venture Capital Provision

Gilles Duruflé, Ph.D., CFA

Final issue date: June 2014

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Table of Contents

Introduction .......................................................................................................................... 4 Context and mandate ................................................................................................................... 4 Content of the report .................................................................................................................... 4

The benefits of venture capital and the case for government intervention .............................. 5 Innovation, start-ups and venture capital .................................................................................... 5 Venture capital key success factors .............................................................................................. 6 The case for government intervention and its pitfalls .................................................................. 7

Current trends in government support to the financing of tech start-ups across Canada and in other jurisdictions .................................................................................................................. 8

Overall survey of OECD countries ................................................................................................. 8 A trend toward indirect and arm’s-length interventions ............................................................. 9 A trend toward less-stringent investment constraints, notably geographical constraints ........11 The increasing recognition of the role of business angels..........................................................12 The growing importance of accelerators, new models for seed funding linked to accelerators and crowdfunding .......................................................................................................................12

Classification of the various forms of government support in Nova Scotia ............................. 14 Provincial programs ....................................................................................................................16

Grants and subsidies ............................................................................................................16 Tax credits ............................................................................................................................17 Allocation for investment ....................................................................................................17

Federal programs ........................................................................................................................18

The Nova Scotia ecology for technology start-ups – Interview results .................................... 19 The importance of the ecology ...................................................................................................19 Statistical comparison with other Atlantic provinces and Canada .............................................20 Data on venture capital provision in Nova Scotia .......................................................................21 The Nova Scotia ecology: interview results ................................................................................25

R&D funding and commercialization of research ...................................................................25 Deal flow and entrepreneurs ..................................................................................................25 Services to entrepreneurs .......................................................................................................27

Accelerators and industry events ........................................................................................27 Innovacorp incubators .........................................................................................................28 Provincial Trade Development Services ..............................................................................29

Business angels........................................................................................................................29 Financing: where is the gap? ...................................................................................................30 Government financing tools ....................................................................................................32

Digital Media Tax Credit ......................................................................................................32 Equity Tax Credit ..................................................................................................................32 LSVCC Tax Credit ..................................................................................................................33

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Innovacorp Venture Capital Investment .............................................................................33 NSBI Venture Capital Investment ........................................................................................34 Build Ventures .....................................................................................................................35

Conclusions and recommendations ...................................................................................... 36 Universities and commercialization of research.........................................................................38 Service to entrepreneurs ............................................................................................................38

Support the design and implementation of a sustainable business plan for Volta Labs/Propel ICT ............................................................................................................................................38 Enhance and change Innovacorp incubator programs and make them more effective ........39 Adapt provincial trade development services to meet the specific needs of tech start-up entrepreneurs .........................................................................................................................39

Support to business angel networks ...........................................................................................39 Tax credits ...................................................................................................................................40

Digital Media Tax Credit ..........................................................................................................40 Equity Tax Credit .....................................................................................................................40

Provision of venture capital ........................................................................................................42 NSBI Venture Capital ...............................................................................................................42 Innovacorp Venture Capital ....................................................................................................42

Leadership of the business community, including its tech dimension .......................................46

Summary of recommendations ............................................................................................ 48

Annex 1 ............................................................................................................................... 50 What is venture capital investment? ..........................................................................................50 How venture capital funds work .................................................................................................52

Fundraising ..............................................................................................................................52 Investing and creating value: the blueprint ............................................................................53 Exiting and distributing returns ...............................................................................................54

Annex 2: List of people interviewed ...................................................................................... 55

About the author ................................................................................................................. 56

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INTRODUCTION

Context and mandate

The recent report published by the Ivany Commission identifies a strategic priority on business start-ups and growth-oriented businesses as a game changer for Nova Scotia. In many ways, that is what this report is about. The report has a particular focus on fuelling entrepreneurship and innovation in start-ups and growth-oriented enterprises in the technology sectors (e.g., information and communications technology, digital media, biotechnology, ocean technology, and clean technology).

As stated in the terms of reference: “Along with many other countries and sub-national regions, Canada’s federal government and provinces are concerned with how best to manage their venture capital, angel investment, and R&D financing roles and initiatives. Canada’s governments invest significantly in Canadian start-ups. As in other jurisdictions, challenges relating to governance have emerged over the years. Often, these challenges are centred on finding clarity of mandate and purpose, defining the relationship with client companies and the role of directors.”

Consequently, the Province of Nova Scotia wishes to review its role in the venture capital industry and identify how best to support the current and future needs of tech companies and high-potential start-ups in key sectors.

For this purpose, the Nova Scotia Department of Economic and Rural Development and Tourism (ERDT) has contracted the consultant with the following mandate:

Part 1. Classification of the various forms of government support in Nova Scotia

Part 2. Current trends across Canada and in other jurisdictions

Part 3. Recommendations to improve investment decision making and implementation

Content of the report

The report is organized in the following way:

Chapter 2 will recall (i) the main characteristics of venture capital, its potential benefits for the economy and conditions for success, and (ii) the case for government intervention in this area as well as the many pitfalls governments have to avoid for this intervention to bear positive results.

Chapter 3 will review the current trends in government support to the financing of tech start-ups across Canada and in other jurisdictions.

Chapter 4 will present a review and classification of the various forms of provincial and federal government support to the tech start-up ecosystem in Nova Scotia.

Venture Capital does not operate in a vacuum. It is just one part of the ecosystem that allows for the development of start-ups in the tech sector. It cannot succeed in isolation. Chapter 5 will review this ecosystem, its strengths and its weaknesses.

Finally, Chapter 6 will present the conclusions and recommendations.

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In order to perform this mandate, the consultant gathered information on the various forms of financing support to the tech start-up ecosystem in Nova Scotia and met in person or by phone with more than 50 senior representatives from universities, government agencies, business angels, incubators and accelerators, venture capital funds and entrepreneurs in Nova Scotia and outside the province. The listing of people interviewed is to be found in Annex 2. The consultant would like to thank all the people he met for their time and insights, and the ERDT team for their support in the completion of this mandate.

THE BENEFITS OF VENTURE CAPITAL AND THE CASE FOR GOVERNMENT INTERVENTION

Innovation, start-ups and venture capital

Innovation is the main driver of productivity gains and economic growth.1 Many economists, including Nobel Prize winner Robert Solow, have demonstrated that up to 85% of economic growth in modern economies cannot be attributed to growth of inputs (capital and labour) but rather is linked to productivity growth and innovation.2

While large corporations were once mainly responsible for innovation, young, innovative start-ups – with their greater agility and flexibility – are playing an increasingly important role in the development of new products, business models and markets.3 Reviewing academic research on company size and innovation, Josh Lerner concludes: “… one of the few things that researchers can agree on is the critical role played by new companies, or entrants in many industries. The role of start-ups in emerging industries has been highlighted not only in many case studies, but also in systematic research. For instance, a study by Zoltan Acs and David Audretsch examined companies which developed some of the most important innovations of the twentieth century. They documented the central contribution of new and small companies: these companies contributed almost half of the innovations they examined.”4

Because of its unique capacity to marshal money, entrepreneurial spirit, expertise and networks, venture capital (VC) is the tool of choice for financing new and innovative companies. “Recent studies have also highlighted a distinctive innovation advantage of some entrepreneurs: VC support. Considerable evidence shows that venture capitalists play an important role in encouraging innovation. This VC support is all the more needed considering that the kinds of companies that they finance – whether young start-ups hungry for capital or growing companies that need to restructure – impose risks and uncertainties that discourage other investors.”5

Research conducted in a mature environment such as the US shows that venture capital has a strong impact on R&D spending, the performance of companies it supports and, in the long run, a very significant impact on employment: in 2011, in the US, companies that had received

1 For a discussion of the link between innovation, productivity gains and economic growth, see Jenkins report, Innovation Canada: a Call to Action, Chapter 2. 2Josh Lerner, Harvard Business School and National Bureau of Economic Research, Alberta Venture Capital Review, February 2007, pp. 9–11. 3 Josh Lerner, The Architecture of Innovation – The Economics of Creative Organizations, Harvard Business Review Press, 2012, Chapter 3, “The Changing Face of Corporate R&D.” 4 Lerner, Boulevard of Broken Dreams – Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed – and What to Do about It, Princeton University Press, 2009, Chapter 3: “Why Should Policymakers Care?” p. 47. 5 Ibid, p. 50.

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venture capital in their early days employed 11.9 million people – that is, 11% of private sector employment – and generated revenue equal to 21% of US GDP.6

The Canadian venture capital industry is much younger. However, its economic impact on the Canadian economy – employment, growth, innovation and exports – is already significant, and venture-backed companies do outperform comparable companies by a wide margin, as highlighted by the main results of the economic impact studies conducted in 2009 and 2013.7

Venture capital key success factors

In Annex 1, the reader will find detailed explanations on what venture capital investment is and how venture capital funds work and add value to their investments.

To summarize, suffice it to say that technology venture capital is important because it is a unique tool to

finance technology start-ups at a stage where they would not be financed by traditional sources of financing such as commercial and investment banks and public markets

add value to these investments, especially at an early stage, by providing strategic advice and operational support and helping link them to much-needed management resources, strategic customers, investors for follow-on rounds and potential exits

However, building a successful venture capital industry is not an easy task and the following success factors, or characteristics of the industry are worth underlining:

Venture capital is a very specialized profession, and the success of VC funds in building successful companies and generating good returns is highly dependent on the experience as well as the industry and operational knowledge of their managers and the depth of their networks.8 Venture capital is not essentially about money but “smart money”; that is, capital plus expertise. For financial investors looking for good returns as well as for government investors looking to building a strong venture capital ecosystem, the selection of managers is a very important step.

Venture capital is not a question of volume. Venture capital funds are very selective, make only a small number of investments and try to concentrate on winners. However, big winners can have a very strong positive effect on the economy, becoming large

6 National Venture Capital Association, Venture Impact – The Economic Importance of Venture Capital Backed

Companies to the US Economy, 6th ed., Global Insight, 2011.

7 The Performance of Canadian Firms that Received Venture Capital Financing, Industry Canada, CVCA, June 2013;

Why Venture Capital is Essential to the Canadian Economy – The Impact of Venture Capital on the Canadian Economy, CVCA, 2009.

8 This very important point is widely supported by an analysis of the managers’ profile of successful VC funds (see

Gilles Duruflé, The Drivers of Canadian VC Performance, CVCA, 2006) and by academic research: Paul Gompers, Anna Kovner, Josh Lerner, and David Scharfstein, Skill vs. Luck in Entrepreneurship and Venture Capital: Evidence from Serial Entrepreneurs, July 2006; and Paul Gompers, Anna Kovner, Josh Lerner, and David Scharfstein, Specialization and Success: Evidence from Venture Capital, February 18, 2006.

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successful companies, generating wealth and building talent pools that can be reinvested in the economy. These successes also contribute to attracting new entrepreneurs and investors.9

In order to diversify risk, build larger rounds and link with more expertise and networks, venture capital funds invest in syndicates (i.e., groups of investors). Successful VC funds look to invest with “like-minded investors,” which means that if a local VC fund wants to attract in its investments good co-investors, it has to have the same return objectives, similar types of expertise and the capacity to participate in following rounds with its co-investors.

Building a healthy venture capital ecosystem is a long-term endeavour that can take decades. It requires patience, continuity and consistency.

The case for government intervention and its pitfalls10

The case for government intervention to support the venture capital industry is well documented in Josh Lerner’s book Boulevard of Broken Dreams – Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed and What to Do about It.11 In a nutshell, it makes the following arguments:

Venture capital has strong positive effects on innovation, wealth creation, economic growth and employment.

The financing of technology start-ups is subject to strong positive externalities: economic return for the whole economy may be superior to the financial return for venture capital funds. Therefore, without government support, the level of VC investment may be suboptimal.

The building of a sustainable technology start-up ecosystem is the result of a virtuous circle with cumulative effects (it is easier to start the 100th start-up in a given place than the 1st one). Therefore, there is a case for government intervention to “start the wheel.”

If there is a case for government intervention to support the venture capital industry, there are also many pitfalls in the design and implementation of support programs, as highlighted by the subtitle of Lerner’s book: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed and What to Do about It.

Venture Capital policy failures occur under two main categories:12

9 See for instance the positive effect of recent successes such as Radian 6 and Q1 Lab, which suddenly draw a lot of

attention to New Brunswick and Atlantic Canada.

10 This whole paragraph draws on the following source: Gilles Duruflé, Government involvement in the venture capital

industry, International comparisons, CVCA, July 2010.

11 Chapter 3: “Why Should Policy Makers Care?”

12 Chapter 4: “Things Get More Complicated.”

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Ill-designed programs, which do not adapt properly to the characteristics of the economic environment or how markets work, and which underestimate risks. This often results in conflicting and counterproductive sets of objectives and constraints and lack of proper skills to implement the programs.

Regulatory capture, which describes situations where “entities, whether part of government or industry, will organize to capture the direct and indirect subsidies that the public sector hands out.”13

The interesting point is that governments are more and more aware of these pitfalls, and the trends listed below reflect attempts by governments to design new programs that would avoid these drawbacks.

CURRENT TRENDS IN GOVERNMENT SUPPORT TO THE FINANCING OF TECH START-UPS ACROSS CANADA

AND IN OTHER JURISDICTIONS

Overall survey of OECD countries

A recent OECD study surveyed member countries on their policies to support seed and early-stage financing for SMEs. Table 1 analyzes the various financing instruments available in these countries by broad categories.

Table 1: Financing instruments (32 out of 34 OECD member countries responding)

Type of Instrument Number of OECD

Countries

Change in Support (last 5

years)

Grants, Loans and

Guarantees

30 Increased in 25 countries

Tax: YIC 9 New in 3 countries

Tax Incentives: Front-end 15 Increased or new in 9 countries

Tax Incentives: Back-end 12 Unchanged in most

Equity Funds: Public 14 Increased in 7 and new in 3

countries

Equity: Fund of Funds 21 Increased in 8 and new in 8

countries

Equity Funds: Co-

Investment

21 Increased in 11 and new in 6

countries

Source: K. Wilson and F. Silva (2013), “Policies for Seed and Early Stage Finance: Findings from the 2012 OECD Financing Questionnaire,” OECD Science, Technology and Industry Policy Papers, No. 9, OECD Publishing.

14

13 Ibid., p. 80.

14 This study only surveyed programs at the national level, not at the sub-national level (provinces or states).

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Grants, loans and guarantees are the most common financing instruments, followed by equity financing (government direct investment funds – called here public equity funds, funds of funds and co-investment funds), and finally tax incentives: front end (tax credits to investors when they invest), back end (rebates on capital gain tax, roll over provisions) and Young Innovative Companies programs (tax relief and reduction in social charges for young tech companies).

Partly due to the contraction of private sources of capital after the 2008 crisis, the number of equity instruments (supply of capital) increased over the 2007–2012 period (table 2). Among these equity instruments, government direct investment funds have stalled or decreased, and funds of funds and co-investments funds have soared.

Table 2: Number of tax and equity instruments (2007–2012)

Based on this OECD survey, on direct analysis of trends in most advanced OECD countries (US, UK, Canada, France, Australia, New Zealand) and on discussions with industry leaders from these countries through the Public Policy Forum on Venture Capital and Innovation (PPF), the following trends can be highlighted.

A trend toward indirect and arm’s-length interventions

Over the last decade, government direct investment funds have been highly criticized for the following reasons: confusing objectives (economic development vs. financial returns), counterproductive geographical constraints, inability, for compensation reasons, to attract

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experienced managers, wrong set of incentives (short-term volume vs. long-term performance), inadequate decision processes (multi-level, cumbersome and too long) and, sometimes, governance issues (political interference).

For all these reasons, it appears that (i) government direct investment funds are usually not considered by experienced private sector VC managers as “like-minded investors” and co-investors of choice; (ii) they do not attract the best entrepreneurs when they have a choice; (iii) they add only limited value to their investments; (iv) their overall performance is inferior to private sector funds – enterprises supported by government direct investment funds appear to perform more poorly than otherwise equivalent enterprises supported by private VC funds; and (v) positive externalities such as impact on innovation seem to be limited.15

These criticisms do not apply in the same way to all situations, and in spite of their limitations, government direct investment funds may still play an important role to kick-start the ecosystem.16 However, commenting on these types of funds, the OECD concludes: “The rationale behind many of these programmes has been to facilitate the development of a venture capital within the country. A number of these have had a regional focus. Many early efforts to support venture capital followed this approach, however, for the most part, the results have not been positive. Issues such as crowding out, lack of proper incentives, lack of skills and experience to invest often prevented these funds from achieving their goals.”

Faced with these conclusions, many governments chose to shift from direct investment to indirect investment either through government funds of funds or independently managed funds of funds, with the objective of supporting the development of a sustainable private sector VC industry able to attract experienced managers and implement best practices.

This was the case in the UK through Capital for Enterprise (government fund of funds) and the UK Innovation Investment Fund (independently managed funds of funds), in Europe (European Investment Fund, government fund of funds), in New Zealand (NZ Investment Fund, government fund of funds) and in Australia (Innovation Investment Fund, government fund of funds).

In Canada, this has also been the trend at the federal and provincial level.

At the federal level:

Following an in-depth strategic review, Business Development Canada (BDC) decided (i) to restructure its direct investment activity around three private-sector-like, sector-focused direct investment funds, with the objective to spin them off, and (ii) to reinforce its fund of funds activity (government fund of funds).

The recent VCAP program aims at developing four national funds of funds managed by independent private sector teams.

At the provincial level:

British Columbia has created BC Renaissance (government fund of funds).

15 James Brander, Edward Egan, and Thomas Hellmann, Government Sponsored versus Private Venture Capital:

Canadian Evidence, NBER, May 2008.

16 Ibid., pp. 42–43.

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Alberta has created Alberta Enterprise Corporation (government fund of funds), and AVAC has developed a fund of funds activity.

Ontario has supported the development of the Ontario Venture Capital Fund, a privately managed fund of funds (managed by NorthLeaf).

Quebec has terminated its direct investment funds (Innovatech, SGF) and supported the development of Teralys, an arm’s-length fund of funds. In addition, for VC deals, Quebec LSVCCs have shifted from direct to indirect investment and co-investment.17

The Atlantic region has set up Build Ventures, a government-supported, private, independent VC fund.

A trend toward less-stringent investment constraints, notably geographical constraints

Several evaluation studies have shown that ill-designed and conflicting investment constraints suitable to economic development purposes (size of investments, sector, geographical constraints or volume to be invested in a given period of time) may have very adverse effects on returns and on alignment of interests with potential private sector co-investors.18 In particular, geographical constraints may have a negative effect on returns, as they reduce the available deal flow, and, more importantly for an economic development perspective, they limit the ability to work with experienced outside investors and attract them to local investments. As a consequence, there is now a growing consensus that government schemes should work with the market, not against it, and that investment objectives and constraints that come with a government investment program should be designed accordingly.

In Canada, funds of funds such as BC Renaissance, the Ontario Venture Capital Fund (OVCF) and Teralys in Quebec have progressively loosened the geographical constraints they impose on funds in which they invest. The VCAP program excludes intra-Canadian geographical constraint and only imposes minimal constraints regarding investments in Canada: 80% of VC funds in which the funds of funds invest have to have a meaningful presence in Canada, and in aggregate one-third of capital (which is the government share in the funds of funds) has to be invested in Canadian firms. The objective is to attract private sector investors in these funds of funds that will invest in best Canadian and foreign VC funds that have an interest in the Canadian deal flow and will be able to generate superior financial returns and be the basis for a sustainable VC industry in Canada.19

In other parts of the world, countries are developing new schemes to get around national geographical constraints and support cross-border investment. For instance, the New Zealand Investment Fund and the Taiwan National Development Fund have signed an agreement that will allow them both to support VC funds that will invest in both countries.

17 Gilles Duruflé, “Venture Capital – Quebec gets ahead of the game,” Policy Options, November 2012, IRPP.

http://archive.irpp.org/po/archive/nov12/durufle.pdf

18 See for instance in the UK: Venture Capital Support to Small Businesses, Report by the Comptroller and Auditor

General, December 2009.

19 The government recognized that this is not easy. This is why it is providing financial incentives at the funds of funds

level to private sector LPs.

http://archive.irpp.org/po/archive/nov12/durufle.pdf

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The increasing recognition of the role of business angels

There is an increasing recognition, supported by studies in the US and the UK and by the OECD,20 that business angels play a very important and growing role in the ecosystem, as they provide not only funding (it is now recognized that the business angel market is similar in size to the VC market) but also experience, credibility, contacts and connections that improve the flow of high-quality firms available to the VC sector.21

In many jurisdictions, this has resulted in government policies to support business angels’ investment:

Front-end tax credits: UK EIS and SEIS, British Columbia, many US states, France. Some of these tax credits are refundable, which makes them eligible to non-residents who do not pay taxes locally and helps attract investment from outside the jurisdiction: Minnesota.

Back-end tax incentives and rollover provisions: US.

Co-investment funds: Scotland, New Zealand, UK, European Investment Fund with a pilot program in Germany, Quebec and Ontario. Usually, individual business angels or business angel networks have to be accredited by the fund. Some of these funds are discretionary (there is a manager that makes an investment decision based on a predetermined set of criteria). Others are non-discretionary: once angels have been accredited, the fund co-invests automatically with them on a fixed pro rata basis.

Investments in business angel funds (Capital for Enterprise funds in the UK, Technology Seed Funds in Quebec22).

The growing importance of accelerators, new models for seed funding linked to accelerators and crowdfunding

Powerful trends are reshaping the environment and the financing chain for entrepreneurship and start-ups in a growing number of tech sectors: the digitization of the economy (“software is eating the world”), the ubiquity of the web and social media, open source, cloud computing, etc. These trends translate into a phenomenal decrease in capital requirements for designing and launching products and companies and are accompanied by a surge in the power of online sharing of information, knowledge and now finance through crowdsourcing and crowdfunding.

20 Financing High-Growth Firms: The Role of Angel Investors, OECD, 2011.

R. Wiltbank, Siding with the Angels: Business angel investing – promising outcomes and effective strategies, BBAA and NESTA, London, May 2009.

Yannis Pierrakis and Colin Mason, Shifting sands: – The changing nature of the early stage venture capital market in the UK, NESTA, September 2008.

Marianne Hudson, Ewing Marion Kauffman Foundation, Why Entrepreneurs Need Angels – and How Angels are Improving, Kauffman Thoughtbook, 2005.

21 William Kerr, Josh Lerner, and Antoinette Schoar, The Consequences of Entrepreneurial, Finance: Evidence from

Angel Financings, 2011.

22 Enterprise Capital Funds in the UK or the Quebec Technology Seed funds are not targeted exclusively to business

angels. However they have been designed to attract business angels among potential investors in the funds.

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New models have emerged, mainly in the US, to take advantage of these new trends: lean start-ups, accelerators, new models for seed funding linked to accelerators, matching and crowdfunding platforms including donations and rewards, lending and now equity.

The rapid expansion of these new models is already bringing significant changes to the emergence and training of entrepreneurs (leading accelerator managers see accelerators as the next generation of business schools), the building of entrepreneurial communities, the financing chain for tech start-ups and the ways in which entrepreneurial ecosystems are being developed and can be supported by public policies.

In Canada, BDC has set up a special group called Strategic Investments and Initiatives, which “currently focuses on strategic investments, fosters entrepreneurial development, encourages global connectivity for tech entrepreneurs, and acts as a VC industry facilitator.”23 This group provides direct financial support to accelerators, has invested in funds linked to accelerators and has set up a convertible note program to invest in leading companies that come out of accelerator programs.

The federal government has also launched the Canada Accelerator and Incubator Program (CAIP), designed to support accelerators and incubators.

In the UK, tax credit programs such as EIS and SEIS are used extensively by business angels and seed funds that gravitate around accelerators and fund part of their cohorts.

Governments increasingly see crowdfunding as an additional way of mobilizing capital for small-business entrepreneurs. When the UK government established a £100 million co-investment fund for small-business loans, it launched a Request for Proposals (RFP). Two peer-to-peer lending crowdfunding platforms focusing on SMEs, including Funding Circle, were selected and have proven to be very effective toward increasing the range of options available for SME financing. Local councils and universities also contribute to Funding Circle. Government support has had a significant impact, as it has boosted the visibility and credibility of these platforms. While this entails risk for the government, default rates have remained low so far.24

23 http://www.bdc.ca/EN/solutions/venture_capital/strategic_approach/Pages/strategic_investments_initiatives.aspx

24 Source: The Quebec City Conference 2013, Main Conclusions: 2013 Public Policy Forum on Venture Capital and

Innovation.

http://www.bdc.ca/EN/solutions/venture_capital/strategic_approach/Pages/strategic_investments_initiatives.aspx

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CLASSIFICATION OF THE VARIOUS FORMS OF GOVERNMENT SUPPORT IN NOVA SCOTIA

The various forms of government support have been classified:25

Grants and subsidies

To universities/companies for the development of entrepreneurship and tech transfer

To companies for R&D, proof of concept and commercialization

Subsidized services to companies for investment readiness

Tax credits

To companies for R&D and commercialization

To individuals for investment in VC funds

To business angels for investment in companies

Other Fiscal measures

Rebates on capital gains tax

Rollover provisions

Loans at preferred conditions

Allocation for investment

Direct investment funds

Co-investment funds

Indirect investment: government investment in funds on a case-by-case basis and government funds of funds

Government investment in funds of funds managed by third parties

Table 3 presents provincial and federal programs available in Nova Scotia according to this classification.

25 Source of classification: Gilles Duruflé, Government involvement in the venture capital industry – International

comparisons, CVCA, 2010.

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Table 3: Government programs to support the tech start-up ecosystem in Nova Scotia

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Provincial programs

Grants and subsidies

To universities/companies for the development of entrepreneurship and tech transfer

The Early Stage Commercialization Fund (ESCF) managed by Innovacorp provides grants up to $50,000 to university and college researchers to demonstrate the commercialization potential of their research. Two competitions are organized every year. Four to six projects are selected at the end of each competition. A separate allocation of about $200,000 per year is dedicated to cleantech projects.

The Product and Innovation Voucher Program is managed by ERDT. It is targeted at projects to improve productivity and jumpstart innovation for a maximum of $15,000 per project. This program has a broader scope than just tech start-ups.

The new Sandbox program aims at creating environments in universities and community colleges where students, innovators and industry can experiment with new ideas that could become businesses.

To companies for R&D, proof of concept and commercialization

Innovacorp holds the I3 Technology Start-Up Competition every two years. Two winners in each of five zones receive awards of $100,000 and $40,000, respectively.

Subsidized services to companies for investment readiness

Innovacorp runs two incubators: the Technology Innovation Centre in Dartmouth, which targets companies in information technology, advanced engineering and a variety of other sectors, and the Innovacorp Enterprise Centre in Halifax, which focuses on companies in the life sciences and clean technology industries. Incubation services are provided at market prices.

Innovacorp supports many events and conferences for entrepreneurs to build the ecosystem and ERDT provides some financial support to the new generation of accelerators (Volta Labs).

Provincial departments and agencies provide trade services (trade missions, trade shows, etc.) to Nova Scotia businesses to support entry into export markets. These services are also available to tech start-ups.

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Tax credits

To companies for R&D and commercialization

Two types of tax credits are specifically targeted at tech companies:

The Nova Scotia Research and Development Tax Credit (the provincial SR&ED). Total credit in 2012 was $21.9 million. This tax credit is available to small and large companies.

The Digital Media Tax Credit that is available to corporations developing an interactive digital media product. Total credit in 2012 was $5.3 million.

To individuals for investment in VC funds

Individual investors in LSVCCs receive a 20% tax credit. Total credit in 2012 was $48,000. It is matched by a 15% federal tax credit, which is going to be progressively phased out.

To business angels for investment in companies

Angel investors investing in eligible businesses receive a 35% tax credit for a maximum annual tax credit of $17,500. Total credit in 2012 was $7.8 million. Tech start-ups represent only a small part of investments that benefit from the Equity Tax Credit.

Other Fiscal measures

There are no measures such as rebates on capital gain tax or rollover provisions in Nova Scotia.

Loans at preferred conditions

There are no provincial programs that provide loans to tech start-ups.

Allocation for investment

Direct investment funds

The Province of Nova Scotia has two organizations that provide direct venture capital investment: Innovacorp and NSBI.

Innovacorp manages the Nova Scotia First Fund. This fund targets emerging venture-grade technology companies with high growth potential and attractive risk-return prospects. Over the 2011–2013 period, it invested on average $4.7 million per year in Nova Scotia companies.

NSBI is a mid- to late-stage investor that provides growth capital to companies in tech sectors: information and communications technology (ICT); defense, security and aerospace; energy; advances manufacturing; and life sciences. Over the 2008–09 to 2012–13 period, it invested on average $7.4 million per year.

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Indirect investment:

The Government of Nova Scotia, through Innovacorp, committed $15 million to Build Ventures, a regional early-stage venture capital fund.

Federal programs

Federal programs that support the tech entrepreneurial ecosystem in Nova Scotia originate from ACOA, IRAP/NSERC, BDC and Export Development Canada (EDC). In addition, Nova Scotia companies are eligible for the SR&ED tax credit, and Nova Scotia LSVCCs are eligible for the federal LSVCC tax credit. Finally, Nova Scotia accelerators may benefit from the CAIP program, whose funding decisions are to be announced soon. It should be emphasized that these programs are either national (BDC, tax credits, CAIP) or regional (ACOA, IRAP). None of them is specific to Nova Scotia.

Federal programs are the main source of non-dilutive money for the following:

University commercialization of research projects through ACOA Atlantic Innovation Fund (AIF) for non-commercial projects (grants)

Early-stage tech companies (R&D, proof of concept, early commercialization) through o IRAP (non-repayable contributions) o ACOA productivity and business skills (grants) o SR&ED (tax credits) o ACOA AIF commercial and Business Development Program (BDP) (non-interest-

bearing loans provisionally repayable)

Accelerators and entrepreneurial events: o ACOA (through BDP) o BDC support to Propel ICT; this accelerator is based in New Brunswick but 26%

of companies that have participated to date originated from Nova Scotia o Potentially the federal CAIP

As a source of venture capital:

BDC Venture Capital (government direct investment funds) is active across Canada. However, its investment activities in Nova Scotia have slowed down recently (see table 4).

BDC and EDC invested in Build Ventures (government fund of funds).

Through its convertible note program, BDC finances the best companies that graduate from Propel ICT. This program can be categorized as an example of discretionary co-investment fund – companies are pre-selected by Propel ICT, but the final investment decision is made by an investment committee led by Propel and BDC. As already mentioned, 26% of companies that have participated to date have originated in Nova Scotia.

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THE NOVA SCOTIA ECOLOGY FOR TECHNOLOGY START-UPS – INTERVIEW RESULTS

The importance of the ecology

Venture capital does not operate in a vacuum but, on the contrary, along a continuum that, for university spin-outs, ranges from R&D to commercialization of the research, seed, start-up and expansion financing and finally exits through public markets or acquisition. For other companies, it goes from company creation by entrepreneurs supported by “friends, family and fools” (FFFs) and business angels to venture capital financing and exits.

The interviews conducted for this report highlighted the following issues:

In a mature ecosystem, companies are started by entrepreneurs with their own money (many are serial entrepreneurs) and that of FFFs. The first investors are usually business angels. Venture capital intervenes in a subsequent phase to accelerate the growth of companies which have the right “VC profile”; that is, strong intellectual property and barrier to entry; large, fast-growing and global potential markets; and strong management teams (actual or potential). Many tech companies that target local or regional markets – and require smaller investments before breakeven – will be able to prosper without venture capital investment.

Non-dilutive government funding usually plays an important role at the R&D and commercialization of research stages of a start-up.

In a young ecosystem, the entrepreneurial and business angel base is weaker, and fewer serial entrepreneurs are able to reinvest their own money and expertise to start a new company. Government funding plays a more important role at the seed and start-up stages to mitigate risk and “start the wheel.” The challenges are to avoid flooding the market with “dumb money” and to find ways to link this government money to the right entrepreneurial expertise.

There is a natural tendency, especially at the R&D stage, to see innovation as a “technology push,” a linear process that goes from R&D to production and then marketing in order to finally reach the market. On the contrary, successful technology start-ups are most often the result of a “market pull” process where market needs are integrated very early in the applied research process and the design of the product. Table 4 illustrates how market pull differs from technology push and integrates the “go to market” dimension early on in the process. One of the challenges facing tech start-up companies, especially in peripheral regions such as Nova Scotia, is to link up very early with markets that are not local but global. This requires commercialization skills and experience, which may be hard to find in a small region or city.

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Table 4

Venture capital cannot create its deal flow from scratch. It usually builds on an initial base of entrepreneurs and innovation. Once that initial base is in place, longitudinal studies show a co-evolution pattern between the flow of start-ups nourished by technology innovation and the development of the venture capital industry.26 A key driver of the venture capital industry is the level of R&D spending: econometric studies show that among the 50 US states, there is a strong correlation between R&D spending and venture capital investment.27

Creating the right environment for the emergence of successful entrepreneurs (entrepreneurship culture, commercialization of research, mentorship, access to expertise and networks) is central to building the foundations of the ecology.

Statistical comparison with other Atlantic provinces and Canada

Table 5 compares Nova Scotia, New Brunswick, Newfoundland and Labrador and Canada on a series of indicators including population, GDP, R&D indicators (R&D expenditures, ACOA/AIF investment, IRAP contribution to firms for R&D projects) and investment indicators (Sustainable Development Technology Canada (SDTC) projects, venture capital investment and number of active VC funds in the province).

When looking at the per GDP indicators, the following points are worth noting:

Nova Scotia is in a strong position for overall R&D expenditure. However, it is weaker for R&D funded and performed by business enterprises.

IRAP funding is higher in life sciences but lower in ICT.

Nova Scotia receives a significant proportion of SDTC funding, compared to the Canadian average.

26 Source: Gil Avnimelech, Martin Kenney, Morris Teubal, “Building Venture Capital Industries: Understanding the US

and Israeli Experiences,” BRIE Working Paper 160, Berkeley Roundtable on the International Economy, 2004.

27 Paul Gompers and Josh Lerner, The Venture Capital Cycle, Chapter 3: “What Drives Venture Capital Fund Raising?”

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Venture capital investment ($) over the 2010–2013 period is higher in Nova Scotia, and is comparable to the Canadian average.

Table 5: R&D and investment indicators in NS, NB, NL and Canada28

ACOA: Atlantic Canada Opportunities Agency IRAP: NRC Industrial Research Assistance Program SDTC: Sustainable Development Technology Canada

Data on venture capital provision in Nova Scotia

Using data from the Thomson Reuters database, table 6 shows that the availability of venture capital in Nova Scotia has considerably improved over the last 16 years.

28 Sources:

Population, GDP, R&D: Statistics Canada;

ACOA, IRAP and STDC;

Venture Capital: Thomson Reuters.

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Table 6: Venture capital investment in Nova Scotia, Canada and the US

Source of data: Thomson Reuters

Venture capital invested has increased from 0.6% of the total amount invested in Canada in 1998–2001 to 1.9% in 2010–2013, when Nova Scotia represented 2.7% of Canadian GDP in 2012. The average per deal has tripled but remains well below the Canadian and, even more so, the US average. The number of funds active in the province has also significantly increased.

Table 9 lists disclosed funds that were active in the province over 2002–2005, 2006–2009 and 2010–2013. During the first period, only one foreign fund and five Canadian funds with no base in the province invested in Nova Scotia. During the second period, there were two and two reciprocally, and during the last period, five well-recognized foreign funds and six private sector Canadian funds with no base in the province invested. This shows a strong increase in the quality of co-investors in the province.

It is fair to point out that two deals played an important role in this improvement: the $29 million investment of Northwater Capital Management in Unique Solution Design and the investment of three renowned US funds (Baseline Capital, Freestyle Ventures and Greylock Partners) in GoInstant. But VC statistics are normally influenced by outliers. This is no exception. Beyond these two deals, seven other private sector funds from outside the region have been attracted by Nova Scotia start-ups: Avrio Ventures, Cycle Capital, Eagle Cliff reinvestment fund, OMERS Ventures, Rho Canada Ventures, Siemens Mobile Acceleration Direct Investment Fund and Vanedge Capital.

By sector, over the 2010–2013 period, 62% of companies that received VC investment were in ICT, 24% in life sciences and 14% in cleantech. In terms of dollars invested, ICT represents 75% of the total, life sciences 11% and cleantech 14%. The average invested per company was much lower in life sciences (table 7).

Out of the 29 companies that received VC investment during this period, 16 had Innovacorp as an investor and eight had NSBI as an investor. Only five of them had neither Innovacorp nor NSBI as an investor. In addition, Innovacorp made investments in five companies that were not reported in the Thomson Reuters database (table 8).

Table 7: Venture capital investments in Nova Scotia over the 2010–2013 period

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Source of data: Thomson Reuters

Table 8: Nova Scotia Companies that received Venture Capital over the 2010–2013 period

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Table 9: Venture capital funds active in Nova Scotia

Source: Thomson Reuters (bold = foreign funds bold Italic = outside Canadian funds)

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The Nova Scotia ecology: interview results

Table 10 summarizes Nova Scotia’s ecology for the financing of technology start-ups by type of financing and services to entrepreneurs. Financing vehicles can be divided into two categories:

Non-dilutive financings, such as grants, tax credits and conditional loans that take no equity and do not dilute ownership

Equity financing provided by entrepreneurs and founders, business angels, venture capital and public markets

The following paragraphs summarize the results of interviews with the various stakeholders on the strengths and weaknesses of this ecology (see Annex 2 for a listing of people interviewed).

R&D funding and commercialization of research

On a per GDP basis, R&D expenditure in Nova Scotia is lower than the Canadian average but significantly higher than in other Atlantic provinces. Dalhousie is recognized for having a strong research base, notably in life sciences and ocean technologies. However, the percentage of R&D that is funded or performed by business enterprises is relatively low (table 5).

Feedback from interviewees suggests that there is a strong engineering and computer sciences culture in Dalhousie. Nova Scotia is now recognized for the quality of talent in these areas and, consequently, the strength of many start-ups’ development teams.

Dalhousie is perceived as very research and training focused and “not very good” at engaging with the business sector, commercializing research, supporting spin-offs and developing entrepreneurship skills among engineers and scientists. Notably, specialized venture capital funds (ICT, life sciences, cleantech) that are active in Nova Scotia made the point that Dalhousie has not reached out to them to showcase its technologies.

This may be changing, as initiatives began recently to make an entrepreneurship curriculum available through the whole university, to set up the Starting Lean program to develop new business projects with students and to strengthen links with the business community.

Regarding the commercialization of research, life sciences funds suggested that Dalhousie might consider developing activities similar to those undertaken by Biotransfer in Toronto to better connect its researchers with the life sciences industry, not just pharmaceutical companies but also entrepreneurs and venture capital funds.29

Deal flow and entrepreneurs

All interviewees stressed that deal flow has tremendously improved in Nova Scotia – both in quantity and quality – over the last five years. Entrepreneurship has been stimulated by recent successes (Q1 Labs, Radian6, GoInstant, Ocean Nutrition), by the wealth and talent that derived from these successes and by new initiatives taken to develop and support entrepreneurship: the Next Phase, Volta Labs and Launch36/Propel ICT. These successes have put the Maritimes on the VC radar screen and attracted expertise and financing.

29 http://www.biotransfer2014.ca

http://www.biotransfer2014.ca/

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Table 10: Nova Scotia Ecology: financing sources for tech start-ups and services to entrepreneurs

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New Brunswick had initially taken the lead. But this trend should be seen as a regional trend and supported as such. Several outside sources of funding mentioned that their attention was first caught by Q1 Labs and Radian6 successes. They subsequently discovered the quality of deal flow and teams of developers in Nova Scotia; interviewees referred to it as a very well-kept secret.

One of the strongest messages we heard from entrepreneurs and funders is that Atlantic Canada is a relatively small region; resources (money, talent) are scarce and efforts to support the development of the ecosystem should be approached as much as possible with a regional perspective.

In terms of sectors, the deal flow is more developed in ICT. Outside funds underline that one of its strengths is that it mainly comprises B2B companies using SAAS models, as opposed to B2C companies, which can include many “me too” companies. An indication of the strength of Nova Scotia’s deal flow in ICT is Propel ICT (Launch 36): out of the first three cohorts that have gone through the accelerator, 26% were Nova Scotia companies, and they raised 41% of total capital raised by the three cohorts.

Development teams are strong in Nova Scotia. However, most entrepreneurs are first-time entrepreneurs, and there is a shortage of sales and product marketing skills and experience in the region.

In other sectors, feedback from specialized funds includes the following observations:

In life sciences, although there are a number of technologies and very-early-stage companies, there is a shortage of experienced entrepreneurs, and most companies are at a far too early stage to attract institutional VC investment.

In cleantech and agriculture, there are not many investment opportunities for VC funds.

In ocean technologies, companies seem to rely less on the VC chain and more on clients and early adopters to leverage other sources of money.

Several interviewees mentioned that the province has limited resources and cannot attempt to cover all sectors or all segments in these sectors. Nova Scotia should build on its strengths. Some leadership may be needed to identify these strengths, make them known and gather resources around them. For sectors that rely heavily on academic research, such as those mentioned above, there is a role for the university and its commercialization teams and a need for vertical incubation/acceleration.

Services to entrepreneurs

Accelerators and industry events

Feedback about the space created at Volta Labs and the various activities that take place in that space (the Next Phase, accelerator, mentorship, meetups, hackathons, etc.) was very positive. The same is true of the feedback on Launch36 and Propel ICT. This positive feedback is supported by the number of ICT companies that have been through these programs and have been able to raise funds from business angels and venture capital funds and by VC statistics presented in the above paragraphs.

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The positive role of other activities to support entrepreneurship and link entrepreneurs with outside sources of money and talent such as Mentorcamp and Atlantic Venture Forum was also underlined. Other regular activities such as Business over Breakfast (Innovacorp) also contribute to support entrepreneurs.

ACOA plays a leading role in supporting these activities. It is joined by program partners and sponsors. However, Volta Labs does not yet have a sustainable business model for the medium term. The results of the CAIP program may bring part of the answer for Volta Labs and Propel ICT. Whatever the results of the CAIP competition may be, a regional perspective should be kept in mind.

Innovacorp incubators

Innovacorp runs two incubators, the Technology Innovation Centre in Dartmouth and the Innovation Enterprise Centre on the Dalhousie campus.

The Technology Innovation Centre has incubated 88 companies since inception in May 1997 in a wide variety of tech sectors: ICT, life sciences, cleantech, engineering, ocean technologies and consulting. Presently, 12 companies are on site in life sciences, cleantech and engineering/manufacturing. Out of these 88 companies, eight were financed by Innovacorp, two of which received venture capital from external funds (table 11).

Table 11: Number of companies incubated at the Technology Innovation Centre

Source of data: Innovacorp

Since its inception in June 1999, the Innovation Enterprise Centre has incubated 43 companies, mainly in life sciences. Presently, 12 companies are on site, all in life sciences. Seven companies received VC funding, two of them from external VC funds (table 12).

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Table 12: Number of companies incubated at the Innovation Enterprise Centre

Source of data: Innovacorp

Outside VC funds and most entrepreneurs in ICT stated that they had not heard directly from the Technology Innovation Centre. Tables 11 and 12 confirm that few companies received funding from external sources. Interviewees that had some knowledge of Innovacorp incubators suggested that they seem to follow the old brick and mortar incubation model where real estate plays a key role. Emerging incubator models are more virtual and put more emphasis on flexible networks and mentorship. Innovacorp agrees with suggestions that a more rigorous acceleration process is needed around these incubators in order to add more value.

Provincial Trade Development Services

A number of federal and provincial departments and agencies provide trade development services to Nova Scotia businesses that need to reach out to Canadian and international markets. Interviewees unanimously mentioned that a multi-sector mission-based approach is not appropriate for the specialized needs of tech start-ups. Entrepreneurs usually find the people they need to contact through their own networks and mentors. What they need is the financial support to travel when necessary. The travel program currently being administered by Volta Labs with provincial support was cited as an example that goes in the right direction.30

Business angels

First Angel Network (FAN) is a business angels network based in Halifax that serves the Atlantic provinces. It usually funds four companies per year. These companies are selected by the managing team that works with the companies to get them ready for investment and then actively presents them to the angel network. Selected companies usually get successfully funded by the network. The team is compensated by the companies for these services. The approach is not sector specific. Between 30 and 40% of investments are in tech sectors. The network invests

30 “In collaboration with the Department of Economic Rural Development and Tourism (ERDT), local Entrepreneur Ben

Yoskovitz and Volta, we are delivering an experimental startup travel program with the goal of attracting foreign investment, building linkages with US based investors and Entrepreneurs and bringing the best-practices learnings back to Atlantic Canada.” http://www.voltaeffect.com/travel-program

http://www.voltaeffect.com/travel-program

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between $800,000 and $1.2 million per year. Most angels in the network are generalists. Few have direct experience in the tech sectors.

East Valley Ventures is a group of business angels associated with entrepreneur Gerry Pond, former CEO of NBTel and co-founder of Q1 Labs and Radiant 6. It has invested in 30 companies in Atlantic Canada, including Nova Scotia. This group brings to the table not just money but also expertise and networks. Its investment pace is presently slowing down as it focuses on maturing the portfolio and working on exits. Gerry Pond is also the co-founder of Propel ICT, and East Valley Ventures members are also Propel mentors.

A similar structured group of tech-savvy business angels does not yet exist in Nova Scotia. However, there is a new generation of successful tech entrepreneurs emerging, who are active mentors and angel investors, notably around The Next Phase and Volta Labs, which they helped to create.

As the region’s business angel base is limited, dynamic and experienced entrepreneurs also reach out early to outside business angels. During our interviews, business angels from Ontario and Silicon Valley were most often mentioned. However, linking to outside business angels is a challenge for first-time entrepreneurs.

Finally, there are relatively large pools of more-traditional investment money in the province. However, they do not seem to be engaged with the tech ecosystem. Contrary to what is happening in New Brunswick with the New Brunswick Business Council, there does not seem to be a place in Nova Scotia where leaders of more-established businesses, together with tech sector leaders and the universities, develop specific initiatives to mentor and support tech entrepreneurs.31

The potential of setting up a business angel co-investment fund targeting tech sectors in Nova Scotia will be discussed below. Such a fund would rely on business angels for deal sourcing, due diligence, term sheets and, eventually, monitoring investments. When appropriate, we asked interviewees whether in their opinion there is presently in Nova Scotia a large and sophisticated enough base of tech-savvy business angels to set up such a fund. In most cases, the answer was “not sure” or “I do not think so yet.”

Financing: where is the gap?

In the ICT sector, there does not seem to be a lack of money at the pre-seed stage: a talented entrepreneur with a good idea who is able to raise an initial $100,000 to $200,000 from his or her own money, friends, family and business angels can leverage this investment with non-dilutive money from ACOA, IRAP and SR&ED to get to a first prototype. By providing knowledge, support and mentorship, the new entrepreneurship programs in the universities, the Next Phase, Volta Labs and Propel ICT help entrepreneurs define and articulate their business plan, launch their business and increase their chance for initial funding by business angels and eventually BDC convertible debentures.

31

See notably the Meals with Moguls, The Early Adopters Team (http://nbbc-cenb.ca/en/work). The Wallace McCain

Institute is another example of initiative of the NB business community, which focuses on developing entrepreneurship.

http://nbbc-cenb.ca/en/work

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At a later stage, if they demonstrate market traction, companies will be able to attract investment from Canadian or American venture capital funds. Build Venture has been set up as a local private sector venture capital fund that can invest in these venture capital rounds and help attract these funds. Attracting outside investors is not easy, and the fact that Build Ventures is the only local private sector investor and has limited resources makes it more difficult. Nevertheless, due to recent successes, the level of awareness regarding the quality of the deal flow in Atlantic Canada has grown considerably, increasing the likelihood that good companies will attract later-stage financing.

The main gap remains between these two stages: between the initial prototype and real market traction that will attract outside investors. It is not only a financial gap but also a gap in expertise and experience. Currently, most entrepreneurs are still first-time entrepreneurs and do not have the sales and product marketing expertise or the networks to reach their potential markets efficiently. Finding and hiring the right talent to do so is difficult and costly. Mentors are helpful, but this experience and specific expertise and networks for a given type of products is also scarce among local mentors.

Entrepreneurs that have succeeded stress that young entrepreneurs also need to reach out by themselves to Silicon Valley or other relevant places to reach their potential market, and to specialized sources of financing that could add value to their business (business angels and early-stage VC funds). To do this, new entrepreneurs need financial support and access to networks. Organizations or programs such as the Canadian Technology Accelerators,32 the C100,33 and the Canadian Entrepreneurs in New England (CENE)34 are helpful in this regard.

East Valley Ventures invests at this stage, and it provides strong mentorship, as its members are all experienced and successful entrepreneurs. However, its investment pace has slowed recently.

Innovacorp also plays a very important financial role at this stage. Its expertise and networks are more limited (see below).

Build Ventures’ initial investment strategy was to invest in series A financing when market traction is already demonstrated. Given the gap to get to this point, it realizes that it may have to invest somewhat earlier and play a more active role to support the go-to-market strategy.

In other, more-capital-intensive sectors such as life sciences and cleantech, the gap is wider, as (i) it takes more time and more capital to get to a point where the company can attract outside VC funds, and (ii) the entrepreneurial base in the region is smaller. A longer incubation time and more resources may be needed.

As a conclusion, there is a need for more mentorship and expertise and, eventually, more money, to bring companies to a level where they will be able to attract outside specialized VC funds.

32 http://www.tradecommissioner.gc.ca/eng/document.jsp?did=141338

33 http://www.thec100.org/

34 http://www.thecene.org/

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Government financing tools

The Government of Nova Scotia has set up the following tools to support the financing of tech start-ups: three tax credits (the Digital Media Tax Credit, the Equity Tax Credit and the LSVCC Tax Credit) and three investment vehicles (Innovacorp, NSBI and Build Ventures).

The feedback from interviews on each of these vehicles is as follows:

Digital Media Tax Credit

The Digital Media Tax Credit is a refundable tax credit for costs directly related to the development of interactive digital media products in Nova Scotia. Tax credit amounts are equal to the lesser of

50% of eligible Nova Scotia labour expenditures, or

25% of total expenditures made in Nova Scotia

A 10% geographic area bonus on labour expenditures (5% bonus on total expenditures) is available for products developed outside the Halifax Regional Municipality.

Total tax credit in 2012 was $5.2 million. This tax credit is available to large companies as well as SMEs and start-ups.

One dimension of the Digital Media Tax Credit that limits its positive impact and was repeatedly stressed by interviewees is its relative unpredictability because (i) it is renewed every year; therefore it is impossible to base a medium- to long-term strategy based on this program, and (ii) there is some uncertainty regarding the definition and what will be accepted as “interactive digital media product.” Responding to correct these two points would increase the impact of the tax credit.

Equity Tax Credit

The Equity Tax Credit (ETC) was designed to assist Nova Scotia small businesses, co-operatives and community economic development initiatives in obtaining equity financing by offering a personal income tax credit to individuals investing in eligible businesses. It is calculated at 35% of investment made by individual to a maximum annual investment of $50,000 (maximum annual credit of $17,500 includes current year and the carry-forward or -back amounts). The program targets SMEs but has no specific sector focus. To benefit from the tax credit, the investment has to be made in common shares.

Total tax credit in 2012 was $7.8 million. The ETC is used by business angel investors in tech start-ups. However, these only represent a fraction of the total tax credit, as it is also used in other sectors such as arts, entertainment and recreation, retail trade, construction, agriculture, forestry, fishing and hunting.35

The following recommendations were made by interviewees in order to make it more palatable to investors in tech sector start-ups and increase the amounts invested: (i) increase the

35 According to Entrevestor Intelligence, these sectors represented 50% of investment that benefited from the ETC

over the 2002–2011 period. Source: Entrevestor Intelligence, September 2012, Vol. 1, p. 7.

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maximum annual investment, (ii) make this tax credit regional, (iii) make convertible debentures and preferred shares eligible, as many VC and business angels deal are structured with these financial instruments, and (iv) make angel pooled funds and not only individuals eligible, as many sophisticated business angels invest through such kinds of vehicles.

Several of these recommendations are already included in the Savoie and Ivany Commission reports.36

LSVCC Tax Credit

This tax credit is designed to assist small and medium-sized Nova Scotia businesses and co-operatives in obtaining equity financing, by offering a personal income tax credit to individuals investing in registered labour-sponsored venture capital corporations (LSVCCs). The tax credit rate is 20%. Maximum annual tax credit amount is $2,000. This tax credit is matched by a 15% federal tax credit on investments of up to $5,000. It was announced in the 2013 federal budget that this federal tax credit will be progressively phased out between now and 2017.

Growthworks Atlantic is the only LSVCC in Nova Scotia. It has played an important role over the years as a local investor. However, since the announcement of the Ontario Sunset Clause in 2005, fund raising has become increasingly difficult for LSVCCs outside Quebec. Funds raised in Nova Scotia declined from $870,000 in 2009 to $240,000 in 2012. With a lag, the investment pace has declined accordingly. Since 2010, Growthworks Atlantic has made one new investment in Nova Scotia and participated in two follow-on rounds. The recent announcement of the phasing out of the federal tax credit will make fund raising even more difficult.

Innovacorp Venture Capital Investment

Innovacorp manages the Nova Scotia First Fund (NSFF), a seed and early-stage venture capital fund investing in ICT, life sciences, cleantech and ocean technologies. This fund invests small amounts at the seed stage, and it may invest in following rounds up to $3 million by company. Up to $250,000, investment decisions are made by management; beyond this limit, investment decisions are made by the Investment committee and the board.

Over the last three years, NSFF has made on average seven investments and invested between $3 million and $5 million per year.

Beyond the provision of capital, the objective of Innovacorp’s management team is to add value to its investments by sitting on the company board, assisting the management team in all aspects of its business strategy, talent recruitment and access to market.37

36 Donald Savoie, The Way Ahead for Nova Scotia, recommendation 2, July 2010; and Now or Never: An Urgent Call to

Action for Nova Scotians, The Report of the Nova Scotia Commission on Building Our New Economy, February 2014, comments by Peter Moreira, pp. 176–7.

37 “We bring more than just investment capital. We’ll work side-by-side with you to figure out your immediate

struggles and the steps needed to overcome them. Once that’s achieved, together we’ll determine what’s needed next for sustained competitiveness and business growth. A network of advisors, mentors and service providers complements our in-house business expertise.

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Interviewees stressed that Innovacorp plays an essential role in the market as the only institutional source of seed capital in the province. Innovacorp was an investor in 21 out of 34 companies that received venture capital over the 2010–2013 period. Innovacorp managers are also considered “good people” willing to help.

At the same time, interviewees also made repeatedly the following observations:

Term sheets and negotiations are unnecessarily long, complex and costly. They should be standardized.

Innovacorp managers should participate on boards as observers, not directors.

Innovacorp’s mentor base is not very strong.

They have few outside connections and are not very helpful in this regard.

Their overhead seems relatively high for the amount of capital they deploy.

This feedback should be seen as a consequence of the constraints under which government direct investment funds have to operate: compensation schemes, dual and sometimes confusing mandates (returns vs. job creation and regional development)38 and decision-making processes. The overall level of expertise of Nova Scotia tech entrepreneurs has increased in recent years, and so too have their expectations.

In their conclusions, several of the interviewees recommended that Innovacorp could build on what has already been achieved and improve its processes. Others suggested looking for alternative models such as co-investment funds and indirect investment by government.

NSBI Venture Capital Investment

NSBI Venture Capital defines itself as a mid- to late-stage investor in tech sectors. However, NSBI does not have a defined allocation for venture capital investing; it has, rather, the possibility to recommend investments to the minister and to cabinet, and these are accepted on a case-by-case basis.

This decision-making process is very long and unpredictable. Moreover, as decisions are made by cabinet, this opens the door to explicit or implicit political interference.39 Both dimensions are very much criticized by co-investors who do not consider NSBI as a “like-minded” investor and have a rather negative view of its role in the market.

NSBI Venture Capital has invested in 15 companies since 2002. 59% of all dollars invested are concentrated in four companies – LED Roadway Lighting, Techlink, Origin Biomed and Unique Solution – which represents a strong concentration of risk.

Every company has its own distinct needs for business assistance. Our investment team will help you with yours. Fundamental business planning, intellectual property protection strategies, product development, financial management, value proposition development, human resource management, sales and distribution channel strategies and competitive analysis are just a sample of the areas of expertise you’ll have within arm’s reach as our client.” (Source: Innovacorp website)

38 Since inception in 2001, NSFF has invested $27.6 million. It has received $3.5 million in distribution, and the fair

market value of the portfolio at the end of 2013 was $18.4 million, for an overall multiple of 0.79. This is not unusual for a government seed/early-stage portfolio of this size.

39 By implicit political interference, we mean the fact that as the decision is made by political instances, one cannot

ignore, beyond business objectives, the possible political consequences of the decision.

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There does not seem to be a strong case to maintain two distinct government direct investment funds. Mid- to late stage is normally a stage where good companies should be able to attract outside VC funds.

All interviewees who responded to this issue recommended that the present situation be changed and the equivalent of NSBI’s venture capital allocation be shifted to a team whose decision-making process would be independent from political instances and compatible with venture capital practices and timelines.

Build Ventures

Build Ventures is a private sector venture capital fund whose main investors are the provinces of Nova Scotia, New Brunswick and Prince Edward Island; the BDC; and EDC. Its mission is to invest in early-stage tech companies in the region.

Launched in May 2013, it has invested $4 million in three companies, two in New Brunswick and one in Nova Scotia. In all three deals, it was the first investor. In two of them, it has co-invested with VC funds from outside the region.

Comments by interviewees (entrepreneurs and co-investors) on the Build Ventures model were very positive. It is perceived by external funds as a local “like-minded” private sector co-investor and a value-added investor.

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CONCLUSIONS AND RECOMMENDATIONS

Venture capital does not operate in a vacuum. It is one component, and a critical ingredient, of an ecosystem based on entrepreneurship and innovation. As mentioned earlier, venture capital and the deal flow of entrepreneurial start-ups in which it invests develop in co-evolution. Research shows that the main drivers of venture capital success are serial entrepreneurs and the ability of venture capital managers to identify these serial entrepreneurs and work with them. On the fund side, characteristics of successful managers are operational skills, industry specific expertise and networks.40

Building a successful ecosystem of technology sources, serial entrepreneurs and experienced investors and fund managers is a difficult endeavour and takes time. It is the result of a virtuous circle, with cumulative effects (it is easier to start the 100th start-up in a given place than the first one). This is why there is a case for government intervention to help “start the wheel.” In the case of a relatively small market such as Nova Scotia, pooling resources, accessing markets and linking with external sources of capital and expertise is an additional challenge

In order to be successful, government interventions must find the best ways to work with entrepreneurs, link capital with expertise (“smart money”) and adapt to industry best practices. These practices are evolving as tech ecosystems become more sophisticated, include more tech-savvy business angels and new waves of entrepreneurship emerge, notably around accelerators and the Lean StartUp approach. International trends in government support of the ecosystem are a reflection of these evolutions:

A trend toward indirect and arm’s-length interventions

A trend toward less-stringent investment constraints, notably geographical constraints

The increasing recognition of the role of business angels

The growing importance of accelerators, new models for seed funding linked to accelerators and crowdfunding

Nova Scotia has taken significant steps to adapt to this new reality. In particular, the province has taken the lead to set up Build Ventures, an arm’s-length private sector regional venture capital fund supported by Atlantic provinces and federal Crown corporations. It has also taken small steps to support local accelerators.

However, as highlighted in the previous paragraphs:

Nova Scotia universities have just recently started supporting the development of entrepreneurship among students in a systematic way, and more could be done to support the commercialization of research and engage with industry and venture capital.

40 Paul Gompers, Anna Kovner, Josh Lerner, and David Scharfstein, Performance Persistence in Entrepreneurship,

Harvard Business School, Working Paper 09-28, July 2008. “This paper presents evidence of performance persistence in entrepreneurship. We show that entrepreneurs with a track record of success are much more likely to succeed than first-time entrepreneurs and those who have previously failed. In particular, they exhibit persistence in selecting the right industry and time to start new ventures. Entrepreneurs with demonstrated market timing skill are also more likely to outperform industry peers in their subsequent ventures. This is consistent with the view that if suppliers and customers perceive the entrepreneur to have market timing skill, and is therefore more likely to succeed, they will be more willing to commit resources to the firm. In this way, success breeds success and strengthens performance persistence”.

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Innovacorp incubators’ bricks and mortar model could be revisited to provide more support (mentorship, networks) to entrepreneurs.

Provincial trade development programs could be adjusted to support tech entrepreneurs that have to become global from day one.

The Equity Tax Credit has not been specifically adapted to attract tech-savvy business angels.

To different degrees, Innovacorp and NSBI face the usual limitations of government direct investment funds, which raises questions on how their models could be improved.

Tech entrepreneurs in Nova Scotia are facing a financial and expertise gap at the seed stage, between the first prototype that can be achieved with a small initial investment by founders and business angels leveraging non-dilutive money and first market traction that would lead to a series A investment with local and external VC funds.

Before coming to specific recommendations, the following objectives should be set forth as general orientations:

The overall objective should be to improve the ecosystem and focus on entrepreneurs. The provision of venture capital is just one part of this ecosystem.

In line with this orientation, specific recommendations are made below on services to entrepreneurs, accelerators, mentorship and value-added provision of venture capital, and also on the role of universities to stimulate entrepreneurship.

Without recommending specifics that would go beyond the scope of this report, Nova Scotia may also want to consider initiatives developed in other jurisdictions to foster a culture of entrepreneurship and innovation in society, such as enhancing science, technology, engineering and math (STEM) curriculum, including computer sciences and coding, as well as innovation and entrepreneurship, in the secondary school system, colleges and universities.

Recommendation 1 Focus on the ecosystem. Entrepreneurs and mentorship should be at its centre.

Atlantic provinces are all confronted by the same challenge of limited resources and distance from the main technology clusters. Outside investors that are much needed do not make much of a distinction between Nova Scotia and New Brunswick. The whole region benefits from its successes and suffers from its failures. When facing the development of their tech ecosystem, governments should adopt as much as possible a regional approach.

Recommendation 2 Adopt a regional approach as far as possible.

In order to be successful, tech companies must reach out very early on: markets, expertise and networks, recruitment of talent, sources of funding (business angels and specialized VC funds). Helping entrepreneurs, directly or indirectly, in this difficult task should be one of the main

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objectives of government support to the ecosystem. The province should notably leverage as much as possible existing Canadian organizations such as the Canadian Technology Accelerators, the C100 and the Canadian Entrepreneurs in New England (CENE).

Recommendation 3 Reach out. To be successful, tech entrepreneurs need to link with external markets and specialized resources: talents and sources of capital.

The following recommendations are based on the analysis of success factors for venture capital, international trends in government support of tech ecosystems and the strengths and weaknesses of the Nova Scotia ecology, as well as comments received from interviewees. As the primary focus of this mandate is on the role of government in the provision of venture capital, recommendations pertaining to sources of financing will be more developed. Other recommendations related to other parts of the ecosystem and which derive from the interviews will just be mentioned as “food for thought.”

Universities and commercialization of research

Excellence in research and training should remain the primary focus of universities. At the same time, recent initiatives taken at Dalhousie and other universities to develop entrepreneurship among students and link them with mentors and industry, such as entrepreneurship curricula across the university, the Starting Lean program, sandboxes, on-site incubators and accelerators, should also be supported and strengthened.

The university should be more proactive in commercializing its research and in linking academics with entrepreneurs and venture capital in the region and outside the region. The university should identify its main strengths in research and be more proactive in making them known.

Recommendation 4 Encourage efforts by universities (i) to stimulate entrepreneurship among students, and (ii) to commercialize its research and link academics with entrepreneurs and venture capitalists in the region and outside the region.

Service to entrepreneurs

Support the design and implementation of a sustainable business plan for Volta Labs/Propel ICT

The government should take a role with other stakeholders and funders to develop and support a sustainable business model for Volta Labs (the space and the accelerator). The solution will depend, among other factors, on the results of the CAIP program. Volta Labs and Propel ICT both have applied. Whatever the results of this competition, a regional approach should be favoured to increase and diversify the pool of entrepreneurs, mentors and potential investors.

Strengthening mentorship and networks around entrepreneurs is key to the success of the ecosystem. However, in order to be successful, acceleration processes should remain very

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selective and demanding and run by entrepreneurial teams. Success metrics should be embedded in the business models of accelerators that benefit from government support. Multiplying accelerators and running them as government programs should be avoided.

Recommendation 5 Support the development of a sustainable business model for Volta Labs/Propel ICT.

Enhance and change Innovacorp incubator programs and make them more effective

Volta Labs and Propel ICT deal with ICT companies. Other sectors such as life sciences, cleantech and ocean technologies should not be neglected, for diversification reasons and because of specific strengths of the region and its universities in these domains.

To meet these needs, Innovacorp should develop a more rigorous acceleration process around its incubators: work with universities to take the best technologies and match them with entrepreneurs; surround them with mentors (experienced CEOs, VCs); and develop initiatives to reach out and link with external sources of capital and expertise (see recommendation 9 on Innovacorp).

In order to do so, Innovacorp would need to attract a specialized partner in each sector who would have the capabilities, experience and proven track record to effectively mentor start-ups, and with operational expertise and deep networks in the industry. Compensation will be an issue. Finding creative ways, such as stock options, to reward success will be needed.41

Adapt provincial trade development services to meet the specific needs of tech start-up entrepreneurs

Recommendation 6 The province should consider adjusting its trade services, designed for more-established businesses, in order to adapt them to the reality of tech entrepreneurs who need financial support to reach out to potential markets and specialized external resources and sources of funding.

Support to business angel networks

First Angel Network successfully funds four companies per year. It is supported by ACOA and NRC. Its model is designed for more-passive business angels, as the network’s management team acts as an intermediary between companies and business angels.

There is room in the region for a network of more-active and tech-savvy business angels. If successful, such a network could pave the way for an angel co-investment fund in the future (see below). It is recommended that the government coordinate with ACOA and NRC to seed the operations of such a network.

41 Attracting and retaining experienced people will not be easy. Complementing these persons with experienced

advisors and mentors would be part of the solution.

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Recommendation 7 Support the development of more networks of active business angels.

Tax credits

Digital Media Tax Credit

In order to increase its positive impact, the tax review currently underway should consider whether the Digital Media Tax Credit could be made more predictable regarding (i) the definition of eligible interactive digital media products, and (ii) its continuity over time.

Recommendation 8 The Nova Scotia Tax and Regulatory Review should consider making the Digital Tax Credit more predictable (eligibility and continuity).

Equity Tax Credit

Attracting business angels and notably tech-savvy business angels is a very important step in building a tech ecosystem, especially in a place where specialized venture capital sources are scarce. Jurisdictions such as the province of British Columbia or the state of Wisconsin have made the demonstration that a well-designed tax credit can have a very significant impact on business angel investment in targeted sectors: following the establishment of the program, angel investment in Wisconsin surged from $3.7 million in 2004 to $67.1 million in 2012;42 in British Columbia, investment by business angels that benefited from the tax credit grew from $31.4 million in 2004 to $70.7 million in 2009.43

The Nova Scotia ETC has not had the same impact. Several elements may explain why:

The maximum investment that can benefit from the tax credit is $50 000 per investor and per year, which limits total amounts invested and also the interest for tech-savvy business angels to get involved and add value to their investment. In Wisconsin, there is no limit by investor, only an $8 million limit per company. In BC, the maximum investment is $200,000. The Savoie report recommended that this maximum be $250,000 in Nova Scotia.44

To benefit the tax credit, an investment has to be made in common shares, when many investments in start-up companies are made in convertible debentures or in preferred shares. These investments vehicles are eligible in Wisconsin45 or BC. The recommendation would be to consider the merits of doing the same in Nova Scotia.

42 Source: Wisconsin Portfolio 2013, http://www.wisconsinangelnetwork.com/uploads/WIportfolio_2013.pdf

43 Thomas Hellmann and Ilkin Ilyaszade, “Angels in British Columbia: practice, policy and perspective,” Business Case

prepared for the 2010 QCC Public Policy Forum on Venture Capital and Innovation.

44 Donald Savoie, The Way Ahead for Nova Scotia, recommendation 2, July 2010.

45 In Wisconsin, “investments must be: clearly identifiable as being cash investments; in the form of common stock,

preferred stock, partnership or membership interest, or equivalent ownership interest. Cash exchanged for debt is not eligible unless the debt is later converted into equivalent ownership interest.” (Source: Wisconsin Economic

http://www.wisconsinangelnetwork.com/uploads/WIportfolio_2013.pdf

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In Nova Scotia, only individuals are eligible for the tax credit, when sophisticated business angels prefer to invest from angel funds. Such vehicles are eligible in Wisconsin or BC. Again, the recommendation would be to consider the merits of doing the same in Nova Scotia.

Finally, the pool of business angels willing to invest in tech start-ups is limited in Nova Scotia. Two recommendations can be made in this regard.

One possible approach would be to set up a regional harmonized tax credit: all investors from Atlantic Canada would benefit from the same tax credit when investing in an eligible company in the region.

Another approach would be to go one step further to attract outside business angels. It would make the tax credit refundable so that outside business angels have the same incentive to invest as local angels. This was done in Minnesota.46 As a result, in 2012, 31% of angel investment came from non-Minnesota-based investors.

The tax credit rate is not an issue. The rate in Nova Scotia (35%) is already higher than in Wisconsin (25%) and in BC (30%), and there are examples of situations where too high a tax credit rate has had adverse effects, polluting the market with easy money that is not invested for the right reasons.47

Tax credits are a cost on the public finances; this is why they are usually targeted at sectors where there are market failures, such as early tech sectors, and where growth and export potential are the highest. For these reasons, in most jurisdictions where they exist, tax credits to investors exclude sectors such as real estate, financial services and wholesale and retail trade and focus on tech and export oriented sectors.48

More work would be needed to define adequately eligible or qualified businesses and investors; but lessons learned from other jurisdictions suggest that implementing these recommendations would increase significantly the total amount invested by business angels in tech companies. It would also increase the size of their investment and contribute to attract tech-savvy investors from the region and from outside that can add value to these companies thanks to their

Development Corporation, Driving Investment to High-growth Business in Wisconsin, Early stage seed business tax credit program, 2012 annual report, pp. 8–9.

46 “Minnesota’s Angel Tax Credit provides a 25-percent credit to investors or investment funds that put money into

startup companies focused on high technology or new proprietary technology. The maximum credit is $125,000 per person, per year ($250,000 if filing jointly). The credit is refundable and non-Minnesota residents (including residents of foreign countries) are eligible.” http://mn.gov/deed/business/financing-business/tax-credits/angel-tax-credit

47 This has notably been the case with some investment strategies related to the 75% tax credit on the wealth tax in

France : “Au regard de leur nature comme des objectifs affichés, ces investissements constituent autant de montages principalement motivés par le taux de 75% de réduction sur l’impôt sur la fortune (ISF), conduisant à des comportements de pure et simple recherche de défiscalisation, et décorrélés de toute volonté de soutien au tissu de PME confrontées à un risque ou en phase d’amorçage ou d’expansion.” French Ministry of Economy, Industry and Employment, “Évaluation des dispositifs fiscaux en faveur du capital-investissement dans les PME,” p. 32.

48 In Wisconsin, restrictions are the following: “With a focus on technological advancements, QNBV certification does

not apply to companies primarily engaged in real estate development, insurance, banking, lending, lobbying, political consulting, professional services, wholesale or retail trade, leisure, hospitality, transportation, or construction (except the construction of power production plants that derive energy from a renewable resource).” (Source: Wisconsin Economic Development Corporation, Driving Investment.)

http://mn.gov/deed/business/financing-business/tax-credits/angel-tax-credit

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expertise and networks, thus addressing partially the financing and expertise gap that has been identified.

Recommendation 9 The Nova Scotia Tax and Regulatory Review should consider changes to the Equity Tax Credit: for investments in tech sectors, which could include (i) raising the investment limit to $250,000; (ii) changing eligible investments to include equity (common and preferred shares) and quasi-equity (convertible debentures) investments; and (iii) making it refundable to attract investors from outside.

Provision of venture capital

NSBI Venture Capital

For reasons explained previously, decision-making processes and allocation mechanisms at NSBI Venture Capital are not compatible with venture capital best practices and may act as a deterrent for VC co-investors. In addition, there does not seem to be a strong case to have a separate government VC team invest at the mid- to late stage in the tech sector. At these stages, performing companies should have already linked with outside sources of money.

The government should focus NSBI on its core missions and shift its venture capital allocation to Innovacorp. If there is a need for a separate investment allocation to respond more directly to circumstantial political objectives, it should be managed directly by ERDT. This recommendation is in line with recommendations of the Savoie report and the Traves report (recommendation 8).

Recommendation 10 Transfer NSBI’s venture capital allocation to Innovacorp.

Innovacorp Venture Capital

Innovacorp plays an important role in the ecosystem as the only source of institutional venture capital at the seed stage. All agree that this role should be maintained and reinforced in the short term.

At the same time, for reasons explained earlier, many suggested that the government should consider replacing this government direct investment fund by an indirect or co-investment model that would lead to better collaboration with private sector investors, as this has been the trend in many jurisdictions.

Before coming to recommendations, let us review possible models, inspired by experiences in other jurisdictions, to operate such a switch.

Indirect investment:

Investing in one or two new private sector regional funds in order to increase and diversify local sources of venture capital: Build Ventures model

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Attracting external VC funds to open an office in the region by investing in their fund: BC Renaissance, Alberta Enterprise Corporation or Teralys model

Investing in a regional fund specifically dedicated to the seed stage and eventually linked to business angels: Capital for Enterprise seed funds (UK) and Quebec Technology Seed Funds model

Co-investment funds:

Angel co-investment funds: Scotland, New Zealand, European Investment Fund in Germany, Quebec

Co-financing fund: Feddev Ontario

Given the present circumstances, could these models be adequate solutions to fill the gap that has been identified at the seed stage?

Build Ventures has made a good start. However, it took more than two years and the commitment of three provinces and the BDC to attract an experienced management team and reach the minimum size for a first closing. It is doubtful that this would be replicable in the short term. In addition, a fund such as Build Ventures does not replace Innovacorp at the seed stage; it is positioned slightly downstream, more at the A and B rounds stage.

Attracting outside specialized VC funds to open an office in Halifax would help link local companies to specialized sources of capital. However, it would take at least $10 million to $15 million of investment to attract an external Canadian specialized VC fund to open an office in Halifax. This fund would make a limited number of investments (maximum 3 to 4) at later stages than Build Ventures investments. Attracting a US fund would be even more difficult and need a significantly larger investment. In addition, selecting one or two funds and monitoring their activity in the region requires, at least on a part-time basis, the services of a knowledgeable fund of funds team that does not exist presently in Nova Scotia.

The case of Real Ventures, one of the Quebec Technology Seed Funds, based in Montreal, may be an interesting source of inspiration for Nova Scotia.

The process for setting up the Technology Seed Fund in Quebec, inspired from the Capital for Enterprise Funds in the UK, was the following: a request for proposal asking proponents to come up with a strategy to invest at the seed stage in tech sectors, an experienced team and at least $8 million from private sector commitment. The government would then match this commitment with a $32 million commitment, and the investment strategy that was defined by the proponent, if retained, would become compelling. The selection was conducted by an independent committee composed of experienced people in the industry.

Real Ventures came up with a strategy linked to an accelerator that they would manage (Founder Fuel), an entrepreneurial management team that had managed an angel seed fund and commitments of over $8 million, notably from business angels. This fund has proven to be successful. It is now successfully raising its second fund and was selected among the high-performing funds of the federal VCAP program.

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Could a similar process be used in the Atlantic region to raise a technology seed fund managed with an experienced team close to business angels, eventually linked to Volta Labs/Propel ICT accelerators?49 This question merits further investigation. If the answer were positive, this could contribute to address, at least in the ICT sector, the financing and expertise gap that was identified at the seed stage. (We asked on several occasions during the interviews whether such experienced teams could be found presently in Nova Scotia. Answers were not very positive.)

The principle of an angel co-investment fund is that it relies on accredited business angels (individuals or groups) for the deal flow generation, selection, due diligence, term sheet and monitoring of the investments, and it only conducts a high-level due diligence to ensure that a predefined set of rules has been followed. Depending on models, the matching ratio is automatic or includes some level of discretion on both sides.50

The success of such co-investment funds depends on the breadth and sophistication of participating business angels and the quality of the accreditation process. The model has had positive effects in Scotland, New Zealand and Quebec to stimulate and leverage business angel investment. In all three cases, there is a dedicated team, supported by government, to set up the angel network’s operations, educate business angels (training, events, documentation templates, etc.), run the accreditation process and manage the co-investment fund. The share of tech sectors in amounts invested depends on geographies: in New Zealand, ICT and life sciences represent 61% of total over the 2006–2013 period; in Quebec, tech sectors (ICT, life sciences and cleantech) represent more than 80% of total amounts invested by Anges Québec.

Many interviewees tended to favour such a model in Nova Scotia. At the same time, when asked whether in their opinion a large and sophisticated enough base of tech-savvy business angels exists to set up such a fund and eventually replace Innovacorp, most of the answers were “not sure” or “I do not think yet.”

The first step to prepare the ground for an angel co-investment fund would be to support the development and sophistication of business angel networks in the province. First Angel Networks already exists and successfully finances four companies per year. However, its model would not be the best fit with a co-investment fund, as it is designed to a large extent for passive angels and does not involve them in deal sourcing, due diligence and the selection of deals. Supporting the organization of other networks where tech business angels were more present would be recommended.

Feddev Ontario is an interest-free loan program, which matches on a 1:2 basis accredited business angels and venture capital funds investing in SMEs in tech sectors up to $1 million. It focuses on late development and early commercialization stages. Feddev Ontario’s experience is that the size and the level of organization and sophistication of accredited angel networks are central to the success of the program. This is why it has raised the maximum level of support it provides to these networks from $150,000 over a three-year period to $500,000 over a five-year period.

49 Before launching the Technology Seed Funds Process in Quebec, a study was conducted to test whether worthwhile

proposals would be received.

50 The New Zealand Seed Co-investment Fund was launched in 2005, and its size in NZ$40 million (Can$36 million).

Anges Quebec Capital was launched in 2012. Its size is $20 million. The maximum matching ratio from the co-investment fund is 1:1 in Scotland and New Zealand and 2:1 in Quebec.

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To conclude, setting up an angel co-investment fund or a seed co-investment fund are interesting avenues to consider for the medium term. Supporting a sustainable business model for Volta Labs/Propel ICT surrounded by mentors and tech business angels and supporting business angel networks with a model that allows for more direct involvement from tech-savvy business angels, as already recommended, would be important steps in those directions.

In the short term, it is our view that there is no better solution to fill the financing gap at the seed stage than strengthening and improving the role of Innovacorp. It was not in the mandate of this report to conduct a review of Innovacorp’s operations or an evaluation of its portfolio and investment activities. The following high-level recommendations derive from best practices, the review of the Nova Scotia ecology and feedback from the market (entrepreneurs and co-investors). More work with Innovacorp’s management and board would be needed to refine these recommendations.

The recommendations are the following (some of them may not be totally new for Innovacorp):

Increase Innovacorp’s venture capital allocation by shifting NSBI’s venture capital allocation to Innovacorp and clarify this allocation. This would allow Innovacorp to play a more active role to fill the financing gap at the seed stage. This is line with recommendation 8 of the Traves report.

Separate Innovacorp’s venture capital mandate (build and finance successful Nova Scotia tech companies) from other economic development objectives.

Focus on seed financing, with possible follow-on up to $2 million.

Simplify and standardize the investment process (term sheets). For the first investment, up to $250,000, Innovacorp could take inspiration from the BDC convertible notes and adopt a convertible debenture program.

Act as a catalyst to attract outside specialized investors.

Nominate experienced external board members as often as possible to the board of investee companies, and only sit on the board of investee companies as an observer.

This more standardized approach, whereby Innovacorp would aim at acting as a catalyst and co-investor for business angels and venture capital funds, should lead to reduced overhead costs.

On the governance side, Innovacorp venture capital should be able to rely on a strong and independent advisory committee, investment committee and board of directors, composed notably of experienced industry people who would ensure that investment decisions are taken independently and that Innovacorp fulfills its mission (build and finance successful tech companies), acts as a catalyst to attract specialized private sector investors and gets from the market the feedback that it needs.51

In the medium term, as the ecosystem matures, Innovacorp should consider shifting part of its direct investment activity to a co-investment fund that would invest alongside accredited business angels and, eventually, to indirect investment through independently managed seed

51 The consultant was struck by the inconsistency between how Innovacorp’s managers presented their role as value-

added investors and the feedback from the market.

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funds. In order to set up these funds, it would be recommended to recruit experienced teams through a call for proposals.52

In addition, if in view of the strategic importance of the tech sectors for the economic future of the province, the government had the opportunity to increase its allocation to venture capital, it should consider an indirect approach and invest in specialized funds that have a focus on the deal flow of the region in order to facilitate an increase of their level of investment in the province.

Recommendation 11 Innovacorp

Leverage Innovacorp’s incubators to set up effective vertical incubation/acceleration programs in tech sectors.

Venture capital: Increase Innovacorp Venture Capital Allocation by shifting NSBI’s allocation. Clarify its mission (build and finance successful Nova Scotia tech companies). Focus it on investment at the seed stage. Improve and streamline its operations (see details). Strengthen its governance.

As the ecosystem matures, Innovacorp should consider shifting part of its direct investment activity to a co-investment fund that would invest alongside accredited business angels and, eventually, to indirect investment through independently managed seed funds.

Recommendation 12 If, in view of the strategic importance of the tech sectors for the economic future of the province, the government had the opportunity to increase its allocation to venture capital, it should consider an indirect approach and invest in specialized funds that have a focus on the deal flow of the region in order to facilitate an increase of their level of investment in the province.

Leadership of the business community, including its tech dimension

Interviewees have reiterated time and again that entrepreneurs and mentors should be at the centre, not government, which should rather act as a catalyst. To be consistent, the Nova Scotia tech business community should take a leadership role to make itself more visible and link with the universities and the resources of the broader business community. More-established business and university leaders should support such initiatives.

Recommendation 13 The Nova Scotia tech business community should take a leadership role to make itself more visible and link with the resources of the broader Nova Scotia business community, including as business angels,

52

Established firms such as Growthworks could apply, or other qualified teams may develop and make an application.

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mentors, employers and champions for an innovative and growth-oriented economy.

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Summary of recommendations

Detailed recommendations are to be found in chapter 6.

Recommendation 1 Focus on the ecosystem. Entrepreneurs and mentorship should be at its centre.

Recommendation 2 Adopt a regional approach as far as possible.

Recommendation 3 Reach out. To be successful, tech entrepreneurs need to link with external markets and specialized resources: talents and sources of capital.

Recommendation 4 Encourage efforts by universities (i) to stimulate entrepreneurship among students; (ii) to commercialize its research and link academics with entrepreneurs and venture capitalists in the region and outside the region.

Recommendation 5 Support the development of a sustainable business model for Volta Labs/Propel ICT.

Recommendation 6 The province should consider adjusting its trade services, designed for more-established businesses, in order to adapt them to the reality of tech entrepreneurs who need financial support to reach out to potential markets and specialized external resources and sources of funding.

Recommendation 7 Support the development of more networks of active business angels.

Recommendation 8 The Nova Scotia Tax and Regulatory Review should consider making the Digital Tax Credit more predictable (eligibility and continuity).

Recommendation 9 The Nova Scotia Provincial Tax Review should consider changes to the Equity Tax Credit: for investments in tech sectors, which could include (i) raising the investment limit to $250,000; (ii) changing eligible investments to include equity (common and preferred shares) and quasi-equity (convertible debentures) investments; and (iii) making it refundable to attract investors from outside.

Recommendation 10 Transfer NSBI’s venture capital allocation to Innovacorp.

Recommendation 11 Innovacorp

Leverage Innovacorp’s incubators to set up effective vertical incubation/acceleration programs in tech sectors.

Venture capital: Increase Innovacorp Venture Capital Allocation by shifting NSBI’s allocation. Clarify its mission (build and finance successful Nova Scotia tech companies). Focus it on investment at the seed stage. Improve and streamline its operations (see details). Strengthen its governance.

As the ecosystem matures, Innovacorp should consider shifting part of its direct investment activity to a co-investment fund that would invest alongside accredited business angels and, eventually, to indirect investment through independently managed seed funds.

Recommendation 12 If in view of the strategic importance of the tech sectors for the economic future of the province, the government had the opportunity to increase its allocation to venture capital, it should consider investing in specialized funds that have a focus on the deal flow of the region in order to facilitate an increase of their level of investment in the province.

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Recommendation 13 The Nova Scotia tech business community should take a leadership role to make itself more visible and link with the resources of the broader Nova Scotia business community, including as business angels, mentors, employers and champions for an innovative and growth-oriented economy.

I appreciated the opportunity to work with the Department of Economic and Rural Development and Tourism (ERDT) on this project. I would like to thank all the people I met for their time and insights and, especially, Mr. Jeffrey Larsen and Ms. Lorraine Glendenning for their strong and kind support during this assignment. If you have any questions or require follow up information I can be reached at either +1 (514) 276-1348 or via email at [email protected].

Gilles Duruflé

May 6, 2014

mailto:[email protected]

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ANNEX 153

What is venture capital investment?

In their reference book The Venture Capital Cycle,54 Josh Lerner and Paul Gompers define venture capital as “Independently managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high-growth companies.” Venture capital is thus defined by three elements: its focus, its investment vehicle and its management team.

Its focus: privately held growth companies. In the same text, the authors use similar expressions as “privately held technology-intensive businesses” or “young firms”: venture capital is focused on the difficult task of financing young, fast-growing technology companies, “technology” meaning information technologies, life sciences and other technologies (mainly cleantech and new materials).55

Being young, most of these companies are still private, but this is not the only reason why venture capital invests mostly in private companies. Another reason is that most of the time, and for motives we shall explain later, venture capital wants to be an active investor and be able to negotiate conditions attached to its investment. When well designed, these conditions are important to protect its investment as well as align interests between management and investors in order to build the company.

In the same vein, when venture capitalists invest in public companies, they usually make private placements in these companies,56 which means that they take a significant share of the ownership of the company and negotiate the conditions of their investments.

Its investment vehicle: equity (common or preferred shares) or equity-linked investments such as convertible debt or warrants, as opposed to debt.

Its management teams: independently managed dedicated specialist teams as opposed to more generalist teams within large financial institutions which would finance different sectors or stages of companies. Venture capital funds usually do not invest outside of their field (“privately held high-growth technology-intensive companies”) and other kinds of funds or investment vehicles (commercial banks, mutual funds, hedge funds, buy-out funds) usually do not invest in venture capital.

This definition raises a question that goes to the heart of venture capital industry: why is it necessary to have “independently managed dedicated pools of capital to invest equity or quasi-equity in privately held, high-growth companies”? Why could other, more-traditional investment vehicles such as commercial or investment banks not finance these types of companies?

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Excerpts from Gilles Duruflé, Why Venture Capital is Essential to the Canadian Economy – The Impact of Venture Capital on the Canadian Economy, CVCA, January 2009.

54 Paul Gompers and Josh Lerner, The Venture Capital Cycle, 2nd ed., The MIT Press, 2004, p. 17. This paragraph is

partly based on this book, especially Chapter 7, “An Overview of Venture Capital Investing.”

55 In the whole document, “technology” will refer to these 3 sectors.

56 These investments are called “Private Investments in Public Enterprises” (PIPE).

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There are several reasons for this, which can be traced to the characteristics of investments in technology start-ups, which, in turn, contribute to determine the specific features of venture capital.

First, a high level of uncertainty: beyond the usual uncertainty factors that surround the building of any company, there are specific uncertainties linked to R&D activities and the development of new technologies, or to the fact that many of these companies address emerging markets (new needs and new products) that are difficult to overcome or even quantify and in which the competition evolves very quickly due to the continuous emergence of new technology solutions, new business models and new companies.

Second, a high level of information asymmetry between the entrepreneur and the investor: for technology start-ups, the usual financial statements are not adequate tools for the investor to monitor the risk and the progress of the company. In companies where there are virtually no revenues or profits, the investor needs a much closer understanding of what is going on inside the company to judge whether it is on track or not, or whether it needs some kind of re-orientation.

Third, these companies have very limited tangible assets; most of their assets are intangible (R&D results, intellectual property and people), which makes it virtually impossible to secure conventional debt financing.

Fourth, it usually takes a long time, up to seven years or more, before these companies can launch an initial public offering (IPO) or are acquired. A limited number of these investments will be great financial successes; others can become complete losses. Therefore, venture capital investment is, by its very nature, highly illiquid and risky.

It is to deal with these unique characteristics that specialized teams and investment tools have been developed by venture capital.

To reduce uncertainty, specialized teams with deep industry expertise and networks to quickly access specialized information on technologies, markets, competition, and potential buyers and to source seasoned management resources. These skills and networks allow venture capital managers (i) to make better-informed investments, and (ii) to work more closely with the management to help build the company and prepare an exit.

To face information asymmetry, venture capitalists rely on

an in-depth due diligence process before investing

a very close monitoring process after investing, including active participation on board meetings and a direct relationship with the management on key performance metrics commonly referred to as “dashboards” and “milestones”

a good alignment of interests between the entrepreneur and investors through customized compensation systems, including stock ownership and options, and contractual clauses such as liquidation preferences

syndication with other experienced venture capitalists to maximize expertise and access to relevant information

All of these activities require specific skills, industry knowledge, and networks, and are highly time consuming. For this reason, venture capital managers only make a small number of investments (one to two investments by a senior manager each year) and manage a limited number of investments at a time (usually up to six). This active involvement implies relatively

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higher management fees compared to other types of investments, which have to be compensated by higher returns.

To deal with intangible assets: equity and equity-linked financing.

To face illiquidity and risk, the dominant venture capital investment vehicle, particularly in the US and Europe, is structured as a limited partnership with negotiated terms that are designed to appeal to long-term investors with diversified portfolios (i.e., institutional investors such as endowments, public and private pension funds, and insurance companies). This provides the venture capital fund with a long-term stable source of capital

This brief review of venture capital investments explains the main characteristics of the industry. The industry did not appear in its present form overnight but took about four decades to develop and reach maturity in the US. From there, with a certain time lag, it has spread to other jurisdictions such as Europe, Israel, Canada and, now, China and India.

How venture capital funds work

The activity of a venture capital company can be broken into three different phases.

Fundraising

First, venture capital managers have to raise a fund.

The dominant model in the industry is that of independent teams that raise funds from institutional investors, mainly pension funds, university endowments and financial institutions. These funds are structured as limited partnerships. This is why investors are called Limited Partners, or LPs, and the team that manages the fund acts as General Partner, or GP. GPs are usually asked to invest a significant portion of their own net wealth in the fund. Alongside with the carried interest (see below), this is an important way to ensure a good alignment of interest between LPs and GPs.

There are several reasons why the limited partnership became the dominant venture capital structure in the US and, increasingly, in the rest of the world: (i) many of the LPs are tax-exempt institutions, such as pension funds, and the limited partnership structure allows gains to be passed from the fund to the investors without taxation; (ii) it is well suited to investors such as endowments or pension funds with long-term investment horizons, (iii) it can be restricted to a limited number of experienced investors and therefore has not required registration with securities authorities, (iv) the distribution system allows for the distribution of a carried interest to the managers, which is a powerful tool to align interests between investors and fund managers, and (v) it has a limited lifespan, which implies that the fund managers have to raise a new fund every three to five years based on their track record. This is the basis for a very efficient mechanism for selecting managers: successful managers are able to raise new funds; unsuccessful managers exit the market.

The term of the partnership is usually ten years, with an extension option of two years. The investment period, during which new investments are made, is usually three to five years. The team is authorized to raise a new fund once the investment period is closed.

The role of LPs is limited to choosing the funds in which they invest and providing capital. They do not intervene in the management of the fund. The main management parameters of the fund

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(management fees, carried interest, investment strategy and restrictions) are defined in the limited partnership agreement. Unless there is a clear breach of this agreement, LPs generally cannot remove the GP. However, they can choose not to invest in the next fund raised by the GP. This is why it is important for GPs to keep a close relationship with their LPs and to deliver results.

Besides private independent funds structured as limited partnerships, there are other types of funds – captive or evergreen funds such as corporate funds, institutional funds (linked to financial institutions), government funds or retail funds (see below) – which present different models for capital calls or for a management team’s compensation.

Investing and creating value: the blueprint

Once the fund is raised, the GP invests it in a portfolio of companies. The key success factors at this phase are as follows:

The quality of the deal flow to which the team has access. GPs not only react to business plans they receive, they actively look for investment opportunities from various sources: universities and research centres, large companies’ spin-offs, serial entrepreneurs, etc., and sometimes create companies themselves to meet a perceived market or technology opportunity.

The thoroughness of the due diligence process, which looks at the management team, the business model, the market potential, the technology, the intellectual property, the ability of the firm to add value to the investment, the required capital to build a successful exit and the potential return. Given the level of risk incurred, the investment opportunity has to have the potential to be a real breakthrough and a big winner.

The ability to structure a deal that aligns interests among the syndicate of investors and between investors and the management team of the investee company.

Venture capital funds only make a small number of investments every year and are very selective in their investments. For 100 business plans received, 10 are looked at in detail, and 1 or 2 actually get funded. However, the fact that an opportunity does not meet one fund’s investment criteria at a certain time does not mean that it will not fit another fund’s strategy.

Venture capital funds usually invest in syndicates, which allows them to diversify their risk and, by choosing the other members of the syndicate, to access more expertise and network. They also invest in rounds, which means that when they invest in a new company, they reserve capital for follow-on financing. Not all investments in the portfolio will succeed. Successful GPs are those who set appropriate milestones to be reached by the company, walk away quickly from non-performing investments and concentrate their capital and time in winners in order to build large exits. Portfolio returns are usually determined by these winners.

To build these exits, venture capitalists work closely with the management of portfolio companies: they are active on the board of directors and help recruit other value-added board members, with key relationships. When the company is still in its early stage, they work with management on the business model, provide hands-on operational support and may intervene to complete or change the management team in order to meet the new challenges that arise as the company grows. They draw on their network to actively connect portfolio companies to strategic customers.

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Leveraging their network within the venture capital community, they help build the following rounds of financing with other value-added investors.

Finally, they help build the investment exit, working with investment bankers to prepare for an IPO or positioning the company for a trade sale to a strategic buyer.

To achieve all this, they rely on very experienced partners with broad and deep industry and operational knowledge and far-reaching strategic networks. These partners concentrate on a small number of investments and devote a lot of effort to build the company.

This is the blueprint of venture capital best practices and summarizes how venture capital managers may add value to their investments. In practice, not all funds or all investments include all these features, and the nature of venture capital investment varies with the stage of the company, its particular environment and the strength and weaknesses of its management team as well as those of fund managers themselves.

Exiting and distributing returns

Once an investment has been sold or when it has become public and its stock has become freely marketable after a period of escrow, proceeds are distributed: LPs receive their capital, and profits are divided 80% to the LPs and 20% to the GP. This part of the gains received by the GP is called carried interest. It is meant to align interests between GPs and LPs and is usually 20%, though very successful managers may be able to raise funds with higher carried interest. Many funds include a hurdle rate, which is a minimum threshold rate of return, below which 100% of the profits go to the LPs. This model is designed to align interests of fund managers and fund investors, and to compensate managers only for realized investment performance. Other models exist, but the one described here accounts for most venture capital organizations worldwide.

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ANNEX 2: LIST OF PEOPLE INTERVIEWED

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ABOUT THE AUTHOR

Dr Gilles Duruflé is an independent consultant advising venture capital and private equity funds, institutional investors and governments. He is also Executive Vice-President of the Quebec City Conference and President of its Public Policy Forum on Venture Capital and Innovation.

He was until 2004 Senior Partner at CDP Capital Technology Ventures, the venture capital subsidiary of the Caisse de dépôt et placement du Québec, in charge of the Funds of Funds portfolio, investing in North American and European VC funds.

He was previously Head of strategic studies at the Caisse de dépôt et placement du Québec. From 1979 to 1991, he worked as Senior Partner in strategic consulting firms in the CDC Group (Caisse des dépôts et consignations, Paris) in Europe and North America.

He is a Vice-President of the Canadian Venture Capital and Private Equity Association (CVCA) and sits on the Board of the Quebec City Conference and on the International Private Equity Valuation (IPEV) Board.

Dr Duruflé obtained his Masters in Philosophy from the CERP (Paris), his Ph.D. in Mathematics from the Paris VI University and the Diploma of the Centre d’Études des Programme Économiques (Ministry of Finance, Paris). He is a CFA and has published numerous books and articles on various subjects related to economics and finance.

Gilles Duruflé Tel: +1 (514) 276-1348 Cell: +1 (514) 887-4966 [email protected]

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