In our article last week, The Lowdown on the Slowdown, we noted that some geographic markets such as Europe and Canada have been less impacted than their US and Asian counterparts. To explore this observation further, it is necessary to look at regional variability in investment performance rather than just investment activity. Falling valuations have been a significant point concern for investors over the past few months, as it affects their decision process regarding whether to invest “now” or “wait”.
One theory explaining the falling valuations argues that prior investment values were overly bid up by intense competition among investors in the high-tech start-up market to artificially high levels based on the VC fund’s investment mandates. Difficulties obtaining higher returns in the public market have driven non-VC sources of funding into the start-up market (Tunguz) (Suster). Excess available investment capital is not necessarily a bad thing; it means more great (and more not-so-great) ideas are getting funded. However, it also means overall deal return on investments will fall as valuations increase while the fundamental business models behind these start-ups remains the same. In the run-up to the slowdown noted in November 2015, valuations between funding rounds should show higher volatility and variability because the portion of the market influenced by speculation that “someone will pay more later” increases.
In 2012 approximately 25% of global venture capital was invested in the San Francisco Bay area (Florida & King). Over the past 3 years, California received 33% of global venture capital in 2015 (KPMG, CBInsights). We expect this concentration of activity will result in a significant amount of non-VC smart money will start moving to markets outside the Valley where investment returns should be higher. This shift may already be happening, as in the fourth quarter of 2015, California’s share of global venture capital fell to 25% (KPMG, CBInsights). This dramatic and precipitous drop reflects how investors are looking to diversify their risk by investing in regions with lower volatility and potentially greater returns.
As our interest lies in companies based in Western Canada, this raised the question for us; does the Canadian market truly have lower volatility in start-up valuations over time? This is challenging question to answer, as private companies keep the value estimates from each funding round confidential. Fortunately, there are many other measures available that can give us a sense of how each market is affected. Below we look at downrounds and IPO performance.
Downrounds
A downround is a round of funding or an exit that is at a lower valuation than the prior round. Imagine you spent $10 million to buy 10% of a company with a post-money valuation of $100 million. At a later date, someone acquires a 10% stake in the same company for $8 million. Your investment just a significant portion of its value. For many, this is worse than having the company actually sell for $50 million, as most investors have attached share preferences to their investments that guarantee a positive return on capital under this scenario.
One excellent free report that tracks what’s up, down or flat and reports on funding activity each quarter is Fenwick’s Silicon Valley Venture Survey (Kramer & Tran). Unfortunately, this report only covers Silicon Valley companies, and to our knowledge there is nothing comparable for the Canadian investment market.
Fortunately, CB insights recently launched the “Downround Tracker” (CB Insights, 2016). While not absolutely comprehensive, so far they have identified 58 downrounds since the beginning of 2015. We went through their list and cross referenced each to identify where each company was headquartered and then compared it to the total number of deals we were able to track in each region. The results are in the table below.
| Percent of Downrounds | Percent of 2015 Deals | |
| Asia | 3.4% | 18.5% |
| Europe | 8.6% | 17.8% |
| India | 5.2% | 1.3% |
| Rest of USA | 53.4% | 34.5% |
| California | 29.3% | 25.3% |
| Canada | 0.0% | 2.7% |
It is worth noting that CB Insights has yet to identify a single downround for a Canadian company despite Canada making up 2.7% of all deals. Not a bad bit of information for investors interested in Canada.
IPO Performance
Another option is to compare post-IPO stock performance, as has been done in other publications (Schubarth) (Milstead). However, this is challenging in the Canadian market as there have only been four “tech” IPOs in Canada since 2014. Those are Shopify, Xenon Pharmaceuticals, Kinaxis and Innova Gaming Group ( as a spinoff of online gambling giant Amaya, Innova has never been a start-up). We compared the performance of these four Canadian IPO’s to Schubarth’s list of Silicon Valley IPO’s over the same period. From IPO to February 25th 2016 the 51 Silicon Valley IPO’s averaged a return of -29.2% with a standard deviation of 44.8 percentage points. Over the same period the four Canadian IPOs averaged a return of -13.6% with a standard deviation of 57.3 percentage points. It validates our operating premise and business strategy that the Canadian IPOs average a higher return (corrected for changes in exchange rate fluctuations).
Conclusion
We know the following: the trend towards greater concentration of investment venture capital in California may finally be falling. This is good for Canada, as investment in Canadian companies should be a direct beneficiary of the shift. The fact that Canada has had zero observed downrounds of financing in it’s venture capital scene, and that Canadian company IPO’s perform with less volatility versus the US are both positives. While overall activity is lower in Canada, the success rates should make any investor active in the marketplace very optimistic about the future for Canada’s entrepreneurs and investors.