Financing gap for early-stage Canadian firms stunting growth and hurting economy

Canada needs to fix a financing gap for early-stage businesses that’s impeding their success and often leading to potential high-growth firms being sold to foreign corporations, says the lead author of a new report.

“From the financial point of view, it [the gap in early-stage financing] really stunts growth. We may lose promising Canadian companies,” Dr. Miwako Nitani, PhD (Photo at top right) associate professor of finance at the University of Ottawa's Telfer School of Management, told Research Money.

The gap in the supply of angel and seed/early-stage venture capital financing for small and medium-sized businesses in Canada is causing broader negative impacts on the Canadian economy, Nitani and co-author Aurin Shaila Nusrat, a PhD candidate of finance at uOttawa, say in their report for the C. D. Howe Institute. Nitani is a fellow-in-residence at the not-for-profit research institute.

For example, the scale of angel investing in the U.S. dwarfs that in Canada. There is an angel investor available for every 17 SMEs in the U.S., compared with an angel investor for every 24 to 60 SMEs in Canada, according to their report.

Shortages in financing for Canadian SMEs are most severe at the low-tier capital level, or investment deals in the $2-million to $5 million range, the authors say.

“Ensuring sufficient capital supply for entrepreneurial firms at this stage is also critical to cultivating attractive deals for other investment tiers,” Nitani noted.

The birth and growth of young firms are key drivers of job creation and economic welfare, the authors say. Approximately 72 per cent of job creation across 18 OECD countries – including Canada – was attributable to firms with fewer than 250 employees, according to OECD data.

Yet scaling up appears to be particularly challenging for Canadian SMEs. Research shows only two per cent of mid-sized firms grow into large ones, along with a noted lag in high-growth services-producing Canadian SMEs.

VC investments in Canadian entrepreneurial companies have increased dramatically in the recent past, the authors say. However, their report points out that VC activity in Canada still falls well short of that in the U.S. when it comes to: total dollar value of investments and the number of deals; total VC investments as per cent of GDP; exit values; and internal rate of returns.

Given the U.S. has approximately 10 times the population as Canada, Canadian VC activity still lags proportionately – amounting to $14.7 billion in total dollar value compared with US$332.8 billion in the U.S.

Why is there a financing gap?

While little quantifiable research has been done on the financing gap encountered by Canadian SMEs, Nitani offered her personal opinion on why there’s such a gap.

Canada lacks the business clusters that exist in the U.S., in California, New York, Boston and other places, which make it much easier for angel investors and early-stage VC firms to identify and invest in promising businesses, she said.

Another possible factor is a lack of interest by institutional investors and VC firms in Canada in early-stage businesses, Nitani said. Canadian banks, for example, tend to be much more conservative and risk-adverse than many U.S. banks.

Nevertheless, there appears to be a healthy supply of debt capital available, as opposed to angel and VC investments, for Canadian SMEs, according to the authors’ report.

But these same Canadian SMEs face higher borrowing costs than large firms, compared with SMEs in such key trading partners as the U.S., the U.K., France and other OECD countries.

High debt costs squeeze free cash flows and may increase Canadian firms’ exposure to financial distress, especially during periods of low demand, the authors say.

“Both in general, and for young, growth-oriented and export firms in particular, the higher interest rates our SMEs face relative to their international peers increase business exit rates, leading to broader negative impacts on the Canadian economy,” Nitani said.

Most Canadian entrepreneurs want to grow their businesses in hopes of establishing a publicly traded company, she added. “But because they don’t have money, they end up selecting the second choice, which is selling their businesses to large corporations – often U.S. corporations.”

Not only do Canadian SMEs face a financing gap, they also lack the financial advice, expertise and networking that can substantially increase a business’s success rate, Nitani said.

Studies show that 31 per cent of Canadian SMEs are not in business five years after launching, while 54 per cent are no longer in business 10 years post-launch.

“Growth requires financing,” Nitani said. “It is, therefore, important for Canadian policymakers to ensure that firms with high growth potential can obtain the financing they need to nourish their development and contribute to Canada’s economic growth.”

Fixing the gap

To address the financing gap, the authors recommend establishing a national co-investment fund that would invest alongside private angel investors to leverage their investment and expertise.

The federal government recently shifted its policy approach to investing in VC funds or co-investing with private VCs in companies, rather than making direct investments, Nitani said. “They should expand this approach, not only for later-stage businesses but also early-stage businesses, and share the risks.”

Federal strategies to increase low-tier capital for early-stage firms might include expanding existing programs, such as the federal government’s $390-million Venture Capital Action Plan (VCAP) and the $450-million Venture Capital Catalyst Initiative (VCCI), or through the National Research Council’s Industrial Research Assistance Program, according to the report.

The authors also recommend that for young and high-growth firms, Ottawa should consider re-structuring the fee payment schedule on Canada Small Business Financing (CSBF) loans, so fees can accumulate over the loan’s life and are repaid by a balloon payment at maturity by the then-grown firms. This would reduce the annual borrowing costs for the most vulnerable borrowers.

In addition, for high-growth firms (those that experienced at least 20-per-cent revenue growth during the preceding three years), the CSBF program could be amended to cover the portion of requested loan amounts that exceed that which financial institutions are willing to provide, the authors suggest.

For exporters, Export Development Canada could help reduce exchange rate volatility through its foreign exchange facility guarantee program.

Nitani said the federal government also possibly could cover the fixed costs associated with early-stage investment, such as the costs of doing due diligence on early-stage companies considered for investment.

To further improve access to affordable capital for SMEs, greater competition among commercial lenders could be encouraged through scaling up of cooperative lenders, and with implementing open banking – which has lagged in Canada compared with other countries, according to their report.

The private sector could help with tailored programs, such as the Scotiabank Women Initiative that provides entrepreneurial women with unbiased access to capital, specialized education and advisory services and mentorship, Nitani said.

The authors also point out the need for policy research on the impacts of foreign funds on the Canadian VC industry. This includes examining whether the increasing presence of U.S. VC funds presents a risk to Canada losing future high-potential, job-creating and export-oriented businesses.

Closing the financing gap for early-stage companies could provide them with sufficient funds to grow their companies and perhaps become publicly traded, instead of having to sell their businesses and intellectual property, Nitani said. “We could keep these companies within Canada as Canadian companies.”

"There is a growing concern that very few Canadian VC-backed companies scale up in Canada and that the large role played by foreign investors may increase the probability of promising companies moving south of the border or being acquired (too early) by foreign companies." – 2019 report by Wendy Bradley et al  for the European Corporate Governance Institute 

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