Venture Capital Investment in Canada has plummeted to its lowest level in more than 12 years, with deal activity showing a significant drop in 2008 from 2007 levels.

This pullback by investors who often drive the growth of more innovative companies could have a devastating impact on both existing jobs and the growth of early- stage companies, says Gregory Smith, president of Canada’s Venture Capital & Private Equity Association and president of Macquarie Capital Funds Canada Ltd., a part of the Australia-based global investing company, Macquarie Group.

“This is a long-term structural issue that we need to fix today in order to achieve any benefits for the future,” Smith says. In particular, the lack of investment in companies that are at the early commercialization stage could be detrimental because it will mean head offices and jobs will end up moving to where the money is. Such a retreat could have real repercussions for Canada’s ability to drive innovation and to compete effectively on a global scale.

“You have jurisdictions [such as] the U.S. and Europe, which have a much more robust and healthy venture-capital industry, and that puts us at risk for losing even more head offices and jobs outside of Canada,” says Smith.

That view is shared by Andrew Heintman, president of Toronto-based Investeco Capital Corp.. He says lack of venture capital is a growing problem in Canada: an economic problem as well as a policy problem, he adds, because lack of venture capital means newer companies are not getting sufficient funding. “One thing that is clear is that a lot more capital will be needed to build the next generation of Canadian growth companies, [but] available venture capital pools continue to drop precipitously in Canada,” he says.

The tale is in the numbers. Total venture capital investment across Canada dropped last year by 36%, with only $1.3 billion invested, down from $2.1 billion in 2007, according to an industry report released by CVCA and Thomson Reuters last month. The drop was particularly steep in the fourth quarter of 2008 — falling 43% to $302 million from the $526 million invested in the fourth quarter of 2007.

In addition, fewer Canadian companies were financed in 2008, with only 371 firms securing venture capital financing in 2008; that’s 10% fewer than the 412 firms that were financed in 2007. The data also pointed out that Canadian investors tended to shift away from large transactions, leaving start-up companies without enough funds to continue growing. Company financings in Canada averaged $3.6 million, whereas in the U.S. they averaged approximately $9 million, says Smith.

While Canadian start-ups seem to attract investor interest at the incubation stage, interest falls off when a fledgling company is ready to start stretching its legs. “The real gap in the ecosystem around venture capital is this commercialization stage,” says Smith. “The U.S. companies are getting more dollars and being able to fund companies in the later-stage development in the venture capital industry. In Canada, we tend to fund earlier-stage companies and when they hit a certain size there aren’t enough funds and that means they need to relocate to where they can get more financing.”

In October 2008, CVCA developed a four-point commercialization support program that would help the government address the primary systemic obstacles to increasing venture-capital investment. This program includes improving the Scientific Research and Experimental Development tax credit program; setting up a third-party managed fund of funds to invest in promising Canadian companies; enabling greater use of government procurement/offsets to encourage domestic and foreign investment; and creating a tax incentive for Canadian companies to invest in venture-capital funds.

“We looked at using tools that the government already had in its existing tool kit that could be enhanced or redirected to support these small to mid-sized companies that have a dramatic shortage of capital,” says Smith. Among those “tools,” the industry would like to see more tax relief when investors choose to support a variety of business activities. “Currently, corporations get a tax deduction for investing in research and development,” Smith says. “We are saying that corporations [investors] should also get a tax deduction for investing in venture-capital funds that invest in commercialization or development-stage companies.”

This type of tax incentive has been fruitful in the past. For instance, government tax credits played a major role in the introduction of labour-sponsored investment funds in the early 1990s. At one point, these incentives included offering investors a 40% tax credit on the first $5,000 invested.

@page_break@But in recent years, both federal and provincial governments have been slashing these tax benefits and in 2005 the Ontario government decided to phase out its LSIF tax credit by the end of the 2010 taxation year. The current 15% tax credit rate will remain until the end of the 2009 tax year; the credit will be reduced to zero for the 2010 tax year and 5% for 2011. It will be eliminated in 2012.

The reduction of tax benefits, combined with the impact of the market meltdown, adversely affected investment by LSIFs and other retail funds. In 2008, these funds invested $310 million, down 24% from $406 million in 2007.

In Heintman’s view, the impact of the tax changes has been sufficient to greatly reduce the amount of venture capital available in Ontario. “That market is withering and you don’t see anything taking its place,” he says.

Heintman adds that the effect of this development is being exacerbated by a general lack of support from Canadian institutional investors such as pension funds and other large investment pools.“And then on top of it all, you have the general state of the economy, which has an even more profound impact,” he adds.

Investeco, an environmental investment company that invests in both private and public companies, has recently raised more than $5 million in private equity.

“In the big picture, it is small but we have been able to get support from the high net-worth market and it continues to be at least a viable place for investors,” Heintman says. IE