Recent declines in the level of venture-capital funding in Canada could lead to a brain drain and job losses, as well as have a negative impact on the new innovation-based economy.

Investments in Canada’s vencap market dwindled to $191 million in the quarter ended Sept. 30, 2009, a 51% drop from the $388 million invested in Q3 2008, marking the weakest activity in the vencap market in 14 years, according to a report released in November by the Toronto-based Canada’s Venture Capital & Private Equity Association, known as the CVCA. The report was produced with research partner Thomson Reuters Corp. of New York.

Early-stage technology firms operating in the knowledge-based side of Canada’s economy will be the most affected by this decline in funding, says Debarshi Nandy, assistant professor of finance with the Schulich School of Business at York University in Toronto.

“This could be biotechnology, computer software or any non-manufacturing industries,” says Nandy. “Debt and credit lines do not usually provide enough money for new firms pursuing large scale investments or capital-intensive industries.”

That lack of funding leads these firms to rely on vencap to fund their projects. As a result, entrepreneurs are heading south of the border to raise the money needed to “commercialize” their ideas and take them to market, says Gregory Smith, president of the CVCA: “Whether it’s building a factory or a distribution network for a viable idea, the funding for that development is what [Canada] is missing.”

The average Canadian vencap-backed company has received $1.9 million in 2009 to commercialize its ideas, according to CVCA research. Meanwhile, Smith says, a comparable firm in the U.S. would have received US$6 million-US$8 million for the same project.

Another result of this paucity of Canadian vencap funding is that job losses are sure to follow, says Smith. According to a CVCA January 2009 report entitled Why Venture Capital is Essential to the Canadian Economy: The Impact of Venture Capital on the Canadian Economy, the Canadian vencap sector created 150,000 jobs between 1996 and 2007. “The mobility of entrepreneurs and ideas is creating an outflow of talent and technology from Canada,” Smith adds. “We are becoming a net exporter of talent.”

Although Canadian vencap firms are still willing to take risks on new ventures, the pools of capital and investment partners needed to raise “fresh money” are shrinking, says John Varghese, managing partner of VentureLink LP, a vencap firm based in Toronto: “We’ve seen a lot of venture-capital firms, both institutional and retail, go out of business in the past three or four years.”

Varghese notes that this makes it more and more difficult for vencap firms to partner up — as they usually do, to spread the risk — and invest in up-and-coming companies.

Meanwhile, institutional inves-tors, such as the Ontario Teachers’ Pension Plan Board, are also showing less interest in the venture capital space, adds Varghese: “They are investing more and more money offshore.”

Because of the shrinking pools of vencap equity, new or “fresh money” brought in by vencap firms in Q3 2009 amounted to $65 million, a steep decline from the $131 million they raised during the same period a year prior, according to the CVCA report. “Fundraising is a leading indicator of potential venture-capital investment activity in years to come,” says Smith. “The fact that the fundraising levels are lower than current investment levels means that we are expecting a drop of 30%-40% in investment in 2010. It’s a troubling indicator on an already very troubled sector.”

A “cold” initial public offering market is a culprit, says Nandy. Usually, money flows into vencap funds when the IPO market is hot, as fund managers and investors are sure they will see a payout on their investments once a company goes public or gets acquired by another firm.

Until the IPO market heats up again, there are a few cost-free initiatives the government can put into place to spur activity, Smith says. For starters, the feds could do away with Section 116 of the Income Tax Act, which requires foreign investors to file a certificate with the Canada Revenue Agency that verifies they have already paid withholding taxes on their investment.

“It’s not tax-generator; it’s a regulatory filing,” says Smith. “And we have found [many] American investors and venture-capital firms avoid investing in Canada for this reason.” IE