Leaner, Meaner Innovation

As venture capital continues to shrink in Canada, a new kind of startup backed by a new kind of money is beginning to emerge.

Things have been better for venture capital in Canada. The industry has been contracting over the past five years, a trend that accelerated during last year’s financial crisis as institutional investors started looking for less risky investments. A recent study by the Canadian Venture Capital Association showed VC investment levels at their lowest in 13 years, with Ontario’s numbers dropping off more steeply than other parts of the country. The CVCA says that the industry is “in crisis” and has been calling on the Canadian Government to create a support program to help keep it afloat.

How are investors responding to this “crisis” and what does it mean for high growth technology startups in Toronto? As it turns out, the landscape is changing on both sides of the equation and what is emerging is a new kind of startup backed by a new kind of money.

15 years ago, at the height of the technology bubble, it wasn’t unusual for a startup to raise between $10 and $15 million in order to build and release the first version of a product. Today, startups are getting products to the market on a lot less. “Web-based infrastructure means technology costs are ten times less than they were. What cost us $500,000 in 1999 in the form of back office set-up costs, software development, and licensing can cost less than $10,000 now,” says David Ceolin, Managing Partner at Innovation Grade Capital, an active angel investor and entrepreneur who founded a successful startup in the mid-1990s.

It isn’t just the costs in terms of tools and people that have changed. The way software gets developed has changed as well.

Many startups have adopted a new approach to getting a first version out to customers. Dubbed “lean startups,” these new companies are focused on getting a stripped-down minimum product to market as quickly as possible to test the demand and customers’ willingness to pay for it. Only after this link between product and market has been established are additional resources devoted to trying to grow the business, including a larger investment in marketing and sales.

Companies that make it this far are more likely to be successful, while those that fail to find a market for their product at least don’t waste as much money on it. “In many cases, the lack of capital is forcing startups to build highly innovative business models that are predicated on engaging customers earlier,” says Duncan Hill, General Partner of Mantella Venture Partners. “This is a great thing for young companies and will serve them well in the long term.” Derek Smyth, a Partner at Edgestone Capital, a leading Toronto VC firm agrees. “It’s a lot cheaper to fail and that’s obviously a good thing.”

The lean startup approach means that companies are looking for smaller seed investments. This puts them outside the domain of traditional Toronto venture capital that typically invests larger amounts of money once the company has a proven product or an established stream of revenue.

One group filling the gap are “angel investors.” These are typically successful entrepreneurs that invest a smaller amount of capital while providing the benefit of both their experience and network of business contacts. And unlike VCs, angels typically do not take a large ownership stake in the company. “A company can now get down the highway quite far with a small round of well-connected angels, under better, less punitive terms than they used to get from VCs,” says Ceolin.

Toronto is also seeing a new type of fund emerge that is focused on making fewer, smaller investments and takes a more active approach to working with companies. Working with a smaller portfolio of companies, these funds are actively involved in the operations of each of their investments, working with startups at the early stages and leaving later stage investments, if needed, to traditional VCs. “Angel and other seed investment sources have become much more critical to the success of the web startup community,” says Rob Hyndman, technology business lawyer and co-founder of mesh, Canada’s leading web conference. “Traditional sources of financing, such as venture capital, have become less relevant, at least until later in the life-cycle.”

So, could the VC “crisis” in Canada eventually result in a wave of more customer-oriented startups backed by more committed, hands-on investors? Those in the community warn that it is still too early to tell, but the signs are encouraging. “I'm convinced that to build a self-sustaining innovation economy, we need to commit to the long-haul,” says Hyndman. “We need to help a generation or two of entrepreneurs achieve success. When they do, they will be back to invest intelligently in the next generation.”

For more information on the author April Dunford, please visit her blog, Rocket Watcher.