When we started McRock Capital five years ago, we had a vision and a blank piece of paper. We believed in Al Pacino’s speech from the film Any Given Sunday, in that “life is just a game of inches”, and the inches we need to succeed are everywhere.
We fought for every inch to get McRock’s first venture capital fund launched, and our portfolio company entrepreneurs fight for every inch to change the world. The difficult part, however, is recognising the inches that will end up helping you the most. Looking back, we know there was one inch we fought for that turned into a mile – access to funding through the Venture Capital Action Plan (VCap).
VCap was announced by the federal government of Canada in 2013 and launched in 2014. It was intended to fill a market gap and attract capital to Canada’s venture capital fund managers from private investors such as pension funds, high-net-worth individuals, corporations and banks. Having a well-capitalised VC industry would, in turn, create a sustainable ecosystem for new and innovative businesses in Canada to access capital.
Today, everyone is talking about VCap and whether the government should continue the program, modify it, or abandon it entirely. Like any broad-reaching government initiative, there have been plenty of supporters but also some detractors. Concerns have been raised regarding the additional layer of management fees resulting from the fund-of-funds structure, the slow speed that the Canadian economy may benefit from VCap, and whether the program is a prudent use of taxpayer dollars.
We recognise that, as direct beneficiaries of VCap, our objectivity on the subject could very reasonably be questioned. Since we are analysts at heart, we set out to take an unbiased look at whether VCap has been successful so far and also find a clear way to illustrate that success.
The “innovation tree” shows how VCap impacted the Canadian VC industry as a whole and how all its beneficiaries interact together as one functional ecosystem. To begin, we want to highlight how successful VCap has been in attracting private capital – defined as any capital not directly invested in VCap by the federal or provincial governments – into Canada’s VC ecosystem. Here are some of the key achievements of VCap to date that you can find within the innovation tree:
• Down in the roots of the tree, the four VCap funds of funds raised a total of C$1.36bn ($1.02bn): C$906m from private capital and C$450m from the federal and provincial governments. For every C$1 of government funding across the four VCap funds of funds, C$2 of private capital was attracted to the VC ecosystem.
• Up in the branches of the tree, 20 Canadian VC funds to date have received funding from either a VCap fund of funds or direct investment from VCap. These 20 funds have raised a total of C$3.34bn – C$2.97bn from private capital and C$369m from the federal and provincial governments through their commitments to the funds of funds. For every C$1 of government funding across the 20 Canadian VCs, C$8.06 of private capital was attracted to the VC ecosystem.
• Looking at the tree as a whole, what began as C$500m in commitments from the federal and provincial governments resulted in an additional C$3.88bn of private capital being attracted to the VC ecosystem, or C$7.75 of private capital for every C$1 of government funding.
Zooming in on the McRock branch of the tree illustrates the benefit of VCap in attracting private capital on a VC fund level. McRock raised a C$70m VC fund of which C$25m came from VCap funds of funds. Within the fund-of-funds allocation of our fund, C$8m was from the government, and this support enabled McRock to attract an additional C$62m from other investors.
For every C$1 of government funding, McRock raised C$7.47 of private capital from a group of leading investors such as Cisco Systems, EDF and Caterpillar. The commitment from our three corporate investors alone exceeds our government commitment and provides these global corporations with direct access to Canadian dealflow and McRock’s portfolio companies.
Beyond the attraction of private capital into the Canadian VC ecosystem, the VCap program also fuels extensive job creation across the country. Through the VCap funds of funds and the 20 VCs, a total of 126 Canadian companies have received funding, resulting in thousands of new jobs being created. Further, only 15% of the VCap’s total commitment to the funds of funds has been invested to date, so we have barely scratched the surface of the potential that this program brings to the economy.
Canadian job creation is an important point because it ties directly into one of the concerns raised against VCap – that the cost of the program may be too high, partially due to the additional layer of management fees that the funds of funds represent. We believe that in order to understand the cost of VCap you must also examine the money that the federal government recovers in the form of income taxes.
First, let us look at how much the VCap pays in management fees compared with how much the federal government recovers in income tax from the people who work at the funds of funds and VCs. We looked at the Canadian workforce of the VCap funds of funds and 20 VCs and, using some standard VC industry assumptions, we estimate that the current employees of the fund managers will pay C$106m in federal income tax during the full fund lives.
Using the same assumptions, we estimate that VCap will pay only C$89m in total management fees during the full fund lives, including all fees paid directly to the four FOFs, directly to the four high-performing VCs, and indirectly to the 20 Canadian VCs. To sum up, the federal income tax paid by the VCap fund of funds and Canadian VC fund workforce offsets all management fees paid by the government across all levels of the program with a surplus of C$17m in government coffers.
Next, let us look at how much the federal government receives in income taxes from all of the portfolio companies that the VCap funds of funds and Canadian VCs invest in. Across all the funds, a total of C$453m has been invested in 126 unique Canadian companies. Applying some basic assumptions based on our experience of investing in tech, we estimate that these 126 companies represent C$63m in federal income tax based on their current employees.
Since only 15% of the capital has been called by the VCap funds of funds, we can expect that a few hundred additional companies will be started through the program during the next few years. Put simply, it is not unreasonable to think the entire C$500m VCap program could be recovered entirely through income tax paid by the new portfolio companies.
We can use the McRock branch of the innovation tree again to serve as an example of this last point. Using the C$8m that our VC fund received from the government, we looked at the government’s pro rata investment in each of our Canadian portfolio companies. We then compared that pro rata investment with the total amount our portfolio companies’ employees paid in federal income tax last year. We found that, in all our portfolio companies, the government’s pro rata investment in each was paid back through federal income tax in a single year.
Even with the success of VCap, there are hundreds of early-stage Canadian companies with incredible innovations that need access to capital to move forward. The capital needs of these companies are far greater than the Canadian VC ecosystem can currently support. VCap benefits Canada and its economy as a whole and we believe that these benefits far outweigh the costs. However, continuing support is required to create a strong sustainable Canadian VC ecosystem.
To sum it up, the Canadian economy is already seeing significant benefits from VCap only three years in. As VC-backed exits continue, the recirculation of capital and the success of the program will expand even further. We believe the VCap program was a brilliant move by the government and, more specifically, the late Jim Flaherty, our former finance minister. VCap provided the necessary nutrients to grow a Canadian VC innovation tree that is seeding an entire forest of unique high-growth companies.
This is an edited version of an article first published on the PE Hub Network. Data sources: McRock Capital, Canadian Venture Capital and Private Equity Association, Government of Canada, PitchBook, PE Hub Canada, Teralys Capital, HarbourVest Partners, Kensington Capital.