Canada Can't Afford a Flight to Fear

As 2023 kicks off, an industry-wide funding pullback is in full effect. VC investing in North America was down a whopping 63% in Q4 2022 year-over-year and now the VC echo chamber is trumpeting far and wide about the impending “flight to quality”.

Merritt Hummer of Bain Capital Ventures defines this phenomenon as follows:

 A “flight to quality” for the venture industry means a reversion to revenue models that are profitable and predictable. 

Broadly speaking, “flight to quality” refers to a consolidation of resources towards companies that are considered to be of higher quality and, thus, lower risk. In the startup world, companies that are seen as being of higher quality will find themselves attracting a higher share of venture capital dollars in 2023 while others struggle to raise. But what is “quality”?

In Merritt’s definition, “quality” is defined in terms of a company’s revenue model, not the company itself. This distinction is important, since the vast majority of high-growth startups do not become profitable until many years in. True innovation takes time and money, which is why venture capital exists in the first place. Thus, a “flight to quality” in venture capital does not (and should not) be interpreted as a flight to profitable or near-profitable companies only.

Unfortunately, in countries outside of the US, that’s often the case.

A Bit of History

Like most countries not named America, Canada’s venture capital industry evolved from traditional investment banking and later-stage private equity. In contrast to the inherently risk-taking approach of US venture capital firms (the origins of which you can learn about in the excellent book VC: An American History), most early Canadian VC firms historically relied on spreadsheets, numbers and traction to make investment decisions. The predictable result was a deeply conservative industry, in stark contrast to our neighbours to the south.

The American approach to venture capital has its roots in 18th century whaling

A corollary of the “top-down” evolution of venture capital in Canada was the emergence of an industry far more focused on later-stage investing than is found in the US. Canada has plenty of investors who are willing to jump on board once a company has product-market fit, but at the Pre-Seed stage there are embarrassingly few VC firms across the country.

To be clear, Canada’s venture industry has matured significantly over the years. Today, there are many more early-stage firms than there were 20 years ago, but that number remains frighteningly low. So while Canada’s tech industry has reached unprecedented heights in recent years, our innovation pipeline is at serious risk of a catastrophic slowdown if more than a handful of those investors flee the risk-taking necessary in Pre-Seed and early Seed for “safer” waters.

The Challenge

The last time we faced a real pullback in the VC industry was in 2008, following the US housing crisis (for those keeping score, that’s 15 years ago!). Plenty of investors are pontificating on Twitter about how “great companies are founded in tough markets,” but the reality is many of them have never seen a bear market, much less invested in one.

Many of today’s investors have only ever known a world where follow-on funding was relatively easy to come by. A world in which many of their companies were able to raise subsequent rounds, even if they missed their numbers (including, heaven forbid, investments where the investor glossed over diligence or FOMO’d into a bad deal). Now, those same investors are at a crossroads: do they continue to invest in risky, pre-revenue / pre-product-market fit startups or become more conservative and wait until there are more numbers to analyze?

For a VC who hasn’t experienced a bear market before, it can be very tempting to give into fear and flee to the safety of numbers. When times get tough, the siren’s song to “go upstream” (invest in later-stage companies, where investment decisions require less subjectivity) becomes loud. All the more so if the firm is still relatively unproven and some of their early winners are suddenly looking like duds.

In the US, there are so many VC firms that dozens — or even hundreds — of individual investors could move upstream without meaningfully impacting the ecosystem. It happens all the time. But in Canada, if more than a handful of our preciously few early-stage investors abandon Pre-Seed, then there will be no startups to invest in at the later stage. That’s how precipitous our position is right now.

You might think I’m over-reacting, but as I sit here in Vancouver, I can literally count on one hand the number of VCs in my city who are actively writing Pre-Seed checks. If even one of us pulls back from investing, the long-term impact will be significant.

The Opportunity

As much as we talk about great companies being founded in tough markets, it’s also true that great investors are forged in difficult times. Some of the best-performing early-stage funds of all time are from the last recession (2008 - 2011 vintage). The problem is, the short-term incentives for venture firms can drive individual investors to more conservative behaviour when times get tough. When capital is scarce, VCs can still make a lot of money by being safe, “okay” allocators of capital rather than leaning in to the opportunity to be great (and risk making mistakes).

The reality is that while becoming a more conservative investor can give the illusion of a short-term safety net, over time the returns of conservative firms reverts to the mean. The performance of such firms becomes more and more mediocre as vintage-defining outliers emerge in the portfolios of the investors who were willing to take risks. Marvin Liao, who has led investments in more than 400 early-stage startups around the world, recently noted:

It’s pretty safe and easy to just invest on traction or the 2nd or 3rd time successful founder. This is unsurprisingly the strategy for many established VC funds and angel investors. And this is also why many of them don’t drive good returns on their investments.

So as we look ahead to 2023, here’s to hoping that Canada’s early-stage investors continue to take risks and support our country’s most ambitious founders.

Our country simply can’t afford a flight to fear. And we won’t own the podium if we don’t take the shots.