Why 2016 won’t be as good as 2015 for the Canadian Tech Ecosystem
2015 was a banner year for the startup ecosystem in Canada.
- Canada had one of the most successful tech IPOs of the year. $SHOP !
- In 2015 Canadian Venture Capital investments were the highest they’ve been since 2000 in terms of dollars spent.
- More companies got funded in 2015. To be clear, this is different from the last point. More seed deals closed in first 9 months of 2015 then at any time ever (including 2000).
- Several Canadian Venture Capital firms closed new funds. Two announced their newly raised funds last week alone. We’ll hear about 4 new ones before the Spring Break. The increase in the amount of dollars available to VCs can be attributed to two things; initiatives by government LP’s and family offices diversifying away from their oil based investment bias.
We’ve come a long way since 2008. That said, we can’t rest on yesterday’s laurels. 2016 and beyond are shaping up to have some challenges.
We need to start discussing them now.
The major macro problem is the collapse of the Canadian Dollar, hitting a low that hasn’t been seen since the 2003. By all accounts we’re going to go even lower. One analyst predicts a 59 cent loonie.
If these predictions come true, we’re headed into territory that we haven’t seen in my lifetime. The lowest point we have ever seen was 61.98 cents in 2002. And with oil hovering around $25 we’re not going back to parity anytime soon.
But Wait, That’s Good Isn’t It?
You can almost hear the glee from Canadian entrepreneurs. At first glance there’s little downside for them.
Canadian startups sell to Americans. In American Dollars. The drop in the loonie from 0.90 cents to sub 0.70 means sales have gone up 35%. While our major costs (salaries) have stayed the same. Boom! Canadian startups now have more money. Huge win for us — let’s celebrate at the pub.
Not so fast. This is a temporary & fleeting win.
For years Canadian startups have received subsidies. A social safety net (healthcare), SRED tax credits for technical expenses and the reticence of Canadian talent to move. These have contributed to a 20–25% discount on what they pay talent here versus our friends in the south. Moving forward, these subsidies are not going to offset the new normal.
First of all, talent is not stupid. They’re called talent for a reason after all. If startups are getting 30% more on the revenue side and not sharing that upside in salaries, people are going to leave these startups.
Why? Because things like this are happening.
Try doing that every month. Shopify also charges in USDs, and they’re concerned with Quarterly numbers. They need to grow.
Beyond Shopify, U.S. based companies with an established presence in Canada (Facebook, Amazon, Salesforce to name a few) are also going to start scaling their hiring in Canada. This is a cost reduction opportunity against their U.S. operations.
In addition to the established players, I’ve also been fielding calls from several CEO’s of ‘Unicorns’ based in the U.S.. They’re thinking of laying off some of their staff and ‘offshoring’ it to Canada in order to extend their runways.
While companies will try to scale hiring in Canada, new grads with less ties (spouses, cars, houses) to Canada are more willing to move south. And why not? Student loans in Canadian dollars can be paid off quicker while working in the U.S..
This will be a repeat of the brain drain we experienced in the late 90’s and early 00’s. There are currently 300K Canadians living in California. The majority of them went there the last time the Dollar collapsed.
Last time the dollar was this low, statistics showed:
- 42% of graduates who left Canada, were the top 10% of their class.
- Tax filers with incomes over $150K were 7 times more likely to emigrate, incomes between 100K and 150K were 5 times more likely.
Bottom line: talent is about to become a huge problem.
‘But,’ say Canadian entrepreneurs ‘we have more money to recruit them, so to the pub!’
The problem is even when you increase salaries, you’re still not going to be that competitive. Your top drawer talent will go south.
Why? Because they’re about to get smacked with higher taxes.
- There’s is a new tax bracket for those earning more than $200K Canadian. That salary sounds like a lot until you recognize that it’s only 130K USD or so. If you plan on countering U.S. based offers, this is going to happen.
- Although it’s not clear yet, it’s likely that government is leaning toward changing the tax structure on Options. Your staff will be paying more income taxes when they exercise their options. This brings us (somewhat) in line with the U.S. in how exercised options are taxed. This means a tax bill they have to pay at the end of each year. I.e. No more Capital Gains tax exemption. In short, one of the pillars of better compensation for Startup employees in Canada may disappear.
Existing Startups aren’t the only ones in a fix. For brand new startups that are just getting going the news is even less thrilling.
The majority of seed investment in Canada is local. This may seem hard to believe but the numbers don’t lie. Even though many U.S. investors do come to Canada (and we should expect more with the Dollar collapse) 60–70% of all Seed rounds are still filled out with Canadian based investors. However, this % will decrease while the dollar amount may stay the same. Don’t expect 2016 to be banner year for seed investment because of the dollar.
Canadian Entrepreneurs will say — ‘we’ll just raise our rounds in U.S. Dollars. To the pub!’
U.S. Seed VC’s are pushing back on valuation that peaked early last year.
Canadian Angels will also push back hard on pricing — after all their net worth is Canadian Dollars. And to round it out, you’ll see Canadian VCs push back even harder in Seed deals, which is the last place we have real pricing power.
Why you may ask?
Canadian VC’s funds are also in Canadian dollars and can’t hedge. Most (but not all) LPA’s (Limited Partner Agreements) prevent our ability to do this.
So if we believe that 59 cents represents a floor on the price of the Canadian Dollar. Pricing in USD represents a currency risk. If the dollar recovers over the life of our fund our loses (if the company fails) actually increase. If the company wins then yay us. But the hole we have to win our way out of gets bigger with U.S. denominated deals.
Those gleeful Canadian VC’s
This a good segue to chat about that other pillar of the Canadian Startup Ecosystem. Venture Capital.
For us VC’s we’ve seen (and would love to keep seeing) our existing investments realize great upticks when startups are either acquired or invested into with USD. This’ll mean higher value rounds for several of my portfolio companies — everything’s coming up Milhouse!
Remember that banner year in 2015 that I talked about? Where we saw several Venture Capital funds raising more money? I lied. Let’s just discount that 35%.
I suspect that if we adjust the numbers to USD for all deals over the periods of 2013, 2014, and 2015 things would not look as rosy.
Several more Canadian funds have announced (or will soon) $200M funds. But, those funds are now equal to a $130M USD fund. Many of these VC’s previous funds were at $150M but when our dollar traded at 0.90 cents those fund were essentially equivalent to the U.S. value of the new funds. Canadian Venture Capital raises are really just treading water.
Pricing Canadian deals in USD means these funds will do far less deals or smaller portions of them then they planned or did in previous years.
This is bad for three reasons.
- Less deals means it’s harder for Canadian startups to get funding.
- Less deals mean less chance at finding a big winner and VC returns are going to go down.
- Even when Canadian VC’s do find a winner they’ll own less of them .
All making it less likely that Canada will have as many funds 3–5 years out.
Series A and B will be much tougher going forward as well. These tend to be where our U.S. counterparts join in investment rounds. They’ll have much more flexibility in pricing versus their Canadian partners. This will reduce the Canadian VC’s ability to compete. We’re going to see smaller exits and less go for broke founders. Where do I get this from?
Many more entrepreneurs are going to be tempted to exit earlier. Why would they?
- Harder to raise capital.
- Harder to compete for talent.
- Harder to get enough capital to grow large enough for a Series A.
- U.S. companies will become more acquisitive of Canadian startups with talent (whereas in the past most acquisition was revenue-based, not talent-based).
This will have a domino effect on VC’s in Canada and venture returns will be harder going forward.
2016 will not at all be like 2015.
It is time for Canadian entrepreneurs and VC’s to look beyond the short term gains the Canadian Dollar will give them.