This article first appeared in the 2008 Lexpert®/American Lawyer Media Guide to the Leading 500 Lawyers in Canada
Canada and its community of researchers and innovators have been global leaders in the biotechnology sector over the past decade. Canadian discoveries and innovations in genomics, proteomics and in therapeutics, to name a few, have greatly contributed to that success. Canada’s performance is evidenced by statistics which show that the country’s biotech industry ranks third behind the United States (US) and the United Kingdom in generating revenues, second to the US in terms of number of biotech companies and first in research and development expenditures per employee. [Source: BIOTECanada]
In 2006, there were more than 530 biotech companies in Canada, generating approximately $4.2 billion in revenue (all dollar amounts in this article are in Canadian dollars unless otherwise indicated). Canadian biotech companies invested approximately $1.7 billion in research and development in 2006, representing more than 12% of total business R&D in Canada. The maturing of the Canadian biotech industry can be further illustrated by the increasing number of Canadian public companies generating revenue and approaching profitability. In 2006, Canadian public biotech companies had revenue growth of 22% and a net loss decrease of 43% compared to the prior year. [Source: Ernst & Young] In addition, a majority of Canadian biotech companies are generating revenue and anticipate achieving profits within a three- to fiveyear time frame. [Source: BIOTECanada/PricewaterhouseCoopers Canadian Life Sciences Forecast 2007]
The Canadian biotech industry faces a number of challenges if it is to continue to grow and develop its global leadership in the future. For example, Canadian biotech companies are generally quite small in size; almost 50% have fewer than 10 employees and almost 75% fewer than 50 employees. [Source: BIOTECanada] Attracting and retaining key employees, both scientific and managerial, must be a significant priority. In addition, Canada’s regulatory process can be cumbersome and expensive; improvements in the regulatory process, including intellectual property protection and more timely review and approval of new products, are ways in which the regulatory framework can be improved to assist the development and growth of Canadian biotech companies.
But the main challenge facing the Canadian biotech industry is access to funding. Canada’s biotech industry is still in its very early stages of growth and, notwithstanding the very real economic improvements over the past few years, sustainability of the industry as a whole remains years away. Without adequate funding, the tremendous strides that have been made in the industry will go unrealized. For example, the total amount invested in C a n a d a ’ s biotech companies in 2006 was approximately US$900 million. One expert has estimated that the industry requires annual investment of at least US$2 billion to sustain the sector. [Source: Burrill & Company, BIOTECH 2006 – Life Sciences: A Changing Prescription, page 392] The Ernst & Young Survival Index reports that in 2005, 44% of Canadian biotech companies had less than one year of operating cash, while another 10% had less than two years. Industry participants confirm that securing financing continues to be a critical factor to their success. A majority of companies will require more than $10 million in their next round of financing and a significant minority will be seeking more than $20 million. [Source: BIOTECanada/PricewaterhouseCoopers Canadian Life Sciences Forecast 2007] Access to sufficient capital is ranked as the number one barrier to successful commercialization of intellectual property.
For the Canadian researchers to remain at the forefront of biotechnology innovation, it is crucial that more effective ways be found to address its funding needs.
As a quick illustration of the challenge, BIOTECanada, the national industryfunded association, has identified a significant funding gap which most biotech companies face: Source: BIOTECanada “Investing in Canada’s Future – BIOTECanada Proposed SR&ED Policy Amendments.” This article focuses on the venture capital and public markets as sources of funding and how they currently contribute to the biotech industry. While contributions from these markets are crucial to addressing funding requirements, there are also government grants, loans and tax incentive programs which play an important and supportive role in the financing of biotech companies. Industry participants advocate changes to Canada’s tax incentive and funding programs to improve the impact of government programs on funding requirements. For example, BIOTECanada has requested that the Scientific Research and Experimental Development (SR&ED) program be revised to extend the time within which accumulated tax credits can be utilized, to increase the maximum credits available, to extend the availability of credits to a wider range of companies, to loosen restrictions on the use of such credits and to give companies the ability to sell their credits to raise immediate funding. Another very important source of direct and indirect funding for biotech companies are licenses, partnerships and alliances with strategic third parties. These sorts of relationships include various arrangements with universities, collaborative research agreements between biotech companies to share the cost of R&D projects, and license agreements with the large pharmaceutical companies. Nonetheless, to address the funding issues most effectively, it is the financial investors which must increase their contribution to provide the most efficient and sustainable solutions.
Science and Technology Strategy
In May 2007, Canada’s federal government released a comprehensive strategy report entitled “Mobilizing Science and Technology To Canada’s Advantage” (the Report). The Report addresses, generally, the opportunities and challenges facing Canada and its business community and provides an overall guide for future government science and technology decision making designed to create the conditions and opportunities for businesses, universities and other scientific organizations to be successful. The federal government’s strategy complements individual provincial strategies reflected in documents such as the Ontario government’s Strategic Plan for its innovation agenda, released by the newly created Ministry of Research and Innovation in November 2006.
The Report recognizes Canada’s strengths, including its strong research base, but also acknowledges that more needs to be done to “turn ideas into innovations that provide solutions to environmental, health and other important social challenges, and to improve our economic competitiveness.” [Source: Report, page 7] The Report sets out priorities for the building of a sustainable national competitive advantage based on science and technology. It recognizes that Canada requires strong private sector commitment to science and technology, including the government’s important role in encouraging greater private sector investment. The Report identifies certain structural reasons why private sector investment in Canada is not at optimum levels, including the relatively small number of research-intensive industries in Canada (at least relative to the US), generally small business sizes which constrain financing and managing research and development, Canada’s regulatory and marketplace framework policies (such as business taxation, intellectual property and regulatory regimes) not being sufficiently conducive to private sector investment in R&D and commercialization and difficulties attracting venture capital investment, especially from pension funds and other institutional investors. [Source: Report, page 27]
While the Report does not provide many specific details on what the government will do to actualize its increased commitment to encourage additional involvement in science and technology by Canada’s private sector, it has undertaken an assessment of both the constraints and opportunities to inform future decision making. The Report provides a clear signal that the federal government will work to support the private sector in increasing its investment in R&D and the companies involved in emerging technologies. The Report sets out the following list of policy commitments by the government to create a business environment that is conducive to greater private sector innovation:
- ensuring competition policies provide competitive marketplaces;
- encouraging foreign direct investment in Canada;
- establishing the lowest tax rate on new business investment in the G-7;
- identifying opportunities to improve the SR&ED program;
- putting in place an effective, forwardlooking, and responsive regulatory environment that promotes a competitive marketplace and protects the health and safety of Canadians and the environment;
- fostering a leading-edge financial system; and
- considering new or different approaches to stimulate the supply of venture capital in Canada, including working to attract institutional investments in Canadian venture capital funds. The recently announced updates to the Canada-US Tax Treaty, addressing tax barriers to improve access to US venture capital by Canadian entrepreneurs, is an example of such an approach. The changes to the Tax Treaty are discussed in further detail below.
Venture Capital Financing
To appreciate the impact of venture capital financing for biotech companies, it is necessary to review the performance generally of the venture capital industry in Canada and to focus specifically on both fundraising and investments by venture capital funds. To a great extent, the venture capital sector’s activities in the biotech and other life sciences industries reflect its activities in all industries.
Put very simply, biotech companies need access to adequate sources of risk capital. The biotech sector relies on venture capital to fuel its R&D and commercialization efforts. There can be little doubt that venture capital has and will continue to play a crucial role in stimulating innovation through the formation and early development of new start-up companies in the biotech sector.
The Canadian venture capital community has found it difficult to raise new funds over the past five years. From a high of $4.2 billion in 2001, fundraising has dropped significantly; in 2006, funds raised totaled $1.6 billion, the lowest level in a decade. [Source: Unless otherwise indicated, all financial and statistical information in this Venture Capital Financing section provided by Thompson Financial.]
The main source of venture capital funds raised in Canada has been individuals. For example, although their percentage of the total has decreased in recent years, individuals still represented 58% of total funds raised in Canada in 2006. Individuals invest primarily in taxassisted retail vehicles called labor-sponsored venture capital corporations (LSVCCs). Certain provinces, including Ontario, are phasing out the tax benefits of LSVCCs, which will likely result in a continuing significant drop in individuals as a source of funds over the next few years. Pension funds are the next largest source of venture capital fundraising, representing 13% of funds raised in 2006.
Significantly, foreign investors as a percentage of funds raised by Canadian venture capital funds increased from 6% in 2005 to 10% in 2006.
Fundraising continues to be a significant challenge for venture capital funds, as $739 million was raised in the first half of 2007, 21% less than the amount raised in the first six months of 2006.
Commentators suggest a number of reasons why Canadian venture capital funds have had a difficult time raising new funds since the technology bubble burst in the early 2000s. Some observers suggest that there remains in the venture capital market a significant overhang from the early 2000s. For example, at the end of 2006, $3.5 billion was available for investment by venture capital funds (approximately two years of investment based on current trends) compared to a high of $5.2 billion at the end of 2002. Such commentators suggest that the sustained decline in fundraising represents a long continued decline in the market following the bursting of the tech bubble; in theory, as the overhang works itself out over the next two or three years, the fundraising environment in Canada should improve.
A second reason suggested by many involved in the industry is the limited participation of institutional investors, such as pension funds and insurance companies. The rate of participation in the venture capital area by such institutions in Canada is much lower on a percentage basis compared to similar institutions in the US. In addition, Canadian participation is limited primarily to very large institutions such as Ontario Teachers Pension Plan, Canadian Pension Plan Investment Board, Caisse de dépôt et placement du Québec and OMERS; smaller and mid-size pension funds and other institutions have not matched the larger institutions in allocating funds to alternative asset classes, such as venture capital and private equity generally. While Canadian institutions with over US$5 billion in assets allocate similar percentages to private equity relative to their US counterparts, participation by Canadian institutional investors having less than US$5 billion in assets is much smaller than similarly sized American institutions. In addition, in Canada the larger institutions which do make significant investments generally favor the buy-out sector, rather than the higher-risk venture capital market.
Part of the reason for lower institutional participation compared to the US may be that the Canadian market is less mature than the US market and does not have the same infrastructure of gatekeepers, advisors and consultants representing smaller institutions in determining their commitments to the venture capital sector; as the smaller institutions do not have the expertise inhouse to effectively evaluate the venture capital market, they chose to avoid it entirely. As the Canadian market continues to mature, the supporting infrastructure should grow, facilitating participation by smaller institutions. The Canadian Venture Capital Association (CVCA) has recognized the importance of generating more institutional participation in the venture capital sector. The CVCA has launched an initiative to provide education and meaningful information to such institutions to provide them with a better understanding of the venture capital sector and to address the barriers to entry identified by these institutions, including attitudes, internal staffing requirements and investment oversight difficulties, market entry costs and limited access to reliable performance data. [Source: Why Canadian Institutional Investors Should Participate in Global Private Equity – “Finding the Key” Report Implementation, May 2007]
A third reason for the constrained fundraising environment in the venture capital market relates to performance of the Canadian venture capital sector. While Canadian venture capital performance has improved over the past several years, it has been slower to bounce back than in Europe or the US. The pooled average return since fund inception in Canada, while improving, lags far behind the US. [Source: Gil Duruflé, The Drivers of Canadian VC Performance, CVCA Annual Conference, May 2007] Institutions which invested during the technology bubble and withdrew when the bubble burst may remain reticent to re-enter the venture capital market.
In addition, even for institutions pursuing alternative asset classes, the returns generated by the venture capital sector compared to the buy-out and mezzanine segments of the private equity market asset classes over the past five years makes it difficult to attract new investors to venture capital.
Investments in Portfolio Companies
Over the past five years, venture capital investment in portfolio companies in Canada has remained fairly steady at between $1.7 billion to $1.8 billion, significantly lower than in 2000 or 2001. While venture capital investments in Canada had been proportionally the same relative to the investment pattern in the US over the past few years, this trend did not hold in 2006 as US venture capital investments increased by 12%.
In the life sciences sector, 78 companies received $493 million in 2006, compared to a total investment of $438 million in 2005. Biopharmaceuticals account for more than 75% of venture capital investment in the life sciences sector, a consistent trend over the past few years.
Foreign (principally US) venture capital funds provided 32% of all venture capital investment in 2006 ($549 million), an increase of 19% compared to 2005. The participation of foreign venture capital funds in 2006 reflected a very significant increase in their market share in Canada compared to historical levels in the 25% range.
Another trend in venture capital investment in Canada exhibited in 2006 is increasing deal sizes with fewer companies receiving funding, but the average amount invested per company increasing. A number of 2006’s most sizeable venture capital deals involved biopharmaceutical companies. The average Canadian venture capital investment in 2006 was $4.2 million, an increase of 40% compared to 2005. Nonetheless, the average investment in Canada remains less than 50% of the average deal size in the US. This is particularly important in the biotech industry which typically requires significantly larger investments to complete the commercialization of new products.
Much of the increase in deal size appears to be driven by the increasing presence of foreign investors, which typically invest significantly more than their Canadian counterparts in each company which they select.
The 2006 trends continued during the first half of 2007. Foreign investment represented 41% of all venture capital investments in Canada in the first six months of 2007 and foreign investors continued to invest significantly more than Canadian venture capital funds in their deals, although Canadian venture capital funds continue to increase the size of their investments.
In the first half of 2007, life sciences companies received 10% less than in the comparable period of 2006, but maintained their share of 30% of total venture capital investments.
Of particular note, there were four transactions in the first half of 2007 of more than $50 million, compared to none of that size in all of 2006. In the life sciences area, Targanta Therapeutics raised US$70 million from a syndicate consisting solely of US investors, while Neuromed Pharmaceuticals raised US$53 million.
While the increased presence of foreign investors in Canada is having a positive effect on both the total amount of venture capital investment and specific deal sizes, it is very significant to note that 96% of all first-time investments are made solely by Canadian venture capital funds. Foreign investors do not participate in initial financing rounds. In 2006, global initial investments in biotech companies reached US$5.4 billion, an all-time high. In Europe, such investments totaled US$1.9 billion, also an all-time high. However, in Canada, initial investments in biotech companies dropped 15%, although, compared to 2005, there was a significant increase in follow-on investments for Canadian biotech companies.
Regional Distribution In Canada
Historically, Ontario has been the major recipient of venture capital investments, reflecting both the number of venture capital funds based in the Greater Toronto Area and the strong technology hubs in Toronto, Ottawa, Hamilton and Kitchener-Waterloo. Recently, however, biotechnology companies in Québec and British Columbia have been the subject of increased amounts of venture capital funding, at the expense of Ontario companies. In 2006, 118 companies in Ontario received $686 million in investments, a decline of 9% compared to 2005. Ontario remained the largest venture capital market in Canada with a 40% share, down from 45% in 2005. On the other hand, both Québec and British Columbia increased their market share of venture capital investments in 2006. Relative to activity in US states, Ontario, Québec and British Columbia finished 2006 in 9th, 10th and 17th place, respectively, compared to 7th, 9th and 20th in 2005.
These regional trends have continued in the first half of 2007. In fact, venture capital investment and activity in Québec led all provinces in the second quarter of 2007, performing significantly better than Ontario.
It is not entirely clear why investment activity in Ontario is declining relative to both Québec and British Columbia. One reason may be that retail fundraising in Québec remains strong, whereas in Ontario, the provincial government’s decision to phase out the LSVCC program is having a significant impact on investments by LSVCCs. In the second quarter of 2007, 40% of all LSVCCs’ investments occurred in Québec.
It is difficult to know whether the regional distribution of venture capital investment generally mirrors investment in the biotech sector; however, what evidence does exist suggests that trends in the biotech sector are similar to the general trends observed across the venture capital spectrum.
In summary, investment by venture capital funds in the life sciences sector has remained fairly steady at around $500 million per year over the past four or five years. Biopharmaceuticals, as a percentage of that investment, has also remained steady at greater than 70% of total investment in the life sciences area.
Importantly, there has been a significant increase in foreign investors which now represent more than 40% of venture capital investment in Canada. There has also been an increase in deal size, with fewer companies being financed. However, deal size in Canada is still significantly smaller than in the US. Regionally, Ontario appears to be in something of a decline while the Québec and British Columbia venture capital markets appear to be growing.
It remains difficult for new companies to get financing. There are estimates that only 20-30% of new companies are able to attract venture capital funding. Venture capital fundraising remains problematic.
While the solutions to improving venture capital investment in Canada are not simple, it seems clear that there needs to be continuing focus on increasing institutional participation, especially among the smaller to mid-sized institutions; that deal sizes need to continue to increase, particularly for biotechnology companies; and that increasing foreign participation is required.
The long-awaited protocol amending the Canada-US Income Tax Treaty, signed on September 21, 2007, represents a very positive development. The protocol contains a new provision intended to allow US residents who derive Canadian source amounts through an LLC to obtain treaty benefits; US residents who are members of an LLC will be able to claim treaty benefits with respect to income, profits and gains derived through the LLC. The protocol also provides for the elimination of withholding tax on interest paid to US residents, including the gradual elimination of withholding tax on interest paid to related parties who are US residents. It is anticipated that the conclusion of this protocol will facilitate investment by US investors in Canada.
There remain other tax issues, such as the extension of the SR&ED program to a wider range of companies, which industry observers suggest should be addressed to further stimulate foreign investment in the Canadian venture capital market.
In Ontario, the provincial government has committed to providing $90 million specifically designated for investment in early-stage Ontario-based companies in partnership with venture capital funds, pension funds and the federal government. Similarly, the British Columbia provincial government has recently launched, and committed $90 million to, a new Renaissance Capital Fund, which will raise 80% of the funds from institutional sources and target investments in the biotechnology and clean technology sectors among others. Both of these initiatives are designed to promote through government sponsorship greater participation by institutions in the venture capital market.
So how then do Canadian biotechnology firms close the gap between the current lack of venture capital and what they need to develop and commercialize new bioscience to build strong and profitable companies? One important source historically has been capital raised from public markets. Public equity investors play a very important role in funding biotech firms in Canada, even though most of the firms that are listed publicly are at early stages of development. As of June 30, 2007, the Toronto Stock Exchange (TSX), the senior stock exchange market for more established companies, had 89 listed life sciences companies and the TSX Venture Exchange (TSX-V), which provides access to capital for earlier stage companies, had an additional 54 listed life sciences companies. [Source: TSX Group Inc.]
Public market performance of biotech stocks has a direct impact on the levels of venture capital investment. Positive venture returns only come when a company makes a public offering or when it is acquired by another company at a premium price. Successful IPO exits are vital to improving Canada’s ability to attract additional capital to fund seed and early stage life sciences ventures in the future. More substantive exits drive more money to invest in the sector. Sectors that do not generate positive financial returns over the long term will not attract capital – and sectors that do will attract more of it.
The public capital markets have remained challenging for Canadian biotech companies in 2007. While there are a few success stories, many public companies remain small, undercapitalized and have suffered decreases in their share prices. To some degree, this experience is similar to what has taken place in global public markets in 2007 as the shares of public biotech companies were generally negatively impacted by the pullback in global stock markets earlier this year.
Because they could not attract venture capital for later rounds of financing, there were a significant number of Canadian biotech companies that, during the early part of this decade, went public to raise the required financing, but did so at too early a stage in their development. The result of going public too early is little liquidity in their shares, increased costs relating to being a public company and difficulty in building investor confidence. The business of commercializing bioscience is inherently risky with enormous technical and commercial uncertainty – and many Canadian biotech companies (being one product or product in development only companies) have suffered from setbacks in clinical trials or in the lab. As public companies, the alltoo- normal trials and tribulations of biotech companies at an early stage in their development must be publicly disclosed; investor reaction to negative news has been swift and often punishing. In contrast, in the US, most biotech companies go public at a much later stage in development because they do obtain substantial later-stage venture capital investment. As a result, these companies generate more research coverage, institutional support and greater liquidity in their shares.
A quick review of the market capitalization statistics for the 89 companies listed on the TSX is revealing. Less than 50% of the listed companies have a market capitalization over $100 million, a rough benchmark for a substantive sustainable company. Further, only three companies on the TSX have a market capitalization over $1 billion, a threshold indicating that a company is or can be competitive in the global marketplace.
Biotech stocks are clearly volatile and will suffer from sharp movements in price based on public disclosure of interim or temporary setbacks in the long 10- to 15- year process to commercialization of a new product. However, the biotech sector has traditionally shown a remarkable ability to respond positively to even just a few wins and the dissemination of positive news and results. Canada has a strong and vibrant stock exchange system in the TSX and TSX-V for life sciences companies and the sector seems to have learned from history that accessing public markets at the appropriate stage in their development is the best route to take, compared to the long-term negative effects of going public too early. Consequently, the public markets will remain a key source of financing and an essential source of value for biotech companies.
It is clear that Canadian stakeholders, including federal and provincial governments, the university and research community, the financial community and the business community, recognize the importance of creating a thriving science and technology innovation agenda for the future competitiveness and prosperity of the country and are committed to finding ways to create the conditions that will provide a competitive advantage for Canadian companies. Biotechnology is an essential component of this agenda. This article recognizes that adequate funding is a major challenge which needs to be addressed for this agenda to be successfully implemented. The recent changes to the Canada-US Tax Treaty, the formation of new funds with government sponsorship to attract more institutional investment and more judicious decisions by biotech companies as to when to go public are steps in a positive direction. The recent formation of new venture capital funds by CTI and Genesys Capital with a specific focus on the life sciences sector also bode well. With innovative approaches and commitment from all stakeholders, the funding challenge for the biotech industry can be met, allowing Canadian companies to continue to be global leaders well into the future. n