Despite challenging global economic conditions, calendar 2022 produced a number of positive developments for the Canadian venture capital ecosystem, particularly seed- and early-stage venture companies and clean technology ventures. While 2022 is unlikely to match the frenzied deal volume or lofty valuations that characterized 2021, the first three quarters of the past year represented a return to pre-pandemic levels, as investors continued to allocate capital to venture companies with a more strategic and disciplined approach than in years past. This insight summarizes trends in the Canadian venture capital ecosystem in 2022 and highlights key considerations for companies, founders and investors looking to raise or allocate capital in 2023.

Fiscal 2022: A challenging year for global capital markets

Global capital markets experienced a turbulent year in 2022, as historically high inflation, the war in Ukraine, lingering impacts of COVID-19 and the bursting of various asset bubbles, among other factors, weighed on investor sentiment and depressed valuations and deal volume throughout the year. With respect to the Canadian venture capital market, a few trends emerged, notably:

1. Rising interest rates lowered valuations. Rising interest rates compressed multiples across various industries and reduced investor appetite for high-growth, high-risk assets, a class of assets in which venture companies are typically overrepresented. Pre-revenue companies generally experienced the most negative impact on valuations and access to capital, while clean technology was a positive outlier in 2022. Investors adopted a renewed focus on the nature and strength of revenue streams for portfolio companies and, in 2022, were more likely to reward companies that produced revenue with a viable plan to convert that revenue to profits. In an environment with higher interest rates, future cash flows will likely continue to be significantly discounted as compared to treatment in prior, low interest rate years so companies that seek to derive a significant portion of their valuation from future revenue and/or growth may continue to experience challenging conditions, while revenue-positive companies continue to attract investor attention.
2. Companies had to survive longer between rounds. Depressed public markets became more relevant to venture company valuations as the amount of time between venture company rounds increased, thereby reducing the relative importance of those companies’ most recent valuations. In general, the impact of public company and private competitor valuations on a venture company’s valuation will increase as more time passes since the last venture financing round. Venture companies were impacted in 2022 by reduced access to private capital and an increasing weight afforded to public company valuations, many of which also suffered from a difficult year for global capital markets. In the United States, the average period of time between a Series B round and a Series A round was 879 days, an interval that increased in every quarter of 2022 and is the longest average interval between rounds since before the pandemic. The average time period between a Series B round and a Series C round also increased, reaching 772 days during the same period.
3. Investors demanded better deals. Higher interest rates and lower valuations were accompanied by stricter deal terms attached to venture capital financings. In addition to lower valuations, investors sought, and were often able to obtain, increased governance and operational rights, in the form of consent and board nomination rights as well as information relating to capital resources and expenditures. Investors negotiated more favourable liquidation preferences and anti-dilution protection than in years past and also expressed a desire for more active involvement in developing exit strategies that are in the alternative to a traditional IPO. With respect to the latter, investors increasingly negotiated for the creation of M&A and capital markets committees comprised of at least one representative of such investor with the aim of exploring the viability of potential exit transactions in the current market environment.
4. Venture debt was a popular fundraising option. Investment in “venture debt” in the first three quarters of 2022 surpassed all of 2021, indicating a desire of founders to avoid dilutive capital in an environment where valuations were depressed. Venture debt generally takes the form of a loan that is specifically structured for early-stage, high-growth companies with venture capital support and is typically provided by private individuals, specialized banks and non-bank lenders. In 2022, a large number of founders and companies pursued venture debt transactions as a bridging mechanism to raise necessary capital while avoiding issuing equity in an environment featuring lower than desired valuations.
5. Early stage ventures dominated the financing market. A high proportion of venture capital was allocated towards early stage ventures, with the Canadian Venture Capital Association reporting that 88% of known Canadian venture deals in the first three quarters of 2022 were seed- or early-stage investments. Information and communication technology services and life sciences were the top performing Canadian sectors in 2022 based on deal value and volume.

Key considerations for founders, companies, and investors

In spite of a challenging economic climate, the data from 2022 illustrates that capital raising opportunities exist for founders, companies and investors that are willing and able to adapt to shifting market conditions. Key considerations for founders, companies, and investors in 2023 include:

1. Use of proceeds. Founders and companies should carefully assess their capital deployment strategies since high cash burn rates will generally not be sustainable (or appealing to investors) in a fundraising environment characterized by lower valuations, slower valuation growth and more stringent deal terms. Venture companies will need to navigate an environment in which fewer capital resources will be expected to produce growth over a longer period of time between financing rounds. Founders should be prepared to articulate their vision for the deployment of capital and justify significant expenses, potentially even needing to obtain the consent of key shareholders or stakeholders. The assessment of capital needs will also impact the company’s capitalization table management, since obtaining capital by issuing equity or convertible securities has the potential to dilute existing shareholders; when valuations are depressed, the dilutive impact to existing shareholders of a venture company issuing equity can be significant.
2. Transaction structure. Not all financing transactions will be appropriate for a given company, so it is important to assess the various options that are available. While institutional venture capital investors overwhelmingly prefer a preferred share structure (for reasons addressed below), a company’s stage of development – seed, early/mid-stage, pre-exit – is a key consideration in the types of transactions that will be appropriate in the circumstances and advance the goals of the various stakeholders. For example, mid-stage or pre-exit companies may have access to bridge financing or venture debt whereas such sources of funding are usually not available to early-stage or seed-stage companies. Notably, venture debt usually relies on a borrower’s access to venture capital as a primary repayment source for the underlying venture debt loan; as such, it is almost always a tool that is used with venture capital instead of as a permanent alternative. Simple Agreements for Future Equity (SAFEs) are an instrument that can help raise financing in the short term while deferring pricing considerations until the time of the company’s next round; SAFEs are used by venture companies at all stages and are often favoured at the early stage to avoid the time and expense of negotiating costly documentation at a time when limited resources can and should be more allocated elsewhere. Given the variety of options available and the complexity of the applicable terms and conditions, companies and founders should consult with their legal, tax and financial advisors to determine the appropriate structure for a financing transaction.
3. Deal terms and documentation. The terms and conditions of a venture capital financing will be a matter of careful negotiation between the founder, the company and the various investors in the applicable round. As noted above, institutional venture capitalists overwhelmingly prefer a preferred share structure for investments because they are able to negotiate preferential treatment, including a liquidation preference, specified returns and the right to convert residual value to common shares. These terms and conditions are usually quite detailed and venture capital participants should obtain legal counsel to review and assist with the negotiation and drafting of these provisions. In addition, venture capital investors will typically negotiate rights for themselves related to governance, liquidity, consent, information, operational control and the right to participate in future financing transactions. The precise package of rights given to investors will be a function of negotiation on a case-by-case basis – and will likely vary across investors – but experienced advisors will be able to counsel founders and companies with respect to market terms and managing negotiations. The substance of these rights will usually take the form of one or more shareholders agreements between the company and each of its shareholders. While shareholders agreements will be discussed in greater detail in a future Insight, some of the key rights negotiated by investors include:
   • Board structure: venture capital investments often require a board composed of a combination of founders and institutional investors. Directors are responsible for managing or supervising the management of the company’s business and, while elected by shareholders, a typical venture capital investment will include a shareholders agreement wherein each of the shareholders agree to vote in favour of nominees appointed by the founders and certain key investors.
   • Pre-emptive rights: a right which provides an investor the ability to purchase securities of a company in future transactions, usually to maintain their pro rata interest in the company (although certain pre-emptive rights can allow investors to increase their pro rata position). Investors with pre-emptive rights are generally entitled to notice of future securities issuances, and are given the option to participate on the same terms proposed to third-party investors.
   • Drag-along rights: a right which provides an investor, or a group of investors, with the ability to cause the other shareholders to join in the sale of the company or, potentially, some other transaction.
   • Tag-along rights: a right which provides an investor or group of investors with the ability to participate in a specified transaction.
   • Rights of first refusal: an obligation of an investor to offer to sell its securities to other shareholders after receiving a bona fide offer to purchase from a third-party.
   • Registration rights: a right which provides an investor the ability to require a company to list securities publicly, registration rights have at least three forms: demand registrations, short-form registrations, and piggyback registrations. A demand registration right allows an investor to force a company to file a prospectus or registration statement. Short-form registrations and piggyback registrations are more relevant in the United States due to the application of securities laws but allow a company to file a condensed registration statement or allow an investor to include its securities in an registration statement initiated by the company or another investor, respectively.
   • Management/Consent rights: a right which requires a company to seek the approval or consent of an investor or group of investors before taking a specified action or actions, such as issuing additional securities, incurring debt, selling assets, or any other specified transaction. The consent of an investor with management or consent rights will typically be required before the company can undertake any number of specified actions.
   • Information rights: a right of an investor to receive specific financial and/or operational information about a company. Investors with information rights typically receive financial statements or other financial reporting, as well as access to management and a company’s books and records.
   • Other governance rights: in an environment featuring a weak IPO market and limited capital markets activity, investors in 2022 increasingly sought opportunities to work with companies to explore alternative exit transactions such as M&A, reverse takeovers and sale transactions by requiring companies to form committees dedicated to identifying and assessing potential transactions.
4. Capitalization table and stakeholder management. The final structure and deal terms of a venture capital transaction will inevitably impact a company’s capitalization table, so founders should proactively consider the issues that can arise to avoid any surprises at, or prior to, closing. To the extent that a new class of securities will need to be created to facilitate a financing, which is usually the case in a preferred share financing, founders and companies should be aware that Canadian corporate law statutes generally require shareholder approval to create the new class of shares and investors will insist on this being accomplished prior to closing. As such, it is important that appropriate relationships with existing shareholders are cultivated well in advance of a financing transaction and that the appropriate legal steps are followed to obtain any required shareholder approval or consent. Existing shareholders will typically focus on the impact of the new financing on their stakes in the venture company, so consideration will need to be given to dilution and, in the event of a down round, how anti-dilution provisions in existing share terms may apply and further dilute certain shareholders. Similarly, lender consent will typically be required in order to obtain senior debt or to revise existing debt arrangements (including with respect to security). A company’s founders and its board of directors, in consultation with legal advisors, should implement a formal process for managing stakeholder relations to ensure appropriate and timely disclosure and the receipt of any required approvals.
5. Asset management system. The identification, registration and maintenance of intellectual property remains a significant source of enterprise value in the information era. In addition, as investors place an increasing premium on revenue-generation, material customer contracts are a key asset for venture companies and increasingly a source of scrutiny during the due diligence phase of the transaction. Investors are increasingly prioritizing due diligence and scrutinizing the results of their investigations, placing a premium on founders and companies that take a pro-active approach to organization, asset maintenance and disclosure. Companies should implement a system to manage, document and maintain records related to all of the company’s corporate finance matters, intellectual property, contracts with third parties, employment/consulting/contractor arrangements, tax matters, owned or leased real property, marketing materials, privacy and data security protections and any other matters that would be of relevance to investors. At the outset of a venture capital financing transaction, the company will typically be required to produce these materials to investors on a confidential basis in connection with their respective due diligence investigations and, to the extent that materials are not immediately available, the consequences could range from critical delays to an outright cancellation of the financing due to red flags raised by the absence of key documentation. The most efficient method to deal with these issues is for companies to create an asset management system well in advance of a financing transaction in consultation with its advisors, internal subject matter experts, and other relevant stakeholders and for responsibility over management of the system to be specifically delegated to an individual or team.

Summary

The Canadian venture capital ecosystem experienced a challenging calendar 2022, in line with global and US economics results and trends. Despite the challenges, opportunities were present, especially for seed- and early-stage venture companies and those in the clean technology space. While deal volume and value were well below 2021 levels, the data as at the end of the third quarter of 2022 represented a normalization of activity to pre-pandemic levels. As tightening investor budgets and compressed valuation multiples impact the allocation of capital to venture enterprises, founders and companies must be able to articulate to investors a detailed plan for allocating capital resources post-closing and, in many cases, strategically navigate a venture capital environment currently offering expensive equity with strict management rights.

On the other hand, existing investors in companies facing capital raising needs will need to consider whether they prefer to accept a steep discount on the valuation of their existing investments or step in to provide support to portfolio companies at a valuation at or close to their prior investment price. The extent to which existing investors decide to provide support (or not) will have a significant impact on the bridge financing market and the number of down rounds for mid- and late-stage venture companies in 2023, as well as M&A and restructuring activity. As noted above, the Canadian venture debt market experienced a robust year in 2022, so it is possible that trend will continue for as long as valuations remain depressed and companies can financing their respective debt obligations. 

For more information regarding venture capital transactions or any of the other matters discussed in this Insight, please contact Suraj Rammohan or Jaskaran Grewal. Upcoming articles will address best practices in preparing for and executing venture capital transactions in 2023, negotiating term sheets, capitalization table management and related corporate governance issues, and key venture capital deal terms and documentation.