Anthony Mouchantaf is a lawyer and the co-founder and president of Toronto-based Rthm Technologies Inc.
As new technologies continue to emerge, they will create new markets, products and companies at an accelerating pace. Economic success in the coming decades will depend on a country's ability to participate in this inevitable tide, and policy makers must be proactive.
While tax policy and foreign incentives are important, government has other, seldom explored policy tools at its disposal. An enticing policy opportunity lies in the major positive spillovers that venture capital can have on a national economy.
On the surface, venture capital functions as a subset of private equity, wherein fund managers deploy capital into private companies on behalf of their limited partners – typically institutional investors and pension funds. They collect a fee for managing the capital and retain a portion of the returns. But modern venture capital is distinct from other forms of private investment in three critical ways.
First, venture capital lies at the extreme boundary of a viable risk-adjusted return framework. Contrasted with traditional investment return targets – the S&P 500 average annual returns are approximately 10 per cent – venture capital is structured to identify investment opportunities that have the potential to yield 500 per cent to 1,000 per cent returns depending on the stage of the company.
Second, venture capital can create major benefits for its host economy. Ten-per-cent growth on a mature company with an entrenched infrastructure and work force will seldom move the economic needle from an employment or technological perspective. On the other hand, a successful venture investment can alter the course of an economy, create thousands of jobs, and pioneer new technologies and derivative products. Take Shopify, a Canadian cloud-based e-commerce company, as an example. Founded just more than a decade ago, and with a total of $130-million in private investment over that time frame, Shopify now has a market capitalization of nearly $10-billion, employs approximately 2,000 highly skilled workers, and has well over a thousand apps in its app store – an important indicator of derivative economic activity.
Third, the conditions that allow modern venture capital to flourish have only materialized in the past few decades as scientific advances have created new rules of market competition. Namely, digital products and digitally integrated products – which encompass the crux of venture capital investment – are characterized by high upfront costs but negligible or relatively low variable costs. The process to scale is therefore comparatively less capital intensive and less operationally risky. Additionally, with a sophisticated global infrastructure of advertising, financial and fulfilment technology – itself a product of the digital age – market access and diffusion is no longer a significant barrier to growth.
Thus, the most critical stage in the life cycle of a technology company occurs near its infancy, at the point of creating and validating a new technology and subsequently assessing product-market fit. This process requires disproportionately large amounts of specialized human capital, but relatively modest amounts of financial capital. This paradigm – recent and distinctive in human history – is what allows for the diversification of risk, and what makes modern venture capital possible.
Although the system functions relatively well in private markets, much of the real value created by startups accrues to their broader communities – such as job creation, technological spillover – and is not captured by private investors. This misalignment creates a compelling yet latent policy tool for government.
Public participation in venture capital may be undertaken through two models. In the first model, government deploys investment directly into startups and manages the portfolio itself. In the second model, government invests in venture capital funds as intermediaries, likely through a sovereign wealth fund.
In the latter scenario, government would act as a limited partner in the fund, guiding investment strategy and selecting strategically relevant sectors and industries. This allows government to diversify its exposure, generate returns and invest with a view to capturing otherwise untapped benefits. By defining investment parameters but leaving investment decisions to professional fund managers, government can ensure these decisions are undertaken with a view toward long-term private market viability rather than continued public patronage. Such a model would transform a relatively modest public investment into a highly effective sector-specific stimulus. This allows government to forgo the burden of selecting, supporting and monitoring private enterprise, for which it is ill-suited, while nevertheless directing capital into nationally and socially relevant sectors and technologies – for which it is best suited.