In a Remote-First World, Do We Still Need Domestic VCs?
Over the weekend, I posted this tweet in response to a suggestion that a lack of domestic later-stage funds was inhibiting Canada’s biotech sector:
My comment ruffled a few feathers, including one person who argued that domestic financing is absolutely necessary because “Americans aren’t even investing outside of their own state.” (In fact, the data says something quite different, but I’ll leave that discussion for a future post.)
Through my role at Commonwealth Ventures, I’ve interacted with dozens of startup ecosystems around the world. In virtually every country I’ve visited, I’ve heard some version of the following argument:
“We don’t have enough companies getting funded at Stage X, therefore, we need more domestic Stage X investors.”
But is it really that simple? [Spoiler: it’s not]
There are plenty of misconceptions when it comes to startup financing. The role that geography plays in investment decisions is particularly misunderstood. I thought it would be helpful to share a framework to think about how location — and specifically proximity — impacts venture capital.
Consider the following (overly simplistic) model of a startup’s early journey:
Each of these stages describes a distinct phase of a tech startup’s commercial journey from inception to early growth. If we consider the typical sources of (equity) funding available to companies at each of these stages, it looks something like this:
Now, if we consider physical proximity of these sources of capital relative to the startup, we end up with this:
Let’s dive into each of these stages with a focus on investor proximity:
Idea Stage
The earliest sources of funding for a startup are typically “network local,” meaning that they are from people within a founder’s personal or professional networks. These individuals invest in a company because they have deep knowledge about the founders (friends, family, past colleagues, etc.) and/or the problem they’re trying to solve (e.g. industry experts). Counter-intuitively, location plays very little role at the earliest stage of investment, due to the emphasis on relationships.
Prototype / MVP Stage
Once founders step outside of their networks to raise capital, physical proximity is a dominating factor. At the prototype/MVP stage, investors are still making a significant leap of faith but without the benefit of a prior relationship with the founder. As such, their investment decisions frequently include factors that might only be appreciated within a local context (schools, academic advisors, past employers, etc.).
A growing number of angels and Pre-Seed investors have recently shown a willingness to invest outside of their preferred geography, however, the majority have continued to focus primarily on their local ecosystems (even when investing over Zoom).
Initial Traction
Once a company has initial traction (users/customers, revenue, POCs, etc.), founders can begin to access sources of capital that are further away. At this point, they can point to early evidence that the company might be onto something.
These additional sources of capital typically remain within the startup’s home country. Seed investors look at early traction through a local/national lens in much the same way that angel and Pre-Seed investors apply local context to resumes. For example, a startup that has a POC with Canadian Tire might impress a Canadian Seed VC, but to an American or European investor it’s less compelling. The numbers aren’t big enough to stand on their own, so the local understanding is important. International investors, by contrast, will rightly ask the question “but will it work here?”
Repeatable Revenue
Once the revenue becomes more predictable, founders can expand beyond national borders and start tapping into regional investors. A U.K. startup with growing revenue can now confidently pitch European VCs, but absent U.S. traction is unlikely to gain interest from Silicon Valley. Similarly, Canadian startups are in a strong position to go south, but are unlikely to find traction with Asian investors.
It’s worth noting that there may still be geographic hesitation at this stage, particularly if the traction remains entirely within one country. A Canadian company with 100 customers in Canada but none in the U.S. is likely to face skepticism from Silicon Valley investors. Similarly, investors considering a U.K. healthtech company with incredible revenue but that has only sold into NHS will face valid questions as to whether their solution is specific to the U.K. healthcare system.
Market Expansion
As a company demonstrates its scalability across geographies and/or sectors, global sources of capital begin to unlock. Potential investors are able to analyze revenue from a variety of sources, each with meaningful history and metrics. Most growth stage investors cast very wide nets in terms of the countries that they’re willing to invest in, but competition for those investment dollars is on a global scale.
This last point takes us back to my original Tweet. Once a tech startup has reached the growth stage, VCs (and increasingly private equity firms) from Silicon Valley and around the world are unequivocally in play. As such, a lack of willingness on the part of U.S. investors to back a Canadian company should rightfully raise questions. Assuming that the company is competing in a large market, a failure to raise growth capital from any Silicon Valley VC means that no top-tier investor believes that the company will be able to generate venture-scale returns. To believe that a hometown VC would somehow see something at the market expansion stage that the most experienced startup investors in the world all missed is, frankly, hubris.
That said, the fact that foreign investors are unwilling to back a later-stage company doesn’t necessarily mean that all is lost. Its growth rate may simply have slowed to a degree that it is too low to be attractive to venture investors. On the other hand, it may hint at serious concerns about the company’s long-term survival. In either case, there are valid reasons why a country might want to prop up such a company (including in areas of national security, healthcare and economic development), but I’ll leave that discussion for another day.
Notwithstanding reasons of national interest, in attempting to answer the question “do we still need domestic VCs?” countries should focus on a more impactful question:
“What can we do to make our companies more globally competitive at every stage?”
In many countries, including Canada, I would argue that the problem isn’t a lack of later-stage domestic capital but, rather, a lack of competition at the earliest stages of investing. In the U.S., the rise of operator angels, solo capitalists and rolling funds has resulted in intense competition amongst investors at the Pre-Seed and Seed stages. VCs in Silicon Valley must compete to get into deals at even the riskiest stages of investment, which pushes them to improve their craft and the value they provide to their portfolio companies. That level of competition drives a degree of continuous improvement that isn’t present in VC ecosystems anywhere else in the world. The result? The most competitive and driven startup support system at every stage.
What does this mean for Canada? To use an analogy familiar to every Canadian: if you want to develop more world class hockey players, you don’t subsidize a domestic league for players who don’t make the NHL. You start at the beginning and build a system that promotes competition and continuous improvement by every stakeholder at every stage along the way.
