Investor liquidity issues are putting the squeeze on Canadian startups

Last week, OMERS Ventures partner Laura Lenz said publicly what so many Canadian VCs are discussing privately.

“Recently, I’ve heard of re-pricing by investors between term sheet signing and final docs signed,” Lenz wrote in a Twitter thread. “I’ve heard of final docs signed and money not being wired because LPs [limited partners] were failing to meet their capital calls. And shockingly, I’ve heard of money being wired and then pulled back.”

Lenz is not the only one—such gossip is currently rampant amongst Canadian VCs. Since the summer, multiple sources BetaKit has spoken with have noted instances of capital calls not being honoured by LPs, including those for two prominent Canadian firms by US LPs. BetaKit is choosing not to name the specific firms being discussed as it has yet to independently verify these claims.

While these liquidity issues are putting the squeeze on some Canadian VCs, the immediate harm is to Canadian startups that are looking to fundraise—including those that had closed rounds, only to never see the funds materialize or be clawed back.

While these liquidity issues are putting the squeeze on some Canadian VCs, the immediate harm is to Canadian startups that are looking to fundraise—including those that had closed rounds, only to never see the funds materialize or be clawed back.
 

“Over the past few months we have heard of these experiences firsthand, as well as hearing from other investors and founders across Canada,” Lenz told BetaKit. “Collectively, we all need to do better.”

Sources with direct knowledge of each deal have confirmed to BetaKit that capital issues have affected three different startups across British Columbia, Ontario, and Québec attempting to raise funds. In one instance, a verbal commitment was revoked following contingent board approval of a spending plan that included layoffs. In another, a term sheet was not honoured following pro rata disputes, blowing up the round and leading to layoffs. In the third instance, funds were deposited to the startup before investors sought to re-negotiate the terms, resulting in the round being re-priced and a portion of the financing returned.

Many of the sources that spoke to BetaKit about ongoing deal challenges did so under the condition of anonymity—some out of fear of reprisals from within Canadian tech’s tight-knit investment community. For this story, BetaKit is choosing not to name any of the companies involved.

“This is extreme for me and a real shock to what’s happening in our market,” Lenz said in a telephone interview, speaking specifically to the behaviour of investment funds being yanked back from startups. “It goes back to how that impacts the company—this is a company that thinks they’ve raised [funds], it’s been wired into their bank account, they built a two-year operating plan on and maybe hired based on it. And now that money’s being pulled back.”

Slow down

Lenz said these “founder-unfriendly” moves may be explained by the current economic climate, but aren’t excused by it.

“What behaviour do you want to portray? What relationship do you want to build?” she asked of VC firms. “We’re not buying a house and trying to get the best price, we’re getting married and we’re going to live in that house with somebody else for the next seven to 10 years.”

Lenz saw similar behaviour after the dot-com bubble burst in 2001 and during the great financial crisis in 2008. While she noted in her Twitter thread that, in the early days of the pandemic, OMERS Ventures considered pulling signed term sheets, “the conversation was less than five minutes as we agreed unanimously that we were investing in great companies regardless of market conditions, and we value our reputation.”

These are all examples of founder-unfriendly behaviour by VCs and growth equity funds. Yes, financial markets and the geopolitical environment are uncertain – as they have always been. Poor market conditions do not excuse poor behaviour.

— Laura Lenz (@LauraLenz) January 18, 2023

It’s worth noting that OMERS Ventures benefits in this context by sole-sourcing its venture capital from one of Canada’s top pension funds; other venture firms and funds draw from a broader (and more fragile) collective of limited partners. In both previous market routs and the current downturn, LPs have been hit by equity market volatility that’s lowered their liquidity and devalued their portfolios. The result is an overexposure to venture capital—an asset class that’s considered higher risk and tends to make up a small sliver of investor portfolios.

“A lot of these large institutional LPs have massive portfolios and VC is a small percentage,” said one VC about the state of the Canadian market. “LPs are looking at their portfolio and finding they’re way overweight in VC: it was only supposed to be five percent, and now it’s 10 percent, and they’re stopping or pausing their deployment of capital to VC because they don’t want to put any more money in the sector while waiting for the public markets.”

Todd Miller, global co-head of private capital advisory at Jefferies, told Secondaries Investor that for the first time in several years, capital calls are outpacing distributions for LPs. “We think that’s going to continue for a while,” Miller said. “That will put pressure on LPs to do more sales, and supply will build. We expect it to be a very active year.”

According to multiple Canadian VCs BetaKit spoke with, several LPs called on venture firms over the summer to ‘slow down’ their pace of investments and capital calls as they sought to rebalance their portfolios. Some VCs listened. Those that didn’t are now facing the consequences.

Call on me

Understanding how Canadian startups are affected by VCs’ relationships with their LPs requires understanding how capital calls are facilitated.

When a VC closes a new fund, the dollar amount—sometimes in the hundreds of millions—isn’t sitting in the firm’s bank account ready to deploy. Instead, it represents a committed amount from the VC’s limited partners. VCs only ‘call capital’ from their LPs when they need a cash infusion to fund an investment deal or cover management expenses. Firms typically set the expected cadence of capital calls—anywhere from per deal to per quarter—with their LP investors upfront.

But LPs, whether they’re multi-billion dollar pension funds or high-net-worth individuals, can be a tough collective to wrangle, and waiting on them to wire funds could slow down—or kill—deals. Calling capital regularly also increases the wire transfer fees investors would need to pay.

Enter the capital call line of credit, facilitated between VC firms and banking institutions to keep capital and deal flow liquid.

VCs take out these facilities from one or more banks, with each line tied to one of their funds. The line is typically a portion of the fund’s total value—for example, $10 million on a $100 million fund—with the bank receiving a notional interest in the fund’s underlying assets as collateral for the loan. Having a capital call line gives VC firms the liquidity to quickly finance a deal without needing to wait on LPs, and pay off the balance once the money rolls in.

There’s also a slight financial incentive for VCs using a capital call line, said Elizabeth Yin, co-founder and general partner at early-stage venture firm Hustle Fund, who’s based in San Francisco. When VCs calculate their internal rate of return, “the clock starts [on that growth rate] when they do a capital call,” she said. Calling capital on a deal that ends up getting delayed weeks or months, while the money sits in the fund’s bank account, can have a small impact on the fund’s IRR.

“We won’t do a capital call until we know we’re going to deploy money, but some people take it a step further and take out a loan [on the capital call line] instead so the clock hasn’t started, put the money to work now and then do the call later to get a bit of a head start,” Yin said.

One Canadian banker BetaKit spoke to downplayed the importance of IRR juicing, however. They pegged a capital call line’s notional benefit to the IRR at a roughly 40 to 60 basis point boost, a modest component of a fund’s overall return.

Domino effect or a red flag parade?

LPs have a strong incentive not to default on their capital calls: to miss one means losing the entirety of their stake in the fund. To do so also passes the danger downstream: VCs that can’t fully clear their line of credit in the allotted time frame (usually within 12 months, often within six) are in default, and the fund’s underlying assets go to the lender. Those underlying assets? The VC firm’s equity stake in a startup.

While the consequences are much higher for investors who have already made several capital infusions, Yin said defaults are more common in the early stages of fundraising from LPs who may have buyer’s remorse or low confidence in the fund. Speaking to the US market in particular, she said this is something that’s happening more in the crypto space.

“Some people are defaulting on purpose because they don’t believe the fund’s worth anything.”
– Elizabeth Yin,
Hustle Fund
 
 

“You have now VC funds, whose paper worth in their fund has dropped maybe even in half or more—we get a list of all the late-stage companies and what they’re worth now compared to before and the drops are crazy,” Yin said. “They’re all over 50 percent cuts in valuation. And so late-stage investors’ portfolios are now … cut in half or more.”

“And their investors are probably like, ‘that’s terrible. Do I want to continue doing my capital calls for this fund?’” she continued. “Again, some people are defaulting on purpose because they don’t believe the fund’s worth anything.”

The banker BetaKit spoke with believes that the chance of defaults happening in Canadian tech is low given the multitude of options available to all parties. For example, VCs could either turn to the fund’s existing investors to pick up the defaulted LP’s share or sell that commitment on the secondary market (private equity firms such as Harbourvest, Hamilton Lane, and Northleaf all offer secondary funds). They added that with roughly $4 billion of dry powder in the sector, some of it in secondary funds, a defaulting LP is an annoyance that VC firms are well-positioned to solve themselves.

As well, multiple VCs told BetaKit that fund managers are incentivized to play nice in a down market. “It’s very delicate,” one VC said. “Nine times out of 10 [if an LP asks to slow down] the VC is probably going to listen, because their business depends on getting that money.”

According to Pitchbook data from the third quarter of 2022, global dry powder across investment stages and sectors reached record highs of USD $585.5 billion.

Lenz is of two minds on the issue, noting that it’s “a fund’s responsibility is to make sure they have capital to deploy, and monitor and measure on a quarterly basis what reserves their existing portfolio needs versus what net new investments they can make.”

But the OMERS Ventures VC was also clear that having to call on other LPs to cover a defaulting investor’s stake “is not a good sign. … It raises potential red flags [for other LPs] of what’s happening in the fund or the market.”

VCs BetaKit spoke with noted that these red flags can have chilling effects downstream. Yin said as late-stage firms hold off capital calls to avoid angering LPs, fundraising becomes more challenging for startups at the next level down. When those companies turn to their insiders for bridge financing, those investors in turn stop funding new or early-stage companies.

“Everyone’s focused on trying to fix their own internal metrics and their portfolio companies,” Yin said.

“For the founders affected it’s probably just gut-wrenching and can destroy rounds and companies,” added one early-stage VC BetaKit spoke with. They noted that VCs prioritizing cash flow and internal metrics over prior commitments “sows a level of mistrust” within the investor community.

“There are many VCs whose word is their bond—but for those whose word isn’t, stories like this make it a less trusting market, and ultimately it makes everything harder than it should be. In other words, stories like this erode trust at a time when we can ill afford it.”

With files from Josh Scott. Feature image courtesy Shutterstock.