Venture capital in the balance: steering through market turbulence

As the dust settled over the post-pandemic venture capital landscape in 2024, opportunities and challenges emerged for venture fund managers and technology companies in Canada. The innovation ecosystem gradually adapted to a new normal in terms of valuation multiples and deal dynamics. Despite pervasive fundraising difficulties across the tech sector, there were notable successes and patterns emerging to signal impending recovery and rejuvenation.

To capitalize on this recovery and mitigate the risks of future market volatility, investors and entrepreneurs must adopt a proactive approach. For venture capital funds, this includes selecting winners from their existing portfolios and allocating dry powder to their best performing investments. In parallel, this means diversifying their portfolios with new investments, having regard to technological advancements such as artificial intelligence. For startups and growth-stage technology companies, the focus should be on building scalable, sustainable business models and demonstrating clear paths to profitability.

Boards of directors and management teams need to assess strategic alternatives proactively and be ready to transact with their advisor teams and have their data room in place when the opportunities to pursue financings or acquisitions arise.

Fundraising dynamics for venture capital firms

Technology companies were not alone in their struggle to secure investors in 2024. The fundraising environment for venture capital (VC) funds also remained challenging. Canadian and international limited partners (LPs) demonstrated a hesitancy to make commitments to Canadian VC funds and required evidence of momentum in fundraising before agreeing to subscribe to new funds. Not surprisingly, fund managers waded through extensive due diligence processes with potential LPs. General partners (GPs) have also generally been forced to extend deadlines for their capital raising efforts.

Despite macroeconomic obstacles that included a relatively high-interest-rate environment, there were bright spots in the venture fund space for those GPs who inspired investor confidence or had a proven track record from prior fund performance. Among others, Amplitude Ventures secured C$263 million for its second precision medicine fund, Pangaea Ventures closed a C$115-million impact fund, Radical Ventures raised an US$800-million artificial intelligence growth fund and Pender Ventures completed the second closing of its C$100M Inflection Fund II.

A new wave of fund managers also braved the venture space in 2024 with the laudable goal of raising funds to finance underrepresented founders and companies driving social impact. This shift was buoyed by increased support from government initiatives. The Venture Capital Catalyst Initiative (VCCI) announced an additional C$25-million investment into five venture capital funds in Canada as part of its inclusive growth stream. The federal government’s social finance fund carried out by, among others, Boann Social Impact, was particularly active. It announced numerous funding commitments with an impact lens, including its commitments to BKR Capital, Active Impact, The51 Food and Agtech and Raven Indigenous Outcomes.  

This increased government funding contrasted with findings in a recent BDC Capital report that revealed that many VC firms are deprioritizing environmental, social and governance (ESG) initiatives compared to previous years. This underscores the importance for impact-driven companies and funds not only to prioritize social and environmental outcomes but, in parallel, to meet investors’ bottom-line expectations.

Deal terms on the VC fund side remained relatively consistent with historical norms. The “two and twenty” compensation rule — comprised of a 2% annual management fee and 20% carry — remained largely untouched, though there was modest upward movement to the management fee for micro VC funds. Preferred returns remained in the 6% to 8% range on a compounded basis. This sets a bar for LPs to achieve a specified return on their investment, or hurdle rate, before GPs are able to participate in the returns from the fund’s investments. More seasoned fund managers were able to negotiate preferred return commitments to their investors at the lower end of this range. Their emerging fund counterparts continued to experience the higher end of the range as they prove out their investment thesis.

The return of the mega deal: decreased volume, increased value

In 2024, deal volume in the venture capital space experienced a year-over-year decline. That was somewhat offset by the increase in average deal value in Canada for the year. According to Canadian Venture Capital & Private Equity Association (CVCA) market data for the first three quarters of 2024, Canada experienced the largest drop in seed and pre-seed stage financings in 2024, influenced by investors’ decreased appetite for higher-risk, early-stage ventures in the current market environment. Investors favoured proven, high-growth, revenue-generating companies that have achieved product-market fit and were either profitable or are on a clear path to profitability.

There were some notable mega deals in 2024. This activity followed the relative dearth of growth equity deals in 2023, as companies that had raised capital in the heyday of the frothy COVID years grew into their valuations. Notable transactions included artificial intelligence (AI) company Cohere’s US$500-million Series D round led by PSP Investments. Autonomous vehicle startup Waabi secured C$275 million in their Series B round led by Uber and Khosla Ventures. Clio, a Vancouver-based global leader in legal technology, made headlines with its US$900-million Series F round led by New Enterprise Associates, representing the largest VC or growth equity financing in Canadian history.

In preparation for enhanced transactional activity, companies should focus on proactively developing a solid business plan with a clear value proposition, revenue model and path to profitability.

Sectoral shifts and British Columbia’s comeback

According to CVCA and Osler transactional data, the information and communication technology sector continued to dominate completed venture financing transactions by both deal count and dollar value. Canadian AI startups, in particular, have been of clear interest to investors. Their popularity as an attractive investment is poised to break the previous record for number of financings and deal values set in 2021.

Another sector gaining significant momentum is cleantech. Cleantech companies are on track to surpass 2023’s record highs in terms of deal value, with significant attention being paid to alternative energy solutions. We expect this trend to continue, fueled by increasing social and financial focus on sustainability, alongside sustained government support through investment and grants. The rise of venture capital impact funds with a specific mandate to invest in clean technologies further supports the high profile that cleantech is carving out for itself in the Canadian market.

Geographically, Ontario once again led the way in both number of deals closed and deal value in 2024. Notably, after a two-year downward trend, British Columbia surpassed Québec in terms of dollars invested for the first time since 2021, largely due to Clio’s record-setting funding round. While coming in at fourth place for deal volume and value in Q3 2024, Alberta’s sectoral shift from its oil and gas roots was on full display, with Calgary and Edmonton becoming hotbeds for AI and quantum computing, clean energy, fintech and agtech. Barring any major outlier deals, Alberta and British Columbia are likely to be in close competition for third place for deal volume in 2025 behind heavyweights Ontario and Québec.

Canadian companies are decidedly on the radar for American VC and growth equity funds on the hunt for attractive deal flow outside of their core U.S. markets. More than one-third of VC financings involving Canadian tech companies in 2024 included U.S. fund participation.

Market correction in the post-pandemic era: flat is the new up

After experiencing significant revenue multiple inflation from 2020 through 2022, valuations have settled back to pre-pandemic levels, with the notable exception of AI valuations. This was evidenced by a downward shift in revenue multiples grounded in traditional valuation metrics. A significant number of “down rounds” and “flat rounds” closed in 2024, as the market retrenched from all-time-high valuations in 2021. Companies continued to use bridge round structures, including convertible notes and simple agreements for future equity (SAFEs), along with preferred share round extensions, to avoid dilutive financings at lower valuations. We expect that valuations will continue to dip disproportionately below prior rounds as this correction continues. Management teams and boards of directors will need to remain creative to keep rounds at least “flat” against their latest financings.

Across all stages, venture deals generally took longer to close in 2024. Prospective investors were more risk-averse, resulting in more extensive due diligence. Investors were also generally reluctant to lead rounds and be price setters. Multiple closings for financings were in vogue, as many investors sat on the sidelines, making it more difficult to round out the syndicate of investors.

Running counter to the more investor-friendly investing environment, VC deal terms remained balanced as between issuers and investors, as reported in Osler’s 2023 Deal Points Report: Venture Capital Financings. Liquidation preferences typically remained at a 1-times (1x) non-participating level, allowing investors to recover their investments in a downside exit scenario without unduly disadvantaging common shareholders. In a large majority of rounds, dividend entitlements were structured as non-cumulative and discretionary. The market standard for anti-dilution protection in preferred share financings remained a broad-based weighted average rather than providing “full ratchet” anti-dilution protection. This provided investors with protection against future down rounds while avoiding excessive dilution for early shareholders. Governance terms continued to promote a balanced power dynamic, with both founders and investors having significant input in decision-making processes at the board of director and shareholder levels. Finally, investor rights — including information rights, rights of first refusal, co-sale rights and registration rights — have been maintained largely in accordance with CVCA model agreement terms. This safeguards investor interests while respecting the operational autonomy of the management team. 

What to expect in 2025: signs of life

In contrast to the choppy market over the past two years, we expect increased traction during 2025 as the private technology market recovers and regenerates. Overall, the market is showing signs of stabilizing to pre-pandemic valuation and deal-term norms. Increased capital deployment is likely, providing optimism that we are on the road to recovery. VC, growth equity and private equity (PE) funds in both the U.S. and Canada are sitting on record levels of “dry powder” — committed but unallocated capital — approaching US$1 trillion. Given the finite window in which GPs must put investor money to work, we expect an uptick in investment activity heading into 2025 as this committed capital increasingly comes off the sidelines.

Along with increased deal flow, we also expect a resurgence of secondary sale transactions. These transactions provide liquidity to early investors, founders and employees while allowing funds nearing the end of their fund life to recycle capital. This trend facilitates the growth of the ecosystem. It also offers opportunities for newer investors to secure a place on the capitalization tables of growth-stage companies looking to scale to the next level prior to a liquidity event.

Technology companies that survived the turbulence of the past few years are heading into 2025 in the “have” or the “have not” category. Companies either possess the growth and profitability profile to attract VC term sheets on attractive terms, or they are deemed un-investible. In either scenario, we expect a continued trend of “dual-track processes” through which companies simultaneously consider both capital raises and acquisition offers. This go-to-market approach enables companies to maximize their optionality and enhance their bargaining position through an auction process.

In preparation for enhanced transactional activity, companies should focus on proactively developing a solid business plan with a clear value proposition, revenue model and path to profitability. As investors and acquirors intensify their due diligence, being “diligence-ready” has never been more important. Companies are well served to seek alignment among their boards of directors and management teams on available strategic alternatives and to build out their external advisor teams and data room in advance of pursuing external financing and acquisition proposals.

Given that the IPO window continues to be largely closed for the Canadian tech sector, we expect a higher volume of strategic M&A, venture capital, growth equity and majority recap PE deals to be on the horizon. Companies, investors and other market participants should buckle up for more turbulence and heightened levels of transactional activity in the year to come.