This is what Telfer School of Management professor Allan Riding found in his recent study about the financing preferences of small and medium-sized enterprises.
While debt financing remains the most popular form of funding, firms that invest in research and development often aren't prime candidates, Mr. Riding said.
"These firms, from the point of view of the lender, are relatively risky. Partly because you never know what the outcome of R&D will be, partly because often R&D requires follow-on investment," he said.
The study, published recently in Venture Capital: An International Journal of Entrepreneurial Finance under the title "Investing in R&D: SME Financing Preferences," was co-authored by Barbara Orser and Tyler Chamberlin, also from Telfer.
"When we're commercializing research and development and successfully coming up with innovation, and we want to take those to market, we need to have a supply of equity financing," Mr. Riding said.
That includes angel investors and venture capitalists who provide capital in exchange for shares in the company.
"Angel investors are absolutely key and essential for very early-stage firms," he said. "When you're looking for your first million or $500,000, angels are it."
Venture capital becomes essential for further, larger denominations of money, but angels are also important for their non-financial value, including advice, experience, contacts, office space and co-signing of loans, Mr. Riding said.
"They're mentors, and they want to be mentors," he said.
The study's findings are particularly important for Ottawa because of its healthy number of tech-based firms, Mr. Riding said, and are a strong indication that equity finance needs to have a larger presence in Canada.
"When I was a teen, I wanted to go to a dance with 95 girls and five guys. The five guys get asked to dance a lot," he said. "That's the way it is in Canada. There's only a handful of VCs."
The high demand leads angels and VCs to spread themselves thinly, and creates an opportunity for U.S. VCs to scoop up Canadian companies after Canadian angels have invested in their early stages.
"It means our small, early-stage capitalists are taking all the risks, and the successes are becoming foreign-owned," he said.
A BIT OF ADVICE
Canadian VCs tend to be smaller in size and budget, which can lead to an over-syndication of firms and complex share structures.
"If you're going to look for VCs, err on the side of a large fund," Mr. Riding said. "The deeper pockets will be there as the firm grows. If they're seeking from a smaller firm, they will have to cast the net more widely."
Another financing option underused by tech companies is supplier financing, or trade capital, an arrangement with suppliers of goods and services where payment terms are deferred.
This means there is time to resell products before payment is due, Mr. Riding said. The method also provides a creative alternative to traditional financing.
"That approach means you reduce your need for the banks, which is absolutely a good thing," he said. "Having alternatives is always a good thing."
Follow-up research will include looking at what other countries around the world are doing to promote equity financing. One promising example is the UK Innovation Investment Fund, launched in 2009. The British government lends money to VCs through competition, enabling small funds to become larger ones and to eventually have the capacity to pay back the money from the government.
TALKING TO AN ANGEL
An OBJ Q&A with Laurie Davis, co-founder of Purple Angel and the Capital Angel Network and former vice-president of Nortel Networks.
Q: How important is equity financing to startups?
A: It's critical. Most new companies wouldn't survive without it. You have to have money before the banks lend it to you. Starting out, there's no alternative.
Q: Are there many good investment opportunities here in Ottawa?
A: I think there's a lot of bright people with a lot of bright ideas who are determined to make their companies successful ... Most angels will tell you, you may invest in one of 50 things you see. That doesn't mean 49 of them are bad, but there's a pretty good chunk of them that aren't a good business opportunity.
Q: What makes a good investment?
A: It's the old adage: the most important thing is the entrepreneur. Do they have what it takes to build a business? Whatever we invest in today, one thing you can guarantee is that two years from now it won't look anything like it looks like today. They need to be able to handle that. Their plan is going to change, and they need to make all the right decisions to weather the storms.
Q: What needs to be done to improve the equity financing landscape in Ottawa?
A: I think a lack of investment is a problem. There are angels, but there's always room for more. An even bigger problem is the fact that firms can't get the second round of funding. They go out of business or grow so slowly that they're overtaken by others growing faster.
Q: What is going on in Ottawa's angel community?
A: There's a bunch of things that are happening. You can't ever solve these problems, you can just make them better every year ... There's actually a reasonable amount being invested all the time, but for the most part it's quiet – a lot happens below the radar. It feeds the feeling that nothing is happening. We need to find a way to improve the mood.