Who drives the Canadian economy?

Silicon Valley has a number of young dons revving up the US economy. Does Canada have such people?

When Ebay bought PayPal in 2002, for US$1.5 billion, that event subsequently gave rise to what has been called the “PayPal mafia.” Dozens of young men, rich overnight, went on to spawn countless companies and venture capital funds that have kept the billion-dollar Silicon Valley merry-go-round turning.

The core of this mafia is composed of about a dozen players, one of whom is Elon Musk, estimated to be worth about US$11 billion, who went on to found Tesla Motors and Space Exploration Technologies. Reid Hoffman, worth about US$3.7 billion, cofounded LinkedIn and invested angel money in Facebook, Flickr, Digg and a few others. He is considered to be the most connected man in Silicon Valley, according to a 2014 Telegraph article. Peter Thiel, worth US$2.7 billion, went on to found venture capital firm Founders Fund, along the way injecting US$500,000 into a nascent Facebook. Other members of the mafia, some worth hundreds of millions, pursued similar endeavours.

This is the type of high-net-worth, hyper-connected, company-spawning mafia that many countries — Canada included — would love to have. Arguably, there isn’t another sector of the economy that can generate such growth. In a 2013 Fortune op-ed item, Ryan Holmes, founder and CEO of Vancouver-based Hoot-suite, expressed the hope that Canada could give birth to a “maple syrup mafia.”

Indeed, Canada cannot boast of anything like a PayPal mafia. Though its technology sector is far from negligible, it has spawned only a handful of tech billionaires, such as Mike Lazaridis of Research in Motion (now BlackBerry) and CGI Group’s Serge Godin.

That’s not to say that Canada is lacking in growth engines. But they aren’t in what would be considered advanced sectors. For example, in the key area of employment, according to the Canadian Federation of Independent Business (CFIB) based on StatsCan figures, the sector that exhibited the strongest growth from 2000 to 2015 was the public sector, in its 500-plus employee segment where ministries and Crown corporations reside.

These organizations grew by 36.7% in that period, while total employment in Canada inched up by only 8.7%. In private firms with 500-plus employees, it increased by 24.5%, while total employment in the private sector went up by 21%.

UNCOVERING THE ENGINE OF GROWTH

Pedro Antunes, deputy chief economist at the Conference Board of Canada, says that total job creation during the resource decade (2004 to 2014) was 1.9 million. Of that total, approximately one million happened mostly in business services and 900,000 in the public sector (education, social services, healthcare and public administration, excluding Crown corporations).

Though a crucial variable, employment does not paint the whole economic picture. Revenue growth is another key component. During the resource decade, the sector combining oil extraction and mining, which represented 7.3% of Canadian GDP from all industries of $1.7 trillion in 2012, grew by approximately 50% from 2004 to 2012. (Detailed StatsCan figures for GDP end in 2012). In that period, this sector witnessed a job growth of 62.2%, superior to its revenue growth. In construction (7.9% of GDP), from 2004 to 2012, revenue shot up by almost 100%, with jobs moving up by 46.2%. The largest private segment of the economy, finance, insurance and real estate (18.5% of GDP, in which real estate represents 12.3 percentage points) grew by 42.1% in the period from 2004 to 2012; employment in finance and insurance grew by 10.2% and in real estate, it fell 3.1%. Manufacturing (10.7% of GDP) shrunk by 1.8%, and employment by 24%.

As engines of growth, oil, construction and finance have run their course (government probably never will), according to Jean-René Adam, co-chief investment officer and vice-president of North American markets at Hexavest in Montreal. “With oil down, construction and consumption explain most of the growth in the recent past,” he says, “but they are based on debt, not on a strong job market. So we don’t think they can hold. And if housing falls, banks will get hit.”

HERDING GAZELLES

Such employment and revenue statistics paint a blunt picture of growth. Where could we go for a sharper, more precise picture? The prevailing idea that small businesses are the engine of job growth has been dispelled, as the CFIB’s numbers do not support that claim. Firms with fewer than 20 employees exhibited 12% growth in the 2000 to 2015 period. From 2005 to 2015 they fared worse at 7%. The mid-level (20 to 499 employees) and large firm segments have done better — 13.2% and 10.8% respectively — but still not as well as the public sector, with a job growth of more than 15.6%.

Research by Missouri’s Ewing Marion Kauffman Foundation, which specializes in entrepreneurship and startups, confirms this on its website: “New and young firms are responsible for net job creation, not small businesses in general,” writes Dane Stangler, vice-president of reseach and policy.

As an increasing number of studies indicate, growth happens in firms that have been identified with names according to their size, performance and age: high-growth firms (HGF), gazelles and high-impact firms (HIF).

“Firms that achieve high growth in a short period of time tend to make a large contribution in terms of employment and wealth creation,” says a June 2016 study by Innovation, Science and Economic Development Canada. HGFs average annualized growth rates greater than 20% a year, over a three-year period, and have 10 or more employees at the beginning of the period.

A 2008 Industry Canada report, Profile of Growth Firms, found that hyper-growth firms (150% growth in employment over four years) and strong-growth firms (50% to 150% growth in employment over four years) together accounted for only 52,800 firms out of a total of 410,000, but created 977,000 jobs out of a total of two million between 1993 and 2003.

A 2008 international comparison placed Canada somewhere in the middle of a ranking of nine countries, with HGFs representing 3.3% of manufacturing firms and 3.2% of services firms. Italy ranked lowest (2.2% of manufacturing and 3.8% of services), and the US highest (5% of manufacturing and 4.3% of services).

Gazelles are a more elusive breed. Four or five years of age, these firms have at least 10 employees and show an annualized growth of more than 20% over a three-year period. In 2013, they accounted for 1.6% of all Canadian enterprises with more than 10 employees based on revenue, and 0.6% based on employment. A comparison with the US is both troubling and encouraging. In the US gazelles represented 2% of all firms in the 2009 to 2012 period, after sinking to a low of 1.5% in the 2008 to 2011 period, according to a Federal Reserve Bank of Atlanta study. Unfortunately, the trend is heading downward. From 1994 to the late 1990s, the percentage of gazelles stood above 3%, then started what appears to be an inexorable slide.

But focusing only on gazelles and small firms can be misleading. A May 2015 report by the Business Development Bank of Canada (BDC), High-Impact Firms: Accelerating Canadian Competitiveness, expands on the notion of HGFs and gazelles, proposing the more encompassing category of “high-impact firms.” Among these HIFs we find mid-sized businesses with 100 to 500 employees. Though they account for only 1.6% of Canadian firms, these mid-sized businesses “are responsible for 12% of GDP and 16% of employment,” states the report. “Furthermore, mid-sized businesses represent 11% of all exporters and their exports account for 17% of total export values.” HIFs also exhibit an average annual growth rate of 25% and invest 15% of their sales in innovation.

RAISING UNICORNS

This roundup of HGFs, gazelles and high-impact firms neglects a crucial sector that exhibits exceptional features: startup firms, mostly high tech, that feed on venture capital for growth. True, HGFs are not limited to high tech, but high-tech startups nevertheless constitute a very special breed of gazelle. They form the type of environment that allowed the rise of the PayPal mafia and the type that many in Canada hope will help a maple syrup mafia emerge.

In the case of US gazelles and HGFs, high-tech firms spring up “at a higher rate than all private-sector businesses,” writes Stangler. “Relative to their share of firms in the economy, high-tech is 23% more likely, and [information and communications technology] as a segment of high tech is 48% more likely than the private sector as a whole to witness a new business formation.”

Throw in venture capital, and you rev up this economic engine even more. In a study that involved about 5,000 companies, Kauffman researchers found that only 4.4% of startup funding came from venture capital. However, venture-capital-backed companies make up 37% of IPOs and 6.5% of high-growth companies. They also have “a disproportionate role in job creation (5.3% to 7.3%) and innovation,” writes Kauffman blogger Arnobio Morelix.

Venture capital’s job starts well before injecting money into the high-growth firms. “Its role is to identify who these growth players are,” says Creig Lamb, policy adviser at the Brookfield Institute for Innovation and Entrepreneurship in Toronto. “Sure, it’s risky business, but VC plays a critical role for an innovation ecosystem to thrive.”

The key exciting feature about venture-capital-backed startups is that they have a strong tendency, in the US at least, to develop into unicorns: $1-billion-plus firms. According to a 2014 study, Canada’s Billion Dollar Firms, by Toronto’s Centre for Digital Entrepreneurship and Economic Performance, in the technology category the US houses 166 such unicorns, while Canada has six.

TURNING MAPLE SYRUP INTO COKE

Yet Canada has a thriving tech startup population. For example, the Toronto-Waterloo Innovation Corridor, Canada’s foremost tech hub, “houses 15,000 tech companies and 5,200 tech startups,” says Jan De Silva, CEO of the Toronto Region Board of Trade. But quantity is not the key issue. Canada’s tech sector shows a chronic incapacity to scale its companies. “We don’t grow our tech startups,” says Sarah Lubik, director of entrepreneurship at Simon Fraser University in Vancouver.

Why not? First, there is the proximity of the huge and alluring US tech juggernaut, which causes many Canadian entrepreneurs to launch tech companies in the US. For example, Musk is a Canadian citizen who attended Queen’s University in Kingston, Ont.; eBay cofounder Jeff Skoll is a native of Montreal; and BC-born Stewart Butterfield cofounded Flickr.

These are just a few names among thousands of potential maple syrup techies and computer nerds who have been converted into American Coca-Cola whizzes. “I’ve heard some estimates that the number of Canadians in tech (in Silicon Valley) is larger than the number of Canadians in tech in Canada,” wrote Ron Piovesan, a Canadian technology business development executive who has lived in Silicon Valley for 15 years, in a Globe and Mail op-ed article.

This is clearly an exaggeration, but nevertheless identifies a troubling trend. “Roughly fifty per cent of engineers who graduate from Waterloo’s engineering department end up in Silicon Valley,” says De Silva.

Also, if Canada doesn’t scale its tech startups, it’s because it doesn’t hold on to them. Over the past 25 years, one tech star after another has been scooped up by foreign acquirers, mostly US, from BioChem Pharma and DMR Group in the 1990s and 2000s to QLT, which is in the process of being acquired by Aegerion.

This might seem paradoxical in view of the fact that the Toronto-Waterloo Innovation Corridor houses many tech companies and startups, but the required talent, according to Holmes, isn’t quite there. He goes on to write: “This is where lots of global cities — Vancouver included — come up short. The reality is that we’re contending with a major shortage of developers, engineers, and programmers. Universities are simply not turning out enough grads with the requisite tech skills. (If this seems absurd in a climate of global recession and mass unemployment, it should.)”

The funding for high-tech startups comes mostly from venture capital, and Canada’s VC firms, like its startups, lack scale, says Mike Woollatt, CEO of the Canadian Venture Capital and Private Equity Association in Toronto. A bumper year, 2015 saw Canadian VC firms inject $2.4 billion into 545 deals, for an average deal size of $4.4 million. In the US, 24 times more money flowed: US$58.8 billion in 4,380 deals, for an average deal size of US$13 million. VC megadeals (US$100 million-plus) numbered 74 in the US; none happened in Canada, the largest deal reaching $79 million. In Canada, the average VC firm is $60 million in size, says Woollatt; in the US it’s US$207 million. “Very few venture firms are able to write big cheques,” he says. “We need bigger venture funds in Canada.”

If funds are insufficient to compete with the US colossus, talent is also lacking. Not technical talent — the quality of which seems to be universally recognized, especially in Silicon Valley. What is lacking is management talent. “To scale, you need great talent,” says Lubik. “But because we don’t have many large companies, we don’t have the kind of senior managers required.”

Which brings us back to a need for a larger capital pool. Because, to a large extent, finding that talent is a question of coughing up the money to pay for it. “To pay, you need the capital,” says Diane Gosselin, CEO of research consortium CQDM in Montreal.

Yet no one is throwing in the towel. The process leading to the rise of a maple syrup mafia is unfolding. In the Canadian tech hubs of Toronto, Montreal and Vancouver, countless players are busy growing Canada’s tech ecosystem. “Now that we have a big startup ecosystem, we’re starting to see returns,” says Woollatt. “For example, the government’s Venture Capital Action Plan two-to-one dollar matching plan has raised $1.3 billion for the ecosystem. With companies such as Shopify, Hootsuite, Kik, Desire2Learn, DWave, we’ve never had this many potential unicorns.”

REVVING UP THE RIGHT ENGINE

Gazelles exist in every industry in Canada, notes the Industry Canada report, from construction and retail to manufacturing and transportation. Certainly, giving support to a gazelle rather than to a specific industry makes sense, and much government help now flows in that direction.

However, there are sectors that would seem to require focused support. For example, should Canada concentrate on implementing a unicorn-growing ecosystem in the finance, insurance and real estate industry, Canada’s largest industry by far? Ontario’s ministry of finance announced its intention of giving special attention and support to the financial services sector in its 2014 report, Ontario’s Long-Term Report on the Economy.

But revving up a financial engine of growth could prove hazardous, according to Howard Davies, the first chairman of the UK Financial Services Authority and a former deputy governor of the Bank of England. In the article “The Banks That Ate the Economy,” Davies warns against the financial sector. “Some argue that financial hypertrophy harms the real economy by siphoning off talent and resources that could better be deployed elsewhere.” He points to the research by Bank for International Settlements economists Stephen Cecchetti and Enisse Kharroubi. “Using a sample of 20 developed countries,” writes Davies, “they find a negative correlation between the financial sector’s share of GDP and the health of the real economy.”

It is slightly unnerving to observe that Canadian banks and insurance companies, whose revenues represented 6.4% of Canada’s GDP in 2011, raked in $63 billion in net profits, 24.6% of total Canadian corporate profits of $256.2 billion that year. That proportion of bank and insurance company profits has roughly held stable since 2003. Yet, apart from the nascent financial technology phenomenon, the finance, insurance and real estate industry is not a bedrock of R&D and innovation, injecting barely more in R&D than retail trade does.

Profits in the manufacturing sector are not as high as in the finance industry (approximately $37 billion, or 15% of total corporate profits in 2011), and its share of GDP has dropped from 22% in the 1970s to 11% today. But manufacturing trumps every other industrial sector as an economic motor, and tuning it up is of the essence. Following years of offshoring that drained the Canadian economy of this productive lifeblood, the BDC honours manufacturing’s crucial role in its report on HIFs.

To begin with, in spite of its diminished position in overall GDP, manufacturing still accounts for an overwhelming 42% of Canada’s HIFs. The services sector makes up only 30% of HIFs. “Canadian manufacturers,” says the report, “are responsible for half (49%) of private sector R&D spending in Canada. Their R&D commitment is also higher. On average, they allocated 4.3% of their operating expenses to R&D in 2012, compared with 2% on average for all Canadian businesses. Finally, the sector is responsible for 62% of Canadian exports.”

Technology is the only other industry boasting an engine potentially equivalent to that of manufacturing. And contrary to the prevailing perception, the tech sector, by some measures, looms quite large in the Canadian economy, as large as banking and insurance, according to a Brookfield Institute study. Looking beyond the usual category of information and communications technology, the institute tracks the high-tech activity that prevails in machinery, chemical and pharmaceutical manufacturing, in aerospace, in scientific R&D and in architecture, engineering and design.

Even this larger canvas for technology underestimates its true presence in the economy, says Matthew Seddon, policy adviser at Brookfield. Nevertheless, the study observes that the tech sector’s $117-billion GDP puts it at a GDP share of 7% in the total economy, a level equivalent to that of finance and insurance, and construction. Its R&D output of $9.1 billion is superior even to that of manufacturing, as it employs 864,000 people, often in high-paying jobs (39.6% above the national average salary) in 71,000 companies, 6.1% of all Canadian businesses, and 5.6% of Canada’s total employment.

Before the resource decade, “the Canadian economy was much more balanced,” observes Adam. “Then there was only oil, and during that time China took a chunk out of manufacturing.” Canada definitely needs to recalibrate its economic engine and the two main pistons to rev it up are manufacturing and technology. The rise of a maple syrup mafia depends on it.