Beyond Tariffs: Considering the Impacts of the Trade War on Innovative Companies
Plus, practical steps Canada can take to support its innovative firms facing trade-related headwinds.
Happy Monday! Amidst the constant chaos that is world trade policy right now, I want to take a bit of time to consider how this situation might impact innovative Canadian start-ups and scale-ups. From the immediate sting of tariffs to the longer-term challenges of accessing capital and sustaining crucial R&D investment, the impacts are going to be felt in multiple ways. I also look at a few ways Canadian governments can respond to help these firms not just weather the storm but potentially emerge stronger on the other side.
Tariffs & Good-Exporting Firms
Let’s start with the obvious: firms that export physical goods to the US market will be badly hit. Even though Canada avoided additional tariffs in the latest round announced last week, the baseline 25% tariff unless a good is compliant with CUSMA means that exporting is getting difficult.
Prior to the trade war, only around 40% of Canadian exports to the US were compliant. For some goods, this was because it was easier to pay an otherwise very low tariff than deal with the necessary paperwork. However, for other goods, it was because the rule of origin requirements (that require a certain portion of the production of a good to have taken place within the US, Canada, or Mexico) were hard or impossible to meet. Unfortunately, for many innovative companies and goods, the latter is more often the case. As one trade lawyer told the Globe and Mail, businesses in aerospace, telecommunications and medical equipment could be vulnerable, given their reliance on inputs from Europe and Asia.
Ironically, last week’s batch of “reciprocal” tariffs may somewhat lessen the blow for Canadian firms. After weeks of primarily attacking Mexico and Canada, these tariffs levelled the playing field globally, making it similarly expensive to export to the US, reducing the chance of European or Asian competitors being able to undercut Canadian exporters on price. Even this is not much of a saving grace, as tariffs will regardless increase the cost of Canadian products and likely reduce sales in the massive US market.
And, unfortunately, the tariffs themselves are only one problem.
Access to Capital
A major additional problem could potentially be access to capital. Canada has a venture capital-dependent innovation ecosystem. According to the Conference Board of Canada’s 2024 Innovation Report Card, Canada ranks third among similar nations in VC investment as a percentage of GDP.
This VC ecosystem, however, is itself heavily dependent on US capital, especially in later-stage rounds. The Canadian Venture Capital Association recently published an excellent data-heavy analysis of foreign investor participation in the Canadian VC ecosystem, which amply demonstrates this.
Canadian investors dominate small deals under $5 million. In 2024, deals with only Canadian investors accounted for 292 of the 386 sub-$5 million deals, investing a total of $380 million out of a total of $541 million.
However, as deal size begins to increase, US capital plays a far greater role. Looking at 2024 again, for deals over $50 million, only 5 deals were with only Canadian investors (for a value of $621 million), 2 were with US-only investors ($341 million), and 13 were with both Canadian and US investors ($3.3 billion). An additional 4 deals worth $630 million were completed with other non-Canadian, non-US international investors.
This picture can also be seen with the prominent role of US capital in later-stage funding rounds, as can be seen below:
The trade war and the chill in US-Canadian relations will impact innovative firms’ ability to raise the capital they need to grow.
Already, uncertainty seems to have been having an impact. Pierre Cléroux, BDC’s chief economist, told the Logic back in February that we haven’t seen the investments expected thanks to declining interest rates “because of the uncertainty that we have” and that their investor sentiment survey shows that intention to invest in Canada has also declined.
The initial impact will be felt in terms of raising new rounds. While there will be no singular impact on the industry (given that some funds will have less exposure or might be better placed to take advantage of resulting opportunities), getting access to crucial US capital will potentially be more challenging. Exchange rates will play an important role in this, and funds that are raised in USD might be more insulated. However, that assumes there are no restrictions on capital flows, and, let’s be honest, we shouldn’t assume anything at this point.
That won’t be the only impact on capital, though. Economic uncertainty reduces the number of exits as investors hold on for more favourable times and valuations. This will further restrict the capital flowing through the VC ecosystem, harming innovative firms further.
And again, uncertainty will have further impacts.
Procyclical Reductions in R&D Expenditure
Uncertainty and recessions heavily impact research and development spending. This will impact innovative firms themselves, reducing their ability to engage in the R&D that marks them out, but it will also affect their potential customers in larger firms and in government.
Private R&D spending by private firms is procyclical—i.e., they reduce spending during downturns due to liquidity constraints and demand shock (see Maikel Pellens et al.).
Uncertainty means that firms dedicate less money to R&D, a situation heightened in recessions when cash flows are restricted, increasing firms’ financial constraints. Furthermore, even if the money is there, the incentives to pursue R&D are reduced, given potential customers and users are unlikely to be willing to pay more for an innovative product than what they used previously. The result is that R&D is often postponed.
For innovative start-ups and scale-ups, this can be a terminal shock, especially when taking into account the capital impacts detailed above.
Dealing with Chaos - Who Knows What Comes Next
The evidence on recessions and downturns and their impacts on innovation is, for the most part, based on typical business cycles. Even COVID-19, while an outlier and caused by an external shock, nonetheless left a lighter imprint on many economies than typical recessions and saw a rapid recovery.
What we face now is nothing like anything we have seen before. Aaron Sojourner, a labour economist at the W.E. Upjohn Institute for Employment Research, captures neatly how different this moment is:
We’re under three months into Trump’s term, and who knows if he will actually try and stay on for a third term. We’ve never faced a global stock market crash that has been brought on by the decisions of a single individual before. While there are, in theory, substantial checks and balances on the power of the President to do this, with the power to impose tariffs ultimately lying with Congress, for example, the Republican majority seem utterly unwilling to exercise those powers.
Any ordinary ability to predict when you are past the worst of downtown or to rely on stable policy environments is out of the window. How this plays out looks likely to supercharge the normal impacts of uncertainty on firms unless there is a dramatic change in US politics.
How To Support Innovative Firms In This Environment
Given how unprecedented this situation is, there is no playbook to draw from. Nonetheless, some plays seem to make sense.
Facilitate Access to Capital
The federal government needs to help reduce capital constraints. They will need to do this with care, as flooding the VC ecosystem with money could cause more harm than good. However, the government can facilitate greater access to capital, in particular through the major pension plans, which collectively manage over $3 trillion yet invest comparatively little in Canada. Quebec is a partial exception, where the Caisse de dépôt et placement du Québec is mandated to invest in Quebec’s economic development while also pursuing optimal returns.
Back in December, the Fall Economic Statement proposed a variety of measures to unlock investment in Canada by the major pension plans. While it didn’t go as far as mandates, the FES proposed a range of measures to remove limits to investments in Canada and to crowd in investment from the pension funds. Post-election, these measures should be picked up quickly to limit the damage, given the timelines involved in raising rounds and investing.
And, frankly, should pensions not voluntarily follow through on this, then federal and provincial governments should begin to look more seriously at following Quebec’s example. Given Canada’s wider business investment malaise, where Canadian workers “receive only 66 cents of new capital for every dollar received by their counterparts in the OECD as a whole, and 55 cents for every dollar received by their US counterparts,” as the C.D. Howe institute found, there is a broader weak investment picture that this forms a part of.
Countercyclically Invest in R&D
There is a need for the government to step up and support R&D. As Pellens and co-authors write, “Given the strong evidence that private R&D investment behaves procyclically, except for a small group of financially unconstrained firms, the degree to which public policy can compensate for this procyclicality seems key to safeguarding long-term growth prospects in economic crises.”
I already wrote last week about the need to rebuild our research foundations to strengthen our sovereign capacities, address our declining productivity, and take advantage of opportunities of a potential US brain drain. Looking at the threat of a recession and the impacts the trade war will have on innovative companies only strengthens that need. If we want to come out of the Trump Shock stronger, then investment in R&D (as well as commercialization-supporting policies) is essential.
Help Companies Access Global Markets
A lot could, and no doubt will, be written about how more strategic procurement by Canadian governments will help innovative firms. This isn’t wrong, and we need to make better use of procurement, but given our size, it has its limits. We also need to look at global markets.
While the US is retreating from globalization, Canada and other countries should not. We will only ever be worse off becoming a closed economy, shut off from the world. As much as we need to strengthen our sovereign capacity at home, we will never be a big enough market to be self-sufficient. This encompasses the goods, services, capital, and talent that we need, as well as the need for customers beyond our shores.
Trade deals, including digital trade deals, are potentially one part of this picture. These take time, and their returns can be less than desired due to low utilization (see above on only 40% of goods exports being CUSMA compliant).
More immediate could be targeted support to help innovative countries enter non-US markets. The US has often been the first point of call for businesses to export to. If the US becomes a more hostile and unpredictable place to do business, then companies will need to look to other markets. However, language barriers, regulatory complexity, and cultural differences can make this a tougher proposition.
Facilitating this expansion is now more urgent. Mechanisms already exist for this. The Trade Commissioner Service, the Accelerated Growth Service, and the Global Hypergrowth Project are all tools that should be examined to see how they can facilitate a larger number of innovative companies’ access to global markets. This could include greater funding and hiring more country and/or market experts (especially important for high potential but comparatively niche innovative sub-sectors). It could also encompass a massive marketing campaign to increase the awareness of the support that is there.
Ultimately, we’re in uncharted territory. But it is clear that the trade turmoil and tariffs pose a significant and complex challenge to our innovative start-ups and scale-ups. From the direct impact of tariffs to the chilling effect on investment and R&D, uncertainty is self-perpetuating. I’ve no doubt only scratched the surface of these impacts too. Yet, there are ways that we can proactively address these issues. A strategic focus on securing access to capital, prioritizing countercyclical innovation, and aggressively pursuing global market diversification will be crucial for these start-ups and scale-ups to not only survive but potentially thrive in this new era of trade volatility.