by Mike Volker
A list of various financial sources and web links can be found at the end of this article. You may skip the following text and go directly to Money Links.
Over the past 10 years, there have been two very positive developments in favor of the high tech entrepreneur. These are:
So, what are some of the sources of funding available? Let's look at the alternatives by considering funding sources for on-going, existing companies and also by exploring funding sources for new businesses or new projects within existing businesses. These sources are really quite different, especially with respect to the risk factors inherent in each. For new ventures in particular, the potential sources will indeed range from so-called "angels" to "devils". (This article will be somewhat focused on those angels and devils living on earth mainly in Western Canada.)
When selling equity, the question of valuation always arises. Too much emphasis is placed on trying to put a monetary value on a start-up venture. The founders start of by arguing that their company is worth, for example, $4 million and therefore a $1 million investment would justify a 20% stake. I think this is backwards. The better approach would be to say that $1 million is needed to make the business viable and that in return for the $1 million, the parties agree that a 20% stake is "fair". This then implies that the current valuation is $5 million (i.e. $4 million pre-money). Without the $1 million investment, the pre-money valuation is really zero, because without the investment, the opportunity can't be realized!
So, a good place to begin is by really knowing your business and its needs in the context of the industry you are operating in, i.e. the market opportunities and threats, e.g.. competitors. You must also be aware of where you are positioned in the growth/share matrix. For example, are you in a high or low growth market. Is your relative market share strong or weak. If you are in a high growth, or emerging market, and if you have a strong market position by virtue of your better mousetrap or intellectual property, then you have the potential of being a shooting star. Yes, risky - but also potentially very rewarding. On the other hand, if you are in a stagnant, low-growth market and you have minimal market share (i.e. you are a new entrant in a well-defined market), get yourself a government job and don't be unusually cruel to yourself.
The important point to note here is that if a company is up and running and has some positive history such as good products and customers and some sales history, even if not super-profitable, financing should be fairly straightforward. Your main work is that of preparing an updated business plan and making the rounds with it. This is where some external advisors, like well-connected board members, can be most helpful.
Investment in young, early-stage firms is often referred to as seed capital. In the past, this was the toughest type of funding to obtain because of the perceived risks and time to fruition. The good news is that, and this fact is borne out by various studies, early stage investments have produced some exceptional returns to their investors. Hence, we are seeing the formation of more and more seed capital funds. Even Banks and dyed-in-the-wool Venture Capitalists are getting into the act!
An ideal source of early stage funding comes from Angels. Angels are typically private individuals who are well-heeled financially and who are prepared to take a leap of faith by investing in a business deal by contributing not just their money but also their expertise. Angels often become mentors to the founder-entrepreneurs. Angels may be hi-tech entrepreneurs themselves who have cashed in on their own ventures and who now wish to re-live their successes vicariously. These are perfect partners! The trick is in identifying them and in attracting their interest.
The average investment made by angels in Canada is just over $100,000 according to a University of Ottawa study by Allan Riding. These angels have a net worth averaging $1-million and have an annual average income of $100,000. They want to make a healthy multiple in the five to 10-fold range on their investments.
Who are these Angels? How do you make contact with them? Often, regional organisations, such as the Ottawa-Carleton Economic Development Corp, or Universities provide matchmaking services to link Angels with entrepreneurs. For the time being, you'll have to rely on networking - Vancouver Enterprise Forum style. A good starting point is to make connections through the Vancouver Enterprise Forum's website, which has links to angel networks (e.g. "VANTEC") and to the Business Development Bank's Angel Forum, as well as the newly created "Capital Connector" on B.C.'s T-Net.
Somewhat akin to angels, are more structured approaches to providing relatively small amounts of captial to young companies. Among these are the Canada Community Investment Plan under which the federal government (Industry Canada) will spend $12 million to assist communities in acting as angels. Communities contribute one-third and the government contributes two-thirds towards small capital pools to fund new ventures. The communities also provide some of the much needed mentoring and angel matchmaking. Approximately one dozen such programs exist (as of Apr'97) in places such as Halifax, Kitchener-Waterloo, and Canmore (unfortunately, none in B.C.-yet!)
Next to Angels, there are the more traditional sources of venture capital. Venture Capitalists (VCs) are individuals or companies whose business is that of investing in companies by providing substantial capital (usually $500K and up) and taking substantial equity positions (usually more than 20%, but rarely more than 50%). Venture capitalists are often affectionately referred to as vulture capitalists. They are often seen as striking very tough bargains insofar as they require a say in running the company through board seats, for example, and they like sizeable equity positions by contributing the required capital. Venture capitalists often fit a well-defined mold. In that repsect, they are very predictable. On average (and there are few exceptions), they look for companies with potential sales of $100 million, proprietary technology, seasoned management team, and a well-defined market. Of course, these criteria preclude many companies from getting the attention of these traditional venture capitalists.
On the positive side, a well chosen VC will work with a company through subsequent growth stages and will act as a banker to the company with a view to cashing in eventually through a successful public offering or sale to other parties.
Angels and VCs are the most likely sources of risk capital. In addition to these sources of equity financing, companies should also seek debt financing from banks and other lenders. Often, banks will lend money to start-ups if they are properly capitalized (e.g. by Angels or VCs) and if they have a good business plan.
So how does this form of VC financing work? This type of VC financing is accomplished through an IPO (Initial Public Offering) or financing on a junior stock exchange like the Alberta (ASE) or Vancouver Stock Exchange (VSE). Companies who seek to raise modest sums, even below $1 million, can entertain such public offerings. These are an alternative to a private VC-style financing. The main difference is that an underwriter (or sometimes a promoter or deal-maker) takes the place of the VC and effectively sells stock to a large number of subscribers. Companies sometimes prefer this approach because they may obtain a better valuation on their business or because it is an "easier" sell. So, if you like the idea of minimal equity dilution, future liquidity, follow-on financing, incentive stock options, publicity, maintaining control, etc., the VSE may be for you!
It is this writer's opinion (and now for some podium posturing) that the VSE could do for the technology industry what it has done for the resource sector. Instead of financing the mining of mines, the VSE could finance the mining of minds. There's little difference actually - except that VSE players are very impatient and they like to see daily news releases on drill results and assays. So, a bit of work needs to be done to change the mind-sets of public investors. On the other hand, what better way than this is there to allow the general public to invest in our exciting new knowledge based economy (Nuala Beck, step up to the plate.)
VSE financing can be a good deal for the company if it is in a "hot" market with a "hot" product (like Internet products last year). This means that the company can enjoy a high valuation and founders will experience minimal dilution. In cases where the company has yet to start generating sales, i.e. when it is still a concept, valuations are the most distorted - in favor of the firm. There is a well-known joke about this: "the worst thing that can happen to you is that you achieve your business plan." Why? Because this is when reality sets in and investors realize that you are really building a business and not running a lottery.
A larger IPO financing such as those we see on the Toronto Stock Exchange or on NASDAQ (US) takes place at later stages of growth when companies with a track record require substantial funding for growth - often beyond what VC's can supply (generally $10 million plus). In the business press, this is really what is meant by "going public". Those words are also a euphemism for "cashing in" by the earlier stage financiers and the founders of the company. On the VSE, for example, an IPO is not intended as a cashing-in exercise and VSE policies attempt to prevent this. Unfortunately, unscrupulous promoters (i.e. the devils alluded to earlier) who are neither Directors nor Officers of the company, often use this as an opportunity to cash in and it is this type of activity which has tarnished the VSE's reputation.
Unfortunately, because of the VSE's "reputation", both the VSE and the B.C. Securities Commission, have tightened their policies and increased surveillance. Why is this unfortunate? It is because it makes the going-public process more cumbersome and expensive for the legitimate ventures and it does virtually nothing to curtail the activities of manipulative promoters who are often neither Directors nor Officers, thereby escaping scrutiny. The VSE is even going so far as to conduct due diligence for the public investor by insisting on feasilibity or technical reports These are a tad silly because the companies themselves ultimately pay to have these reports prepared (who would pay for a negative report?). Rather than attempt to vet a deal, why not follow the American model which simply insists on fair, plain, and true disclosure. Then let the investors decide on their own. After all, not every drill hole will pay off!
An IPO, although it means Initial Public Offering, is not the only way for a company to become public, i.e. have its shares traded by the public. A very popular mechanism by which a company can obtain this status is by transacting an RTO.
An RTO (Reverse Take-Over) allows you to take a short-cut in going public. All you need to do is to find an already public company which has fallen on hard times such as a mining company which is inactive with virtually no assets or liabilities. Its real asset is its listing status. Let's say that MP Resoures Inc., an inactive mining "shell", has 1 million shares issued. It can be "taken over" by your Company, Supertech Inc., (fictional names) by issuing, for example, 9 million new treasury shares. The shareholders of Supertech will then effectively own 90% of MP Resources and hence now control MP. The acquisition of Supertech by MP is also referred to as a "vend-in", meaning that Supertech was sold to MP for a certain value (usually determined by an indepdendent, arms-length business valuator), that value being realized by the issuance of shares. This is where things get interesting: what value is put on the MP shares? Well, usually it is the current (or recent) trading price (which may be discounted by up to 20%) of MP, which is subject to manipulation (by promoters - not insiders) buying and selling.
The RTO is often referred to as a "back-door" listing because you can escape some of the red-tape associated with an IPO. The VSE (which is self-regulated) and not the Commission (which is a government body) typically calls the shots with RTOs. Some well known companies first went public this way: Magna Automotive (TSE), International Semitech (TSE), and MotionWorks (VSE). This will get you a listing, but it will not necessarily get you any capital. However, once your stock is trading, you can attract new investors more easily by offering them liquidity and you can sell new shares through private placements or exchange offerings, e.g. via an "Exchange Offering Prospectus" (i.e. EOP - you may as well learn all the buzz-words) which is not quite as rigorous as an IPO style Prospectus. Typically, it is easy to attract private placement investors before the completion of the vend-in on the expectation that they will enjoy both liquidity (ability to sell their investment) and short-term (a.k.a flipping) capital appreciation.
Some companies, such as Magna International, initially went public only because they had a broad shareholder base (mostly employees) and founder Frank Stronach wanted to have a market for his stockholders (who were also employees). He just needed a public vehicle and needed to do so without doing an IPO. RTO's are most attractive and can work well if you can line up private investors first and then use the RTO to provide them with subsequent liquidity.
Of course, once you are public - regardless of how you got there - you can (in theory, anyway) always do subsequent financings via private placements. Such placements constitute the vast majority of VSE-style financings. The main challenge is to maintain an active market for your stock. If not, the trading price will decline, making future financings very costly in terms of dilution. And, remember - you are now in two quite different businesses - one involved in product sales and the other involved in stock sales.
A final word on going public - it is not for everyone. Founders must prepare themselves for volatile variations in stock price and the constant care and feeding of their public shareholders. You can "waste" your whole day just pacifying disgruntled shareholders who want to know why their stock has dropped a few cents or why they didn't double their money last month! You will have to file regular quarterly reports and issue frequent press releases (even if you have little news).
Enough said. Let's suppose that you do decide to become a publicly-traded firm. How do you do it? Answer: Get a Sponsor. A sponsor is, typically, a broker, a.k.a. investment dealer or underwriter. A sponsor should also act as your "fiscal agent", advising you on all financing matters pertaining to the public markets. The sponsor assumes the role of the Venture Capitalist. The sponsor does the so-called due diligence work on your company and manages and coordinates, along with an army of lawyers, the going public process. While you can actually go public without an official sponsor, forget it! If you can't get a sponsor excited, you won't get investors excited either. The best way to find a sponsor is to identify at least three firms, hold a few meetings, and decide on which one can best help you meet your goals. The various stock exchanges will give you a list of their members and help you identify likely candidates. Also, speak to your peers - i.e. other companies who are public.
Traditional bank loans have been administered in the form of a Line of Credit which can fluctuate depending on a company's day-to-day cash requirements. These loans are "demand" loans which can be "called" at anytime by the bank (and when they are called, you will note a tone of unfriendliness in your banker's voice at which point you will likely feel like doing a bit of your own "calling"). But, on a positive note, banks are becoming more innovative, especially in the way in which they deal with knowledge-based businesses (that's what they like to call hi-tech companies). They are considering more aggressive ways to lend money through such instruments as convertible debentures. How about "junk bonds" for technology companies? Don't laugh - we may be seeing more of these (again!) in the future.
Since banks are asset lenders, one should certainly consider "term loans" which are similar to mortgages. Term loans could be used to acquire capital assets (equipment, property, etc). Other financial organizations, in addition to banks, can be approached for equipment financing (i.e. leasing companies).
Factoring is an innovative type of debt financing which some banks as well as private firms, such as First Vancouver Factors, are engaging in. Factoring involves a company's use of its Accounts Receivable asset to secure immediate cash. It works like this: You sell your products on credit to credit-worthy organizations (big business, governments, universities) which usually take from between 30 and 60, or even 90, days to pay you. This is very hard on a growing concern because you are really acting as bank to your customers. Sometimes banks will assist you with a line of credit secured by your receivables and other assets. However, a Factoring "house" will essentially "buy" thee receivables from you. This will cost you more than a conventional line of credit in terms of interest charges and fees, but may provide working capital as needed. It should also be noted that a good factoring firm can act as your in-house credit department by helping you avoid high-risk clients and by acting as your collections department.
Another form of debt financing takes place when suppliers grant credit to companies. This eliminates the need for companies to raise as much capital since their trade suppliers are, in reality, banking them. This form of financing is often the easiest and cheapest to obtain. Equity financing, on the other hand, is very expensive. It may not appear that way, but remember - when you sell equity you are selling a share of profits for life!
In B.C., there is a very positive and supportive infrastructure comprising such organizations such as the B.C.Advanced Systems Institute (which will invest in product development projects), the Science Council of B.C. (which will provide marketing grants as well as research dollars), and the National Research Council's very popular IRAP program (for funding various types of projects). The value of the "soft dollars" provided by these organizations should also not be underestimated. Connections and contacts can be valuable, indeed! For more information on these organizations and their funding programs, check the links at the end of this chapter.
Other lucrative government programs entail government grants such as the provincial government's VCC program and federally sanctioned tax shelters (more on these later!). And, there are many more - ranging from trade assistance to project financing.
Accepting or taking money, especially from "strangers", regardless of the form of financing - be it debt or equity - requires a certain degree of formality or legal process. Obviously, anyone providing a company with their hard-earned money will want some assurances that their investment is protected and that the recipients will not squander the proceeds or "cheat" the investors. Even with the best and most honorable of intentions, it is still necessary to spell out the details as to what conditions or privileges are associated with the investment (e.g. is a board seat included? how and when can the investment be repaid?). Although much of the responsibility for ensuring due process rests on the shoulders of the parties negotiating with each other, there is also a substantial degree of government regulation - much of which is often overlooked by unwary entrepreneurs.
So what? Suffice it to say that when you are raising money you MUST engage the services of a competant securities lawyer to ensure that you are not offside with the regulations. You will find that the rules vary from province to province. It is actually easier for a B.C. company to raise relatively small amounts of investment capital than it is for an Ontario company to do likewise. On the other hand, the B.C. company may only be able to sell its shares to B.C. residents!
And then there is the matter of disclosure - what it is that you must document and disclose to your investors. That's another great source of legal fees! Do you need a prospectus? Or will an Offering Memorandum do the job? Again, check with a lawyer! This subject can be very complex and intriguing. For the time being, take comfort in knowing that there is a lot you don't know but at least you do know that there's a lot you don't know! (Which is better than what you knew before reading this! Right?) Fortunately, Simon Fraser University in cooperation with the VSE and others, regularly offers an excellent and professionally presented 3-day course on "Going Public" held at SFU's downtown campus.
A new seed venture fund called "Competitors" based in Toronto (with an office at the University of Guelph) was started in mid-1996 to help launch companies requiring $150,000 to $200,000. This fund expects to invest in some 15 to 20 companies before the end of 1996. According to Paul Palmer, President, this fund's main criterion is whether the combination of the entrepreneurs' ideas and character along with the seed funding can make them viable and generating $1m in revenue within two to four years.
Another seed fund, the Canadian Science and Technology Growth Fund is a national fund which was recently (1996) initiated to invest in the commercialization of university-based research. This fund is headed up and directed by some well-known former Canadian research managers. This fund, by taking advantage of some provincial (Ontario) tax credits and being RRSP-eligible, attracted many individual investors from the general public who, collectively, invested close to $10 million in this fund in early 1997.
Many funds like this are being formed in B.C. as well. In fact, in March, 1997, a new $25 million Seed Fund was announced as a result of many years of discussion and prompting by the universities' Industry Liaison people. This fund, known as The Western Technology Seed Investment Fund is managed by Ventures West Management Inc., the Business Development Bank of Canada, and Cascadia Pacific Management LLC. It will provide seed capital and management expertise to help develop technology based opportunities created by Western Canada's universities. For more information and links to these organizations, check the attached notes from the Vancouver Enterprise Forum's annual financing presentation.
Another form of tax-motivated financing involves the creation of Limited Partnerships through which investors are able to write-off almost their entire investment in the current year. There are a number of financiers who specialize in the use of such vehicles. They are quite complex, but they do have their merits especially if prospective investors can use the tax breaks.
Immigrant Investor and Immigrant Entrepreneur funds have also played a role in the formation of new capital pools by selling entry visas to wealthy foreign investors and entrepreneurs. Information on these can be obtained by various government trade offices such as the BC Trade and Investment Office. Talk to them.
And then there is the RRSP. Certain types of investments, e.g. shares of publicly traded technology ventures, can be held in an RRSP. Combine an RRSP investment with a VCC grant and a special tax-credit deal, and investors can enjoy tremendous leverage, allowing them to make a $1.00 investment for a dime! This is what you call creative financing.
And, don't forget about leverage. No one likes to be the sole investor. It is possible to start with a small amount of founders capital, possibly personal borrowings, which can then leverage some golden sources which in turn can then attract risk capital.
For a summary of funding sources, please refer to the table,"Money Links". Here you will find money in different colors as well as sources for additional information.
"Innovation in finance is as important as innovation in product development".