After spending five years developing improved technology for breast-cancer screening, Z-Tech Inc. has one more major hurdle: clinical trials in more than a dozen hospitals across North America. Until recently, however, there were three million things standing between the Toronto-based company and completing those tests — each of them a shiny coin bearing the picture of a loon.
Just to get to this stage, Z-Tech had raised more than $14 million from its owners, their friends and family, early-stage “seed” investors and venture capitalists. Vice-president of finance Ron Baker says those rounds yielded satisfactory results, but to speed things up, this time he chased a new funding source. In January, Z-Tech borrowed $3 million from MMV Financial Inc., a boutique Toronto lender specializing in venture debt — a high-interest loan to fledgling firms that also gives the lender shares in the borrower. Sounds pricey, but it gives high-growth firms short-term cash without the expense and hassle of a full-scale share offering. A venture capitalist might have spent four or five months on due diligence before investing in a firm with virtually no revenue. Yet, Baker says the $3-million loan came together in four weeks, with minimal disruption to management or outside shareholders.
Z-Tech faces an interest rate of almost 13%, plus an undisclosed equity kicker. But, Baker maintains the three-year loan cost Z-Tech’s owners much less than raising more capital, which would have further eroded their precious equity. “You always keep your options open,” he says. “But venture debt fills a real gap in the marketplace.”
Across Canada, entrepreneurial firms such as Z-Tech are eagerly searching for new solutions to financing growth. After years in the wilderness, they enjoy a surfeit of choices. Long lambasted as insular and conservative, Canada’s lenders and venture investors are flush with money, looking for deals and continually innovating. As private-equity consultant Sean Wise points out, “There are absolutely more options now than ever before.” Things aren’t perfect: many bankers remain reluctant lenders (see “So, what about the banks?“), and new equity products often come with the label “For overachieving tech companies only.” Still, these days, most firms will find new products, attitudes and price points that will make their search for funding less painful — and much more rewarding.
Here’s a look at what’s new and hot in SME financing — as well as a few traditional sources sometimes overlooked in a brave new world of venture debt, capital-pool companies and other head-spinning innovations.
ANGEL INVESTORS: Banding together to fund you
Across Canada, moonlighting entrepreneurs, semi-retired executives and other venturesome high-net-worth individuals are looking to invest in private, early-stage businesses with great growth prospects. They come in earlier than the venture-capital funds, consider relationships to be as important as the business plan, focus less on high-tech businesses than most VCs and invest anywhere from $20,000 to $500,000.
Some angels are mainly after higher returns than they can get from indexed mutual finds. But many others are motivated by the thrill of being involved in a risky, growing business that needs both their expertise and cash. They tend to enter the picture after a firm has burned through its “love money” (from “friends, family and fools”), and well before it can earn the attention of VC funds. They hope to hang in for three to five years, then collect a big payout as the firm starts making hay in its market or attracts venture capital.
While there’s no hard data on angel investing, it’s a much bigger deal than most people suspect. Dan Mothersill, president of the National Angel Organization (NAO), places it at two to three times the total invested by VC funds, which would put it at $4 billion to $6 billion. He and other observers believe the number of angels is growing as successful boomers sell their businesses or retire early and turn to direct equity investing for fun and retirement profits.
Better still, angels are coming out of hiding. Whereas they used to keep a low profile to discourage endless appeals for money, today more and more of them are uniting in “angel networks” to systematize the vetting of potential deals and share the risk with fellow angels. Wise, president of Toronto-based Wise Mentor Capital and a close observer of the equity scene, says this reflects a new mentality: “Before the tech bubble, they were very much more lone wolves, investing in one company at a time. Now they have banded together to share best practices, increase their bandwidth, work together on due diligence and boost deal flow.”
In Halifax, entrepreneurs Brian Lowe and Ross Finlay founded the First Angel Network (FAN) last year, after working way too hard to raise $1 million for their own biotech business. By the end of 2005, FAN had 48 members in Nova Scotia and New Brunswick, each with a net worth of at least $1 million. Its counterparts include the Toronto Angel Group, Ottawa’s Purple Angels, the Winnipeg Angel Organization, Vancouver Angel Group and Keiretsu Forum Calgary/Edmonton. Even some smaller centres are getting in on the act, including Kingston, Ont. and the “Silicon Vineyard” of B.C.’s Okanagan Valley.
These organizations aren’t just luncheon clubs; they’re here to do deals. A typical angel group meets monthly to view pitches from four or more early-stage companies seeking equity investment of $50,000 to $200,000. The petitioners are well coached, and generally pay a hefty fee to appear before the angel groups. That covers pre-screening and a dry-run presentation in which a handful of angels preview their presentation and offer tips to improve their later pitch to the full group. Each angel makes individual investment decisions.
In Calgary, 25 members pay $1,000 a year to join the Keiretsu Forum, part of a North America-wide network (“keiretsu” is a Japanese term for a group of affiliated firms that share objectives and leads). Chapter manager Linda Nummela says businesses as diverse as marble quarries and makers of custom-fitted golf clubs have paid the $1,750 to present to the group. Even if they’re among the 80% who aren’t funded, few leave empty-handed. Besides coaching on strategy and presentation skills, they may receive tips on alternative financiers, potential clients or where to find a CFO.
Mothersill isn’t sure whether the networks have boosted the total capital available, but says they’re bringing entrepreneurs closer to like-minded investors. And the NAO is leading a charge to get venture investors a 30% tax credit, to encourage even more angel activity.
But you don’t have to go through formal organizations to find an angel. They’re all around: a recent U.S. study shows 3% of Canadians invest in private businesses. And most aren’t joiners. Andrew Patricio, a partner in Toronto-based Biz Launch, says many of his clients are accessing relatively large sums from non-aligned angels. Local angels invest after a lot less due diligence than regular VCs, and are generally more open to investing in a variety of sectors. Patricio says he knows one entrepreneur who just scored $500,000 to make fishing rods, and a makeup distributor who raised $250,000.
ASSET-BASED LENDING: New players, cheaper money
Michael Herman, a lawyer at Goodman & Carr in Toronto, sees a lot of growth in asset-based lending in the mid-market — not just for distress situations but for everyday working capital. From the banks, which recently established specialty teams in this field, to aggressive U.S. firms such as Capital Finance and homegrown boutiques such as Century Services Inc., “there’s a fair amount of liquidity for people to tap into.”
With ABL, the lender’s security is tied to a specific asset, such as equipment, inventory or accounts receivable. For firms with collateral, it provides greater flexibility than lending geared toward cash flow, and lenders generally impose fewer financial conditions.
John Levac, RBC Royal Bank’s Toronto-based ABL sales manager for Ontario to B.C., says the bank’s minimum deal is $1 million. But some specialty finance companies will go lower: Toronto-based Greenfield Commercial Credit (Canada) Inc., for instance, does deals starting at $200,000.
Glenn Agro, a Mississauga, Ont.-based partner at accounting and consulting firm BDO Dunwoody LLP, says ABL used to be limited largely to big enterprises, “but now we’re seeing it in companies with revenue of $10 million to $200 million.” With the cost falling, he sees it as an increasingly viable alternative to mezzanine financing or venture capital: “It’s more competitive than it was a year ago. It used to be prime plus four [percentage points]; now it’s prime plus one or two.”
ABL financing requires more paperwork than an average bank loan, as the lender needs to monitor your sales and inventory weekly or even daily. “There’s more work for the client, in terms of reporting to an ABL lender,” says Agro, “but, after the fact, most companies say it has improved their business.”
ABL has lots of room to grow. According to a survey by the New York-based Commercial Finance Association, outstanding ABL loans totalled US$362 billion worldwide in 2004, with Canada accounting for just US$10.5 billion. Even so, the latter was up 38% from 2003. A recent report by Montreal-based law firm Ogilvy Renault LLP predicts that ABL will occupy “an ever-increasing segment of business lending in Canada.” It quotes the CEO of Chicago-based LaSalle Business Credit LLC as saying, “Our biggest opportunity is cross-border.”
PRIVATE EQUITY: Keen on smaller companies
While institutional private equity isn’t new, it’s growing fast and eager for deals. The segment includes buyout funds, which inject capital into troubled companies or other firms ready to move to the next level (e.g., an acquisition or public listing), and mezzanine lenders, which provide a debt/equity hybrid to growing companies that ranks behind senior debt but ahead of common equity should the borrower default. Excluding venture capital, private-equity capital in Canada totalled $30.2 billion in 2004, up 16% over 2003. Flush with cash, “the traditional private-equity firms are becoming more aggressive,” says Peter Wallace, CEO of Toronto-based Newport Partners Income Fund, which invests in private businesses itself. “They want to invest in smaller companies.”
What’s attracting all that capital? Performance. According to Toronto-based industry statisticians Thomson Macdonald, mezzanine and buyout firms in Canada enjoyed a 20.1% average annual return over the five years ending Dec. 31, 2004, while VC firms lost 2.4% a year.
As a result, fresh capital injections from pension funds, corporations and, increasingly, retail investors are changing these sectors. Typical deal size for mezzanine lenders used to be $10 million to $50 million, says Robert Palter, a principal at McKinsey & Co. in Toronto. Newish players such as the $75-million Return on Innovation (ROI) Fund now make deals of just $1 million to $3 million. As a labour-sponsored fund, ROI Fund is unique in that, rather than taking only equity in long shots, it offers a mix of subordinated loans and equity capital to stable, mature companies with positive cash flow. This has brought venture financing to smaller firms in such diverse sectors as real estate, coffee distribution, pipelines and plumbing-supply manufacturing. But this is not prime-plus-two bank lending: ROI Fund’s first six investees paid an average rate of 13.68%.
More good news for entrepreneurs: private-equity providers are again looking at an array of businesses. “It’s not all about technology and intellectual property,” says Palter. “People are even willing to look at service businesses if they have a good value proposition.”
Buyout funds traditionally aim to take effective control of mature operating companies, improve them over three to five years, then cash out through a major “exit event” such as a buyout, public offering or merger/acquisition. The average target: a 30% compounded annual return. With competition for good deals growing, more buyout funds are working with smaller companies (i.e., less than $10 million in revenue) and increasingly are willing to accept minority ownership stakes. Typical is Winnipeg-based Richardson Capital Ltd. Its RFG Private Equity Limited Partnership No. 1 emphasizes its ability to deal with existing management rather than run over them. And, while it prefers to invest $10 million to $60 million, it will consider smaller investments for “extraordinary” opportunities.
“On the buyout side, there’s a lot of equity looking to be placed,” notes Goodman & Carr’s Herman. “The market has become much more competitive, which is good for sellers.” But don’t expect average deal size to fall too far, he adds. Investors require more due diligence and hands-on approaches than do lenders, and those costs don’t change when you move to smaller deals with lower potential paybacks.
If your established firm needs a deep-pocketed partner over the medium term, ask your accountant or lawyer for introductions to local private-equity players. If they don’t know who to talk to, have them consult with more plugged-in colleagues on your behalf.
PUBLIC VENTURE CAPITAL: Mind-boggling growth
“Public venture capital” used to mean venture-capital-type investments by governments. Out of the west, however, there’s a new sheriff in town that’s casting a long shadow over Bay Street. The TSX Venture Exchange, the combined (and relocated) offspring of the Vancouver and Alberta exchanges, is promoting a new concept of public venture capital: risk capital raised directly from individual investors through the regulated (but still speculative) TSXV.
“It’s a vital source of capital for early-stage companies,” says Kevan Cowan, TSXV senior vice-president. “The banks won’t step up, and a lot of people say labour-sponsored funds don’t work.” Although the TSXV is still largely a market for Western-based resource stocks, that’s changing fast as more conservative eastern investors see the merits of public capital for emerging companies.
The result is mind-boggling growth. Last year, TSXV firms raised $6 billion, up 46% over 2004. Most of that was from private placements with individual and institutional investors hoping to get in on the ground floor of promising ventures. Cowan expects growth to continue as the Bay Street lawyers, brokers and accountants who keep the blue-chip TSX bubbling catch the venture spirit.
That can-do attitude is exemplified by the Capital Pool Company program, an initiative that was just short of a crapshoot when the Alberta exchange pioneered it in the 1980s. Then, risk-ready investors bought nickel shares in “blind pool” companies with neither revenue nor business plans. Today, the TSXV encourages brand-new firms with no business to go public and raise up to $1.9 million. But it requires the founding managers and directors to have past securities experience and kick in the first $100,000 — and see their shares cancelled if the company goes bust. Within two years, a CPC must complete a transaction to become a “real” business in an exchange-approved deal. This “qualifying transaction” may be a buyout of another firm, but more often is a reverse takeover (RTO) in which the CPC issues shares to acquire an operating company larger than itself. That puts the owners of the acquired business in charge.
The idea is to create capital pools that will become new operating firms or enable other businesses to go public via an RTO for less than a traditional initial public offering (IPO) would cost. Cowan says a venture-exchange IPO could cost $350,000 to $500,000, a high hurdle for firms that only want to raise a few million. But a CPC company can list for about $60,000. It can then use its access to an orderly, supervised market to attract more investors-usually with far less equity dilution than if it were to deal with hard-bargaining VCs. Last year, CPCs accounted for 85 of the 135 IPOs on the TSXV, up from just 29 in 2003.
As Wise notes, the CPC route extends access to risk capital to many types of businesses that lack the IP assets or easy “scalability” venture investors normally demand. And the public listing offers a regulated market into which to sell your shares, unlike angels’ illiquid holdings. With the TSXV’s growing clout, says Wise, “there’s been a huge perceptual change. People now see the Venture Exchange as legit, not a last resort.”
While manufacturing, service and resource firms all use the CPC program, the most successful players are tech companies. Those completing qualifying transactions last year included Time Industrial, an Edmonton-based developer of cost-tracking systems founded by Evan Chrapko (co-founder of the 1999 high-tech darling, DocSpace Co.), and Kaboose.com, a Toronto-based online media company. Kaboose CEO Jason DeZwirek says the program will help his firm raise more capital without having to turn to VCs, who he says want preferential treatment and too much equity.
Cowan says more than 1,300 companies have completed a qualifying transaction since the program started 20 years ago. Of these, 200 have graduated to the TSX itself-a success rate comparable with companies backed by VCs.
VENTURE CAPITAL: A modest and imperilled rebound
Despite their high profile in business plans and the press, VCs play a small though key role in the business universe. Fewer than one firm in a thousand wins venture capital support. In 2005, just 591 did so in Canada, raising $1.83 billion, according to Thomson Macdonald.
To win VC backing, which could be worth $500,000 to $25 million, your firm must have outstanding growth prospects. VCs try to at least quintuple the value of their investments over five to seven years-which makes up for the 60% to 80% that sink or tread water. They’re primarily interested in tech companies, mainly in IT and biotech/life sciences, that harbour the greatest global opportunities and upside. Non-tech companies landed 18% of all venture financing in 2004, mainly from labour-sponsored investment funds (LSIFs) with a mandate to invest broadly in small businesses and economic development. Winnipeg-based Ensis Growth Fund, for instance, has invested in such local firms as Jazz Golf Equipment ($3.6 million); Krave’s Candy Co. ($536,000), which produces Clodhoppers confections; and Tell Us About Us Inc. ($400,000), a provider of market research and customer-satisfaction programs.
In general, though, VCs exist to fund the best and brightest. Any non-tech investee firm will normally need to have a strong brand or some other tangible intellectual property that will make it a long-term winner, not just in Canada, but in the U.S. and beyond.
The good news is that VC disbursements have rebounded since the tech crash. Total investment is up 10% since 2003, though still far off its 2000 peak of $5.8 billion. And, unlike some funding types, VC investing isn’t largely limited to Ontario. In 2004, the province attracted 41% of VC dollars, but Quebec’s share was 39%, B.C.’s 12% and Alberta’s 4%.
Still, Ontario’s government hung a big question over the VC world last September when it announced it will phase out its 15% tax credit for investing in LSIFs. In 2004, they accounted for 71% of investment funds raised by Canadian VCs. Experts say any reduction in that source would disproportionately affect new investments (as funds focused on follow-on investments with existing clients), as well as the early-stage and non-tech companies that rely on LSIFs.
Still, Robin Louis, chairman of Ventures West Management Inc. in Vancouver and president of the Canadian Venture Capital and Private Equity Association, sees a silver lining. He says foreign VCs feel at a disadvantage in Canada, given LSIFs’ legislated edge. Should the latter disappear, Louis expects foreign-based investors will fill the gap.
In the end, the supply of venture capital depends on how successfully VCs can get out of older investments. So Wise positively beams over the recent spate of auspicious exits, such as Computer Associates’ January purchase for an undisclosed amount of Control-F1 Corp., a Calgary-based maker of automated technology-management software; last summer’s $90-million sale of Montreal-based Airborne Entertainment Inc. to a Japanese mobile-media giant; and last April’s $69-million IPO of Terry Matthews’ March Networks Corp., the first IPO of an Ottawa-area tech company in six years: “These sorts of exits mean the money can be put back into the funds where it came from, and it will attract new investment.”
VENTURE DEBT: Fast cash for the early going
Venture debt is a loan to a high-growth (and higher-risk) company that faces a cash squeeze but doesn’t qualify for bank lending. Private equity and mezzanine funds such as Roynat Capital have been providing convertible debt (loans with an equity component) to bigger firms for years, but the deal becomes venture debt when it’s done with an early-stage company with little or no revenue.
Venture debt was brought to Canada by Minhas Mohamed, a fund manager for Quorum Group, a Toronto-based supplier of private expansion capital. In 1997, one of his investee companies needed $5 million to get to a certain milestone, but arranging another equity round would have taken too much time and effort and required a valuation no one wanted at the time. Mohamed found a solution in a U.S.-based lender of venture debt. It was that lender’s first Canadian deal, but it worked very well. The client company hit its milestone, says Mohamed, and was sold soon after for about twice as much as it would have been had it accepted another round of venture capital.
Mohamed soon quit his job to team up with the U.S. lender to bring venture debt to Canada. Focusing mainly on IT and life-sciences firms, they did $150 million worth of deals in five years. In 2003, Mohamed formed MMV Financial, raising enough capital from other investment funds to finance $300 million of deals. In 2005, MMV invested US$54 million in 22 firms, with most deals falling between $1 million (the minimum size it will consider) and $5 million.
Since venture debt requires less due diligence than venture capital, it is fast. But it’s not cheap. MMV charges about eight points above prime — or a recent 13.5%. To get that venture sparkle, it also insists on receiving warrants that could amount to 2% to 3% of the firm’s overall value. Compared to the pain of diluting your equity base through another round of venture capital, however, 13.5% can look pretty good. But don’t feel sorry for the VCs: they call in MMV when they’re trying to avoid dilution in their own portfolio companies.