The Technology Fast 50: Hungry from the start

Canada's top technology startups are growing at unheard–of rates — in spite of a venture capital drought, or perhaps because of it. But will they hit the wall?

Sometimes it pays to be the little guy. In 2008, when the sub-prime mortgage crisis upended the multi-billion-dollar property valuation industry, Real Matters, a Markham, Ont.-based startup that provides property information to banks and insurance agencies, was in the unique position of being nimble in a market dominated by giants. Compared to larger firms, which must go through layers of management and bureaucracy to develop new technology, “we’re like the little speedboat,” says CEO and founder Jason Smith. “We can get in there and innovate.” With the rules for property valuation in flux, Real Matters has cashed in on the ability to turn on a dime. In its first five years, the company has grown a staggering 40,500%, with revenue in 2009 exceeding $20 million.

Though Real Matters owes some of its success to being in the right place at the right time, the firm’s evolution into a flexible, efficient shop was by design. A serial entrepreneur who founded his first company in high school, Smith says he knew better than to “[spill] the money ahead of the customers.” So instead of hiring developers and producing software out of the gate, Smith started small, spending the first year — and just $75,000 — talking to potential clients and refining the business plan. By “allowing the customers to drive growth instead of guessing,” Smith says he’s been able to invest strategically and remain lean, even as the firm expands. “How we’re winning is staying agile and flexible,” he says. “That’s wired right into the DNA of our company.”

Real Matters is not alone in achieving tremendous growth despite a modest start. In the 12 years that business-services provider Deloitte has compiled the list of Canada’s fastest-growing technology firms, never have those at the top started so small and grown so fast. The staggering growth rates of this year’s Fast 50 — the average of the top five was a record-smashing 43,000% — reflects how high-tech startups have evolved in the face of austerity. Whether by necessity or choice, these companies have gotten off the ground with very little capital. Headed by experienced entrepreneurs, they are filling small holes in big markets with innovative products that cost less and perform better. All of which explains why the Fast 50 didn’t just survive the recession — they thrived. But it also raises questions about the future of the Canadian technology industry. Do these niche firms stand a chance of becoming major players? Or are middling revenues — and an eventual acquisition — the best that the next generation of entrepreneurs can hope for?

To explain this year’s staggering growth rates, Duncan Stewart, director of Deloitte Canada’s technology, media and telecommunications research group, points to the humble beginnings of those at the top. Based on revenue growth over five years, this year’s list measures the increase in sales from 2005 to 2009. Though the winners include established firms like Research In Motion, whose sustained growth has put it among Canada’s fastest-growing companies every year since 1998, the top five are all rookies — a Fast 50 first. Unlike in past years, says Stewart, most were just getting off the ground in 2005, with baseline revenues that barely surpassed the minimum requirement of $50,000.

As Stewart sees it, these low Year 1 revenues speak to the decline in resources available to tech startups — what he calls a “crisis in venture capital.” Over the past decade, the traditional sources of venture capital funding have dried up. The belief that venture capital performance has been poor, and a desire to diversify internationally, have prompted many institutional investors to move their money out of the asset class, leaving “fewer and fewer venture funds with less and less to invest,” says Steve Hurwitz, a Boston-based lawyer and co-founder of an annual venture capital conference in Quebec City. In 2009, venture capital investing in Canadian tech companies and fundraising by Canadian VC firms dropped to the lowest levels since the mid-1990s (though there has been a slight uptick this year). The extent of the contraction is especially apparent when compared to the United States: a study compiled by Canada’s Venture Capital & Private Equity Association found that from 2003 to 2008, venture capital investment as a share of GDP dropped 35% in Canada; meanwhile, south of the border, it increased by 17%.

For their part, those heading the firms that topped the Fast 50 maintain that the limited resources haven’t hindered their development. Some say they avoided venture capital altogether, preferring to pursue angel investors or strategic partnerships. Others insist that starting small was their choice, and that when they were ready to raise capital, they had no trouble doing so. Either way, their trajectory suggests that tech startups are increasingly taking time to test the waters before jumping in.

The consequence, says John Ruffolo, Deloitte’s global thought leader for technology, media and telecommunications, is that “a lot of these companies had to bootstrap themselves and focus in on developing their business model.” Dan Shimmerman launched Varicent Software Inc., a Toronto-based firm that specializes in sales-performance management, from business partner Marc Altshuller’s basement in 2003. For the first year, the duo kept their day jobs (both worked at Clarity Systems), putting their energy into refining their product and strategy rather than attracting resources. Not putting the cart before the horse has paid off: in addition to growing revenues more than 40,000% over five years, with 2009 sales topping out at $25 million, Varicent recently raised $35 million in venture capital. “Good businesses are always going to find investors,” says Shimmerman.

Rather than carving out new markets — or, as Real Matters founder Smith puts it, “knocking on doors and trying to sell a brand new widget that [nobody] has the budget for” — the fastest-growing tech firms are making inroads by finding better solutions to existing needs. For instance, Richmond Hill, Ont.???based Storage Appliance Corp. has achieved a whopping 64,000% growth (a new Fast 50 record) with Clickfree, an automatic computer backup device that, unlike most external hard drives on the market, doesn’t require users to install software. With a single keystroke, Clickfree can upload or download all the contents on a computer, organizing them by file type. “It’s backup that a five-year-old could use,” says CEO Bryan McLeod. Likewise, Avigilon founder Alex Fernandes says the “secret sauce” for his Vancouver-based surveillance-solution provider, which posted 33,000% revenue growth from 2005 to 2009, is an alternative that’s both higher performing and cheaper than conventional systems.

Now more than ever, says Hurwitz, investors are looking for a product “that is disruptive. It does more than compete; it replaces the competition.” At the same time, says Mark McQueen, president and CEO of VC firm Wellington Financial, the “push to reduce the amount of money required to find out if a company can succeed” has placed more of an onus on tech startups to prove that their products have what it takes. Software Appliance spent several years on development and licensing before going to market with Clickfree in January 2008. “We decided the best way to build it into a business was just to go out there and sell it to retailers,” says McLeod. By July, they had shown that they could tap into a sizable market: after just one 10-minute spot on QVC, the shopping network sold out of its entire stock of 6,000 units; it took only five more spots for viewers to snap up 20,000 more. The firm has since been capitalizing on what McLeod describes as “a huge pent-up demand for computer backup,” selling more than one million units worldwide.

To a certain extent, the ability to prove a product without significant outside investment is industry-specific — thanks to cloud computing and lower development costs, it has become cheaper than ever to launch a software firm — but it’s also a privilege most often afforded to those with deep pockets. It should come as no surprise then, that many of this year’s winning firms are run by serial entrepreneurs with money to burn. Bill Tatham, founder of enterprise software provider NexJ Systems, whose revenues grew 36,000%, sold his first software startup to Siebel Systems in 2000 for $1.76 billion (see sidebar). Similarly, Avigilon founder Fernandes’s previous startup, QImaging, was snapped up by a large New York Stock Exchange???listed conglomerate for $20 million in 2002, enabling him to become “the biggest and major shareholder of the company” this time around.

For many investors, says Wellington’s McQueen, the strength of a management team has become “even more important” than the product. “A bad management team can ruin an idea, but a good management team can always improve an idea if the market is moving on it,” he says. As such, many of those leading Fast 50 firms credit their solid track records with helping to move their companies beyond the incubation stage. Storage Appliance’s McLeod, for one, says the fact that he and founder Ian Collins are “seasoned startup guys” has made it relatively easy to attract $15 million, even in tough times. Tatham, who recently raised $22.5 million, concurs: “People take confidence in that fact that you’ve made the money before.”

Perhaps the most significant upside to launching with limited resources, says Thomas Hellmann, director of the University of British Columbia’s W. Maurice Young Entrepreneurship and Venture Capital Research Centre, is the lasting effect it has on corporate culture. “The DNA of a company gets formed in its very early stages,” he says. “So [those that start with less] tend to be cost-efficient, they tend to be focused and they know that they have to do things with very few resources, and they have to perform in order to survive.” ParetoLogic, a Victoria, B.C.???based software firm whose name is derived from “pareto,” an economics term that pertains to efficiency, has prioritized cost-cutting since launching in 2003, says CEO Elton Pereira. “We’re all about maximizing our revenues and profits and our customer base, given a certain amount of resources.” By outsourcing development wherever possible, conducting rigorous market testing and selling exclusively online, he’s turned Paretologic, which specializes in online security, into a company with $88 million in annual revenues, and profit margins that regularly exceed 50%.

Knowing how to do more with less was a significant factor in enabling these firms to continue to post record growth as the economy took a turn for the worse. While many of their competitors were forced to batten down the hatches, these firms capitalized on the ability to do the opposite. By staying lean and “getting rid of dead wood” from the outset, Avigilon’s Fernandes says he had room to bring on talented people who were laid off from other IT firms. Likewise, Real Matters has continued to quickly roll out new products, completing software builds in just three weeks. More than anything, it seems the recession has given them the chance to step up to the plate. “When it’s [tough] out there, and you’ve got to fight hard, it’s actually opportunistic,” says Shimmerman. “You can really start to separate the winners from the losers — the guys that are really here to play hard, and the folks that crawl up in their office and hide under the desk.”

So, what’s next for the Fast 50? Though rapid growth can be a predictor of future success, quite often, says UBC’s Hellmann, “these are transitory, not permanent super-performances.” To get to the next level, say experts, these firms would be wise to take an employee-centred approach to expansion. “You can make a big mistake in terms of whom you hire,” says Mikhel Tombak, who directs an innovation program at University of Toronto’s Rotman School of Management, “because you’re just grabbing whoever you can.”

There are also concerns about the implications of starting small, both for individual firms, and the industry as a whole. According to Hurwitz, Canadian tech firms have been hobbled by receiving only a fraction of the venture capital of their American competitors. As a result, he says, many are being sold to large companies “early in their life cycle, long before they reach industry leadership” — which, he says, is “the real hollowing out of Canada.” Deloitte’s Stewart, meanwhile, compares the long-term effect of a company that starts with limited resources to a baby that doesn’t get enough food. “They still survive and still go on, but they’re a little smaller than you’d expect them to be.”

There is, however, reason to hope that tech startups may get more of a hand up in the future. In response to the decline in venture capital, several provincial governments have created their own funds, and universities are increasingly investing in research and development, particularly in the biotech and clean-tech sectors. At the same time, a recent reform to Canada’s Income Income Tax Act has made it as easier for U.S. venture capital firms to invest in Canadian startups. “Over time,” says Hurwitz, “that’s going to have a significantly favourable effect.”

But those heading Canada’s fastest-growing firms are hard-pressed to complain about what might have been. Instead, they’re looking ahead. Some are contemplating taking their companies public; others have their sights set on becoming market leaders. “You build your business around making sure you’re continuing to grow your sales, and you’re building a better business every single day,” says Storage Appliance’s McLeod. “The exit strategy always finds you.”