Something
Ventured:
June 15, 1998
By Brent
Holliday
Greenstone
Venture Partners
"Yeah
you're working Building a mystery
And choosing so carefully " - Sarah McLachlan,
Building a Mystery
This
week's column has a new format. It takes the shape of a
discussion between two individuals over the merits and
pitfalls of getting early stage equity capital from
public or private sources in BC. First, I would like to
introduce my counterpart in this discussion, Jerome
Gessaroli, an Investment Advisor with Brink, Hudson and
Lefever in Vancouver. Previous to joining Brink Hudson,
Jerome worked for 10 years in the high tech sector where
he was responsible for a wide range of business
development activities.
Jerome
and I feel that this discussion is timely with the
recent announcement of the VSE allowing Venture Capital
Pools (VCPs) similar to the JCP program in place at the
Alberta Stock Exchange. A VCP is a publicly traded
company without an operating business. Its only assets
are funds raised by the IPO and its Board of Directors.
The Board is mandated to seek out and acquire a
promising business. The rules for any non-resource
company (this is a technology column, after all) are
that a qualified management team must be in place, a VSE
member dealer must be involved and it must raise between
$300,000 - $500,000. The VCP has 18 months to complete a
"qualifying transaction."
As
for private venture capital investment, it takes many
forms and I have a complete list of resources and
information here.
Jerome
and I will discuss the financing choice between VCP and
venture capital for early stage companies and then the
choice for the growth stage company later on. First,
here is an example of an early stage technology company.
Let's say that there is a company seeking $300K to $500K
in financing to finish developing a product and get
their first customers. They have demonstrated a market
need and some protectible or unique solution.
There
are a few reference companies that are lined up to test
the product. The management team is made up of the
technologist founder and an experienced marketing
manager with a successful track record, who will assume
the role of CEO to start. They got to where they are
today with their own money and some friends and family
money. Now they need an equity infusion to hire more
people and get the company going. What
are the benefits and pitfalls of the two major equity
financing options available to them?
Brent
Holliday (BH): For any early stage technology company,
the reason entrepreneurs stay up at night is shortage of
resources, most notably cash. I think we all agree that
ultimately, for the early-stage company to survive, it
doesn't really matter where they get the cash, just as
long as they have it.
If
we assume that the entrepreneur has a choice of where to
get capital, then we can talk about merits. Sometimes
they don't have that choice. In the case of our
fictional company I'll assume that the VC is interested.
Venture
capital from a proven institutional source is more
expensive money than a VCP. What I mean by that is that
VCs tie a lot to their money (think of it more as a
marriage than a handout), whereas public markets give
you the money with somewhat less restrictions. But I
would argue that the value brought by the VC leads to
more successful companies in the long run.
VC's
demand superior management performance and can help the
company in many ways (recruiting, seeking partners,
bringing in more financiers, strategic direction, access
to other companies and their technology within the VCs
portfolio of companies). VCs are your best friend and
ally when things are going well. When things go awry,
the VC can effect change and does so in the best
interest of the company, because that is where their
investment is. This makes entrepreneurs uncomfortable,
but accountability is crucial to any manager's success.
Jerome
Gessaroli (JG): Indeed, an early stage tech company's
primary concern is often insufficient funds. Either the
company can use additional working capital immediately
or sees a requirement for a another financing round to
meet a major milestone (e.g., completion of commercial
product development, executing a marketing plan, etc.).
Whereas the usual IPO route is good for raising $1M -
$3M on the VSE, it can be an expensive and time
consuming process.
A
key feature of the VCP is that it allows for a
relatively quick and inexpensive process for raising
capital and vending in a business. That business can
access the capital in the VCP while it develops a
prospectus or offering memorandum to raise any further
funds, if needed.
Once
public it is not uncommon to see a company's valuation
increase significantly. Depending on investor interest,
it may trade at higher price-earnings multiples (if
there are any), or higher price to sales multiples. This
is definitely a benefit. Not only are your shares worth
more, but it opens up a host of new financing and
business strategies not previously available. I'll touch
on these in a later discussion.
Owners
of a public company will have to devote some time and
effort in communicating with its public investors and
brokerage community. They will also incur costs doing
annual reports, public filings, and investor related
literature. Not a large cost, but still there.
Finally,
I agree with Brent on the fact that VC money is usually
more expensive than public money. The venture
capitalists will "extract their pound of
flesh." Keep in mind that any equity financing
(public or private) is usually the most expensive
capital there is.
A
general dictum to remember is to give up as little
equity as you can. Remember, your company may well have
to do a number of financing rounds if it is to really
grow and become significant. Each round will dilute your
position.
BH:
Let me pick up on your last point. Every entrepreneur
gets the advice to not give up much equity. It's a tough
call for any entrepreneur to balance what is the right
way to raise equity for the company. There are two
variables at play. One is the amount of cash you will
need to get significantly cash positive and the second
is the valuation of the company when it raises that
money.
Let's
say our fictional company really needs $5 million over
the next three years. If they raise it all today, at a
low valuation because they have nothing concrete to show
that their idea works, they will lose 90% of the
company. That's not desirable for anyone.
Conversely
if they get just enough to get some significant
milestones met and then raise another $1m and then go
through the same process again and again, each time
raising the valuation a little bit, then they will have
the most possible equity at the end of the day. This is
also not realistic because the CEO will spend their
entire existence raising money and not building the
company. Ask any CEO who has tried this route. They will
tell you that it is unworkable.
Somewhere
in the middle of the two scenarios is the right way to
raise money. Get enough to get you some time between
financing rounds yet try to get better valuations to
protect your share. Venture capital allows a negotiation
of valuation between the entrepreneur and the VC (or
group of them). One on one. The parties involved can be
creative (ratchet clauses, tranche payments, warrants)
in finding an acceptable middle ground. Also, many of us
have been on the entrepreneur's side and we are
realistic about what works and what doesn't work for
early companies (we often insist on employee share
option plans with enough to keep everyone motivated).
A
company going the VCP route, as Jerome said, can get
attractive valuations on the initial financing. But, the
decision on what the value should be at IPO is not made
between parties in the same fashion as the one on one
negotiation with a VC. Jerome can correct me if I'm
wrong here, but my take on the public market financing
is that valuation is recommended by the investment
banker based on many factors (market mood, ability to
sell the deal to stock brokers and fund managers) and
then it is tossed to the whims of the public. If the
company does not get good coverage
("promotion") in the public market, the value
may drop, making it tough to raise more money. In other
words, our fictional company may hit most of its
milestones and feel that its value is X but, for any
number of reasons, the market doesn't think so.
There
is no ability to negotiate the valuation now and the
founders will get their equity diluted. Of course, you
could be a wild success in the market and have your
stock value climb, making it easy to raise more money.
But, VCP companies, if they are anything like JCP
companies on the ASE, have very low stock liquidity,
meaning their shares don't trade much and it's tough to
get people interested. Going back to the example of the
CEO constantly raising money, it is compounded here by
the CEO's need to constantly educate the public on what
the company is doing right.
JG:
Brent has raised a number of points worth examining
closer. First, there may be some confusion over a VCP
and a company doing a regular IPO. Brent commented that
many JCPs on Alberta are illiquid and don't have high
valuations. That's true they don't. But they're not
expected to. Remember, a JCP (or VCP in Vancouver) is
merely a shell with some money and a Board mandated to
vend in a business. Higher valuations and trading
volumes aren't expected until the "qualifying
transaction" is announced. With a regular IPO,
there is a defined business which is going public. Thus
depending on a whole host of factors, that company may
trade at greater valuations than if it was private.
Second,
Brent mentioned the method by which a company going
public is priced. He's correct to suggest it is based
partly on the advice of the investment dealer who takes
into account market conditions and the like. But a price
which is fair to both the company and investors is
important. A successfully priced IPO will allow the
company to do a future financing easier, if one is
required. However, the final decision must, of course,
be agreed upon by the dealer and the company.
This
goes directly into a third comment regarding financing
options. There are a number of financing options for
public companies. They include, brokered or non-brokered
private placements, special warrants, secondary
offerings, VCPs or regular IPOs, tradeable debt,
convertibles, etc. The option also exists for going to a
more senior market (e.g., TSE or NASDAQ) in the future.
A
fourth point discussed is coverage or promotion. Just
like any product sold in the market, to create interest
and demand for the shares one has to raise the profile
of the company. By definition, if we're talking about a
company getting listed on Vancouver, it will be small
and relatively unknown. Thus it's essential that
brokers, analysts, and the public get to know the
company. While it does take some effort, if a company
has financials to support its story (i.e., of rapid
growth) it will be noticed by the market and its shares
priced accordingly!
Finally,
regarding the point on employee shares or options,
public markets definitely have the advantage. A
tradeable security exists with a posted market price.
There is liquidity for employees. Private companies can
set up phantom markets, valuation methodologies, etc.
but they have limitations. This point should not be
underestimated for high tech companies. Employees are
increasingly asking for equity participation. With the
high demand for technical staff, offering employee stock
options is now being viewed as an essential recruiting
tool.
BH:
On the stock options point, everyone wants employees to
remain with the company. The key to the plan is not the
liquidity (every private company hopes to liquidate by
eventually going public or being bought) but the vesting
period. As a CEO of a start-up I want to show the
employees that they will get options, but I also want
them to vest over a period of years, such that they
don't cash them after 1 year of work and walk away.
I
want to wrap up the discussion with one final point. An
entrepreneur has a choice of where to get capital for an
early stage venture. They will get advice from many
people. If that entrepreneur believes that they are
savvy enough to seek the "cheaper" capital of
the public markets from the very beginning, then they
should do it.
If
they do not believe that they need the assistance and
guidance of experienced VCs, then they will probably not
ever reach a deal with VCs anyhow. Venture capital is a
marriage. If the parties don't trust each other from the
start, it will be a rocky road.
What
I would like to see is a continuation of this discussion
with CFOs of both public and private companies in a
panel format. They are the important third party missing
from our discussion.
As
luck would have it, Ernst & Young is hosting an
event for learning more about the VCP program for senior
managers of high tech companies. Complete details and
registration forms are available at: http://www.vef.org/vcp.htm
Random Thoughts
Report
on Business Magazine had a story on the incredible
economic turnaround of Ireland, based mostly on a
conviction to technology and highly skilled workers.
Ireland is home to manufacturing facilities and software
development houses for many of the biggest names in the
technology industry. Their unemployment rate has been
cut by two thirds since 1987 and their deficit, once as
bad as ours in the mid-90's, is almost gone.
The
point is that the government made a concerted effort to
make Ireland a place to do business and employ its
highly educated workforce. Tuition to university and
college in Ireland is free! And the corporate tax rate
is 10% (ours is around 40%). Dublin is going through
some growing pains associated with the new wealth
created (traffic jams, etc.) and there has been little
spin off of new Irish companies so far (due to a lack of
venture capital!!!), the country is much better off
after making technology its focus for the future...
Nice
to see that Mary McDonald's BC Venture Capital Report
showed that VC funding had increased 10 times in 5
years. The point I tried to make to the reporter (who
misquoted me) was that there is plenty of capital for
growth stage companies (some revenue, product finished,
management team complete, huge market opportunity), but
not as much for the very early stage, just after the
research funding runs out. This is the domain of the
Western Technology Seed Investment Fund and some angels.
Response From Last Week's Column:
I
agree with most of the points in your column, however I
feel you undervalued the resource based economy problem.
I also feel we need to encourage people to stay and have
those that leave pay for all the education subsidies we
give them over the years.
We
are spending millions keeping Skeena Cellulose and other
companies going, although their time has come to change
from pure resource companies into large manufacturing
companies. Instead of shipping raw wood anywhere, we
need to take any raw resource and convert it into the
usable product before it leaves the province. Instead of
selling pulp to Japan, we need to sell paper, and only
paper. Instead of selling 2x4's or tree trunks to
Washington State, we need to sell prepackaged homes.
Ship them as a complete package, or ship walls. Get
around the tariffs by producing finished products. It
may employ one person to cut down a tree, but we could
employ another four if that tree were worked before it
was sent out.
Obviously,
it would require a higher skill set for a carpenter who
creates the wall, than the lumberjack who chops down the
tree. Each improvement we make in the less skilled,
raises our ability to support people with more.
Millions
are spent subsidizing universities. What we need to do,
is make loans repayable at one rate for people who work
in BC and a much higher rate for those who leave.
Probably in the neighborhood of 100-200% higher. I.e.,
if two people take out a student loan, and one stays,
the other leaves. The person who moves to the States,
has to repay the student loan and any hidden subsidies
at $300/month for three years. The other student stays
and only has to repay the actual tuition costs,
$150/month for three years.
I
run a small software development house in Coquitlam.
Work is good, however it is has been difficult to get
funding to market our software. Many lending
institutions look at our books and see that we have had
net losses for three years in a row and no assets. Now
that our first software package is ready, it is
difficult to get any money to bring it to market.
Luckily, we have started consulting and that income will
get us going, albeit slowly.
René
Gauthier
Actually,
I have mentioned the movement from rocks and trees to
hydrogen and silicon in some of my previous articles. I
couldn't agree with you more. Skeena Cellulose burns my
butt, too. Your idea about student loans is creative,
but I think there are some problems with it. What if the
only job in lemnology is in Australia? Do I still have
to pay? If we stopped bailing out failing companies and
invested in education that gives people the skills (and
experience.. I love co-op) for the technology and
knowledge industries in BC, we would be better off.
What Do You Think? Talk
Back To Brent Holliday
Something Ventured is a bi-weekly column designed
to supplement the T-Net British Columbia web site with
some timely, relevant and possibly irreverent insight
into the industry. I hope to share some of the
perspective and trends that I see in my role as a VC.
The column is always followed by feedback (if its
positive or constructive. I'll keep the flames to
myself, thanks).
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