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Entrepreneur's Dilemma: Public vs. Private Venture Capital Investment in BC
A bi-weekly column with timely, relevant and possibly irreverent insight into the BC technology industry.

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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