New VCs: Avrio

In the midst of the venture capital slow down here in Canada, It's nice to see a few new funds plant their stakes in the ground. Avrio Ventures has quietly been building a solid portfolio with their first fund, which is focused on investments in neutraceuticals, industrial bioproducts and food technologies. Get to know them; with a team that includes Bud Kirchner, you can bet this is the first of several funds.

Business Development Bank Canada: 2006 Results

BDC released its annual report last week, chock full of interesting data points. Here's a handful:

- 0.3% of Canada's businesses can be classified as large. The remainder are SMEs.

- In 2006 27,000 entrepreneurs received assistance from its staff of 1,700. That's 1 BDC staffer for every 15 entrepreneurs.

Venture Capital Activity:

- BDC made just 8 seed investments totalling $6.6 million last year.

- Other vc investments by BDC: 69 direct VC investments totaling $106 million

The venture capital numbers seem surprisingly large, given the widespread rumors that BDC is dialling down its direct venture capital investing for the near future. If this is the case, it's a move I applaud. BDC has done a heroic job focussing on the needs of SMEs of all kinds. Its assistance is often overshadowed by the beating it takes from private VCs over BDC's participation in venture capital. (Do you hear the Export Development Corp or Sustainable Technology Development Canada taking the same hit?)

BDC loans have done some good things for my clients in the last two years, so I'm inclined to get a little misty eyed about them. Read their report, look past the investor relations cheerleading, and see what you think.

Startup Trademarks: THE Source

It's hard to find a startup savvy trademarks lawyer, but I did and have been jealously guarding her name for years now. Jessica Stone Levy and I were compadres in New York before she moved to Seattle for the love of Microsoft and her husband. She understands the dynamics of branding as well as the technicalities of law, and I loved using her when the large firm she worked for didn't have a conflict. She now has removed the whole conflicts issue by striking out on her own and is providing bang on advice over at her blog. Check it out here for all you need to know on trademarks and for an explanation of why iTunes is a ridiculous trademark.

High Net Worth Money Makes its Way to Series A?

Vancouver's Strangeloop Networks coyly announced today that it had secured a $11.5 million Series A round from "A group of private investors." This phrase is often PR shorthand for high net worth folks who've been enticed by their tax-planning advisors into an interesting investment vehicle. Sometimes, this is a straight share investment; other times, it's a more complex (and, might I add, less founder-friendly) GP/LP structure that's being funded. Either way, these kinds of announcements another sign of an interesting trend - the financing of high tech companies by players off the venture capital grid.

There are other examples out there - in Toronto, Bluecat Networks is a notable example - with more to come. Stay tuned.

Startup Patents: Questions Every VC Should Ask

One of the key elements to any pitch for money is your explanation of your company's "unfair advantage" - that is, the barriers to entry that prevent other competitors from challenging your position in the market. For companies seeking venture capital to grow, the unfair advantage almost always hinges on your trade secrets and technology.

Many companies seeking money pitch an intuitive technology story. They discuss the unique features and functionality they've created, describe the patent protection they've applied for, and....stop.

In my view, the more compelling pitch is one that explains your intellectual property strategy. Selling your view of the technology landscape and your strategy for carving a defensible niche can be a compelling part of the pitch. Your story can shape part of the VC's investment thesis for him and, more importantly, they showcase your analytical rigor and credibility. Here are the questions I suggest my clients answer in any pitch to VCs:

1. Who are the prospective infringers of your technology? (Be sure to include any likely infringers outside of your industry.)

2. Have you drafted your patent applications so that, if the patents are issued, these potential infringers would be direct infringers of your rights?

3. Have you organized your patent applications to facilitate future licensing strategies? (For example, filing a patent that combines claims for an embedded solution)

4. Trade secrets: Do you have proprietary manufacturing processes? How are you protecting these? (Since process is not readily discoverable by examining your product, you may not wish to make that process public in a patent. However, this decision needs to be made in context. Have your competitors filed for patents on manufacturing processes? If so, you need to explain why you are/are not following that trend.)

My two cents.

Venture Law Lines Seminars

We are putting the finishing touches on our fall seminar series, complete with guest speakers, and will be publishing the details shortly. Any topic ideas? Send them over.

Red Canary Press

The folks at Red Canary regularly publish a gem of an online paper that nicely brings together many elements of the Canadian high tech community. I sat down with one of their reporters recently for an interview on practical issues arising for startups as they prepare for commercial release. You can take a look here.

Near-Shoring: Canada's Best Hope for Technology Growth?

Almost two weeks ago, Microsoft announced that it would open a development center in Vancouver. The purpose? To attract and retain skilled foreign-born developers who are hampered by restrictions on work visas in the US. Ask anyone who has struggled to get ahold of one of the handful of H1B visas made available each year, and they'll tell you how hard it is to work in the United States in the current environment.

A colleague in California believes that this is the next great opportunity for Canada's technology community. Stop sending me Ernie Eves, he says, and start sending incentive packages that will attract similar businesses to Canadian centres like Toronto.

The opportunity for Canada is compelling, he says. In the US, immigration reform is dead until 2009, after the next presidential election. Which means that for the next two years at least, the influx of foreign workers to the US will be limited to 65,000 or less. Further,the more than 550,000 foreign students who are graduating from the US' leading institutions such as Stanford and MIT will find it hard to stay and work there. That's a locally-trained talent pool waiting to be tapped by a more immigration-friendly country like Canada.

There also are other factors which may continue to limit access to foreign technology talent in the US. Most notably, the US Department of Defense and the Commerce Department have introduced broad restrictions on the ability of foreign students to participate in federally funded research projects that relate to sensitive areas. The US government has gone so far as to propose that disclosure by American porfessors of certain kinds of research and information to foreign born students may be a deemed export of technology in contravention of US export controls laws. While institutions such as MIT have strongly opposed these controls on research and innovation, few doubt these will be part of the innovation fabric of the US for the forseeable future.

What does this mean for Canada? As my Californian friend points out, there is a tremendous appeal to "near-shoring" some US operations to Canada instead of offshoring them to different time zones. Can we capitalize on Microsoft's move and create a trend? Where are the economic development wonks when we need them?

Nearshoring Private Equity: The Next Great Opportunity For Canada

A continued source of frustration for Canadian startups is our inability to access US private equity. Ontario's Premier even recently visited Silicon Valley to try and tout the advantages of investing here. One of my US colleagues, who spent time with Mr. Eves, points out that he needn't have bothered: if Canada really wants to attract US private equity, my friend says, it should do nothing.

Congress, he says, is doing a solid job trying to drive US private equity overseas on its own. Congressional hearings began last week on proposed tax law reforms which, if passed, will effectively double the tax that private equity fund managers pay.

This reform has been on the table for a while, but as an election year approaches, momentum has swelled. As part of an election platform, this kind of tax reform makes for a compelling story: managers of private equity or tax funds receive most of their compensation as capital gains on their investments (the "carried interest"), which are taxed at 15%; the reforms would tax carried interests at the same rate as ordinary income. Hedge fund managers should be taxed at the same rate as policemen, candidates are telling the electorate.

Leading Democratic candidates are on record as supporting this amendment, and the belief is that the legislation will inevitably pass when the next President is elected. According to some colleagues, it will be challenging for funds to find another loophole to work around it.

So where does that leave Canada? With a potentially huge opportunity to entice private equity and hedge funds to move their operations here. Think of us as a startup facing an incumbent(the US) in competition for private equity customers. Our tax regime would be far more favourable and isn't likely to change in the near term: carried interest income in Canada simply isn't a significant part of the tax base. Making investments in the US from Canada is a straightforward affair under current tax treaty rules. Plus, Toronto is a financial service centre, a travel hub, and a terrific centre; switching costs appear low. As long as we do nothing to change our tax regime, we have a chance to add high income earning professionals and their funds to our tax base.

Canada as a tax haven? In this case it's possible, and a potentially huge opportunity. City of Toronto, start your business development engines.

Technology Buyouts: A Primer

While many predict that the BCE LBO marks the beginning of the last of the mega LBOs, few believe that there will be any slowdown in buyouts of technology companies. Here's an overview of the basics, taken from the mouths of investment bankers I've worked with in the last 18 months:

The Appeal of Technology Companies: An LBO is financed by a combination of equity investment, long term debt and higher yield short term debt. Technology companies have been historically viewed as too unstable and unpredictable to service and retire debt of the size required for an LBO. This view has been shifting as technology life cycles mature, and customers have moved beyond 18-24 month "rip and replace" cycles, generating predictable maintenance revenue streams for their suppliers.

The End Game: LBO sponsors seek 20% return (far less than VCs). Getting there depends on a combination of: the current trading multiple (the rule of thumb is that stock must trade at 10-15x editda or less if the acquisition price is to be reasonable), and the ability of the Company to improve the bottom line as a private company (by cutting costs,growing revenue, and investing in growth of new revenue streams out of the public eye).

The Ideal Candidate: Technology companies who are in a transitional phase, and therefore have the potential for transformational change and growth when taken private. Attributes that sponsors often look for are:

- Solid, top line revenue growth of 10-15% year over year (good, but not a driver of real growth)

- Annual recurring maintenance revenue

- Core business of the company is in sectoral decline

- There are embedded growth options within the business which cannot be pursued aggressively without compromising profitability (and impacting stock price)

- Managment is solid, with a strong cost conscious mentality


Ideal Stock Market Conditions: An attractive candidate also needs certain shareholder dynamics to build the business case for why it should not be in the public markets:

- Lack of street sponsorship (the company has no analyst coverage, or the coverage is too small to have focus and generate the interest of marginal buyers)

- Low liquidity (the company's stock float is thin, making it hard to bid up stock)

- A large block of stock is held by one group or institutional investor who could galvanize support for the LBO.

The Players: This is a rapidly growing pool that includes old guard players such as Silver Lake and Golden Gate Capital. In the US, an increasing number of VCs have joined in, including Technology Crossover Ventures, Austin Ventures and Battery.

The Canadian Potential: Still a question mark. Alias and GEAC are examples of larger successes. On the smaller end, many Canadian companies have been bought as part of the growth strategies of other LBO companies. Will Canadian companies harness LBO money? Can they? What's next? Maybe Wellington will tell us.

Executive Compensation: The BCE Buyout

One of the more eagerly awaited documents in the coming weeks is the package delivered to BCE shareholders setting out the details of the proposed buyout. Will there be sticker shock when one sees the compensation paid to the executive team?

Until recently, leveraged buyouts were a vehicle used primarily by small cap and midcap companies who were looking for a way to rebuild value out of the public market's eye. Away from the need to meet quarterly revenue targets, it was reasoned, a company could focus on transformational change, shedding unis and people that were not profitable and investing in technologies and partnerships that would add long term value (but not necessarily short term revenue).

Another driver was executive compensation: in a privatized company, management could receive a significantly larger equity stake - usually 20%. In a multi billion dollar deal, that's a lot of coin.


Here's how management compensation usually works: Management is required to invest a portion of any proceeds they would have otherwise received on the sale of their shares into the LBO (usually 50-60%) in shares in the new private corporation. They also receive options (15% is typical). Any change of control bonuses or golden parachutes are extinguished, which is often a huge tradeoff by management.

Surely these numbers adjust downwards in a deal of this size, you may argue. This does not seem to be the case, Take a look at Sungard Data Systems, which at $11 billion was the largest LBO to date when it closed in 2005. The executive team received just under 20% of the company.

When an executive team owns a chunk of the company, what kind of behaviour does this incent? In order for their equity stake to be valuable, all the debt assumed to fund the buyout must be serviced and then extinguished quickly. When your core franchise is in decline,as is the case with BCE, you have to bet that cost-cutting and revenue from your other busineses will service the debt while you rebuild. If not, the breakup looms.

Assuming BCE follows the usual model(and time will tell), you have to grudgingly admire those of the BCE team that stay with the surviving corporation. They're taking on what is venture capital - scale risk themselves.

Stay tuned.

Scooter Libby vs Michael Milken

Two men. two "tragic, tragic falls" resulting in criminal convictions. Only one sentence was commuted.

If I were just coming out of a coma, my money would be on Michael Milken. As a young associate in New York, I was involved in the Drexel Burnham bankruptcy. After a year on the file, I knew the names of all of Milken's leveraged buyout partnerships, and nursed a secret love for Arthur Liman, Milken's lawyer. Mr. Liman was one of the last old time advocates; so compelling and persuasive was he that, for about a week after Milken's sentencing hearings I fantasized about becoming Mrs. Liman, Arthur's shiksa second wife, who he lovingly mentored to professional greatness.

The sentencing memorandum he prepared on behalf of his client ran to more than 140 pages and included testaments from Milken's seventh grade teacher. By contrast, Scooter Libby's sentencing memorandum was a pithy 33 pages. Both advocated probation.

What words moved a President to commute a prison sentence? Let's compare:

Philanthropy

Milken: "Michael Milken has donated in excess of $350 million to ...provide significant support to more than 700 charitable organizations and programs throughout the world."

Libby: "He helped a Viet Nam veteran obtain an endorsement deal for prosthetic limbs."

Contributions to the Public Interest

Milken: "Michael Milken has been teaching math classes regularly to children at the Maclaren Children's Centre..at the H.E.L.P. group... and at various other schools."

Libby: "Mr. Libby volunteered repeatedly to help train young policy analysts in the defense Department's annual Summer Study program...in Newport, Rhode Island."

Professional Accomplishments

Milken: Democratized access to capital by creating high yield securities, making capital available to the more than 95% of American businesses who lacked the pedigree to attract traditional institutional money.

Libby: "[Libby] pored over analytical reports in a way I do not believe is common in busy, high level political appointees."

Huh. You should know there are other submissions on Libby's behalf that are far more supportive of him. But the above extracts represent far more interesting choices by his lawyers. So what if Scooter got free summers in Newport? No need to emphasize the point when arguing for probation. My Arthur would never have allowed it.

VC Pride

"Toronto: As Gay As It Gets": This is one of the ads that the City of Toronto has paid to post in several US bars, in an attempt to attract tourism dollars. Apparently, gay travellers on average spend more and stay longer than straight visitors.

These also happen to be attributes that also are highly desirable in an investor. Which makes me wonder, maybe it's time to look beyond straight venture capital.

How would this poster look as part of a pitch deck?

Back to serious business tomorrow.

Pitching for Strategic Money

How does a pitch for funding from a strategic investor differ from the one you would make to a VC? The answer lies in the mandate the investor - whether it's a business development group, a specially-designated ventures unit, or a fund with a corporate LP - has been given by its corporation.

Many corporate investors are not driven by the need to generate venture capital level returns (although it woudl be pleasant). Instead, many corporate investors effectively act as a hedge on the company core business and strategic thrusts. They provide a way to tap into new technologies and business models which are still emerging but, if successful, could radically alter the company's business. For example, Nokia Ventures used to invest in micro-payment applications and other applications that might differentiate its parent company's mobile phones in the marketplace and/or generate another stream of revenue by transforming the wireless phone into an application platform.

When pitching to a strategic investor, I always recommend that companies think of the business case that the investor will haveto make to its own internal management. Try and shape the pitch so that it includes answers to some of these items:

- What is the immediate and long-term fit of the proposed investment with the overall strategy of the company? How does it link to the company's strategic thrusts?

- What potential is there for increased shareholder value, public image, or operational gains?

- Are there any conflicting (or positive) relationships between the proposed investee and other initiatives within the company?

- Why is investing better than building, buying or partnering?