Thursday, November 27, 2008

Don't Forget Canada's Art Entrepreneurs

I'm a big fan of Canadian art, in part because the struggle to succeed as a professional Canadian artist is so similar to that of Canadian business entrepreneurs. A few events to consider in support of Canadian artists this week:

Mistletoe Magic: tonight the John B Aird Gallery (Bay & Wellesley in Toronto) will be hosting its annual silent auction of small (read: very affordable) art works created and donated by some of Canada's leading artists. Stunning stuff, in support of a great gallery, and great company. Previews today. Great opportunity to buy small works by artists who sell for thousands of dollars.

Out in Edmonton, one of the great longtime supporters of First Nations art, The Bearclaw Gallery, is hosting a Christmas show featuring some of its newest artists. The Bearclaw has a long tradition of fostering new artists, and they have some terrific (and affordable) stuff from a new generation of First Nations artists on display. You don't need to go to Edmonton to check it out - all is on view at

Monday, November 24, 2008

The Failure of Government Funding, or Why I Wish I’d married Buzz Hargrove

I promised the rest of my firm I’d go back to using this blog for posts about term sheets, and convertible debentures and the like, and I will. But I need one last riff:

I was comparing notes on the state of the start-up world last week with a U.S. colleague. (It’s important to note that since the dot-com meltdown of 2001, it’s become uncool for lawyers to use the term “start-up.” Instead, we call all of you “emerging growth companies” when we talk amongst ourselves.) We both are seeing very little investing in our regions, but my U.S. friend believes Canada is a far better place for emerging growth companies right now. After all, he told me, don’t you have all kinds of government subsidies available?

Here’s the truth about government funding for emerging growth companies in Canada: there is little, maybe none. No government policy or program in Canada today that provides meaningful, direct support for emerging growth companies. What exists instead are a number of job creation schemes that have been launched in the names of “entrepreneurship” and “innovation.” None of these programs have much impact on the economy, because they bet on universities and small businesses as the engines for economic growth.

Entrepreneurship” is really policy-wonk code for programs to assist first-time small business owners. I’m not going to go into further detail here. “Innovation” is the current buzzword of choice. As Russell Wangersky points out:

“Alberta has an Innovation Fund. Ontario has the Ministry of Research and Innovation. Saskatchewan? The Ministry of Enterprise and Innovation….In Ontario’s 2007 Throne Speech, the word “innovation” is mentioned three times. The 2008 Alberta budget? Seven times. Newfoundland and Labrador’s 2008 Budget? Three times — and Newfoundland has both a department of Innovation, Trade and Rural Development, and an Innovation Strategy. The last British Columbia budget? Seven times, along with the introduction of a $75-million Innovation and Integration Fund….The word is used three times in Alberta’s 2008 Climate Change Strategy, four times in the 2008 federal budget, and on and on.”

In government policy-speak, “innovation” refers to job creation money for pure research. In some provinces, it even extends to real estate development to provide facilities from which that research can be conducted, mentored and commercialized. The underlying rationale for this kind of government financial support seems to be that if academic researchers had more money or prettier labs, they would come up with better ideas. Or, people with better ideas will immigrate from other places to innovate here. (Or Saskatchewan. Or New Brunswick.) Immigration policies are interesting, but they don’t have anything to do with creating emerging growth companies or driving growth of an innovation economy, except in a very theoretical way.

What happens next? Because a focus on pure research does not yield near-term economic results, there is an inevitable policy shift. After all, researchers are not capable of commercializing the results of their new, improved thinking. And so a second layer of innovation-related funding inevitably follows: the creation of government- funded mentors and advisors to support early-stage rollouts of companies. In Ontario, there is even tax incentive legislation proposed to further incent the rollout of university-originated companies to assist.

But what if the ideas are, ultimately not fundable? Governments will move to a third cycle of innovation policy – job creation for investors. At the provincial level, it often starts with a direct government investment program. Form a crown corporation, staff it up and start spending. At some point, many tens of million of dollars later, the province will realize that it is not in the business of investing, and it will hand off its portfolio to an outside manager. Since many investment decisions were driven by political concerns and job retention, the portfolio is often not much of a prize for a manager to acquire.

At this point, the innovation policy cycle usually shifts again – to the fostering of a venture capital infrastructure to support local businesses. Why not allocate government dollars to professional investors like VCs, so that they can properly manage and nurture young start-ups? A fund of funds, like Ontario’s Innovation Fund, is then created to search out desirable VC funds and provide them with capital.

Of course, unless there is a mandate to deploy that capital immediately, it can be years before it makes its way into a VC fund and then to emerging growth companies. As far as I know, there have been no announcements of investment by TD Capital since assuming the management of Ontario’s Innovation Fund. And really, who’s to blame them? Every other fund of funds appears to be standing back from the market – if the Ontario government did not insist that their $80 million be deployed in a timely manner, why go against the market?

Now, with anecdotal evidence such as this as to the negative impact of “innovation” funding on economic growth, you might think that at some point government would look to providing some direct economic incentives to increase growth – things like tax breaks. But the cycle remains ghoulishly popular - Alberta and Saskatchewan currently are at various stages in the formation of their own fund of funds programs. Really, someone should take them out for a drink and speak with them. But will it make a difference? Saskatchewan is like your girlfriend who keeps dating married men even after you try and talk her out of it. Is she ever going to learn?

Where are emerging growth companies in the midst of this? Government seems to bet that the markets will take care of them – if enough venture capital is fed into the system, this and SRED will provide adequate stimuli. This may well work if there’s no market meltdown. Many of our clients have been the unintended beneficiaries of government programs that are intended to develop and drive growth in specific industry verticals such as nanotechnology, genome research and clean tech. There is a tremendous amount of money available, provided you can match government money with private sector funds. And it is here that the absence of capital grinds growth of emerging companies to a halt.

The one exception to Canada’s policy cycle grind appears to be Quebec (although recent revelations about the Caisse may suggest otherwise), where the government and its financing institutions seem to have determined that spending on high risk, high tech companies will provide more economic stimulus to the region. I grow fonder of the province each time I do business there. If Quebec were a man, I’d buy it a drink and flirt with it in front of my husband.

But, in the current climate, with innovation funding tied up in policies that bank on some distant future, emerging growth companies in the rest of Canada have few options. As the government considers an economic stimulus package for January, it’s time to ask whether innovation policies should be re-worked to preserve and stimulate growth for current innovators, rather than focus on developing possible future classes.

Of course, asking questions is a rhetorical exercise if one has no voice. And I’m not sure emerging growth companies in Canada do. We have relied on related bodies such as CATA and the CVCA to advance some kind of policy that will assist. We’d be much better off if we coaxed Buzz Hargrove out of retirement. Sure, the speeches would be longer, but we’d be heard.

Monday, November 17, 2008

Time for Management BuyOuts of VC Companies?

The numbers are clear: since 2007, hundreds of millions of dollars have been invested by VCs in new companies, or follow-on investments made in existing portfolio investees. Equally clear is that a number of VCs are in stasis; either they are not succeeding in raising new money, or they are winding down their current fund and shuttering operations to wait out the current market. Either way, the implications are clear: a number of portfolio companies must either grow organically without new funds, or find an entirely new investor syndicate to (a) support further growth, and (b) battle with incumbent VCs who will wish to retain their stake. In parallel, investees may find themselves with an entirely new set of investors if a retiring VC sells it sposition in the secondary markets - probably at a discount.

A question I am increasingly asked is whether, given the circumstances, it makes sense for management to pursue a buyout of a VC investment, rather than wait to see who shows up at the next board meeting. For later stage investees, I can understand the appeal. If a VC has limited follow-on funds to support its investment, management must slow growth and bridge the business through cost cutting and hardship. (This leads to what I've come to call the fundamental "Achievement Gap" between Canadian and American venture capital - backed businesses.) In this scenario, it makes more sense for management to perform if they own signficantly more of the business. Likewise, if a VC is discounting its equity position as part of a portfolio liquidation, managemetn may well want to offer the same money for better autonomy.

The key driver of any MBO is a belief that a placing more equity in the hands of management will drive more value in a business, through a combination of financial engineering (cost cutting) and strategic growth. At a thousand-foot level, it's easy to see how this might appeal. And, until teh market collapse this fall, the TSX Venture Exchange was a regular vehicle fo choice for achieving liquidity for VCs and increased holdings for management. Now, private debt might be necesssary. Certainly there are a number of companies that might have the early revenue, together with leverageable assets, that might attract the kind of debt that would finance an MBO. How will this play out? Something to watch.

Tuesday, November 11, 2008

Startup Empire: Notes on the Side

Preparing for Startup Empire this week? It's important to come away from these things not only with an informed view of what your investors want, but with a view to the potential pitfalls of those requirements. You'll save yourself a lot of time if you develop your own view of what terms are acceptable risks for you to take with an investor, and what terms need some adjustment. Take, for example, term sheets, and preferred shares versus debentures. As you listen to the presentation on this, I want you to keep in mind a few things:

1. In the current environment, everything is relative. The investment you get in may be the only source of ready cash you see for the next two years. As a captive investee, you therefore need to carefully consider how the balanced control provisions your investors request are.

2. A convertible debenture financing now perhaps a more dangerous instrument than before, since it can place significant control in the hands of the lender. Debt holders have rights that shareholders don't - they can call their loan and request their money back. This means that a debenture holder can shut you down if you don't have the cash to pay them and they want out.

3. In Canada, most VCs (and some angels) will insist that a debenture be secured. This allows the investor to take certain actions upon non-payment of the loan. This means that if there is a default, the investor may take possession of and sell the your business' assets and apply the proceeds to the repay the debt.

4. A VC will tell you it would be irrational for them to actually do this, as the return would be pennies, and that's logical in most cases. HOWEVER, there are several scenarios when an investor may decide it wants any remaining cash back from the business.

5. One way to mitigate these risks is to pay very close detail to the "boilerplate" language in the security agreement you're asked to sign. Make sure the events of default are narrowly tailored - they should NOT include insolvency or other standard items that make it easy for the debenture holder to trigger repayment. This is the same conversation you have with any investor, but in a different language (the language of debt) - make sure you have it.

6. Related, but different point: increasing numbers of US resident angels and friends and family are joining rounds of investment here. There are a few implications to keep in mind:

- US residents are typically taxed on conversion of debentures to shares if part of the amount converted is interest. Interest-bearing debentures need to be altered to debentures plus warrants (one example) to provide the same risk of return.

- even if your US investor wishes inerest, usury laws in some states (including California) limit the amount of interest that can be charged on a debenture to rates well below norms up here (depending on size of debenture and size of investor)

Monday, November 10, 2008

Trialstat: When Start-ups Go Into Receivership

In what has to be the oddest piece of reporting on the high-tech scene I've seen in a while, this morning's Ottawa Business Journal breathlessly reported details of the receivership of Celtic House portfolio company Trialstat. The piece - and again, I remind you this is on the front page of the on-line edition - sets out amounts owing line by line to insurance brokers,lawyers and accountants. Is there really so little to report on the Ottawa scene that a summary of a court filing appointing a receiver merits front page coverage?

If you are going to write about a receivership like this, here are some points to consider mentioning:

1. A receiver is appointed to take possession of the assets of a business on behalf of secured creditors, pay out priority claims (employee wages) and distribute the remainder to the secured creditors. Privately-appointed receivership effectively places the assets and the business in the hands of its secured creditors, and out of the hands of management.

2. If, however, a receiver is appointed by the courts, this can signal potential conflicts among creditors. It also (in theory) reduces the lenders' ability to control the sale of assets of the business, since these steps are now subject to court scrutiny.

3. With many start-ups there are often not enough receivables or commercializable IP to bother with the expense of a receiver, court-appointed or not. Here, the story might be different. One could speculate that Celtic House, with its track record for incubating its own companies, might be seizing the ip for its own for future re-development. An alternate thought: conventional wisdom has it that SAAS model businesses are unlikely to be completely shut down - if there's service revenue with margin, the saying goes, there's probably a buyer for the service. Receivership may be a way to complete a sale of the business with maximum returns to the lenders (BDC and Celtic House) - unsecured creditors and shareholders are cut out of the process.

4. Jonathan Barker, a prince of a guy, was one of the first Ottawa-area entrepreneurs to build a business based on a SAAS delivery model. It will be interesting to see where he and his team go next.

Sunday, November 09, 2008

It's Not a Cold Sore, It's a Paper Cut

Now stop staring at me and lend me your lip balm.

Tuesday, November 04, 2008

Notes from Seattle on the New Green Deal Economy

Great read from Cascadia Capital’s Michael Butler on why the new energy economy will thrive in the U.S. He sets out 10 core factors that indicate we are in the early stages of a “post-petroleum era.” My favourites:

- combatting climate change has reached a tipping point and is embedded in the collective consciousness.

- The U.S. is entering a period of “re-regulation” which will favour alternative energy

- “[W]hat other growth options do we really have? The harsh reality
is that our use of leverage over the past 10-20 years covered up a lack of growth in our economy. We simply were not as productive as we thought we were. Where will our future growth come from?Information technology, biotechnology and telecommunications are maturing as GDP boosters, manufacturing is re‐tooling for the knowledge workforce, and defense spending will be scrutinized, so even though alternative energy is virtuous and vital, it may ultimately win by economic default.”

You can download Butler’s proposal for a “new Green Deal” Economy from Cascadia’s web site. He’s been writing some of the most interesting pieces on the next 10 years out there; his is a voice to monitor.

Monday, November 03, 2008

So Sue Me?

I wear my pink ghetto roots with shame today, as I read with despair (courtesy of my buddy Jessica) of the launch of Sue magazine, "For women in litigation." This month's topics include; "Feeding the Male Ego", "Girls Just Want to Have Funds"...No no no no no.