Equity Crowdfunding Comes to Ontario – finally!

Canadian-100-dollar-billsThis could be big, really BIG! For entrepreneurs and startup founders this could be a monumental change, potentially opening the floodgates onto the dry and barren land of seed funding. At the very least it should offer new options for cash-starved startups and early-stage businesses. The recently proposed (as of March 20, 2014) Ontario Securities Commission (OSC) new set of regulations provides for

“a crowdfunding exemption that would allow businesses, particularly start-ups and early stage businesses, to raise capital from a potentially large number of investors through an online platform registered with the securities regulators.”

More specifically, this ‘Crowdfunding Exemption’ would allow startups and SMEs to raise up to $1.5M per 12 month calendar year with investors being able to invest up to $2,500 per deal and up to $10,000 per year.

Why is this so important, then? The issue is that under the current Canadian securities laws, startups can only raise money by selling equity in their business to so-called “accredited investors,” who are strictly defined and typically include family members, angel investment firms or venture capitalists. Should you wish to raise funds from a broader circle of individual investors, your company needs to go through a process of stock listing on a publicly traded exchange that is normally prohibitive to a startup.

The advancements in internet technology, however, make it possible these days to approach and raise the required capital in small amounts from a much broader group of individuals. Why is this approach relevant? It all has to do with risk management and sharing. To illustrate the issue let me quote from my article recently published in The Ottawa Citizen.

“Let’s say I need to raise $0.5M for my startup. I go to you and ask you for the whole sum or just a $100K chunk. Even assuming you have the means, you are going to agonize at length over your decision. However, if I ask you to invest $10-15K, you will spend far less time worrying and be much more predisposed to take the chance. By employing this tactic, an entrepreneur will likely raise her $0.5M because the risk is shared among many investors and each of them does not risk that much.

This is exactly how I raised, some time ago, angels financing for ATMOS Corp. I brought in about 20 private investors, with each contributing between $10K and $25K. The beauty of this approach is that nobody is going to loose sleep and the entrepreneur gets his objective accomplished. In fact, this is the same principle in action that powers the IPOs and syndicated VC rounds albeit in a smaller scale. It works, therefore, use it.”

The key to increase seed financing in this country is to implement some practical systemic initiatives. People respond to incentives. If we want to encourage seed funding to enable entrepreneurship and startups we need to create incentives which reward financial risk taking. The OSC proposal is a good step forward to create a viable framework enhancing options for seed investing. The Canadian Advanced Technology Alliance (CATA) led by John Reid should be congratulated for spearheading the industry lobbying effort. Not to rest on laurels, the Angel Investment Incentives initiative should be advocated, advanced and implemented next. With these two in place we would have a really strong system platform to support the entrepreneurial startup culture in Ontario.
Nevertheless, some folks are concerned about a potential for fraud and taking advantage of un-sophisticated investors. Would you agree that the advantages outweigh the risks? What do you think?

PS
The Notice and Request for Comment is available for public consultation on the OSC website www.osc.gov.on.ca and the comment period runs until June 18, 2014.

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To Hang In or to Let Go? When to KILL your Startup

Horse dead

“When the horse is dead – dismount” is succinct practical advice sometimes attributed to the famous cavalry general Lord Mountbatten. No matter what its origin, the essence of it is clear: stop agonizing and procrastinating when something ends; the only thing left to do is to get off the horse and move on with your life.

The fact is, not every startup works out; in reality most of them fail. It is a fact of life supported by a mountain of stats data. And yet, it is extremely hard for most people to disentangle themselves from what usually was a significant personal emotional investment. The biggest hurdle to overcome here is what’s known as sunk cost fallacy. It usually goes like this: “We have invested so much (money – if you are financial investor, or life – if you are a founder), we worked so hard, we achieved so much, etc, etc that we cannot possibly let go.”

“If we could only get more funding or bring in better talent, we would succeed!” NO, you would NOT if you missed the market opportunity (assuming there ever was one), the customers are not buying, your team is burnt out and your investors look ready to kill you. Under these circumstances no amount of whip cracking will help; just get off the dead horse and move on to pursue better prospects in your life.

I have been recently involved with a startup whose story perfectly illustrates my points. The founders developed a business plan addressing an emerging market problem which, although initially nascent, appeared to be destined to become a major issue (and therefore a market opportunity) in about a year or so. Theirs was a chance to pioneer a new industry and get all the glory of it.

They managed to raise some modest angel funding that allowed them to toil for about a year initially, investing their sweat equity and some cash of their own to develop a product prototype. At this point they attracted a $2M seed investment from a Toronto-based VC fund.

The experienced founders executed well, built a strong development team and launched the first product before the year was over. Good product reviews arrived and a couple of early-adopter customer purchases materialized. The CEO was walking tall, receiving inquiries from top tier VCs such as Kleiner Perkins, Sequoia, NEA, etc. A substantial funding round appeared to be a sure thing. However, during the second year of operation sales were slow as the market was taking its time to develop. Consequently, venture capitalists were in no hurry to jump in and adopted a wait-and-see attitude.

With the high burn and dwindling funding prospects, the seed investors started to worry. I remember going to Board meetings and hearing remarks like: “We may have to do a reset”, “The only thing a VC can do is replace the CEO”, and such. Sure enough, the founder-CEO was asked to find her replacement and the expensive $60K headhunter-led search started.

When a company is still in the startup mode, searching for a winning business model, as opposed to being in the execution mode, replacing the CEO is rarely a good idea – unless, of course, the existing CEO is clearly incompetent. There is a major difference between a non-linear skillset of a founding CEO with his vision, passion, and commitment, and a hired-CEO with his usually linear execution skills. Such a change is a major and costly disruption in the life of a young startup. If nothing else, it takes about a full one-year business cycle for the new CEO to fully understand the realities of his business. In addition, with the departure of its CEO the company loses an enormous amount of the painfully accumulated company specific business experience.

With the new face put on the company, the VCs provided additional cash support by twisting some arms in financial circles to close a new investment round of $3.5M. With these resources in hand, the team embarked on the second-life journey. However, in spite of the new face, talents, cash and the energy, the market readiness has not changed. Fast-forward through a few heroic-effort but modest sales, high burn, etc and 3 years later the company is again running out of money.

At this point, everyone is exhausted and out of ideas for what to do next. The horse is dead but it is so hard to admit it! The sunk cost fallacy is raising its ugly head: we invested so much, right? It is so hard to admit a mistake and let go. Thus, the company is put in a dormant state: most employees laid off, the hired CEO stays part-time while pursuing other income opportunities, the original investors write it off mentally but still keep it on the books, the most recently sucked-in investor has no clue what to do so lets the ship drift, barely keeping the lights on for appearances just in case…

But wait, that’s still not the end of this story. After a year of this malaise, the original founder-CEO gets approached to see if he could step back in and see what could be done with the company. Another restructuring follows with $0.5M new funding to see what could be done. More heroic sales efforts come with some modest results but the market still isn’t there. Finally, all the key members of the crew quit to pursue better prospects in their lives but the controlling investor hires yet another expensive sweet talking miracle-maker who promises resurrection and the recovery of that sunken cost…

Technology startups are not mature proven-viability companies that could be “management engineered” and played with. They are essentially experiments in market or technology. Their founding premises and hypotheses need to be quickly tested and verified before large amounts of money are deployed. If the business model fails repeatedly, abandon ship no matter what the sunken cost is.

Angel Investment Incentives – Blueprint for Ontario

There is no point in re-inventing the wheel. The existing time-proven British Columbia Equity Capital Program (BCECP) provides excellent blueprints to be adopted by the  Government of Ontario following its election promises (see this post).

The program provides individual investors (angels) incentives by way of a refundable tax credit when they invest in eligible small business. The highlights of this program include:

  • 30% refundable cash credit (good as cash) with a maximum of $200,000 investment for a maximum annual tax credit of $60,000 per individual investor
  • Ability to invest directly, or in a holding company known as a Venture Capital Corporation (VCC), which in turn can invest in one or more eligible businesses
  • RRSP eligibility for VCC shares which can drive max tax savings up to 74% !
  • Hassle factor – low; apparently administration of the program is fairly smooth with a minimum of red tape

More details on the BCECP program can be found in this succinct overview.

As a support document for the policy-makers there is an excellent recent study published by the Ministry on the effectiveness of the BCECP program.

A program like this implemented in Ontario would do wonders to re-invigorate our stagnating high-tech ventures, resulting in great economic benefits for everybody. There was an initiative earlier this year involving Terry Matthews of Wesley Clover and Bruce Lazenby of Invest Ottawa to have this included in the last provincial budget but it fell through. Now is the time to try again.

So, what are we waiting for? Let’s push our elected politicians to fulfill on their promises and provide support for startups, small business, and new ventures.

How Can Canadian Startups Access AngelList?

The recent phenomenon of AngelList in the US holds a promise of revolutionizing seed funding for startups. The reason for it is three-fold: it addresses the toughest stage of startups – I call it “Two guys and a piece of paper” – financing, it applies the effective principle of risk-sharing, and thanks to the recently passed US JOBS act, it uses a legal framework which makes it palatable to the investors and founders. With the recent addition of the syndication mechanism it all works even better. The question is how could Canadian (or other non-US) startups access it and benefit from this nirvana?

There are at least two practical issues to address:

  • The legality of fundraising through the sale of equity under Canadian laws. The issue is that under the current Canadian securities laws, startups can only raise money by selling equity in their business to so-called “accredited investors,” who are strictly defined and typically include family members, angel investment firms, or venture capitalists. Should you wish to raise funds from a broader circle of individual investors, your company needs to go through a process of stock listing on a publicly traded exchange that is normally prohibitive to the startup. Alternatively, you need to operate under an exemption. More details on that are available in an excellent and succinct six-page document, “General Overview of Canadian Securities Laws Relating to Raising Capital By Early Stage Companies” prepared by FMC Law, members of the CrowdSourcing Advocacy Committee of CATA, and available through their office. Are there any other complications when soliciting funds in the US?
  • The practicality and the effectiveness of a Canadian startup (“Two guys and a piece of paper”) raising funds in the US market. Clearly, investing abroad in an unknown entity is yet another hurdle to overcome for US investors. The reality is that only a few sophisticated US investors would feel comfortable in this scenario.

One of the solutions to these concerns might be a structure involving a US holding parent company, say a Delaware corporation. That way the US parent corporation receives the investment through AngelList and flows through the funds to its Canadian subsidiary which is the operating entity. A structure like this might even qualify as a CCPC for tax purposes. In addition, we get the benefit of the generous Canadian SRED refund for R&D expenses (up to 65%) while simplifying a potential liquidity event (exit) for the benefit of the US investors. I have used an investment structure like this in one of my previous ventures and can vouch that the complexity and the cost overhead is quite reasonable.

So, since the issues around AngelList are new and fresh, now is your chance to weigh in. Please share your experience, thoughts, and views in the Comments section below.

On the Virtues of Controlling Your Ego

Oh, the pleasures of having your ego tickled! Who is immune to that? I bet even the pope upon election cannot suppress an inner smile from having all those impressive titles bestowed upon himself. However, the trouble with startup founders is that it is so easy to ingratiate yourself with a grandiose feel-good title which often leads to unforeseen difficulties in the future.

I have been recently working with a tech startup founded by a brilliant engineer with a strong research background and interests, who adopted himself a couple of co-founders:  another engineer and a sales guy. For several years they were pursuing a bootstrapped advanced engineering design services business with its usual ups and downs, but were recently ready to turn it into a product-focused venture. As I started to work with the company a number of issues popped up related to the deceptively innocent sins from the early days of company setup.

The use of self-awarded job titles in an early-stage company could be a problem if the real qualifications do not correspond to the scale of the job title. It all starts quite innocently. The newly formed company needs formal management, so the main founder becomes the President & CEO,  a technical expert becomes VP of Engineering and the sales guy naturally becomes the VP of Sales & Marketing. This might be fine if the startup is moving at the speed of Hyperloop and the calibre of folks involved is adequate to the task – but this is rare with early-stage companies.

In this particular case, the individuals involved were all very talented but simply did not have the management or business experience to occupy these positions as the company started to grow. The problems manifested themselves at several levels:

·        Fundraising – the quality of the management team is key in any investment decision, and in this case was not passing scrutiny, but just becoming a major hurdle in raising the sought $2M round

·        Customer relationships – as the company typically had large organizations as its customers, the imbalance  of titles in the intense customer interactions was creating awkward situations when our “VPs” were often dealing either with junior corporate managers or with true senior executives; not good in either case!

·        Internal operations – with the business growth came the increase in staff hiring, HR issues, etc. and it became clear that being a brilliant engineer does not necessarily translate into a “titled” manager

·        Shareholders – having individuals as subordinates, while at the same time being major shareholders, creates tricky problems which could easily de-stabilize the company; reasonable measures and safeguards need to be put in place to protect against catastrophe

It took me, as an appointed company Chairman, quite a while and a lot of tip-toeing and gentle maneuvering to rectify this situation. We ended up re-classifying job titles as CTO, Director of Sales, and, a face-saving, Chief Designer. This created room to bring in more experienced talent to help steer the company. It goes without saying that nobody likes to feel “degraded” and it was not easy on all the fragile egos involved. It all worked out for the better but could have been avoided if only we learned to control our egos!

Take-aways from this post:

·        Members of the Founders team should go easy on the job titles and avoid loftiness incommensurate with experience

·        As a controlling Founder, be careful with the use of fancy titles, in lieu of adequate compensation, as a bait to attract talent  – it could be difficult to undo it

·        Expect and plan to bring along experienced new hires while having org chart room and job titles available

·        Don’t confuse shareholders role with the employment function; build safe guarding measures to protect from interference

Rise of the $10 Million VC Seed Fund

This trend could be helpful in cash-poor Ottawa where we already start seeing micro-funds such as Lionica, Mistral, and others ‘under construction’.

David Cummings on Startups

With the massive drop in cost to start a tech company, combined with successful VCs raising larger funds requiring bigger investments, there opened up an opportunity in the market for super angel / VC seed funds. In Atlanta alone we’ve seen several new funds within the past 12 months in the $10 million – $20 million range including Mosley Ventures, BIP Early Stage Fund, and Forté Ventures.

Here are a few characteristics of the $10 million VC seed fund:

  • Sole general partner that makes the decisions and runs the fund
  • Ability to move faster than both angels and traditional VCs since they have committed capital and don’t have a consensus decision making process
  • Invests $200k – $500k and can go up to $2 million
  • Example investment strategy might be 10 $400k investments ($4 million) and six $1 million follow-on investments (it’ll likely be more nuanced with varying levels of…

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Founders, Investors, and CEOs

Why do so many founders in high-tech startups fail to successfully go through the corporate transitions and come out as winners at the end? 
Three amigos
A good example is the story of SiGe Semiconductor. Founded by John Roberts with 2 other cofounders back in 1996 and ultimately acquired by Skyworks in 2011 for $210M, the company went through several reincarnations with three waves of investors either wiped out or severely diluted. Close to $150M was poured into the company and thus the ultimate outcome was a modest success, primarily benefitting the last-round investors. Even though the founder, who was forced out around 1999, had a good vision, laid down a solid foundation and lifted the company off the ground, at the conclusion he ended up with nothing or next-to-nothing. Why?
Why do Boards struggle with managing the dynamics of the typically conflicting interests between the VC investors, founders and management, often resulting in the failure of their ventures? The histories of most high-tech startups are full of colorful stories of fascinating ups and downs of the relationships between these three groups of players as they go through the evolving startup life cycle. Those relationships often go from the seduction stage, through a reasonably calm but rather brief marriage, only to end up in bloody separation and divorce battles. What could be done to make it a bit more civilized and productive?
And why are so many CEO careers often brutally interrupted, paused or derailed in the most often stormy and highly stressful world of high-tech ventures? In the world of high-tech startups, the CEO job, even though often glamorized, is actually one of the most fragile on the planet. Apart from the occasional glory when things go well, most of the time they are the lightning rods for anything that may go wrong with the venture. Since typically high-tech startups are high risk ventures, guess who gets severely beaten and pays the highest emotional toll most of the time? Looking around at the careers of early-stage company CEOs in the Ottawa Valley such as: Jim Derbyshire, Rick White, Jim Roche, George Cwynar, Paul Slaby,  Kevin Rankin, and many others, one could generally observe a large turnover rate with a half-lifetime of 2-3 years and a pause of 1-2 years before they land a new gig. Isn’t this a terrible waste of top talent? Why is this?
The key to understanding and dealing with these issues is to realize that startups, just like human beings, go through a predictable life cycle consisting of infancy, childhood, adolescence, adulthood, and maturity/exit. Each of these stages has its specific characteristics and requirements which necessitate different talents and qualifications to navigate through it. We could typically distinguish a Founders Team, Growth Team and Exit Team. Between these major stages of the life cycle, the company and the people involved go through a transition.  In general, these are typically Entrepreneurial Transition, Growth Transition and Maturity Transition.
The problem arises when the key players in these transitions (founders, investors, CEOs) are not prepared for what is about to happen and drift blindly into the white waters ahead of them. Navigating corporate transitions in the seas of ambition, passion, and conflicting interests is a skill that could be developed. And since these transitions often carry a heavy emotional toll, you cannot afford to be naïve about it but rather you must plan ahead and put in place protective measures against being screwed.

The battle of crowdfunding in Canada

There is a fierce battle going on right now in Canada’s high-tech sector, lobbying for the legislative changes in the country’s security laws to enact, so-called crowdfunding” or “crowdsourcing” legislation, which would permit Canadian entrepreneurs to raise up to $1M for their startups in small chunks solicited (often over the Internet) from a fairly large number of individuals.

What is the problem, then?
 The issue is that under the current Canadian securities laws, startups can only raise money by selling equity in their business to so-called “accredited investors,” who are strictly defined and typically include family members, angel investment firms or venture capitalists. Should you wish to raise funds from a broader circle of individual investors, your company needs to go through a process of stock listing on a publicly traded exchange that is normally prohibitive to the startup. More details on that is available in an excellent and succinct six-page document, “General Overview of Canadian Securities Laws Relating to Raising Capital By Early Stage Companies” prepared by FMC Law, members of the CrowdSourcing Advocacy Committee of CATA and available through their office.

The advancements in internet technology, however, make it possible these days to approach and raise the required capital in small amounts from a much broader group of individuals. Why is this approach important? 
It all has to do with risk management and sharing. To illustrate the issue let me quote from my article recently published in The Ottawa Citizen.

“Let’s say I need to raise $0.5M for my startup. I go to you and ask you for the whole sum or just a $100K chunk. Even assuming you have the means, you are going to agonize at length over your decision. However, if I ask you to invest $10-15K, you will spend far less time worrying and be much more predisposed to take the chance. By employing this tactic, an entrepreneur will likely raise her $0.5M because the risk is shared among many investors and each of them does not risk that much.

This is exactly how I raised, some time ago, angels financing for ATMOS Corp. I brought in about 20 private investors, with each contributing between $10K and $25K. The beauty of this approach is that nobody is going to loose sleep and the entrepreneur gets his objective accomplished. In fact, this is the same principle in action that powers the IPOs and syndicated VC rounds albeit in a smaller scale. It works, therefore, use it.”

As is often the case, our American friends are much faster on their feet and have already kick-started the required changes by the U.S. President Obama enacting the Jumpstart Our Business Startups (JOBS) Act
 on April 5, 2012. The act includes provisions to relax rules around online equity crowdfunding and will allow businesses to raise up to $1-million  via online “funding portals”. There is a real risk of Canada falling behind on the legislative side but also, more importantly, of having Canadian startups falling behind their competitors in the US.  Recently, Andrea Johnson, Partner with Fraser Milner Casgrain, summarized nicely the risks of falling behind the U.S. in this video interview with BNN.

Given that, unlike the US, Canada has no federal securities regulator and
 instead, securities are regulated at the provincial  level, we are likely looking at a rather fragmented approach to this problem –  with some provinces taking the lead and others a wait-and-see approach. In a typical fashion, it will likely take about 2 years for Canada to get its act together and catch up. The only bright side and some hope is the energetic lobbying campaign currently underway conducted by  the Canadian Advanced Technology Alliance (CATA) led by John Reid, president and chief executive officer. They deserve our strong support so take action today by writing and talking to your MPP or MP!

In a broader context of supporting and fostering entrepreneurial culture, why do we often
 have to be so reactive and lackadaisical in Canada? We need to create conditions in this country which encourage and make it easy to pursue new, especially knowledge-based, business creation. How about Canada as a startup nation? We already have a reasonably solid R&D infrastructure, we have system incentives, through the SRED mechanism, to encourage innovation. What we do not have are strong financial incentives that support risk- taking and capital raising for early-stage companies. This is not rocket science, a number of attractive measures have been put forward, including the proposed angel financing tax credit or these crowdfunding ideas. We need to lobby our politicians to take action now!

The Jenkins Report – risks for refundable SRED

Recently, the so-called Jenkins Report, “Innovation Canada: A Call to Action,” was released by the Independent Panel on Federal Support to Research and Development (R&D). Its purpose was to provide “advice in respect of the effectiveness of federal programs to support business and commercially oriented R&D, the appropriateness of the current mix and design of these programs, as well as possible gaps in the current suite of programs and what might be done to fill them.”
 
The full report is available on line and in various summaries as well as commentaries such as this one:
 
 
Of particular interest and concern to start-ups, early-stage companies and small business, is this innocently sounding recommendation of:
 
“simplifying the Scientific Research and Experimental Development (SR&ED) tax credit and redeploying funds from the credit to direct initiatives that support small and medium-sized enterprises (SMEs)”.
 
Apparently, what’s behind this recommendation is an idea of replacing or reducing the “refundable R&D tax credit” by direct “initiatives” (read: grants, investments, etc). This is a huge RED FLAG and RISK for early-stage companies which often rely on cash from SRED refunds as a substitute for the shortages of venture investment funding in the current dismal climate. We can only applaud the idea of simplifying the existing system, but reducing or replacing the “refundability” aspect of it would be a killer and the serious blow to many high-tech startups which rely on this cash to fund their R&D work.
 
Direct funding initiatives, such as the popular IRAP program, are much more finicky, uncertain, bureaucratic, and frequently run out of money. In truth, we need both programs: refundable SRED and direct initiatives.
 
In any case, we can not afford to allow for the cancellation of  the refundable SRED credit – This would really hurt innovation and the creation of knowledge-based companies.
 
We need to lobby our politicians hard to improve the existing system but with an utmost care of not hurting the cashflow of newly-born fledgling enterprises.

CIX – you need to be there!

Canadian Innovation Exchange (www.canadianinnovationexchange.com) taking place this year on December 1st, 2011 at MaRS Discovery District in Toronto, is a cross-breed between a traditional VC Fair, a conference and a giant networking event. You can expect a mixed crowd of hungry company founders and entrepreneurs, jaded investors who have heard it all, benevolent government folks, some media and a variety of hanger-on service providers.
 
The purpose of the event and the reason you may want to be there is well captured in the organizers pronouncement:
 
“Every early-stage company needs exposure and not just in the customer space. Young companies need to establish a profile and promote themselves in the investment community and support industries as well. Even if you are not currently in an aggressive fundraising it is still a useful move to get your company on the radar screen. You are essentially laying down a foundation on which you can build in the future.”
 
At the heart of the event is, the so-called ‘CIX Top 20 competition’, which is essentially a public pitch contest by a number of pre-selected companies. The deadline for the CIX Top 20 applications is October 14 this year, so, you may want to go for it now before you miss it.
 
I participated in the first CIX event in 2008 and have managed to win CIX Top 20 for Kaben Wireless Silicon Inc (www.kabenwireless.com). You get a commemorative plaque plus some media exposure as well as the associated bragging rights.
 
The biggest value for your $495 registration is mostly the exposure and the contacts you establish as a result of your heavy networking. It is well worth the money.
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