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.

Venture Money In, Entrepreneur Out

The delicate relationships between founders and venture capitalists are rarely openly discussed and even less frequently have carefully laid down rules that protect both sides sensitive interests. Since nothing ever goes smooth in early-stage company, the reality of the situation calls to put in place measures which would allow to deal with unavoidable conflicts in a civilized manner while protecting interests of both parties. The article below illustrates these realities.

NOTE from Paul: The guest post below is written by Bob Hebert and originally appeared on his site. It is re-blogged here by permission.

A recent edition of Profit Magazine is headlined “Lessons from Canada’s Best Employers”. It features a collection of “highly successful” entrepreneurs regaling on how to create “loyal, turbo-charged teams” and great businesses.

Inconveniently, at least one of the featured entrepreneurs was removed from the helm of his business before the magazine hit the newsstands. A man of undeniable vision, this entrepreneur had proven adept at attracting and energizing a team of bright, young employees in the pursuit of that vision. He possessed the same evangelical abilities with customers who signed up in droves for his product offering. But as the business grew, the supremely confident entrepreneur proved less adroit in evolving the hands-on, micromanaging leadership style that served him well when the firm was small. This in turn had a negative impact on his ability to attract, manage and retain an executive team capable of scaling the business. Though strong revenue growth temporarily cloaked the costs of this churn, maturation clouds were on the horizon. Given enough time the young entrepreneur may well have sorted out the leadership requirements of a growing, more complex business. But time became a scarce resource the moment the entrepreneur pursued big-time U.S. venture capital to fuel the next stage of his firm’s growth.

While in the business of risking capital, venture capitalists take every step possible to de-risk their investment decisions. Each success and failure is analyzed and processed into lessons learned, best practices and playbooks for future investments. Proven leadership is valued over its alternative, and young, promising entrepreneurs are rarely more than a few missteps from replacement. This is especially true in Silicon Valley where a class of serial CEOs and executive teams provide a bench of standby replacement talent. With the costs of trial and error learning thus needlessly high, it took but a few execution errors for the Canadian entrepreneur to find himself unceremoniously dumped at the helm of his own company. It took less than 4 months for the entrepreneur’s new ‘partners’ to become his executioners.

Learning is an iterative process, a cycle of action, reaction, reflection, adjusted action and so forth.  Self-awareness lubricates the cycle either increasing or reducing the time for individual learning. Hubris is a decided inhibitor. Entrepreneurs who own their businesses outright have the benefit of time to learn from the trials and tribulations of growing a business. But for those who secure professional investors or go public, their time becomes enmeshed with others money and a compression effect takes place. Their trials must now be almost error free. For our young Canadian entrepreneur, an award winning company and glowing magazine articles could not protect him from these realities. The good news, if it can be called that, is that he now has time to reflect on the meaning of hubris, humility, personal development and resilience.

About the Author

Robert Hebert is the founder and Managing Partner of StoneWood Group Inc., a leading executive search firm in Canada. Since 1981, he has helped firms across a wide range of sectors address their senior recruiting, assessment and leadership development requirements.

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