These events will take place:

• Tuesday, January 18th, 2011 from 7:30 a.m. at Miller Thomson, Scotia Plaza, Toronto – register here!
• Thursday, January 20th, 2011 from 7:30 a.m. at the RIC Centre, Mississauga – register here!

Breakfast will be served on payment of the supplementary fee.

Give this a listen, it’s a rewarding chat!

Click here to register!

And click here to download our full schedule from next Tuesday, September 21st until June 2011!

In particular, please accept and pass along to qualified potential members our cordial invitation to join us for our upcoming Investment Meeting and Membership Social featuring Toronto’s leading early-stage private investors!

It is taking place Tuesday, October 19th, 2010 from 2:00 to 5:30 p.m. at the Royal Canadian Yacht Club city clubhouse, 141 St. George Street, Toronto.

RSVP to Robert Koturbash or register here by October 12th, 2010

Engaging presentations by innovative investment-ready companies
will be followed by hors d’oeuvres and cocktails

CPC overview
CPCs are administered and regulated by the TMX Group and trade on the TSX Venture Exchange. This is considered a junior exchange to the Toronto Stock Exchange where listing and on-going regulatory requirements are more suited to smaller sized companies. Once a CPC is listed on the TSX Venture Exchange, its shares can be bought and sold just as with any other exchange like the NYSE, Nasdaq, etc. As the company grows it is quite common for them to ‘graduate’ from the TSX Venture Exchange to the Toronto Stock Exchange.

CPC company formation
A CPC starts off when a set of directors puts up seed capital to form the CPC. A minimum of 3 directors are required to put in $100k to $500k of total seed money. This capital is used to write up an investment prospectus and do due diligence on target companies to execute a reverse take over transaction (also known as a Qualifying Transaction “QT”). At this stage, the CPC is not listed on the TSX Venture Exchange. At this point in time, since the CPC is not a real operating company but more of an investment/holding company, CPCs are often referred to as shell companies at this stage.

At any given point in time, there can be over a hundred CPC companies established and in the process of finding a qualifying transaction. According to Mark, “Just as in any investment transaction, it is important to ensure there is a good match between the CPC company and the company the CPC will invest in via the reverse take over. From the CPC standpoint, the directors will be looking for companies with good management, good growth potential, and good operations. From the company standpoint, engaging with a CPC shell that can provide strategic value in addition to the CPC’s capital is important. Companies should look at the background of the directors of the CPC and how they can help with their experience in managing a public company with things such as investor relations and ability to access capital markets/institutional money.”

The next stage is to take the company public. The CPC needs to have at least 200 shareholders in order to go public, with an individual in the go public transaction buying no more than 2% of the shares offered to the public. A household can hold no more than 4% of total shares outstanding. Between $200k to $1.9m can be raised, so long as the total of seed and IPO does not exceed $2 million. A broker is used to assist the CPC directors in the IPO and in finding retail investors to capitalize the CPC. From a CPC investor standpoint, because the QT may not be known or finalized at this point, you are investing in the directors of the CPC and their plans for the type of company they will do a qualifying transaction. Says Mark, “I would say that 2/3 of the CPCs are established because the directors have a target in mind for a qualifying transaction. However, for half of these, the target does not pan out. As an investor in a CPC, it is important to be comfortable with the directors and their ability to find a quality QT”.

Once a CPC is established, the CPC has up to 24 months for it to execute a QT. According to Mark, it typically takes 3 months after a CPC is established to do the prospectus, secure the 200 investors, and find an appropriate qualifying transaction.

Concurrent financing
Once a target company is identified, it is quite common that additional financing will be required in order to do the reverse take over transaction. The TSX Venture Exchange requires the CPC to provide capital to cover 12 months of operations for the target company. To raise concurrent financing, the CPC typically engages a broker to help pitch the company to institutional investors such as pension funds and mutual funds. According to Mark, “Probably around 90% of the CPC deals require concurrent financing. Concurrent financing can range from several hundred thousand to over one hundred million dollars depending on the company targeted for the reverse take over. I like to target a need of at least $5 million to take the opportunity to institutional brokers and investors.”

Reverse take over
Once a suitable target company is identified and goes through all of the approvals and paperwork (and audited financials), the CPC completes the qualifying transaction. In essence, the target operating company exchanges its shares for the shares of the CPC shell and takes over the CPC shell company. The management team of the target operating company generally stays as is and the board of the target operating company is re-constituted to possibly include directors of the CPC. The benefit to the target operating company in this approach is that it saves the company the time and expense for it to go through the regulatory process of becoming publically listed. Since the CPC has already gone through this process, the transaction to take the target company can be done in weeks vs. months.

When are CPCs a good vehicle for companies to raise capital?
CPCs are best suited for growth companies that need capital for expansion. CPCs are not meant to replace early stage seed funding to help companies develop an initial prototype or secure early customers. In order for institutional investors to be interested, they will be looking for reasonably established companies that can use capital to aggressively fuel a growth strategy. They will want to see a roadmap for how a $5m to $10m market cap company can grow to $50m to $100m.

From a founders point of view, CPCs should not be viewed as a way to ‘cash out’. Rather its a vehicle to become a public company and open up additional financial strategies such as using company shares as currency for acquisitions or accessing follow on financing from institutional investors. Says Mark, “With the lack of a robust VC financing ecosystem in Canada, being able to secure institutional investors is becoming a more important part of an early stage company’s finance strategy. Since institutional money managers typically do not devote a large portion of their funds to private companies, having publically traded shares via a CPC can help early stage companies tap into this equity class.”

Costs
Costs to get listed and maintain on-going regulatory compliance on the TSX Venture Exchange are less than the TSX Exchange and less than US exchanges. According to Mark, “We see a lot of early stage US companies using the TSX Venture Exchange as an initial vehicle to become publically traded as its more cost efficient for the initial listing and does not subject the company to more costly on-going Sarbanes Oxley regulatory requirements. Between the CPC and the target company, the legal, accounting, audit, and exchange costs to initially get listed start around $200k + commission paid to a broker for any money they help raise. On an ongoing basis, a company can expect to spend $50k to $100k in annual costs for annual reports, audits, and investor relations.”

Investor relations
When deciding to go public, one thing an early stage company should not overlook is the additional responsibilities that come with being a publically listed company. Especially on some of the junior exchanges like the TSX venture exchange, a company can become ‘orphaned’ if it does not implement a proper investor relations strategy. Meaning that even though the stock is publically traded on an exchange, if nobody is interested in buying it the daily trading volumes will be so low that if you were a shareholder and wanted to sell your shares you may not be able to as there would not be enough people wanting to buy shares. Ensuring management regularly meets with its main investors, gets analysts to cover their company, is proactive in marketing their company as a growth story, generates interest in people to buy shares, etc has to become a core function of the business in addition to operations excellence to produce the financial results to back up their story.

Angels or VCs? The Road to Market

401 Bay Street
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Toronto, ON
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A few years ago, Regent Associates did a study of 250 M&A transactions that they were involved with in the technology space over a span of 8 years. This covered transactions in Europe, US, and Canada. Specifically they wanted to find out the key areas that buyers looked for in a transaction so they could better advise their clients on how they could best position themselves to drive a higher exit valuation. Based on this study, they developed a framework as to how they could rank and assess a company on various factors that were proven to drive exit valuation. “A good example of this framework in action is with a client that had approached us wanting to be sold,” says Jim. “We reviewed the company against the framework and felt they would be undervalued based on low scores against some of the framework areas. We advised them to develop these areas of their business and then come back to us. The company successfully improved themselves and when they came back to us 18 months later we were able to sell them for a 40% premium over the valuation we felt they would have received when they first approached us”.

The various categories of the framework are described below. When working with clients Jim typically scores the company in each factor in the framework. These scores are compared to a company’s peers to help focus on the areas where the company can improve on to optimize the value a buyer will see in the company.

Financial

This category includes basic financial metrics such as profitability and revenue growth. Companies with high profit margins and high rates of revenue growth will obviously command a higher valuation.

Other aspects include the type of revenues a company generates. Due to their nature, recurring revenues can add to the valuation of a company as it makes the company’s cash flow more predictable. “The SaaS model is the example most technology entrepreneurs would think of in terms of a recurring revenue business model,” says Jim. 
“However, even if the company does not have a business model that supports SaaS, they can look to adapt their model to provide more recurring revenues. For example, a company that sells big ticket one-off products could look to build up more of an offering around maintenance and post-sales services for their product where they can sign their clients into multi-year maintenance contracts. This will give the company more of a recurring revenue stream and insulate them from a peaky revenue steam.”

“Companies with strong cash generation are also more attractive to buyers,” says Jim. “Such a company can take on more debt that can be used to finance growth. It also makes a leveraged buy-out an exit possibility.”

Market & barriers to entry

In this category the factors include the strength of customer relationship and degree of uniqueness the company enjoys in its market. “Companies that have a direct and strong relationship with the end users/purchasers of their product will get a higher exit valuation,” says Jim. “If a company sells through a channel and fails to build up a relationship with the end client, they run the risk of the channel swapping them out for another product that may offer the channel partner a better financial relationship. Even if they sell through channel partners, it is important for companies to build up strong relationships with end users.”

“We have also found that a company’s brand plays a large role in the value a buyer is willing to place on a company,” says Jim. “We have found that a strong brand can make up to 70% of the value in a company. Companies should proactively cultivate their brand to ensure they are recognized and well regarded in their space.”

In terms of barriers to entry, companies should use many mechanisms to defend their position. This can include things such as legal protection though patents and trademarks, relationships through exclusive arrangements with key suppliers, and internal expertise through strategic hiring. “Anything a company can do to make it harder for competitors to enter their space will help command a premium on valuation,” states Jim.

Human resources

In the category of human resources, the model looks at both technical skills and management skills. “In the early stages of a start-up the founders are the key people that have the technical skillset to drive innovation and the leadership qualities to drive the company forward,” says Jim. “As companies grow, it is important to distribute these skillsets deeper across the company. Often after an exit, the founders will want to leave, either since they have the largest financial gain or they just prefer to be entrepreneurs rather than work in a large corporation. As such, a buyer will place a premium on a deep management team where the company can continue to innovate and execute even with the loss of the founders.”

Strategic fit

This factor relates to the degree that the company that is being acquired is a strategic fit into the buyer’s product portfolio. “We have seen cases where buyers are willing to pay a 50%-70% price premium for a company that fills out a missing piece of the buyer’s product portfolio and gives them access to the IP and expertise of the company they are acquiring,” says Jim. “That being said, companies should not lose sight of their customers and try to build a company that serves the needs of a few companies they feel may acquire them. There is always the risk the targeted buyers will acquire another company or develop something internally. Partnerships are an excellent way to lay the foundation with a potential buyer. A partnership is a low-commitment way that a potential buyer can start to get deeper experience with a company. If things work out well and strategic synergies start to develop then this can help lead to a deeper relationship such as exclusive arrangement or acquisition.”

Governance

The last factor involves good governance. “We have found that a strong board of directors can add a 25% premium to the value of a company,” says Jim. “This is due to the buyer having more assurance that the company was well governed and there will be no unexpected surprises the buyer needs to deal with.”

This talk has focused mainly on an exit via an acquisition because this is the most likely exit scenario. “Even in the 90’s when IPOs were more frequent, we found an exit by acquisition was 15 times more likely than IPO,” says Jim. “In this scenario, companies received valuations in the range of 0.5x to 3x revenue or 8x to 20x EBITDA. These are large potential ranges since the valuation of a private company is very subjective. As such, it is important for start-ups to be aware of the factors that drive exit valuation and to ensure they are building these up as they grow their company. The more deeply rooted that these factors are in a company will put the company in a stronger position once they start to attract acquisition interest.”

Good advice indeed. Whether you are an entrepreneur or investor, if you rank your start-up that you are involved with across these factors, there are probably going to be a few areas you identify that can be strengthened. Starting to strengthen these areas now will help the company operationally in the short term and also provide benefit in the long term by building in stronger value that a buyer will place on the company.

craig at mapleleafangels.com