The scenario is fairly typical. A budding entrepreneur needs money to start up his fledgling company. He shuffles from bank to trust company to credit union, then to another bank, another trust company, and so on. His credit cards are maxed out; the equity in his home is scrunched by two mortgages; his life insurance and RRSP are fast disappearing; and the love money from his in-laws is about to be cut off.

Is he looking for money in all the wrong places? Perhaps. Many companies in the early stages of growth have difficulty raising the money they need from traditional sources of financing. Fortunately there are other places to turn, especially for those in emerging or knowledge-based industries. These are angel investors and venture capital firms.

Canadians are starting new businesses at a faster rate than ever before. And, of all small and medium-sized enterprises, knowledge-based businesses, such as computer software and biotechnology firms, are the fastest growing. These companies' rapid pace of change, complex technologies, intangible assets and unpredictable cash flows make them less than ideal customers for conservative lending institutions. But this high risk level — and potential large returns if successful — is just what makes these start-ups attractive to investors like angels and venture capital funds.

Touched by an Angel

"Most small businesses are looking for investor capital, and usually angels, because they can't quite fit into the traditional financing [model]," says Marilyn Hanson, CGA, who has been advising entrepreneurs on how to start their businesses for more than 13 years.

Angel investors are generally wealthy individuals who invest their own money directly in a business. A business start-up can raise anywhere between $25,000 and $250,000 from individual angel investors, although $100,000 is an average angel investment.

This money doesn't come cheaply. Angel investments are the most risky investments around, and new companies in the early stages of development with unproven products or services and an incomplete management team represent risks that demand high returns. While angels may look for good management, leading-edge technology, a cost advantage and a receptive market before they invest in a company, they seldom find all of this. So, angels expect to be well compensated for the risk they take. They often want up to seven dollars for every dollar they put into a new company, although they may have to wait up to seven years to get it.

While this may be a high return in relation to returns on other types of investments, very few angel investments are this profitable. Since most of the companies they invest in don't have enough income to support dividends, their return comes by way of share appreciation and the gain they make in selling out. But many exits don't come by way of initial public offering (IPO) or acquisition by a competitor or supplier. Instead they come as a buy-back by the founder for little more than the initial amount invested, or worse still, on liquidation.

While angels come up with the much-needed cash for a struggling new company, often they also come with considerable business experience, contacts and fresh ideas. And they usually want to play an active role in the company.

"Most angels will always take a seat on the board," Hanson says. "They'll have majority voting shares ¼ They really do control it. The entrepreneur who started the company has to be content with less than 50% ownership and running the place as a general manager." For those new companies in the seed and start-up stages that lack a well-rounded management team a hands-on angel could be a tremendous help. "As I always tell people," Hanson says, "'50% of a large operation worth several million dollars is better than 100% of a failed company.'"

Angels also invest in industries with which they are familiar and in which they've had previous entrepreneurial experience. Most of the angels and companies Hanson has brought together are in manufacturing or technology and are located in the Orillia, Ontario area where she practises. "Investors are very specific," she says. "You have to be in the right town and in the right sector, and then of course you have to have quite a good prospect."

The angel market has been a largely untapped capital market, mainly because angels are hard to find. Angels don't advertise themselves; many prefer to remain quite private for fear of being inundated with business plans and proposals.

"Angels are few and far between," Hanson says, adding, though, that there is better access to them now with the venture forums and breakfast clubs that are popping up across the country. At these venture fairs, forums or clubs, would-be entrepreneurs take to the podium for a five-minute presentation of their bright ideas. And angels looking for the latest big thing in which to invest have a venue for one-stop shopping.

In addition, the federal government has tried to make financing more accessible for small and medium-sized, growth-oriented businesses located outside of the country's financial centres. Under the Canada Community Investment Program (CCIP), Industry Canada has been subsidizing local governments or institutions that form facilities for investor/entrepreneur matchmaking. Twenty-two of these projects are dotted across the country from Whitehorse, Yukon, to Mount Pearl, Newfoundland. They draw on the CCIP's funds to support matchmaking with investors (both angel and venture capital), as well as the mentoring of fledgling firms and post-investment advisory services.

Nothing Ventured, Nothing Gained

Another option to get your company off the ground (if you have the funds) is to become your own angel, as Frederic Charpentier of Gloucester, Ontario-based BitFlash Graphics did. Charpentier funded the start-up of BitFlash, an Internet graphics technology provider, two-and-a-half years ago with $250,000 of his own money. Once he had a proven technology — a software that provides Internet site developers the means with which to create seamless graphics without the need for plug-ins — he sought further funding to market his product and expand his company. In stepped the venture capital firm, Skypoint Capital Corporation, based in Kanata, Ontario, with $1 million from the Skypoint Telecom Fund.

While angels are generally individuals who invest their own personal funds, venture capital firms are often professional fund managers that invest other people's money. Venture capital firms usually specialize according to particular stages of development or industry sector.

Skypoint focuses on early stage companies, mainly in the telecommunications or data communications industry. Why this specific sector? "It's a fast growing industry and it has been accelerating in growth," says CEO Leo Lax. This rapid growth, combined with major changes in telecommunications regulatory environment and the acceptance of new technologies as a way of producing new services, is making this particular sector a very hot market for starting new companies, Lax explains.

Ventures West Management Inc. also invests almost exclusively in technology companies, though not exclusively in early stage businesses. "Our investments cover a spectrum from early seed investments to later stage investments in companies with $10 or $20 million in revenue," says Robin Louis, president of the Vancouver-based venture capital firm.

Venture capitalists can invest as little as $50,000 or as much as $20 million, but most deals are in the $500,000 to $5 million range. Most venture capitalists set minimum thresholds for the size of deals they are prepared to consider, not only to account for the high evaluation and monitoring costs they incur, but also to encourage larger deals overall, since they can make more actual dollars on a larger deal.

While there may be more venture capital around than there used to be, not many venture capitalists are throwing their money at needy companies. In general, they invest in fewer than three out of every 100 potential opportunities they're given. But when they do invest, venture capitalists invest big. According to the Business Development Bank's (BDC's) seventh annual survey of the economic impact of venture capital released last November, venture capital constitutes, on average, 36% of the shareholders' equity in the 592 companies surveyed. This compares to 32% provided by the entrepreneurs themselves, 20% from corporate investors, and the remainder coming from private investors, employees, government and universities.

As with angel investments, high-risk venture capital deals demand high rewards. Venture capitalists look for high rates of return. "You can't be in the venture business anywhere these days if you don't produce a rate of return to your investors in excess of 20%," says Louis at Ventures West. Lax concurs, indicating that Skypoint expects 20 to 30% annual return on its 10-year fund.

But these investments are not the quick buck they are perceived to be since the return isn't realized until the venture capitalist exits via a buyout or an IPO. And the expected return often depends on which stage the company is at at the time of the investment, since higher rates of return are expected for riskier, early stage deals, and lower rates for later stages when expansion or even a buyout is more likely.

Lax says Skypoint mitigates the risk it takes in funding start-ups with its knowledge of the industry. Although most venture capitalists prefer to leave the business operations to capable managers, some, like Lax, may be as active and hands-on as angel investors. "We help the entrepreneurs shape their ideas and introduce them to the people in the industry."

All venture capitalists¸ though, look for either an experienced and involved board of directors with good connections and/or a strong management team comprising individuals who not only have the required technical expertise, but also have previously made money in a similar business. Louis says the number one criteria for Ventures West is good management, followed by a big and rapidly growing market and a clear plan on how to carve out a better part of that market.

Some venture capitalists have access to a stable of professional managers and may even support an executive in residence, whom they can call upon to provide managerial help when needed.

This advisory role is a strong component to the venture capital efforts at the BDC. Luc Provencher, FCGA, deputy CEO of the BDC, says the Crown corporation provides an "integrated business solution" that includes consulting, lending, quasi-equity financing, as well as venture capital investments.

The BDC will invest less than other venture capital sources — in the $300,000 to $500,000 range for small-business start-ups. But this financing is done in partnership with other venture capital providers. "For every dollar we invest, others are investing at least three," Provencher says, adding that the BDC helps the entrepreneurs find these other sources of financing.

LMS Medical Systems of Montreal received $3.1 million in venture capital funding from the BDC and three other sources combined. As part of its support of the venture started by Dr. Emily Hamilton, the founder of a unique method that measures the amount of risk present during the progress of labour and childbirth, the BDC put W. Robert Laurier, a former managing partner at Arthur Andersen, in place as a consultant. With this funding, as well as a grant from McGill University, LMS has developed Hamilton's findings into a computer software that is undergoing clinical trials at several hospitals in Canada and the United States. Laurier is now firmly in place as president and CEO of the company and has secured an additional $2.4 million in a second round of financing from all four venture capital sources to build the company and market the product in the United States.

Other venture capital firms want to add value to a company, perhaps by sourcing clients or arranging strategic alliances, in an effort to accelerate growth and maximize their return. This is the role Lax sees for Skypoint. "Our process is to help them initially to put together a technology overview of what's unique and special about their idea. We take them with their presentation to some of the potential customers who may be interested in these types of applications."

Once they invest though, most venture capitalists aren't involved in a company's day-to-day operations, but they do usually want a say in significant decisions. They often want at least one seat on the company's board and expect to be consulted on major strategic or financial matters, with a right to veto certain types of proposed transactions. But they don't look for control.

Venture capitalists make their investments incrementally over time, often in two or three rounds. And they generally insist on a commitment from the company's founders to bring about an exit, such as an IPO. If the IPO doesn't happen, they may then require the founders to buy back their shares plus any unpaid dividends.

Last fall, BitFlash was in the midst of securing its second round of financing and was courting U.S. investors. "We have to look toward U.S. expansion," Charpentier says. "It's always very helpful if you have some large U.S. investors behind you to do that. But Skypoint will be participating all along." Charpentier is confident that Skypoint will see BitFlash through to IPO.

All in Perspective

So are new companies being well served by these existing sources of financing? Evidence suggests that some definitely are; it all depends on the business they're in.

Jeanette Santa Juana, CGA, sought but could not find either an angel investor or venture capital funding to meet her needs when starting up a funeral home a few years ago. "Unless you have the kind of business people are really interested in, it's really difficult to find angel investors," Santa Juana says. "Venture capital lending caters to medical and computer technology and things like that. Things that they can see might grow extraordinarily." These thoughts are supported by the recent BDC survey data - almost 70% of the $1.7 billion in venture capital invested in the surveyed companies in 1998 went to those in the high technology and life sciences sectors.

Santa Juana sent out approximately 75 business proposals and received interested responses on 10. "Each of the 10 was willing to fund us the money, however, there were a lot of strings attached," she says. "Some wanted majority interest in the company; one firm even wanted 99% equity." Santa Juana instead turned to a U.S.-based cash flow lender to finance her start-up, which she established in Los Angeles. "We finally decided on debt financing rather than equity because we didn't want to have anyone telling us how to run the business," she adds.

Despite recent efforts to make investor financing more accessible, searching for equity still entails a tremendous amount of hard work and, often, disappointment. Those on the receiving end of financing proposals admit to proceeding with only a small minority of them. And, once an investor does bite, the entrepreneur may have to give up more than anticipated.

But, as CGA adviser Marilyn Hanson says, "If you want to get a company up and running, selling your product and service, that will happen with proper investment and should still bring a great sense of satisfaction."

Site Design by: Bay Street Online Communications