COVER

Starting up a business

BRENDA DALGLISH June 27 1994
COVER

Starting up a business

BRENDA DALGLISH June 27 1994

Starting up a business

New companies are bypassing banks to raise funds

Terry Bergan knew that he was in for trouble when his bankers thought that a turf farm was a silly idea. In 1986, Bergan visited his banker to discuss a loan to develop a sophisticated instrument, invented by his father, an engineering professor at the University of Saskatchewan. “I walked into the bankers’ office and they were still laughing about the turf farm,” he recalls. “When I told them that I wanted money to make a device that would weigh moving vehicles, that really cracked them up. They told me in no uncertain terms how ridiculous it was.” Since then, Bergan, now 39, like most other small business people with ideas that are bigger than their bank balances, has gone through endless frustration over financing. “As a technology company in those days,” said Bergan, “you couldn’t find a bank that would give you the time of day.” Eventually, with the help of government research-and-development fiinds, a wealthy private investor, venture capital funds, a foreign bank and, most recently, the stock market, Bergan has built a Saskatoon-based company, International Road Dynamics Inc., that directly employs 50 people and sells $8 million worth of high-tech highway measurement instruments each year.

Bergan’s enterprise is typical of the kind of company that Canada needs to ensure long-term economic growth. It has developed unique, specialized products to meet a growing demand in a number of international markets, and it provides skilled, well-paid jobs for Canadians. But as the age of the New Economy dawns in Canada, governments, entrepreneurs and even bankers have come to realize that emerging companies like Bergan’s can be hobbled by the inflexible, outdated lending practices of Canada’s Old Economy banks. International Road Dynamics’ original asset was Bergan’s father’s research on the scientific principle that the weight of moving vehicles is different from the weight of stationary vehicles. Companies like Bergan’s, which are long in sophisticated knowledge (or “intellectual capital,” in the jargon of the New Economy) but short on traditional brick-and-mortar assets, are in danger of floundering because they cannot get adequate financing through conventional channels.

Now, motivated by the need to create jobs, governments are starting to focus on the problem. And the banks themselves recognize that they are missing out on a host of important business opportunities as some of Canada’s best and brightest new companies bypass them entirely by getting funds from a new generation of financial competitors. Warren Walker, senior vice-president of commercial banking in Canada at the Bank of Nova Scotia in Toronto, says that never during his 20-year career has there been a greater sense of urgency for governments, small businesses and banks to work together to help business create jobs. “Make no mistake, we will only be as successful as our customers,” added Warren. “There’s a healthy dose of self-interest in this for us.” Indeed, the rewards of investing in a successful knowledge-intensive, high-tech company can be rich. In 1988, John Eckert, Loudon Owen and John McBride, three Toronto investors, hit the jackpot with their first venture. They raised the first $350,000 of external financing for Softimage Inc., a Montreal software creator, mainly from friends and associates. Now, Softimage, whose animation technology was featured in the movie Jurassic Park, is about to be taken over by software giant Microsoft Inc. of Redmond, Wash. And they are about to score a significant financial profit as a result of their early investment. Eckert says that a $5,000 stake in Softimage in 1988 is now worth $1.5 million. “Softimage was a dream company,” says Eckert. “It had an excellent product and excellent management. I think there are other Softimages out there.” Granted, investing in New Economy companies, ones that usually involve a high degree of sophisticated technical knowledge, is often more complex than investing in traditional businesses that tend to have simpler products geared for established markets. In Bergan’s case, for example, the instruments he develops are complex and have very specialized uses, primarily monitoring the weight of transport trucks to help highway officials protect roads and bridges from damage caused by overweight loads. For bankers who found the concept of turf farming exotic, a sophisticated technology based on an abstract scientific principle was difficult. Susan Smith, senior market manager for a newly created knowledge-based-industries lending unit at the Royal Bank of Canada, says that gaining sufficient expertise to understand new technologies is the banks’ first challenge. “If you don’t understand it,” she said, “how can you lend to it?”

To remedy that, most of Canada’s Big Six banks are rushing to establish such special knowledge-based units. The Bank of Montreal, among others, has targeted the KitchenerWaterloo technology triangle in southern Ontario, which specializes in computer-related businesses. In Saskatoon, which has become an international centre for agriculture biotechnology research, several banks are racing to get up to speed in that industry.

In addition to targeting specific industries, the banks are also experimenting with new kinds of financing arrangements that do not rely as heavily on their traditional asset-based lending criteria, which called for securing a loan with collateral worth up to two or three times as much as the value of the loan. Instead of placing so much importance on assets and collateral, they are paying more attention to cash flow. And, instead of making loans, they are buying ownership stakes in companies. This is seen as a better financing arrangement, because the banks will have the potential to be rewarded proportionately to the amount of risk to which they are being exposed.

Despite those initiatives, bankers concede that they will never be able to lend money to businesses that are still in the early, highrisk start-up phase. Without a commercial product and proof that a market exists for it, banks cannot take the risk. For start-up and research-and-development lending, small businesses, and particularly technology companies, will continue to rely principally on cash from mortgaging their founders’ assets, from family and friends, and from socalled angels and venture capitalists.

Angels, the Broadway term for wealthy investors who finance the production of new plays primarily because they love the theatre, is the term now being applied to a growing number of wealthy individuals, often entrepreneurs themselves, who invest in companies that are in the start-up or development phases. In return for their investment they get partial ownership of the business. Bergan’s angel was Tom McClocklin, a prominent Saskatoon businessman, who put up cash at a crucial moment of the company’s development. Allan Riding, a business professor at Carleton University in Ottawa who has interviewed about 300 angels across Canada, says that the most surprising thing about them is how many there are and how much capital they invest each year. ‘They lose money sometimes,” said Riding, “but they expect to. Money is only part of the reason they do it. They also just like the excitement of being involved with growing businesses. It’s kind of a hobby.” He estimates that angels invest, in total, between $200 million and $300 million a year in small businesses. Venture capitalists, or professional investors who provide the same kind of financing as angels—but with someone else’s cash instead of their own—raise close to another $100 million a year for small businesses.

Other recent arrivals on the New Economy

financial scene in the past 10 years are nonbank financial institutions that have carved out specialized lending niches, capitalizing on the commercial banks’ lack of understanding of the high-technology market. Steven Hudson, founder and president of Torontobased Newcourt Credit Group, the largest non-bank finance company in Canada, with $2.4 billion in assets and 8,000 clients, says that he formed Newcourt after working for a Toronto hospital as the accountant in charge of arranging financing for new equipment. Instead of borrowing money from banks to pay for highly specialized, multimillion-dollar machines, hospitals and others who require such equipment increasingly use financing provided by lenders affiliated with the equipment manufacturers. Because those non-bank lenders know the equipment technology and the market so well, they will usually finance the equipment on better terms than the banks will provide.

Relationships are also a key element in the growing ties between New Economy borrowers and non-bank lenders. Banks have typically shuffled account managers around without ensuring that the incoming replacements understand the special needs of the companies that have loans outstanding. Bergan, for one, says that during the five years that he relied on Canadian chartered banks, he never had an account manager for more than a year. Each time the bank moved his account manager, he had to educate the new one about his business.

Finally, the stock market, which is usually the last stop for raising capital to finance a company with proven potential, is now paying closer attention to new high-technology ventures. Instead of having one or two general technology analysts who cover everything from computer software developers to satellite manufacturers, some investment dealers are adding an array of specialists to their ranks. Said Nelson Smith, a managing partner of Yorkton Securities Inc. in Toronto: “Hopefully we’ll convert scientists into financial analysts.” Yorkton, along with a few other boutique dealers including Marleau Lemire Securities Inc. in Vancouver, is focusing on knowledge-based New Economy companies and the investors who want to buy them.

BUILDING A BUSINESS

START-UP

PHASE:

A good idea that needs work.

FINANCING:

Founder’s savings; investments from family and friends.

DEVELOPMENT

PHASE:

A prototype product is ready for commercialization.

FINANCING:

“Angels” and venture capital funds; government R and D aid.

PRODUCTION

PHASE:

Product sales begin and grow.

GROWTH

PHASE:

As sales increase, company expands production volumes and product lines.

FINANCING:

Public stock offerings.

BRENDA DALGLISH

For his part, Bergan applauds the changes in the financing market that have taken place since he launched International Road Dynamics. Even though his company has grown rapidly—sales have jumped to $8.5 million from $594,000 in 1987—Bergan, who is about to list his company’s shares on the Vancouver Stock Exchange, cannot keep an edge of bitterness out of his voice when he talks about his experience with the banks. “If this business had had to depend on only the Canadian banks,” he said, “it wouldn’t exist today.” Nor is he won over by the Canadian banks’ sudden new interest in technology businesses. “All the Canadian banks have shown up at our door, wanting to do business with us,” he says with satisfaction. “We’re not interested.” Furthermore, adds Bergan, even the turf farm that the bankers laughed out of their office before him is thriving. In the knowledge-based economy, it is often the innovators and the risk-takers who are laughing all the way from the bank.