Are Public Financings of Small Companies in Canada Sensible?

Canada has one of the most developed public venture capital markets in the world. From its roots with the Vancouver Stock Exchange, public venture capital has been raised in Canada for nearly 100 years. Between 2001 and 2002 alone, more than $2.4bn was raised through the TSX Venture Exchange. Although small relative to total TSX financings, the amounts are still large enough to warrant analysis of the public market’s effectiveness for raising venture capital.

Small Business is Not a Little Big Business

In spite of the role of the public venture capital market in Canada, a preponderance of financial analysis, literature and commentary focuses on large companies. In finance texts and articles, little effort is taken to analyze the unique characteristics, requirements and financing needs faced by small businesses. This is unfortunate. Financial-management principles applied to big business are not always suitable for small business. In a timeless 1981 small business finance article in the Harvard Business Review, Welsh and White comment that it is erroneous in finance to think that a small business is just a little big business. Among other things, the unique structural differences and limitations of small companies affect their ability to successfully utilize public venture markets.

To determine whether public venture markets are a suitable financing vehicle for small companies, and correspondingly, are sensible for investors, we examine a fictitious small company, Ace Automation Inc. (AAI), which chooses to raise public venture capital through an IPO. The experience of AAI corresponds to the typical financing process of a small company in Canada. The company’s current and future value is first estimated, based on the stage of the company’s life, its anticipated growth rate, and current multiples at which similar (albeit) larger companies currently trade. The analysis then addresses whether equity can be offered to PVM investors that provides a realistic possibility of an expected return. The second part of the article takes the analysis one step further by adding various issues that small public companies face and assessing their impact upon investors and the company’s growth prospects.

AAI’s Experience of Raising Capital

Ace Automation Inc. is a computer components company providing a high-end computer peripheral to PC manufacturers. AAI was founded three years ago and has managed to establish itself through some initial equity provided by the founder and, later, by an equity infusion from friends and family. AAI now needs additional funds to finance its rapid growth over the next three years. Table 1 provides some financial data on AAI. The size and type of company described here is not far off from the type of listings sought by TSX Venture Exchange.

Having done some background research on raising capital, AAI’s founder thinks his company may be able to tap Canada’s public venture market. After a review of several recent small high-tech financings and discussions with a couple of corporate finance professionals dealing in the public venture market, AAI’s founder developed the financing plan shown in Table 2.

AAI’s current size is typical of, if not larger than, many other high technology companies that have raised financing through public venture markets in Canada. The company’s profit margin is assumed to be 8 per cent. This allows a valuation based on a price-earnings multiple. The amount being raised, $1.5m, is well within the range of most financings for companies of this size. The growth rate of AAI’s sales is estimated at 75 per cent per annum over the next three years. Such aggressive growth is necessary to attract the attention and interest of public venture market investors.

While this growth rate is high and comes with significant risk, it is within the realm of possibility for a small company. Given the age, size and competitive marketplace for AAI, the IPO will likely have to be sold as a unit offering, consisting of a share plus one warrant. Though every company will have differing amounts of shares outstanding, the data for AAI would not be considered out of the norm.

The out-of-pocket costs to arrange the IPO consist of fees for:

• accountants to audit financials;
• lawyers to assist in preparing the prospectus;
• the sponsoring brokerage firm taking AAI public; and
• filing and exchange fees.

These costs can vary significantly from company to company, though the $150,000 figure used is fairly standard. Additional costs facing AAI, which are typical of a public venture market financing, include a selling commission of 8 per cent, and broker warrants and shares to the sponsoring broker’s corporate finance department.

AAI also has a number of option agreements with its founder, its board members and key employees. Small public companies usually have such option agreements.

To provide a valuation for AAI we used actual price sales and price earnings multiples for the computer-peripherals industry at the time of writing, as shown in Table 3. Using these multiples, AAI’S pre-IPO value is $1.8m based on price sales and $2.24m based on price earnings. Given the number of AAI shares currently outstanding (i.e. pre-IPO) of 4.5 million, AAI’s share price can be estimated at between $0.40/share and $0.50/share as shown in Table 4. For the sake of simplicity, AAI takes the average to set its current share price of $0.45/share. This will be the price used to sell its IPO shares.

To determine whether AAI’s IPO share price is reasonable the company must determine the number of shares it will have on a diluted basis post-IPO. Taking into account the existing issued shares, the brokers’ and investors’ warrants to be issued, the shares paid to the broker’s corporate finance department and the options granted, AAI estimates that, on a fully diluted basis, it will have 12,749,999 shares outstanding.

The approach taken in Table 5 calculates AAI’s estimated sales and earnings in year three (assuming a 75 per cent-per-annum growth rate) and then applies the price sales and price earnings multiples to determine an estimated future value. Assuming all warrants and options are exercised we can calculate a share price range based on the two indicated future values. Thus, AAI shares have an estimated value between $0.76 and $0.94 per share in three years.

However, to determine whether the initial IPO share price provides a fair return to public venture market investors, we should discount the share price back to the present, taking into account the riskiness of the company and the investment. We chose a discount rate of 40 per cent to reflect the uncertainty that AAI can execute its aggressive business plan as anticipated. Given the company’s size, its business, projected growth rate, and the discount that venture capitalists would apply to similar investments, the 40 per cent discount rate is not unreasonable. The discounted share price ranges between $0.28 and $0.34 per share.

A comparison between the IPO share price and the present value of the future share prices leads to a somewhat worrying observation. Investors are being asked to buy shares at $0.45 when they are worth substantially less. While one may quibble with certain assumptions and numbers, overall, the company as described and the financing terms as noted are within the bounds of a typical public venture market financing.

Concern About Financing Structure and Costs

Investors under this financing framework are not well served. The problem does not lie with the target investment itself. The company is quite profitable and growing rapidly. Nor is the problem with the multiples used to value the future share prices. Price-sales of 1.8x and price-earnings of 28x are quite generous. In fact an argument can be made for valuing AAI at a discount to these multiples, given its small size, unproven operating history and relative lack of liquidity.

The problem appears to be the financing structure and costs. An obvious observation is the high relative cost of going public for small companies in Canada. This cost comes in two forms:

• Cash commissions to place the stock combined with out-of-pocket costs incurred for auditing, legal, filing, and sponsorship purposes. $0.18 of every dollar AAI raises will be consumed in commission and out-of-pocket expenses. In a 2003 Canadian Investment Review article on IPO costs in Canada, Kooli and Suret report very similar findings and comment that, ‘small Canadian firms should explore different funding sources’.
• Share dilution through the issuance of investors’ and brokers’ warrants and shares to pay for corporate finance services.

Issuing so many warrants early in the company’s life damages AAI’s capital structure. Even earnings growth of 75 per cent per annum over three years cannot make up for the extensive share dilution incurred through the IPO. By doing some sensitivity analysis, AAI will require a per-annum three-year growth rate of 100 per cent or more simply to provide a fair IPO price to investors.

Unfortunately, as we consider some other implications of taking AAI public, the public financing strategy becomes even less attractive. AAI, being publicly traded, now faces additional challenges that it did not face before its IPO. The costs here are two-fold:

1. Out-of-pocket expenses to maintain its public listing.
2. An opportunity cost of executive effort spent on the public side of the company as opposed to its operating side.

Ongoing out-of-pocket expenses of a small public company includes items such as:

• extra legal and accounting fees;
• additional fees if the company undertakes activities (e.g. an acquisition) requiring exchange approval;
• continuous disclosure requirements including press releases, quarterly financials, annual audited financial statements and annual reports; and
• handling investor and broker enquiries.

Management time running a public company covers:

• time taken to meet with the investment community and give presentations; and
• effort in providing adequate and timely disclosure.

Estimates may vary from company to company, but we can assume that a president and CFO each put 25 per cent of their time into these activities. In fact, AAI may be overly optimistic in this respect. A survey by the Canadian Listed Company Association found that regulations can consume up to 70 per cent of management time. It is possible to contract some of this work out to the company’s legal counsel, accountants and investor-relations professionals, though this would raise costs.

Both of these ongoing costs are significant and the opportunity cost can hurt the company permanently. AAI is small and like most small businesses can probably be described as having insufficient human, structural and financial resources. Now that the president and CFO must give significant attention to disclosure matters, investor relations and the company’s share price, at the expense of the company’s operations, it is reasonable to suggest that the likelihood of AAI meeting its business goals will decline. This is not such a big problem with larger companies that have entire management teams in place, each with their functional specialties. Small companies don’t have this luxury. In addition, if a large company makes a business error or misses a milestone of some sort, it can usually take a charge against earnings and carry on. A similar error in a small business may result in bankruptcy.

Share Liquidity

Another important factor with small publicly traded companies is share liquidity. Unless the company has caught the imagination of public venture market investors in a significant way, liquidity is often a concern for both the company and investors. Raising AAI’s profile is a critical and time-consuming duty of management, as described above.

Let’s assume that a significant number of shareholders have bought AAI for its long-term prospects and don’t plan on selling. Does this suggest that the supply of shares on the market will be limited, leading to the share price being bid up by lack of supply? Not necessarily. As part of the financing structure, 833,333 broker warrants and 100,000 shares were issued to corporate finance. The shares (and shares subsequently purchased by the warrants) will be sold into the market relatively quickly. These securities are considered as part of the compensation package for doing the IPO, not as investments. The brokers and dealers are only holding these securities to sell in the short term. As the share price for AAI starts to increase as a result of its executives’ time and effort in marketing the company to the investing public, the investment dealers/brokers will look to sell into that strength, limiting share appreciation.

Conclusion

Based on the analysis in this article, we can conclude the following:

• The initial cost for a public venture capital IPO for small issuers in Canada appears to be quite onerous.
• The existing financing framework dilutes a company’s share structure to the point where even high-growth companies may have trouble providing sufficient earnings to compensate for shareholder dilution over a reasonable period.
• The ongoing effort required by senior management to meet continuous disclosure rules and investor relation responsibilities increases a company’s risk and negatively affects management of the company’s operations and growth.
• Based on these points, investors who participate in public venture market IPO financings may be at a disadvantage from the start.
• Economies of scale appear to underlie several of the concerns. For instance, the cost, other than selling costs, to raise $5m or $10m may not be much greater than to raise $1m or $2m. Also, larger companies, with greater management depth, can better handle ongoing disclosure and investor-relation matters.
• The compensation structure for investment dealers and brokers may be inconsistent with developing a strong aftermarket.
• Companies suitable for public venture market financings appear to be those with exceptional growth rates. This would preclude many good but slower growing companies from going public at an early stage.

If all but the highest growth companies are not suited to the public venture market, then which, if any, small companies are? Though it is beyond the scope of this article to demonstrate, a mineral or oil exploration company, the traditional staple of the public venture market in Canada, may be most suited to the junior public markets. These companies have the potential for large increases in value, should they find resources in sufficient commercial quantities. Discovery of commercial deposits can lead to such large increases in company value that they can overcome the high financing costs and, even more importantly, the large dilutive common share effects of a public venture market financing.

Junior exploration companies are also simpler to operate than a small industrial or technology company. Thus raising public venture market financing would not be as harmful to exploration companies, in terms of management focus, as it would be to others. If this is the case, the public venture market and the securities dealers servicing that marketplace should rethink their target market and perhaps refocus their activities on their traditional corporate constituents in the mineral and oil exploration sectors.