Growth Times

As my previous posts show, Ontario’s current hub-centric model for promoting innovation and entrepreneurship is expensive, unfair, and ineffective. The Minister of Research and Innovation should take note and explore alternative models, rather than continuing to pour taxpayer’s dollars into an expanding bureaucratic network with high fixed costs and built-in inefficiencies.

The Chamber of Commerce in Ottawa has taken notice too and is criticizing the lack of oversight of OCRI and its expansion in activities it traditionally conducted, according to an article in the Ottawa Business Journal yesterday.

To explore alternatives and fuel a discussion, I have highlighted a menu of options below. As a disclaimer, I am not a policy expert on the matter of entrepreneurship, but a practitioner, so do please consider those as draft proposals for crowdsourced discussion and improvement.

Overall, propositions fall into 2 groups: clean up and downsize the current system (lots to do on that end , to compensate for the unbridled expansion of the innovation bureaucracy in recent years), and replace it with tax refunds for commercialization investments and (possibly) loan guarantees for entrepreneurs.

Proposition 1: Let active entrepreneurs design the system

Conduct a public consultation with active entrepreneurs or, probably better, let’s put together an objective, wide-ranging group of entrepreneurs and task them with proposing changes to the system. Give the floor to a good range of start-ups and early-stage ventures.

Entrepreneurs are the true actors of commercialization, they are the only ones who ultimately take new ideas and turn them into reality. However, the system so far seems to have been designed and run with limited inputs and influence from those, and I personally noticed an assumption at hubs that entrepreneurs don’t know what they are doing when it comes to commercialization – which is far from the truth. As “clients”, they should be listened to: that’s Commercialization 101.

Proposition 2: Cut executive compensation at innovation hubs

This one is a complete no-brainer — assuming we do not suppress the positions of CEOs and executives at innovation hubs, another proposition worthy of consideration. If you want to restore trust in the public system, you need to rationalize compensation at innovation hubs, and that means slashing it at the top of the pyramids.

There is nothing in what hubs do that justify such salary levels for their CEOs and top executives. If one is going to receive a check every month with no correlation between pay and contribution to the economy, then that pay should be the minimum that’s needed to fill the position. $400K+ is by no means the minimum needed to fill up the position of CEOs at institutions with less than 100 employees like MaRS, Communitech or OCRI. This is true in this period of economic uncertainty, and it will remain true afterwards.

Proposition 3: Eliminate grants and special funds

Governments contribute more to economic growth with tax cuts than with increases in spending. It’s not me saying it, it’s Canadian CEOs, according to a recent poll in the current issue of Canadian Business.

Direct spending by the government is less effective than tax cuts for a number of reasons, primarily having to do with the government not being as careful with its money as companies and consumers. As a result, money is often handed out based on relationships rather than expected performance. That in turn distorts the market, fuels taxpayer’s resentment, and generally does not deliver the expected results.

Hubs love innovation grants and special funds. MaRS, in particular, is pushing very hard to control those, because it has understood that they constitute the key source of discretionary power. As a local entrepreneur emailed me: “Whenever there is government pot of money involved, you get a bun fight and everyone trying to control the supply of buns.” And as the end result, only a small portion of the buns actually reaches the intended recipient.

MaRS apparently took full control of the Investment Accelerator Fund this month. Of course, that calls for hiring more people, so on April 20 they issued this job ad for an Investment Accelerator Fund (IAF) Coordinator, just to help the “IAF Managing Director and Investment Team”. Only entrepreneurs “already engaged with program Entrepreneurs-in-Residence (EIR) or MaRS Advisors to access specialized advisory services” qualify. Since you need to be selected to work with those, paying lip service to the institution is not optional. In business I believe that would be called Tying, also known as Forced Bundling, and it is illegal. Not to mention Dumping of services, too.

Grants and any selective attribution of money are the source of too many evils – they should only be considered a last resort to help entrepreneurs. With little transparency and many potential conflicts of interest, this is a scandal waiting to happen. As entrepreneur Stephen van Egmond commented in part 3 of this series, it is hard not to think of the Canadian eHealth fiasco. So I say let’s be smart and preempt it before we waste more millions: eliminate all grants and special funds all together. Good riddance.

Proposition 4: Eliminate consulting services delivered by public advisors

I developed this point in the previous posts, so I’ll summarize it here: the direct delivery of strategy and marketing services by public advisors is not efficient due to a lack of performance management “by design”; it also distorts the market and hurts the creation of a viable ecosystem of private providers; and finally, it leads to conflicts of interest when coupled with grants and programs.

Moreover, hub advisors paid by the taxpayer should not be allowed to maintain their own private companies on the side, a rule that is already enforced for any government employee. Assuming consulting services are still provided by the hub in spite of the recommendation not to, then there should be fair and competitive procurement policies and only private providers with no work association to the hub should be allowed to bid. Decisions should be fully documented. The people who are hired to make those decisions should come from diverse backgrounds (including minorities – see part 2), and should be tied by strict rules and independent oversight.

In any case, public hubs should focus on what a hub normally does: connecting and educating large number of entrepreneurs (assuming chambers of commerce and universities don’t do it). Not catering to the interests of a few select ones. The private sector does that better.

Proposition 5: Eliminate public incubators

I also talked about this before. In a nutshell: public incubators like the ones ran by MaRS and Communitech are not needed. They compete with viable commercial space and private incubators. Cancel the incubators program and sell the buildings to the private sector. Then use the money to feed tax refunds for entrepreneurs.

Companies primarily rent offices at those public incubators because of the proximity to public subsidies. The “chance encounters” and “creation of a global address” arguments are based on little more than hot-air theories with no fact to back them up. They do not justify multimillion-dollar investments. If I want chance encounters, I can easily go to one of the gazillion events organized by the entrepreneurship communities in those areas.

The hubs actually built those incubators to create endowments equivalent to a perpetual public subsidy. With 80% of the MaRS budget after real estate costs going to salaries, this subsidy is mostly used to add more bureaucrats. Few taxpayers I know would agree with that.

Note that with the extension of SR&ED to commercialization activities (as proposed below), private incubators and commercial office space would be indirectly subsidized, and they would still have to compete for that money with other commercialization activities. That’s a much healthier, market-based way to support entrepreneurs than creating public incubators.

Proposition 6: Require public reporting of all grant decisions and results, with independent third-party oversight

There should be detailed public reporting of the money given to hubs, and of the results delivered: not just on activity and effort (“we helped x companies” and “had x appointments”), or results that might have happened anyway, but on actual “performance improvement”.

This is notoriously difficult to measure, but there is an excellent proxy: the willingness of entrepreneurs to pay for your services at market prices (and without bundling those services with grants!). Hubs should drink their own medicine on commercialization and charge market prices for their advisors. Being in that business, I predict they would fail to cover even 20% of their disproportionate cost base. Only lean cats survive in the wild.

Assuming we don’t get rid of hub advisory services and grants all together (a shame), there are some alternatives, although mediocre:

• Require full disclosure of all program decisions: who applied for grants, who got selected, who completed the selection, and the rationale for the decision.
• Have a (truly) independent third party, paid by an independent body, conduct random, anonymous survey of client satisfaction. To that end, the audience should be defined as any start-up in the area of service, and not just companies that contacted the institution or were selected as a client.
• Have a third-party auditor also conduct random sampling of results for the recipients of those grants.
• Enforce a strict separation between the attribution of grants and the advisory services. Short of that, entrepreneurs will fear for their grant (as they do now) and not disclose their true evaluation of the services.

Note all of this adds to the red tape and costs to the taxpayer though, and since those advisory services and grants have terrible ROI by design, the best option remains scrapping them.

Proposition 7: Require annual reports, financial statements, and full disclosure of all public salaries above $100K

Right now it seems that hubs like Communitech and OCRI escape any form of salary disclosure, even though they received large provincial grants. It’s also unclear whether the disclosed salaries for MaRS include all compensation. According to information I could not verify, the CEO’s annual compensation might be closer to $700K after bonuses. In any case, this all points to potential loopholes in the sunshine disclosure.

Requiring disclosure of all financials and salaries above $100K for institutions receiving public money (be it municipal, provincial or federal) would extend much beyond hubs and would be useful in adding some transparency to the public sector as a whole. This disclosure should include all of the money received, and offer detailed breakdowns.

Proposition 8: Drop the Ontario Network of Excellence initiative

The Ontario Network of Excellence (ONE) has been designed to be a MaRS-led province wide network that will affect every organization that supports entrepreneurs in Ontario. Organizations that submitted expressions of interests to ONE are being asked to prepare their business plans now.

The “access to expertise just around the block” – as mentioned on the page I referenced above – clearly points to a frightening expansion of this bureaucracy, with little in it for entrepreneurs. With the internet, I believe we’ve always had access to (actual) expertise, and we don’t even need to go “around the block”. This looks like more red tape and the fact that a large component of it will be coordinated by MaRS means they will apply their own “worst practices” to the whole network, i.e. no transparency and deficient result report.

Trimming down bureaucracies has always been a great way to fuel innovation, so let’s cancel that initiative.

Those 8 propositions is what it would take to clean up the current system. Having done that, we could move to provide actual support to actual entrepreneurs!

Proposition 9: Refund commercialization expenses through the tax system

I believe the most productive approach to channeling public resources towards entrepreneurs would be to extend the successful SR&ED tax refund to commercialization activities.

First, tax incentives are much fairer because they involve clear attribution rules, with much less room for subjective decisions. A startup in Huntsville would have the same “chances” of getting that money as one hosted in the MaRS incubator. The decision would not rely on whether you pay lip service to hub bureaucrats, and those bureaucrats would not need to be entrusted with picking winners – let’s leave that to venture capitalists.

Second, tax incentives are more efficient, because they feed less red tape: tax auditors conduct random controls, that’s it. That means bureaucrats take a smaller cut. The money goes directly to entrepreneurs, who get to decide independently how to invest it.

How would that work in practice?

Right now, SR&ED offers great tax credits of 35% up to $3M and 20% after that for R&D investments (broadly defined to cover most product development with some level of technological risk). It is controlled by Canada Revenue, anyone can claim the credits (with detailed documentation that makes fraud difficult), and even solo entrepreneurs can give themselves a salary and claim it to receive 35% of it back. My suggestion would be to simply extend that to commercialization activities for start-ups and early-stage ventures.

The key challenge would be to find the right selection criteria to restrict it to true innovation plays, but even that should not be a big problem. In fact, it would feed an interesting debate: what type of innovation, as a society, do we want to encourage? Is it just technological innovation? Not my pick, but you could do that by restricting the commercialization tax refund to SR&ED recipients, or to startups with patents. On the other end of the spectrum, it could even be extended outside technological innovation: after all, as Peter Drucker said, there are many sources of innovation, and I’d argue that a lot of it today takes place in business models and packaging existing technologies rather than from lab technologies. Think iPad and even Blackberry (or, to go farther in time, the banking system, which created lots of value even though it was not technological in nature).

Note there is already a program called the Ontario Tax Exemption for Commercialization (more details on OTEC here), however it provides a ten year tax exemption for new corporations that commercialize intellectual property that is developed by qualifying Canadian universities or colleges. Two problems: the tax exemption is of little use to startups in their pre-revenue years, and the requirement that the IP be developed at universities or colleges makes it very restrictive. So I think an extension of SR&ED would be easier.

But the acronym doesn’t really matter as long as entrepreneurs are in charge of their commercialization spend and the government refunds part of that to compensate for the higher risk in starting new ventures.

Proposition 10: Extend the Canadian Small Business Financing Loan Program

This idea was put forward by Ian Graham of the Code Factory in Ottawa (thanks Ian), who foresees a challenge with tax refunds: an entrepreneur needs to spend money to get the credits back, so a kickstart would be great. With the Canadian Small Business Financing Loan (CSBFL), the government guarantees 75% of a loan and the entrepreneur 25%, working with the banks to do this.

The problem with CSBFL today is that it is only for capital expenses, which are used as collateral for the loan. A similar program for operating capital (salaries and opex) would be ideal.

I see risks of fraud if there is no tangible collateral for the loan, and I tend to think that entrepreneurs should find a bit of money to pay themselves before starting. However, assuming that the risk is addressed in the design of the program, it would indeed be a useful program that could get lots of entrepreneurs started.

Proposition 11: Make it more attractive for both Canadian and foreign private investors to invest in Canadian early-stage ventures

In the footstep of recent successes to lobby the federal government for the modification of section 116, which removed some bureaucratic obstacles to foreign investments in Canadian start-ups, we must continue to make it more attractive for foreign angels and VCs to invest here.

The proposed extension of SR&ED to commercialization activities would go a long way in making such investments more attractive. Other measures should be explored to reduce red tape and optimize incentives (through the tax system).

In parallel, we should also explore the successes of other regions, such as the Silicon Valley or Israel.

Proposition 12: Engineer an “Own the Podium” culture, again

Canada has a great immigration policy, a solid engineering base and long winters to keep us all working. It also has universal healthcare. This is great for entrepreneurs.

We have the key ingredients to create a real culture of entrepreneurship, to make local champions like RIM less of an exception and more like the norm. What’s missing is self-confidence and entrepreneurship-friendly policies.

We need to trust that Canadians can own the Podium, that they can win without social assistance. We need to accept failure and frown upon inaction. We need to stop wasting time applying for grants. The Silicon Valley wasn’t built on grants, it was built by attracting the best talent, the best companies, and setting up an environment in which they could freely use their skills, try things out, and try again until it worked.

We also need rules that are designed by entrepreneurs, not by bureaucrats. I’ll give you a tiny example, one that affects me personally: stock options are taxed differently for contractors and employees. And SR&ED does not refund money spent on contractors. Yet the best mode of delivery of my services is as a contractor, not as an employee. Now because of this, it is difficult to offer stock options payment to my clients, or leverage SR&ED when I get involved in product development work. Take many rules like that, put them together, and you have the basis for a system that is not as friendly to entrepreneurs as it could be.

So we are back to proposition 1:  the government should crowdsource its innovation policy-making to active entrepreneurs. An entrepreneur would not have given MaRS $130M to buy buildings and create a bureaucracy of smoke and mirrors.

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Karen Mazurkewich, Financial Post, in an interesting article on Monday entitled “The new uber-angels” comparing the VC-fund approaches of Ontario and Quebec, declares on the Ontario Venture Capital Fund that “What Ontario didn’t — or couldn’t — predict was the lack of potential co-investors for these funds.”

Karen, I would invite you and Ontario’s decision-makers to step up your due diligence and review Growth Times’s August 4th, 2009 blog post entitled “Who Will Match Ontario’s $250M Emerging Technologies Matching Fund?”……………..

Really, was it that hard to anticipate? Ontario could have predicted this, but there were political and financial forces at play and incompetence at the top. Let me guess that the persons in charge will actually get rewarded with more assignments and rewards for their mistakes, while the rest of us in the private sector get to work harder to actually make innovation happen.

[Addition to the post following subsequent inputs I received: the setup of the Ontario Venture Capital Fund remains such that Business Angels can barely play. The restrictions pretty much rule it out ($1MM min investment, full net worth disclosure, etc.). They should reduce the barriers for Angels to participate, given they are one of the few true sources of capital these days.]

As a rule, I am starting to realize that the public institutions in this province, and that includes a lot of the nonprofit hubs, are not quite designed to really encourage innovation. Except in rare cases, they are designed to grab taxpayer’s money and redistribute it to their supporters based on loyalty, not performance.

One thing Ontario and Canada really needs to get urgently, is that smart regulation has much more leverage than direct intervention. If Ontario really wants investments, it should work to repel section 116 to get American capital flowing here.

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Josh Kopelman, Managing Director of First Round Capital, wrote a great post today building on Fred Wilson’s VC math problem, and call Why VC Performance Has Fallen Off A Cliff.

I argued in a recent post that in parallel to the “moonshot” approach Josh rightly describes as the norm for VCs,  there must be a model that focuses on extracting revenues from a portfolio of tech companies with lesser risk.

Overall, it’s pretty clear to me that what we call VC companies should cover the entire risk-return frontier for any early-stage tech company, because that would allow large investors to place their bet as they like in this category. I’m not suggesting VCs turn into bankers or private equity investors, but there is a clear case for filling the early-stage funding gap towards tech ventures that hold less risk and more proven revenue models than moonshots.

For all the analytical firepower of VCs, it feels a lot like playing this field is still an art not a science. If really, VCs take a classic portfolio approach to early-stage returns, like I’d argue they should, then risk-return is a continuum and the industry ought to cover it entirely to offer interesting options to large-fund investors.

Which brings me to this: the expectation of a 20% return yearly is completely unrealistic, when the average growth rate for the world economy is 2-3%  (tidbits from my finance classes at Stanford – I don’t think our average growth rate has gone much above that since I finished my degree there…) If VCs as an industry grows faster than that rate, then by definition it will have to return to the mean (back from the moon) sooner or later, hence the cliff. Risk has nothing to do with this, since we are talking about a risk-return continuum in a vast portfolio managed by the entire VC industry – over time the failed companies bring you back to that 3% mean.

If you can do better than 2-3%, or say 5% to be a bit more optimistic about the growth capacity of our system, then you’ve nailed some distortion in the market and/or you’re taking more risks than you should. It’s hard but possible to do that as an investor, but impossible to do it sustainably as a large industry. Sooner or later, the industry will lose big, just like gamblers. Keep in mind again that I am talking about the VC industry as a whole, not individual players here – there is much variability there.

The problem with promoting those 20% rates is that it fuels hype and bubbles – the only viable mechanism to achieve those returns for the entire VC industry, if not a sustainable one. So I think it would be great if VC as an industry could stop pretending it can do much better than the mean, and focus instead on offering a decent continuum of risk-return options to their investors based on early-stage plays. From that angle, VCs are just expanding the range of investment options available and that, I think, would be good enough for everyone.

Unfortunately, the current system is set up to create monopolies of sorts by maintaining a complete imbalance between money pools and money needs. VCs are encouraged to bet on moonshots because that’s how, individually, they can make it and retire (with that feeling of intellectual superiority one gets for betting on the right horse at the tracks). They don’t lose much money on failed investments, but they make tons on successful ones, so of course they swing for the fences. The first thing VC firms should do is take a good look at their compensation system and rehaul that.

As things go well and returns grow, a few investors that actually beat the mean quite consistently (there will always be some – they are the right dots in the normal distribution of investors) make everyone hope over time that they can too – and thus the system as a whole progressively takes more risk without realizing it.

Meanwhile, companies with a lower risk-return ratio – but not low enough to warrant a bank loan – have a heck of a time finding money. Angels fill some of that gap, but while they’ve structured themselves greatly in the past few years, they don’t have the discipline a VC firm could bring, which only would attract the big money from the big funds.

Unlike what some observers think, I’m convinced the VC system is here to stay. But not without adjustments – either angels will structure themselves more and more to fill the void VCs left, or VCs will get back in there as they should. The overall lesson as a VC is that you can shoot for the moon if you wish, but keep your feet on the ground, because your industry will go back to the mean sooner or later.

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A great post today by Suzanne Dingwall Williams of Venture Law Associates LLP in Toronto, regarding the recent considerations by the U.S. to increase the number of H1B visas for skilled foreign workers, apparently thanks to a push by venture capitalists.

The stats she quotes are startling: 

“A recently released study by the NVCA notes that (a) immigrants have started more than 25% of U.S. public companies that were formerly venture backed, and (b) more than 50% of the employment generated by U.S. public venture-backed companies has come from immigrant-founded companies like Intel, eBay, Yahoo!, and Sun.

The New York Times has also taken note, citing Harvard Law professor Vivek Wadhwa’s claim that 52.4% of today’s Silicon Valley startups have at least one foreign founder. US VCs are figuring that, to expand domestic deal flow, they need to expand the immigrant entrepreneur base.”

Having lived in six countries including the U.S., I can tell for a fact that the amount of energy I deployed to learn about and obtain the visas and other administrative passes giving me the right to stay and to work is stupendous. In volume, it easily equals the time required to launch the operations of a start-up. This truly is wasted time. If the U.S. had made it easier for me to stay after my years at Stanford, I’d likely be there. I truly love Canada and Toronto is my favorite city in the world – but on a professional level, for tech entrepreneurs the environment is just not comparable to California. So the main advantage of Canada over the U.S., as Suzie points out, is that it is easier to immigrate as a skilled worker here.

But if that advantage diminishes, what’s left to retain immigrant tech entrepreneurs in Canada?

Better public support for start-ups? More grants? Sure, that’s one thing we have over the U.S. But it’s also a double-edged sword: in the previous years and months, the government and semi-public/nonprofit bodies have rapidly enriched their offering to better support the local tissue of tech entrepreneurs. That part is great. But a problem that’s not often raised -no one wants to publicly irk the hands that feed them, I guess- is the increasing institutionalization of venture commercialization actitivities that came with it: internal competition between agencies and “nonprofits” (whose employees clearly profited from this boom) are now leading some of them to expand into the private sector’s realm, for example by offering free market research and consulting services for start-ups. That move even goes against the public service mandate, as those services are generally only available to handpicked “clients”.

Even though it is motivated by a will to better support start-ups, it troubles me that the government and the bodies it supports increasingly choose to nationalize this activity as opposed to supporting the private providers already present. I didn’t leave the most successful communist country in the world – I’m talking of France – to land back in a growingly soviet-like environment, and have to make a living by begging for public grants! Hubs and catalysts are much needed. But it is to complement and promote, not replace, our private entrepreneurial ecosystem.

Sure, there is a lot of good work done hand-in-hand by private, public and publicly subsidized nonprofit organizations here, but when it comes to actual commercialization projects, it’s been my experience again and again that someone with a guaranteed salary and an institutional job simply doesn’t deliver as much value as a private sector provider whose next job depends on the quality of the one at hand. But unfortunately for us, it’s hard to compete with free. ”Free” also creates the wrong culture up north, with start-ups getting used to focusing on the technology and not investing much in commercialization and marketing, which obviously comes back to bite them. The higher valuation Americans place on commercialization activities, in my opinion, is another characteristic of the U.S. entrepreneurial ecosystem that still makes it more compelling than the Canadian one. With higher quotas for H1B visas, it won’t just attract better entrepreneurs , it will also attract better professionals to support those entrepreneurs.

As for VCs in Canada, there are few left, and so companies here are forced to look south or reduce their fundraising expectations and go after angels (who have done a tremendous job filling the gap left by VCs in early stages, but simply don’t have the same financial firepower). Interestingly, the VCs that are left also tend to only provide small amounts and thus really start looking more like angels with extra overheads. Among the Canadian clients I helped this year, and other start-ups I know here that received term sheets from Canadian VCs, not one accepted them. They went for local angels or U.S. VCs. Canadian VCs are stuck in the middle.

Luckily for Canada, U.S. H1Bs are not as compelling as the permanent residence our country is handing over to skilled workers, since they are tied to employment – it’s E visas and green cards the U.S. should make easier for entrepreneurs to obtain (and perhaps they are working on that too, I haven’t checked). But if the great Canadian advantage in facilitating entry and residence of skilled workers goes away, there will be little left here for immigrant entrepreneurs. A Canadian spouse and public healthcare (also something the U.S. may address) as the main reasons for most of them to stay here doesn’t make for great headlines about the state of our entrepreneurial system.

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Varun Mathur, the Techvibes Community Manager, who I just learnt is based in Toronto (I look forward to meeting you, Varun), made an excellent point yesterday in his Techvibes post on What Separates 37signals And Twitter ? 

For all the talk about “getting to revenue” as fast as possible, VCs are still valuing companies based on hype and unproven potential for exponential revenues. You can build valuations based on traffic, but if you can’t attach a realistic average $ amount to a visitor, and if you are going to hemorrhage your traffic as soon as you offer ads, then your valuation is built on shaky grounds – which in finance means you should likely be extremely conservative or discount it.

I don’t say there is never a case for giving high valuation to companies that have great brand awareness and usage even if they haven’t made a buck yet, but my thesis is that the risk of this revenue never materializing should lead to discounting valuations more heavily than they currently are. VCs should put their valuation through a simple risk-based, probabilistic tree analysis, contemplating the likelihood of 3 basic scenarios:

1. will never get to revenue and can’t sell or IPO company
2. can never get to revenue but can get company acquired
3. can get to revenue (and then look at the different types of revenue to differentiate linear from exponential in particular)

The problem, which ultimately has to do with the probability and payoff you attribute to each scenario, is especially with number 2. Even in this market, founders and VCs can rely on overpriced acquisitions to unload a company to an unsuspecting acquirer (hello eBay).  And so, with the right connections, the probability of scenario 2 is still implicitly weighted higher than it should likely be in VC valuation models.

My theory is that the Silicon Valley is an echo chamber for tech venture hype (just like Wall Street for blue chips), and a lot of founders and investors are masters at amplifying and riding this wave – rather than focusing on actually creating a revenue engine. In other words, ladies and gentlemen, yes, there are a lot of respectable-looking scammers in that business, and very successful ones too.  VCs won’t tell you this but lots of them love embracing irrational exuberance, because bubbles is how they get rich quick. 

Right now the real-time web is where this exuberance can be found. To Varun’s point questioning whether 37signals didn’t get Twitter-type valuation because of its Chicago location, I would add that perhaps the main reason why a valley-based Twitter will get a higher valuation than a Chicago-based or Canada-based twitter is that irrational exuberance dies off quickly when you have to take a 5h flight to close an acquisition -  reality-distortion fields don’t work well that far from the epicenter of the tech mecca. Locations that can turn perception into reality have a clear edge in businesses that rely on hypothesis for their valuation. So, yes, if 37signals want to reach astronomical values, it would do well to move to Mountain View or Palo Alto, drop any source of revenue, and change its name to reduce the likelihood their past revenue figures will constrain their future valuation.

However, that’s not all. In all fairness, one must point out that the potential for exponential revenues by 37signals as a platform developer targeting, well, application developers, is lower than a Twitter that can be used by potentially anyone. There is a lesson here for business models. Based on whether you target revenue or fundraising, your runway and product mix looks very different. In the first case (seeking revenues), you often need to diversify across a small range of products to test and create multiple sources of revenues – alpha, beta and subsequent market iterations are less dangerous because they don’t impact your long-term success as badly as a highly hyped flop from a VC-funded venture. You can fix things, there is less pressure to grow to $100M in 5 years, and quite often the decision to give you money is distributed across many potential users as opposed to concentrated on just a few VCs (who know and speak to each other).

In the second case (seeking capital), you often have only one chance to build buzz, and if it fails to support your story, it’s unlikely you’ll raise a round, and it’s likely you’ll die of capital thirst. So you want to bet the farm on one-single make-or-break application. It’s a different discipline. But still, the problem remains in the fundraising model, that it doesn’t encourage you to build your product with a revenue model in mind, until often too late in the game.

All in all, that’s a real problem for venture consultants like me as we generally encourage start-ups to get to revenue asap, and then a Twitter investment by VCs reactivates pipe dreams that all you need to do is a cool app and you’ll be a millionaire. If you are after VC money, it’s better not to make revenues if those are going to disprove the revenue potential of your model… Maybe that’s why new VCs need to emerge that don’t take a “winners take all” approach to investment, and instead focus on growing real revenues across their portfolio. Mmm, sounds like a hybrid of VC and management consultant… Did I just evolve my model? Thanks Varun!

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Develop, Fund 37signals, Capital Access - Financing, Initial public offering, monetization, revenue generation, Revenue model, Silicon Valley, tech venture, twitter, valuation, valuation model, venture capital

It’s official, the Ontario’s Emerging Technologies Fund (ETF)  is now open for business. This $250-million fund will co-invest into companies in high-growth sectors such as clean technology, life sciences and advanced health technology and digital media and information and communications technology. Co-investments are made along with qualified venture capital funds and other private investors. For more information see http://www.ocgc.gov.on.ca/

I am generally not a fan of public sector intervention in the private sector, but this comes as a positive move in contrast, since the government has wisely decided to let VCs and angels screen investments for the fund money instead of trying to do it itself. And frankly, after distorting the economy through massive subsidies to under-performing foreign car manufacturers, any public money directed towards innovative ventures is welcome. It also comes as somewhat of a relief to the Venture Capital industry in Canada, which is doing much worse than in the U.S. (yes that’s possible, apparently!), and is down to almost nothing according to this report by their association. Not that there was much in the first place!

The main question is whether there will be dollars to match. In other words, this program unlike, say, SR&ED, doesn’t make investments more attractive. It just makes it possible to invest in more companies. Since the VC model is under attack for its supposedly poor returns (with arguments I am still quite skeptical about, but that’s another story), all eyes are turned towards them to see whether they make use of that fund, or it goes primarily to Angel investments. After all, as the book Fool’s Gold asserts (thanks to the National Angel Capital Organization for the link), Angels Finance 27 Times More Start-ups Than VCs, at least in the US.

To ventures who wish to apply for a slice of this pie, my recommendation is to work both on your frontend, i.e. ultra-targeted pitches, b-plans, networking with VCs and Angels, influential advisory board, and your backend: management team, sales process, go-to-market and scaling strategy, monetization, exit. Those are both sides of the same coin, and unfortunately one of them often get neglected. Needless to say, we can help.

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Canadian entrepreneurs, Fund Angel investor, canada, Canadian innovation, emerging technologies fund, Ontario, venture capital

A great post 3 days ago by ReadWriteWeb COO Bernard Lunn on 10 Things to Be Clear About Before You Start a Company. I had the chance to meet Bernard last month at the Web 3.0 conference when we had dinner with a group of Web 3.0 business pioneers (including Alex Iskold of AdaptiveBlue and Andraz Tori of Zemanta). Bernard is one of those unassuming types with a bottomless wealth of knowledge activated on demand. You know, that type of folks everyone likes to have a conversation with, with a good glass of wine to complete the picture.

One of the many ideas that intrigued me in his post is that of checking whether you’re made to grow a lifestyle business, or to pursue a growth company. The reason it caught my attention is that lately I met a lot of tech entrepreneurs who started a business, acquired a few clients and grew revenues, and at that point started to play with the idea that they may need to raise money — and yet are far from clear on what changes this pathway will require from them and their business.

A number of those entrepreneurs, after putting everyone in marching order towards an external investment, end up not taking the plunge. While there are side benefits to preparing for an investment, the collateral damages of not taking it in the end outweigh those benefits. When the founder(s) (and their board when there is one) haven’t done their own groundwork beforehand, and aren’t ready to make the investment leap (of faith, in many cases) after pursuing it and even securing offers, it destroys value, hope and useful resources that could have been better deployed elsewhere. In fact it often ends up destroying the company itself.

That’s not to say a company founder shouldn’t be cautious about protecting her/his interest and that of the company from predators. It is critical to secure the best valuation by putting the company’s operations in order, finding the most attractive angle to document the story for the investor’s pitch, and adopting a systematic approach to raising investment that puts investors in competition with one another and keeps them on their toes. Without it, it’s normal to expect the company’s founder to hesitate.

But often, “doubts” about the potential investors and term sheets hide the darker truth that the founder sees all this as “letting the baby go” (which is often not the reality) and is not ready for it. It becomes an excuse for humming along thinking the sun will keep shining on the business and it “will continue to grow organically if we keep doing things right”. If this is true then don’t seek outside investment in the first place. Market validation has more cachet than any investor’s endorsement.

I wrote above that a founder rarely “has to” let the baby go. Any investor will tell you they’d rather keep the original founder at the helm if that founder shows the right level of flexibility and adaptivity to grow with the company. The trick is to start thinking in terms of “influence” not “control”. The main reason a founder is asked to let the baby go by external investors is that the founder stands in the way of growth by focusing too much on control, and not enough on influence.

There is a huge difference between getting a company to a few customers and taking it over what I’d call the “Growth Company Landmark”: the inflexion point at which most of what the CEO needs to do is managing other people and external investors, as opposed to securing new clients and running R&D. That point differs by type of business but, for many I came across, it was between $1M and $2M in revenue. At that stage, it is obvious to everyone that a huge transformation needs to take place and that the founding CEO needs to adapt, or curb the company’s growth.

Four evenings ago, I met a 52-year-old entrepreneur. As we kept chatting on the parking lot, he confided almost with tears in his eyes that he had once lost a fantastic outside investment opportunity, and regretted not to have been more aggressive in seeking growth and the corresponding financial resources. Now, by his one admission, he couldn’t get any of his three companies above the $2M mark. Such a waste of potential. Entrepreneurs, please, know what you want before you go for it.

Scale Bernard Lunn, business angel, growth company, innovation entrepreneurship, Investment, Outside invesment, ReadWriteWeb, tech ventures, venture capital, venture consulting, Zemanta

Canadian Business totally misses the mark in its poorly researched editorial on Ontario’s Green Energy Act and the Emerging Technologies Fund in the June 15 issue.

I support innovative ventures in the cleantech space on a daily basis through my consulting practice at Growthroute Ventures, and I recently co-authored an article entitled “Could Ontario be the Next Germany?” with regard to both the Act and the Fund, published in Renewable Energy World Magazine, the most widely-read magazine on clean energy.

As we all know, Ontario has been pouring money by the billion into the car manufacturing industry and other dinosaurs. It is about time some public support be devoted to innovation in cleantech. The Green Energy Act is modeled after the German incentives, which are recognized in the industry as widely successful. California, which Canadian Business refers to as a great model, has in fact been seriously discussing moving towards the German system. But more importantly, Canadian Business’s assertion that California’s model is significantly different in its support of clean energy — claiming it does so less selectively– is downright incorrect. Among many other examples, the western State pays a premium for 5 years on all solar photovoltaic projects, and offers select incentives to wind and biomass projects. This “winner-picking” approach Canadian Business criticizes is a constant in the energy industry, as a quick look into the huge tax incentives our government is offering for oil sand exploration, or all the public money that has gone into nuclear power R&D, would have told the editor. The support now offered to cleantech is a minuscule fraction of those amounts. If Canadian Business advocates for a leveled field, it should make sure it is looking at the entire field first.

As for the Emerging Technologies Fund, it is again just a drop going to innovation against the ocean of dollars poured into the US car manufacturing black hole. Canadian Business forgets to note that Quebec recently announced the launch of a fund offering over 3 times the amount of Ontario’s fund, and that la Belle Province is increasingly being seen as much more supportive to innovation than Ontario. Dismissing the Ontario’s ETF initiative on the basis that there is little venture capital money to match, and that “most VC-backed investments fail”, demonstrates a serious misunderstanding of how venture capital works. VCs bet that out of 10 investments, nine are going to fail or just get by, and one or two are going to make up in a big way for all the others. The metric that matters here is the investment ROI on the entire fund, not on individual investments. The VC industry raises its money from larger funds, who allocate their investments based on ROI and risk. Until now they had found it quite lucrative to place bets on VC funds.

But Canadian Business argues that VC investments are inherently too risky. Taking the magazine’s logic to its conclusion, it is not advocating against the Ontario fund as such, but against the VC model as a whole, in essence saying that VC investments are bad investments, and that no money should be put into that model. The truth is, the VC model may be under fire, but again, one needs just to take a look at the broader picture to see that is but a flawed assumption: how about the recent financial returns from the securities industry, the car manufacturing industry, or real estate? If we are to invest anywhere, I say putting more money in the hands of VCs (and angels too, by the way) is as good a bet as any. Actually, it is a much better bet.

The VC industry in the US is widely seen as a critical catalyst for the rise of the Silicon Valley. Companies like Google, eBay, Facebook, Cisco Systems and a number of other innovation heavyweights act as vivid proof that the model works. In my daily job, I constantly witness how the quasi-permanent lack of funding for early-stage innovation in Canada stifles growth and highly-qualified employment. I am not arguing against Canadian Business on the importance of letting markets do their magic, and getting out of the way, but at a time when the government is distorting those by throwing money at any moribund dinosaur that can still shout, I say any effort to direct funds to the innovative sector through the existing channels should be encouraged and supported. Certainly, reducing taxes and removing regulatory barriers to all forms of investment is needed (making it easier for US VCs to invest here is a definite need!), but it does not prevent other initiatives that leverage the power of targeted incentive towards sectors of strategic importance for our collective future.

Shame on you, Canadian Business, for popularizing half-baked arguments on the Green Energy and Green Economy Act and Ontario’s Emerging Technologies Fund. You couldn’t serve the purpose of traditional corporate money-grabbers any better, at a time when the job-creating innovative economy is in dire need of your support.

PS. And while I’m on Canadian Business, what is it with its choice for the “25 most influential people in business“? All white male except for one woman! The magazine might want to drink a bit of its own medicine, see their last-page article “Women wanted“, as I doubt there aren’t more females or visible minorities in the top 25…

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Canadian entrepreneurs canada, cleantech, emerging technologies fund, Fundraising links, green energy act, innovation, innovation policy, Ontario, venture capital, ventures

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Fund, Market business case, customers, Revenue model, technology commercialization, venture capital

My friend Fred Sweeney of VG Partners pointed me to this interesting call for help by the biotech industry in Canada, whose start-ups are finding it difficult to raise money to survive, let alone thrive. In these times of hardships, the ventures with the least obvious path to commercialization and revenue are the ones who suffer first and most. Given the lengthy development cycles and uncertain payout, biotech ventures evidently stand at the frontline of the crisis.

What all that shows is that a start-up should at all times be able to articulate the revenue model it is proposing to pursue. It should tie all its current efforts to this model, or “reverse-engineer revenue” as per the expression I coined at GrowthRoute. Doing just that provide three benefits: one, you stand in first row against competing start-ups when comes the time for VCs to hand out cash; two, keeping your eyes on the prize helps you identify where to focus your efforts today, and better allocate your current resources; three, spending some time thinking about how you will make money could point to nearer-term sources of revenue you may not have thought of.

Without a destination and a map to get there, you can have a tight ship and yet run it in circles. Better to never count on the government to get you back on track.

Develop, Fund biotech, biotech industry, business model, canada, commercialization, customers, eyes on the prize, Fred Sweeney, government programs, innovation, innovation entrepreneurship, Revenue model, Technology, technology commercialization, venture capital, vg partners