The Primer for Angel Investment in Canada

If you are new to Angel investing or if you are building a business, this primer will provide you with a great starting point for understanding the Angel framework in Canada. For a deeper dive into the asset class refer to A Practical Guide to Angel Investing at https://builtbyangels.com/resources

T HE P RIMER F OR A NGEL I NVESTMENT I N C ANADA

is published by

National Angel Organization (NAO) “Improving the Success of Angel Investors”

243 College Street, Suite 100 Toronto, Ontario M5T 1R5 Phone: (416) 971-4352 E-mail:info@angelinvestor.ca www.angelinvestor.ca

The National Angel Organization would like to thank RBC Financial Group for its support of Canadian angel investors and for making this publication possible.

T HE P RIMER F OR A NGEL I NVESTMENT I N C ANADA

C ANADA M UST I MPROVE I TS A BILITY T O C OMMERCIALIZE I DEAS Gordon M. Nixon, President and CEO, RBC Financial Group

Over the past decade, Canada has made great strides in developing the right macroeconomic conditions for improved growth and prosperity. But if Canadians are to sustain a high standard of living, they must become much better at turning innovation into profitable businesses. This is what the innovation debate is all about. It is here that Canadians are lagging – in research and development, in commercialization, and in growing new companies into viable enterprises with the scale and scope for long-term success. And it is here that angel investors across the country can and do make giant contributions to our collective prosperity. I trust angels across the country will find this inaugural edition of The Primer for Angel Investment in Canada to be an informative resource as they consider investment opportunities in the future. At home and around the world, Canadians have proven themselves as world-class researchers, innovators and entrepreneurs. Our big challenge remains our ability to commercialize innovation and create new and growing companies that provide good jobs in Canada and generate the wealth to sustain our quality of life. Angels take the new ideas of our scientists and entrepreneurs through the so-called “valley of death” – that very early stage in the life of an idea where the level of risk is at its highest and the financing the most difficult. This is where proof of concept is either established or where many potentially good ideas can die from lack of relatively modest funding. Angels also help facilitate the growth of at least some of our smaller companies into viable larger companies that are headquartered in Canada and have the potential to become international players. We don’t want to be in the position of simply providing the seed corn for enterprises in other parts of the world to profitably exploit. The time has come for the world of business, finance and government to review the regulatory, institutional and tax systems and consider changes that could be made to ensure that Canada has the financing system that meets the needs of the future economy. RBC Financial Group applauds the efforts of the National Angel Organization and others in this regard. As Canada’s largest financial institution, we support the activities of angel investors and others who are keen to contribute to our national prosperity. Quite clearly, the success of our economy and our ability to sustain and support a high standard of living for all Canadians will depend on our ability to start and to grow Canadian companies.

T HE P RIMER F OR A NGEL I NVESTMENT I N C ANADA

E DITOR ’ S N OTE I first heard of angel investors more than a decade ago when I wrote a column on small business issues for The Financial Post . At that time, information about early-stage investing was largely anecdotal and tended to focus on the practice almost as if it were the domain of the privileged few. There appeared to be no common bonds — either in existence or in development — between Canadian angels, venture capital firms, merchant banks or other private investors. This was a time when the Canadian mutual fund industry was in its infancy, and Canadians themselves were yet to wholeheartedly embrace investing as a means to wealth creation and preservation. Today, Canadians’ knowledge and understanding of investing is exponentially ahead of where it was in the early 1990s. It is also clear that angels and other investors have a great deal in common in terms of their objectives and appetites to equate risk with reward. But while Canadians have been quick to accept many different forms of investments and become a captive audience for an industry of financial experts, consultants and advisors, angel investors have not had a similar benefit of information sharing or counsel. Until recently, angels – who, by nature, take significant investment risk — have had to continue to rely on personal advisors and their own tried and true practices and principles for success. This book is an effort to bring together the best practices and principles that have helped Canadian angel investors succeed over the past years. Its genesis was the program and discussion at the 2002 Angel Investor Summit held in Toronto, but its content is the result of angels from across the country sharing their experiences for each others’ benefit. As such, this book is not exhaustive; it is a work in progress. As the National Angel Organization continues its work at raising awareness and discussion around issues related to angel investment in Canada, I hope that future volumes will improve and enhance the content of this effort. Much study has been recently devoted to the significant impact that early-stage investing, entrepreneurs and small and medium businesses have on the Canadian economy and the country’s prosperity. I hope this is a contribution to their continued success.

Chethan Lakshman RBC Financial Group Toronto Summer 2004

T HE P RIMER F OR A NGEL I NVESTMENT I N C ANADA

T ABLE O F C ONTENTS

C ANADA M UST I MPROVE I TS A BILITY

T O C OMMERCIALIZE I DEAS by Gordon M. Nixon E DITOR ’ S N OTE

by Chethan Lakshman F OREWORD

by Henry Vehovec

C HAPTER 1

T HE P ROSPERITY C HALLENGE

by Roger L. Martin

C HAPTER 2

D UE D ILIGENCE by Paul LaBarge

C HAPTER 3

A NGEL T RANSACTIONS :

I N S EARCH O F T HE I DEAL S TRUCTURE by Delilah Panio with input from Kevan Cowan, Warren Dowd, Alain Lambert and Wendy Thompson I NCUBATORS : A N A NGEL I NVESTOR ’ S B EST F RIEND ?

C HAPTER 4

by John Cook and Carolyn Dewar

C HAPTER 5

B RIDGING T HE G AP : H OW T HE P RUDENT A NGEL

C AN S URVIVE T HE D OWN -R OUNDS by W. Daniel Mothersill

C HAPTER 6

T HE S YNERGY B ETWEEN A NGEL N ETWORKS

A ND C ORPORATE V ENTURING by Bryan Pilsworth

C HAPTER 7

C REATING I NVESTMENT O PPORTUNITIES

T HROUGH T HE SDTC by Dr. Vicky Sharpe

C HAPTER 8

B UILDING A N A NGEL G ROUP

by Brad Ross with input from Ian Campbell, Joe Dales, Tony Farrow, and Mike Volker

C HAPTER 9

B UILDING A N ATIONAL A NGEL O RGANIZATION

by Henry Vehovec C HAPTER 10 T HE I NNOVATION AND P RODUCTIVITY T AX C REDIT – NEW A R ECOMMENDATION FOR C ANADA

A NGEL I NVESTOR L INKS

T HE P RIMER F OR A NGEL I NVESTMENT I N C ANADA

F OREWORD In the summer of 2003 we printed 2,500 copies of the inaugural Primer for Angel Investment in Canada. Published as a starting point for building awareness of the economic importance of early investing we weren’t quite sure what the demand would be. In the weeks that followed we received requests from entrepreneurs, investors, businessmen, consultants, academics and policymakers from all three levels of government across the country. By the time we reached the Montreal Angel Investor Summit in late October, we were already concerned about having enough copies for the almost 200 attendees.

We had struck a chord. Clearly there was and is an emerging grass roots awareness and realization of the importance of angel investing.

Angel investors have a reputation for being private, independent and even reclusive individuals that shy away from the limelight. They typically want to avoid being on lists, targets of junk mail and the recipients of ill-conceived business plans. The content of this document is comprised almost entirely by the volunteer efforts of angel investors and professionals working in the early capital formation space. Proofing, layout and publishing services have been generously donated by RBC Financial Group. In this extremely busy world people found the time and money to put this together. Why? A robust and active angel investor community is critical to the sustainable success of any economy. As multiple studies have shown, net new economic growth comes from small and medium sized enterprises. Collectively, angels invest more than five times the entire venture capital industry combined. Angels invest in some way or other in more than 60% of business start-ups. Angels address the funding, innovation and management gaps between love money and venture capital. Clearly, as economic stakeholders, we all benefit from the success of angel investors. Canadians’ standard of living can only be improved or maintained through continued prosperity that comes from ongoing productivity improvements. Productivity improves through innovation. Genuine innovation often is the result of the effort of small companies that are initially funded by angels, among others. I am particularly pleased and proud of the accomplishment this document represents. We have no pretensions that the content is comprehensive, exhaustive and conclusive with respect to sharing ideas and making recommendations regarding angel investing in Canada today. The Primer was originally conceived as a vehicle to capture the content of the National Angel Organization’s (NAO) Angel Investor Summit. As angels tend to be a diffuse lot, we hope the Primer will act as a collection area for ideas; a provocative catalyst to build awareness and offer support and encouragement for all of us to build and enrich our own businesses, angel groups and networks.

T HE P RIMER F OR A NGEL I NVESTMENT I N C ANADA

The Primer is a starting point not only for those new to angel investing or building a business but also for the NAO. The NAO’s mission is to help angel investors become more successful and thereby help the economy. We are building a truly representative group of 100 Founders that will span geographies, industries, clusters, generations and cultures. All angel investors who read this Primer are invited to join us on our journey. Challenge the thinking of what you read in the chapters ahead and let us know your thoughts. We hope what you read inspires you to get involved or perhaps make a future submission yourself. Good things don’t happen by themselves. Collectively we can and need to make a real difference. In the foreword to the first edition we challenged readers to help us build on the angel initiative. NAO members were invited to speak at events from coast to coast. In Nova Scotia, we met nascent and emerging angel groups. In British Columbia we helped kick off the country’s first women’s angel network. As NAO Chair, I was invited to speak at separate national conferences encouraging business development in technology, life sciences and clean energy industries. In response to Finance Minister John Manley’s request for input to the federal budget we conducted round table discussions with a total of more than one hundred angels in Halifax, Quebec, Montreal, Ottawa, Kingston, Toronto, Golden Horseshoe, London Edmonton, Calgary and Vancouver. At the Angel Investor Summit, NAO Public Policy Committee Chair Andrew Wilkes moderated a debate deliberating the benefits of various tax incentive schemes. I am thrilled to report that we have been able to include a three-page summary of those discussions in this second printing of this Primer (see page 73). The full version is posted as a PDF on our website (www.angelinvestor.ca). We have received many ideas for follow-on editions of this Primer yet feel compelled to produce another run of this first issue as it is still relevant and there continues to be high demand. Angel investing touches every aspect of economic development that is critical to maintaining our standard of living. In subsequent issues and publications we will provide information on aboriginal angel investing, cluster specific investing issues, the importance of angels in social capital and venture philanthropy. We will also comment on the cultural and structural shifts that must take place if Canada is to become the most attractive jurisdiction in the world in which to make early investments.

To those that read this and see that it can be better, I ask you to join us. I look forward to hearing from you and hope to see you at the NAO Summit in Calgary on September 27-29, 2004.

Henry Vehovec Chair, Founder & Member, Founding 100 National Angel Organization Summer 2004

A CKNOWLEDGEMENTS Pulling together this primer was an exercise that exhibited qualities typical of the work of successful angels: cooperation, selflessness, expertise and excellence. Henry Vehovec, as the guiding and official leader of the National Angel Organization, and David Moorcroft, RBC Financial Group’s senior vice-president of Corporate Communications, spearheaded the book’s creation and made sure it came together. Chethan Lakshman, also from RBC, donated time and editorial skills to ensuring the copy flows. Martin Jones and the team at Advance Planning Communications smoothed many rough spots to make the piece better and Kathy Watt of Graphika is responsible for the project’s compelling design and layout. Finally, Tony Payne of Transcontinental O’Keefe Printing brought all these efforts together in the bound volume you now hold in your hands. In addition to all the authors and contributors who took the time to share their opinions and insights, Kerri-Lynn Hauck, Ian Campbell, Michael Brougham and Jamie Nelson served as scribes and note-takers during the sessions of the 2002 Angel Investor Summit – where seeds for much of this project were planted. We would also like to thank members of the NAO board of directors for their guidance and contribution: Alfred Apps, Ed Babineau, Ian Bandeen, Philip Belec, Bob Chaworth-Musters, Warren Dowd, David Glue, Bernard Hamel, Paul LaBarge, Andrew Wilkes. Dan Mothersill while wearing many hats including contributing author, NAO communications chair and board member, continued to prove that he is a connoisseur of all fine things, including writing and ideas. Last, and certainly not least, the ongoing work of Rob Henderson, general manager of the NAO, deserves special recognition for this project’s success – from conception to completion.

Henry Vehovec and Chethan Lakshman

C HAPTER 1

S U M M A R Y As Roger Martin, dean of the Rotman School of Management at University of Toronto, notes in the accompanying speech first delivered to the Canadian Club in Toronto in January 2003, Ontario is failing to keep pace with comparable economies in the U.S. In fact, compared with the 14 U.S. states larger than half Ontario’s size – from Indiana and Massachusetts to New York and California – Ontario ranked 14th, ahead of only Florida. Worse still, our relative competitiveness and prosperity are falling. In 1980, Ontario ranked 11 th among this elite group and was $850 per capita behind the median; in 2000, Ontario ranked 14 th and was $5,900 per capita behind. Martin, who is also chairman of Ontario’s Task Force on Competitiveness, Productivity and Economic Progress, focuses on Ontario’s performance. However, his remarks are relevant for Canada as a whole. Among his conclusions is that Canadians need to invest significantly more in our future prosperity. By investing in and supporting the development of early-stage companies, angels are making a valued contribution to Canada’s prosperity and helping to nurture a future

T HE P ROSPERITY C HALLENGE by Roger L. Martin

I am pleased to speak to you today on behalf of my fellow members of the Task Force on Competitiveness, Productivity and Economic Progress. At issue is the competitiveness and economic prosperity of our province. Let’s start with the good news. Ontario is a terrifically prosperous place by global standards. If it were a country, it would rank second in the world in prosperity. And it is actually larger in population than all but the U.S. in the top ten countries. So it is the richest consequential jurisdiction outside America. This is very good news for Ontarians. However, there is more sobering news, which we need to take to heart and take action on. We have looked closely at Ontario versus our true peers — which are not small countries, because we are considerably more prosperous than them. Instead, we compared Ontario to the 14 U.S. states larger than half our size — from Indiana and Massachusetts on the small end and New York and California at the large end. Unfortunately, in this more elite group we rank 14 th out of 15, ahead of only Florida. And worse still, our competitiveness and prosperity relative to this group are falling. In 1980, we ranked 11 th and were $850 per capita behind the median; in 2000 we ranked 14 th and were $5,900 per capita behind. What does it mean to be $5,900 behind in GDP per capita? It translates almost exactly into $10,000 per Ontario household in after-tax disposable income. Think about it this way: $10,000 per Ontario household in after- tax income is slightly more than all the money spent in Ontario on mortgages, plus rent, plus new car purchases.

economy that can be competitive with the best in the world.

C HAPTER 1: T HE P ROSPERITY C HALLENGE

Raising our performance by $5,900 would fill the government coffers as well. It would enable Ontario to double annual spending on all levels of education with its portion and the federal government to use its Ontario portion to fund the entire Romanow bill. So the harsh truth is, we are not keeping pace with the finest economies in the world. The difference between the standard of living in Massachusetts and Ontario is exactly the same as the difference between Ontario and Slovenia. What explains the gap? At its simplest level, an economy generates prosperity when four factors are positive: • a high proportion of its citizens are capable of working; • a high proportion of those capable of work both want to work and can find gainful employment; We can relate Ontario’s $6,000 per capita gap to these four areas as follows: • On the first factor, it turns out that Ontario has more working age citizens proportionately than our peer states – providing us with an advantage of $1,000 per capita. • On the second factor, more Ontarians seek to work than those in peer states, but our unemployment rate is higher – creating a net disadvantage of about $750 per capita. The state numbers are unavailable for 2002, but when they come out, they will probably show what the U.S./Canada numbers show, which is that Canada is $250 per capita ahead. • On the third factor, Ontarians work approximately as hard as those in peer states – as of 2000, the disadvantage was $400 per capita. On the basis of these first three factors, Ontario is even with its peer states. Proportionately, it has as many people working as hard as the leading economies in the world. Nothing yet explains the $6,000 per capita gap. • The fourth factor, productivity is the big challenge. When dedicated Ontarians work an hour, do they work as productively as an employee in the average peer state? The answer is no, to the tune of the entire gap of $6,000 per capita. And why is that? Is it because they work in bad industries, industries that have lower productivity potential? The answer is no. We have done the most comprehensive analysis ever of the structure of Ontario industry against the structure of the peer states and, in fact, Ontario has, on balance, a superior mix. This should result in an advantage of $1,000 per capita if everything else is equal. Are these industries being hollowed out? That is, do we have the worst parts of the industries we are in? We don’t yet have an absolutely definitive answer, but the initial data suggests strongly that the answer is “no”. In fact an analysis of two-thirds of the industries suggests that the composition of our individual industries should provide an advantage of approximately $600 per capita, other things being equal. • those who do find employment, work hard; • and they work productively and effectively. This leaves an actual gap of over $7,000 per capita. There are two main pieces to the gap. First is our level of urbanization. It turns out that because of scale economies and the benefits of agglomeration, we can expect a worker in an urban environment to be more productive than one

C HAPTER 1: T HE P ROSPERITY C HALLENGE

outside of an urban area. And Ontario is considerably more rural than its peer states – 72 per cent versus 82 per cent. As a result, we would expect Ontario’s productivity to be $3,000 per capita less than the median of our peer states. That leaves a gap of over $4,000 per capita per person – for a worker in the same part of the same industry in the same type of environment. What accounts for the remainder? We don’t fully know yet, but there are pieces of the puzzle that we do know and others that we are in the process of exploring.

In total, we posit four pieces:

• The clearest piece of the puzzle is investment . In two critical ways, we invest significantly less in enabling our workers than our peer states. The first is investing in machinery and equipment (M&E) that makes workers more productive. Over the past 20 years (and probably more, but that is as far back with the data that we have gone), Ontario enterprises have invested 14 per cent less in M&E annually than the enterprises of our peer states. Suffice it to say, 14 per cent per year, decade after decade, adds up. The second is in higher education. While Ontario invests as much in K-12 and colleges as its U.S. peers, the U.S. peers invest just less than double, per capita and per student, in university education. And by U.S. peers, we don’t mean governments. We mean the entire jurisdiction, from all sources, including government funding, tuition and donations. In total, we graduate 92 per cent of the university students annually and spend 55 per cent per student compared to our peer states. This is a major problem for productivity. The data is extremely clear: higher levels of education are tightly correlated with higher wages, and higher wages are tightly correlated with higher productivity.

So more education produces more productive workers.

On this front, we invest considerably less to produce considerably less productive workers on average. So investment is the first explanation and the data is quite clear: We invest less and we get less. • The second issue, related to the first, is motivation – motivation as individuals to work and invest, and motivation as firms to invest. Motivations are influenced by the marginal tax rates faced by labour and capital. Ontario’s marginal tax rates on labour and capital are considerably above those of our representative peer states, suggesting that our motivations to work and invest are lower – which may partially explain the investment numbers I touched on earlier.

C HAPTER 1: T HE P ROSPERITY C HALLENGE

• The third issue, which is related to investment and motivation, is aspirations . We are analyzing this question as we speak, but our view from the initial data is that Ontario firms have systematically lower aspirations with respect to competing internationally than their peer states. This results in lower investments in R&D, branding, international distribution and innovation in general. • The fourth issue is the structures of our key markets and institutions. On this front, we know that one feature of the Ontario structure is that government is more highly involved in the economy than in the peer states when measured by the government’s revenues as a share of GDP. Ontario’s is higher than all peer states other than Florida, which is poorer than Ontario. And this may have an effect. The net combined effect, we hypothesize, is that because of lower aspirations, we invest less in education and M&E. And we are motivated to aspire lower and invest less by high marginal tax rates on capital and labour. These high marginal tax rates are a product of a structure by which our governments process a higher share of our output than those of our peers.

So what does Ontario need to do to close the $6,000 per capita gap in prosperity – or more to the point, the $7,000 per capita gap in productivity?

The $3,000 per capita attributable to our rural structure will take a long time and may not be in the interests of Ontarians in general. But what about the $4,000 per capita gap in effectiveness? Some suggestions: • We need to raise our aspirations with respect to upgrading ourselves and the way in which we compete. This is doable. We just need to try harder. • We need to figure out how to tax in a more effective manner — one that enables us to collect the revenue we need without producing the high marginal rates that reduce motivations. This is not a race to the bottom. Massachusetts, now the richest jurisdiction on the planet, has figured out ways to collect substantial revenues in a way that appears less harmful to motivations. • We simply need to invest more in our future prosperity. This includes both M&E and higher education. We need to invest more instead of consuming. Our work on this question is incomplete, but from what we can tell, the various levels of our government spend more on consumption of current prosperity versus investment in future prosperity compared to our peers. In aggregate, Ontario and our 14 peers spend the same proportion of their total spending – 32 per cent – on a combination of debt service, basic government operations, environment and protection. Of the remaining 68 per cent, they can choose to spend on consumption of current prosperity – health care, social security, social services, income stabilization, culture and recreation – or investment in future prosperity – education, transportation and communication, infrastructure, and research and development.

C HAPTER 1: T HE P ROSPERITY C HALLENGE

Ontario’s proportion is 72 per cent consumption and 28 per cent investment. The peer states show a markedly higher 36 per cent proportion of investment. This is a big deal. If our proportion were the same as the peer states, it would mean $6.5 billion per year in greater investment in the province of Ontario, or $65 billion per decade. That would mean a vastly different future, a future more like that of Massachusetts, which can spend three per cent more than Ontario per person on current needs while continuously spending 50 per cent more on generating future prosperity. I believe this is doable, but it will take the will of individual Ontario citizens, of Ontario corporations and of our governments – provincial, federal and municipal. It will take a new kind of will, the will to overcome the comfortable but unproductive, status quo. I will give an example of one such issue: university tuition, which is currently regulated at a level of $4,100 for everything except professional schools. And that level is in the middle of five years of increases regulated at two per cent — considerably below inflation, so that real tuition will fall steadily over the five-year period. And before the conclusion is jumped to that this is all about self-interest, I want to make clear that all the programs in my school are deregulated already, so what I am talking about would not help me at all. Thankfully, this government deregulated professional school tuition in the mid-1990s. Had they not done this, I most certainly would not be dean of the Rotman School, nor chairman of the Task Force on Competitiveness, Productivity and Economic Progress. When he was president of the University of Toronto, Rob Prichard first asked me to consider taking this job of dean of the Rotman School. My first reaction was to decline. A key reason was that I had been out of Canada for long enough to have been unaware of the deregulation of professional school tuitions. And my assumption was that they were still regulated. I felt that there was no reason to consider leading a school that had absolutely no chance to compete internationally. But fortunately, the current government made the change, and as a consequence we have taken on the challenge of building a globally competitive business school in Ontario – as have several of our fellow schools.

Let’s explore the facts regarding regulated tuition.

Level of education is tightly correlated with wages, productivity and prosperity. A better educated population makes for a more prosperous province. That notwithstanding, we invest only half the level of our peers states in higher education. We do this by having a system that, until very recently, has been a regulated monopoly – only public universities were allowed. And our provincial government, in addition to reducing real funding, maintained strictly regulated tuition at a low level and one that has been falling in real terms. So students and their parents are prevented from investing in the very universities that the government underfunds. This suppression of tuition is bad for the prosperity of our province.

C HAPTER 1: T HE P ROSPERITY C HALLENGE

That notwithstanding, there is a universal consensus that tuition should be suppressed – an absolutely rock-solid, universal consensus. Each political party believes it strongly. The Progressive Conservatives have been and continue to be committed to falling real tuition. The Liberals have promised to go further and freeze tuition. And the NDP — who knows? But none of these parties are crazy. Their polling numbers show that the electorate is overwhelmingly behind suppressing tuition. And students are vigorously and vocally against any increases in tuition. Even university professors are generally against increases in tuition. So what supports and sustains this powerful consensus? First, it is comfortable. “No increase” feels better, for all the above groups, than does an increase and the hassles that would come with it. Second is the issue of access. The fear is that with higher tuition, access will be impacted negatively. This is a very important issue, which we should explore. Tuition is indeed higher in the U.S., including in our peer states, though not nearly so much higher as the comparison to US$35,000 Ivy League tuitions make it sound. Fifty-four per cent of full time U.S. students pay tuition (including fees) of US$5,000 or less, many pay a lot less. The average across all full-time students is US$9,000. So tuition is indeed higher in the U.S. — and that logically creates a question of access. However, it must be understood that increased education has a strong private return to the individual for each increasing level of education. This is well documented. Thus, it is in the student’s interest to invest in his or her education because it pays off. So, if the higher tuition in the U.S. discourages access among less well-to-do students, we should expect to observe higher participation rates in university education among the poor in Canada versus the U.S. Otherwise there would be no accessibility problem linked to higher tuition levels. And among well-to-do kids, we would expect equally high participation in Canada as in the U.S., because they should be insensitive to the cost of education and should understand the economic benefit to which I just referred. If anything, participation among wealthy kids in Canada should be higher if they show any price sensitivity at all. In Canada, wealthy kids should participate at a rate at least as high as in the U.S., and poor kids at a greater rate. We should observe higher participation in Canada than the US, if accessibility is the real problem. So let’s go to the data. Per 1,000 of population, the U.S. graduates more university students per year than Ontario by eight per cent and more than Canada by 23 per cent. This is the opposite of what the above accessibility theory holds.

C HAPTER 1: T HE P ROSPERITY C HALLENGE

So the U.S. has managed to deal with its accessibility problem better than Canada despite higher tuition. That is, unless our accessibility to the poor is higher, and our overall numbers are lower because our wealthy kids skip university because they are lazier and less intelligent than their U.S. counterparts. I don’t believe this. The political left, in particular, has this issue all wrong. It should actually read more Karl Marx, who in 1890 launched a blistering attack on subsidized university tuition, arguing that it is simply a subsidy for the rich out of general tax revenues. He is right and the left is wrong. High tuitions in the U.S. help to fund generous scholarships for needy students. Is U.S. accessibility perfect? Hardly, but higher U.S. tuition has not led to lower accessibility than in Ontario. And the conservatives have it wrong as well. True economic prosperity depends heavily on higher education, and starving higher education isn’t helping a bit. Students also have it wrong. This is the most important investment they will likely make in their lives, and suppressing its quality does nobody a bit of good. And parents have it wrong. This is the best investment they can make on behalf of their children. Basically, this is an issue in which every relevant constituency is dead wrong — and they have no logic or data to buttress their views. The status quo is comfortable and remains well entrenched in an unwitting conspiracy of corrosive complacency. As such, it is a challenge of will: will to do the best thing for Ontario’s future. Ontario faces a choice. We need to show will on this issue if we are to reverse the slide and close the prosperity gap. Without will, we will continue to slide, and in relatively short order, will lose complete touch with the lead pack of prosperous economies.

C HAPTER 1: T HE P ROSPERITY C HALLENGE

A UTHOR

Roger L. Martin is dean of the Joseph L. Rotman School of Management at the University of Toronto. He was appointed to a seven-year term beginning in September 1998. He is also a professor of strategic management at the Rotman School. A Canadian from Wallenstein, Ontario, Roger was formerly a director of Monitor Company, a global strategy consulting firm based in Cambridge, Massachusetts. During his 13 years with Monitor, he founded and chaired Monitor University, the firm’s educational arm, served as co-head of the firm for two years, and founded the Canadian office. His research interests lie in the areas of global competitiveness, integrative thinking, and organizational learning. He has written Harvard Business Review articles in 1993, 2002 and 2003. His first book, The Responsibility Virus: How Control Freaks, Shrinking Violets - And the Rest of Us — Can Harness The Power of True Partnership (Basic Books), was published in October 2002. He writes extensively on Canadian competitiveness policy in The Globe and Mail , National Post and Time magazine. He is currently chair of the Ontario Task Force on Competitiveness, Productivity and Economic Progress. Roger received his AB from Harvard College, with a concentration in economics, in 1979 and his MBA from the Harvard Business School in 1981. He serves as a director for The Thomson Corporation; is on the Advisory Boards of Butterfield & Robinson and Social Capital Partners; is a founder of E-magine; and is a trustee of The Hospital for Sick Children in Toronto.

C HAPTER 2

S U M M A R Y Before investing, angels are cautioned to conduct due diligence on five key elements of the company, these being the legal, financial, technology, marketing and human resources aspects. The experience of many investors is that failure in just a few items can easily result in failure overall. The article lists a number of questions to ask with respect to each of these categories and provides six warning signs of a potentially flawed deal. Investors are also advised to understand the core technology and validate the fundamental values of the individuals involved, as this will provide the best index as to whether or not an investment should be made.

D UE D ILIGENCE by Paul LaBarge

INTRODUCTION There are five key elements that angels should consider before investing in a particular enterprise. These are the legal, financial, technology, marketing and human resources aspects of the company. Each of these areas presents the investor with several fundamental issues, which should be examined and addressed before embarking on an investment. The experience of many investors is that a failure in just a few items can easily result in failure overall. Thus a major challenge for investors is to distinguish between those items that are deficiencies, and can be remedied, and those items which are fundamental flaws.

TECHNOLOGY There are several factors to consider with technology. For instance, is there a demonstrated demand for the product? Creating a superior rat-trap – or even a wholly new product or technology for which there is little consumer need – will rarely result in a well-trod path to the company’s door. A product’s success is directly related to its utility. Secondly, will the technology function reliably under the real-world conditions proposed? To what extent has it been effectively tested? Does the technology offer benefits that are not available from competing products – such as added functions or features or lower costs – or does it simply duplicate offerings currently available? Is the technology protected? Are patents in place? To the extent that there is no proprietary technology, what evidence is there of an ability to create a competitive business? Efforts should also be made to check the employment history of management and to determine whether or not the technology or any part of it was engendered in the course of prior employment. Former employers may have substantial resources dedicated to the enforcement of their patent and technology rights.

C HAPTER 2: D UE D ILIGENCE

An investor is also advised to understand the technology from the bottom up. This often involves talking to the full development team. It’s not unusual for senior people to have a limited grasp of the internal workings of the technology. Finally, it is important to be honest with yourself as an investor. To what extent do you actually understand the technology and how it works? If you do not, it may be advisable to solicit the advice of a third party expert or simply walk away from the opportunity. HUMAN RESOURCES As an angel investor, you are betting on the talents of the management team, its ideas and its core values. How well do you know these people? Are their values aligned with yours and can you work closely with them to move the company forward? What have they achieved in the past and what are their reputations among their colleagues or in their industry? What is their previous history with investors? Unfortunately, there are entrepreneurs who move from one failed venture to another, and seemingly, have no problem raising money from naïve investors. In considering the management team, ask yourself whether or not they represent a full package. Does the group understand the marketing, financial and intellectual property implications of their venture, or are they just a “one-trick” pony? Who really contributed the most to the group’s innovative ideas? Is that person still with the venture and still participating in a meaningful way? Credentials are an important part of the assessment process, bearing in mind that they do not necessarily tell the whole story. There are many talented and experienced people with limited or no university backgrounds. Consequently, an assessment of each individual’s participation in the development of the technology may yield a more realistic assessment of the team capabilities than would their CVs. FINANCE Take time to assess the true value of the investment you are making. During the technology bubble in the late 90s, many angels failed to do this and sometimes lost their entire investment. High valuations usually lead to unrealistic expectations and endanger an angel’s investment in the next financing round. Valuations must be based on sound and realistic projections. A financial spreadsheet is germane only to the extent that the underlying assumptions are realistic or factual. Consequently, investors should focus on the assumptions. In particular, the absence of certain items in the financial material may indicate a lack of understanding or expertise with regard to the overall business operation. Also, pay close attention to indicators that demonstrate whether or not the entrepreneur has the capability to build a successful business. These include such metrics as revenues per employee and sales cycle, and such considerations as adequacy of staffing and the investment infrastructure.

C HAPTER 2: D UE D ILIGENCE

LEGAL The existence of proper incorporation and the shareholders agreement will tell you a great deal about the sophistication of the people involved. One element that can consume inordinate time is trying to understand the dynamic between the participants in the venture. Shareholder agreements will not, by themselves, adequately protect the investor in the case of ill will. However, the process of negotiating an agreement or reviewing the terms of the existing agreement may yield insight into the ethics and values of the individuals. In assessing the feasibility of the enterprise, investors should examine the level of fairness within the existing structure. A failure to recognize the contribution of essential participants may be a signal that the enterprise does not have the necessary cohesiveness to succeed. Investors should also be aware that an excessively complicated share structure may become a substantial distraction from the operations of the business. The enterprise is best served when shareholders have a unity of interest. MARKETING This often proves the weakest link in a new venture. How realistic are the proposals in the business plan for moving the product into the marketplace? In fact, do the principals even have a business plan? Are they familiar with the channels in their industry and do they have a plan for accessing them? Who, if anyone, among the principals has a track record in marketing – and is that track record in the same industry as the current venture? WARNING FLAGS Sometimes, angels are wise to walk away from a potential investment. Here are a few signs that trouble may lie ahead:

1. To the extent that there are inconsistencies in values, or trust is not present, then no investment should be made.

2. If there is resistance to due diligence and if people are defensive in their response, than there are probably buried issues. 3. If the deal has been shopped around, one must ask why others have refused to invest and what negatives are present. 4. Excessive passion for the technology may demonstrate an unwillingness to be flexible in meeting the needs of the marketplace. 5. Evasive responses and lack of market knowledge about competitive technologies and alternate solutions probably indicate that the entrepreneur does not have the requisite competence to justify an angel’s participation. 6. And finally, one should be realistic with respect to the likelihood of working productively with the people leading this venture.

C HAPTER 2: D UE D ILIGENCE

CONCLUSION The lessons of due diligence are two-fold. First, there are a series of questions that every investor should ask and that will provide the analysis necessary to make an appropriate business decision. Secondly, the investor can avoid the potential for analysis paralysis by making the effort to understand the core technology and validate the fundamental values of the individuals involved. This will provide the best index as to whether or not an investment should be made.

A UTHOR

Paul C. LaBarge Partner, LaBarge Weinstein

Paul C. LaBarge is one of the founding partners of the firm of LaBarge Weinstein, a business law firm established in Ottawa in 1997 and concentrating in the technology sector. Prior to founding his current firm, he was a partner with Gowling & Henderson, Lang Michener and later established the Ottawa office of Blake, Cassels & Graydon. He received his BA in Economics from McMaster University, law degree from Osgoode Hall Law School and was called to the Bar in 1976. His practice today concentrates primarily in tax, corporate law and mergers and acquisitions. He has extensive experience in legal and financing transactions not only in the technology sector but also in natural resources, real estate and the privatization of public entities. He is currently a director of a number of publicly-listed and numerous private technology companies.

A NGEL T RANSACTIONS : I N S EARCH O F T HE I DEAL S TRUCTURE by Delilah Panio with input from Kevan Cowan, Warren Dowd, Alain Lambert and Wendy Thompson C HAPTER 3

S U M M A R Y By pooling assets, angel

investors can share the risks and leverage the expertise of partners. They can also participate in offerings with high-quality private growth companies, which may not be available to the individual angel investor. This article examines two specific types of structures that facilitate group investing – limited partnerships and capital pool companies – and discusses the benefits and disadvantages of each. It also outlines two other structures, which are currently unavailable, but are worth considering for the future.

INTRODUCTION

In response to current market conditions, angel investors are looking for ways to minimize risk while contributing to the development of new ventures. Clustering or investing in groups has been identified as one means for angel investors to reduce transaction costs while increasing opportunities and returns.

By pooling assets, angel investors can share the risks and leverage the expertise of partners. They can also participate in offerings with high-quality private growth companies, which may not be available to the individual angel investor. This approach also gives investors more negotiating power with respect to the terms of the financing and the direction of the business. And by pooling their money, angel investors can present an attractive value proposition to growth companies that readily competes with formal venture capital dollars. While there is no “ideal” angel structure, this paper will address two specific types of structures that facilitate group investing: limited partnerships and the Capital Pool Company TM (CPC TM )program of TSX Venture Exchange TM . It also outlines two other structures, which are currently unavailable, but are worth considering for the future. LIMITED PARTNERSHIPS Angels have used limited partnerships for many years as a way to bring together capital and expertise for specific investments. Syndication allows for greater leverage of funds than individual investors can achieve on their own. HOW LIMITED PARTNERSHIPS WORK In Canada, a limited partnership is formed between a general partner, who is liable to all creditors of the business, and limited partners, whose liability is limited to the capital contributed to the partnership. Limited partners are not allowed to participate in the management or operations of the business or they risk losing their limited liability status.

Capital Pool Company, CPC and TSX Venture Exchange are trademarks of TSX Inc.

C HAPTER 3: A NGEL T RANSACTIONS : I N S EARCH O F T HE I DEAL S TRUCTURE

In Canada, limited partnerships are regulated under provincial legislation.

According to the Ontario Limited Partnerships Act:

13. (1) Limited partner in control of business. – A limited partner is not liable as a general partner unless, in addition to exercising rights and powers as a limited partner, the limited partner takes part in the control of the business. (Source: Consolidated Ontario Business Corporations Act, Related Statutes and Regulations, 25 th Ed., 2002) A key issue is determining when a limited partner’s activities amount to participation in the management or operations of the company. This issue is further complicated if the limited partner is itself a corporation. If a limited partnership is to be used, qualified legal advice should be obtained. WHY ANGELS SHOULD CARE Limited partnerships offer angels several advantages. They allow angels to syndicate on bigger deals than they might otherwise have access to. They distribute the transaction costs, which in turn facilitates comprehensive due diligence and the negotiation of more favourable investment terms. The liability of the limited partner is limited to the size of its investment. And limited partnerships can be structured to allow for investments in single or multiple targets over time. For example, the limited partnership could make calls for additional funds from limited partners for subsequent investments. There are also disadvantages with limited partnerships, however, and angels should be aware of them. In particular, limited partners cannot be active in the management or operations of the limited partnership or the target company. This will be a negative feature for many angels who like to be actively involved in the businesses in which they invest. As well, establishing the limited partnership can add complication and expense. CAPITAL POOL COMPANY TM (CPC TM ) PROGRAM The Capital Pool Company (CPC) is a product of TSX Venture Exchange and originated with the Junior Capital Pool (JCP) program on the Alberta Stock Exchange in the 1980s. The CPC is an alternative route to the traditional initial public offering (IPO) or reverse take-over (RTO) for taking a company public. The CPC program is currently available to residents of British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, and Quebec. This means that residents of these jurisdictions can participate in the initial public offering of the CPC. HOW THE CPC PROGRAM WORKS The CPC program introduces investors with financial market experience to entrepreneurs with development-stage companies requiring capital and public company management expertise. Unlike a traditional IPO, the CPC program enables seasoned directors to form a Capital Pool Company with

Capital Pool Company and CPC are trademarks of TSX Inc. and are under license by TSX Venture Exchange.

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