SME Financing in Canada, 2002 — Part I: Risk Capital

Initial Public Offerings

Entry into public equity markets offers mature SMEs increased access to the capital they need to finance larger-scale operations and to facilitate sustained growth. Post-initial public offering (IPO) risk capital financing is required for SMEs to meet financing needs that have exceeded their ability to borrow. This type of financing is particularly important for SMEs in KBIs.

An IPO of shares on a stock exchange is often the "exit strategy" of choice for VC funds, as once a public market is established they can sell their shares. Through IPOs, historically, venture capitalists have achieved the maximum value for their investment. However, going public is not without its disadvantages. The capital raised through an IPO is seldom sufficient to meet all the company's growth requirements. However, once on the stock market the company's ability to raise capital through further issues of shares is dependent to a large extent on the performance of the stock market, which may be little influenced by an individual company's performance.

Getting the price, the size and the timing of the share issue right is an art, and the extent to which the company succeeds in this will have an influence on its ability to make future issues. However, these are only some of the factors that influence any decision to use this financing option. Other factors relate to the internal readiness of the firm – demonstrated by a strong financial position – which is needed to carry it through the IPO and sometimes difficult post-IPO stages.^{Footnote 31} These factors may include:

• a capable and experienced management team;
• a prominent board of directors;
• an experienced team of financial, legal and underwriter advisors;
• innovative new products;
• a new business concept;
• a large market share; and
• a consistent record of high growth or high growth potential.

Achieving many of these criteria is difficult, especially for SMEs in the high growth stage. Apart from this, the success of any IPO ultimately depends on firm performance, economic and market conditions. If these conditions deteriorate when a company wants to go public, valuation acceptable to the marketplace may not provide sufficient capital to the company, and could dilute the ownership and valuations of existing shareholders to the point where it is not attractive to undertake the IPO – which could lead to prolonged problems for the company.

Structure of Canadian Exchanges

In 1999 the Toronto Stock Exchange (TSE), along with the Montreal, Vancouver and Alberta exchanges were restructured which brought the competition that once existed among the Canadian exchanges to an end, although the competition between exchanges and markets worldwide has never been greater. The TSE has become Canada's premier stock exchange, capturing 98 percent of value traded on Canadian stock exchanges in 2000 and becoming the fourth most active stock exchange in North America after the New York Stock Exchange (NYSE), NASDAQ (North American Securities Dealers' Quotations) and the Chicago Stock Exchange.^{Footnote 32} In 2000, NASDAQ Canada^{Footnote 33} was opened in Montreal as a wholly-owned subsidiary of the New York-based NASDAQ market. This new stock exchange gives Canadians the opportunity to invest directly from Canada in all 4,100 NASDAQ stocks through Canadian brokers. According to NASDAQ Canada, 142 Canadian securities are listed on NASDAQ and 42 Canadian companies are solely listed on NASDAQ U.S.

The Canadian Venture Exchange was created in 1999 through the merger of the Vancouver and Alberta exchanges, creating a national junior market in Canada with offices in Calgary, Vancouver, Winnipeg and Toronto. The Montreal Exchange continues to service the needs of the Quebec junior markets through an affiliation with the Canadian Venture Exchange (CDNX).

The CDNX specializes in financing for emerging companies and fostering their development so they can graduate to senior markets, such as the TSE. Of the IPOs on the TSE in 2000, 38 percent were graduates of the CDNX.^{Footnote 34} In July 2001 the TSE announced that it would acquire the CDNX. The CDNX has a Capital Pool Company (CPC) Program^{Footnote 35} that focusses on providing risk equity to early-stage businesses, and is designed to increase their visibility and provide an opportunity to work toward having a presence on senior exchanges. Since CPC began in 1987, more than $369 million in capital was raised for qualified companies. Companies that graduated from the CPC program have gone on to raise more than $3 billion in financing since the inception of the program. Additionally, of the 38 percent of former CDNX companies that issued IPOs on the TSE, one quarter were formerly CPC issuers.

Highlights of Canadian Exchanges during 2000-2001

According to a survey of IPO activity in Canada in 2001published by Price Waterhouse Coopers^{Footnote 36}, there were 74 IPOs brought to market in 2001, down 27 percent from 2000 (see Table 11). The technology and media sector saw the largest decline in the number of IPOs, with 80 percent fewer in 2001. The mining sector also saw the number of IPOs issued drop in half, while the oil and gas sector experienced a significant increase.

Table 11 – Number of IPOs on Canadian Exchanges

Sector	2000	2001	% Change
Financial Services	24	33	37.5%
Mining	20	10	-50.0%
Oil and Gas	3	8	166.7%
Technology and Media	35	7	-80.0.%
Life Sciences	11	5	-54.5%
Products	7	5	-28.6%
Other	1	3	200.0%
Real Estate	0	3	-
Forestry	0	0	-
Total	101	74	-26.7%

Source: PriceWaterhouseCoopers, Survey of IPOs in Canada in 2001 http://www.pwcglobal.com

Researchers suggest that owing to the events of September 11, 2001 and the then present economic downturn, a pent-up supply of IPOs may be on the horizon waiting for a more opportune time to go public. According to PriceWaterhouse Coopers, markets are "cyclical and unpredictable," therefore companies hoping to issue an IPO should be well prepared and ready to move quickly when the market is receptive to their company and industry's growth potential.

The total value of Canadian IPOs in 2001 dropped by 14 percent from 2000 (see Table 12). The sectors hardest hit were technology, media and life sciences. The focus of IPOs in 2001 shifted away from these sectors and toward what is often referred to as "bricks and mortar." Large increases were evident in the products and real estate sectors.

Table 12 – Gross Value of all IPOs on Canadian Exchanges (Millions of Dollars)

Sector	2000	2001	% Change
Financial Services	$3,716.8	$4,071.8	9.6%
Mining	$25.0	$5.9	-76.4%
Oil and Gas	$51.1	$22.4	-56.2%
Technology and Media	$2,682.7	$26.0	-99.0%
Life Sciences	$289.3	$30.3	-89.5%
Products	$40.0	$798.7	1,896.8%
Other	$30.0	$416.9	1,289.7%
Real Estate	-	$505.0	-
Total	$6,834.9	$5,877.0	-14.0%

Source: Price Waterhouse Coopers, Survey of IPOs in Canada in 2001 http://www.pwcglobal.com

Canadian and American Stock Exchanges : Initial Public Offerings

Research indicates that Canadian markets have somewhat fewer regulatory requirements than American markets, particularly for smaller firms^{Footnote 37}. It costs considerably more in time and money for Canadian firms to go public in the United States than in Canada. This is particularly true for Canadian companies undertaking a joint issue – an issue involving both a Canadian and an American stock exchange – because they must have both American and Canadian advisors to deal with each set of regulatory and process requirements. According to recent research,^{Footnote 38} companies going public in Canada tend to be much smaller than their U.S. counterparts. Canadian exchanges have different listing requirements than U.S. exchanges. Canadian SMEs, however, continue to go public in the U.S., either solely in American markets or jointly with a Canadian stock exchange^{Footnote 39}. This suggests that other factors, such as the size and depth of American markets, may allow for easier access to capital, and override the regulatory benefits of going public in Canada.

When launching an IPO a company has to take into account the likelihood that its issue will be underpriced.^{Footnote 40} There may be many reasons for this, including the interest of issue underwriters (investment dealers and brokers) to guarantee that they can sell out an issue of shares completely in the shortest possible time. This creates a tension between the company's need to have the price high enough to provide sufficient capital for the firm's growth requirements and the investment dealer's interest in having the issue price low enough to ensure a wide investor interest and complete subscription. Thus it is understandable that underpricing of IPOs is a common characteristic of all public capital markets.

Many studies have concluded, however, that IPO issues tend to be less underpriced in the Canadian market than elsewhere.^{Footnote 41} This may be largely explained by the influence or aggressiveness of large institutional investors in the U.S. marketplace, which results in lower valuations and greater underpricing of new issues in the American market. Such investors are the major market for new issues. They are interested in seeing under-priced issues, since this helps to boost their portfolios as the market adjusts post-issue to the "real" price of the shares. While institutional investors are important players in the Canadian market as well, they have not wielded the same degree of influence as seen in the U.S. markets. Given the greater underpricing of issues in the U.S. public capital markets and the increased costs associated with the issuance of a Canadian IPO in the U.S., it might appear paradoxical that Canadian companies continue to issue there. However, it is likely this choice is less a function of the regulatory structure or the disadvantage of underpricing of issues and more related to relative market conditions. Recent research^{Footnote 42} suggests that this may be partly a function of business strategy, i.e. an attempt by the company to attract not only investors but also greater visibility among potential customers and strategic partners in the major market. It may also be a function of differing market conditions in Canada and the United States public capital markets. For example, it may reflect the capacity of the market to absorb IPOs. Given the relative sizes of the Canadian and U.S. markets, a very large IPO in Canada's terms may just be a medium or small one in U.S. terms and can easily be accommodated, whereas it would be considered too risky for issuance on a Canadian stock exchange. Likewise, Canadian market makers may perceive a "glut" of IPOs from a certain sector at a particular moment. The same numbers of IPOs from that sector in the U.S. may be viewed very differently. Other market conditions may also contribute to making U.S. capital markets more attractive than the Canadian market at a given moment for a Canadian issuer. Indeed, there may be many other factors which contribute this choice, further study would be required to provide a definitive answer. Further research may be conducted by the SME Financing Data Initiative to provide insight into the benefits and drawbacks of where a company conducts its IPO.

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31. E. Wayne Clendenning & Associates, Issues Surrounding Venture Capital, Initial Public Offering (IPO) and Post-IPO Equity Financing for Canadian SMEs, 2001, commissioned by Industry Canada.

32. The Toronto Stock Exchange, http://www.tse.com

33. For additional detail on the launching of NASDAQ Canada, visit http://www.nasdaq-canada.com/

34. The Canadian Venture Exchange, Facts at a Glance, http://www.cdnx.com.

35. For more information on the Capital Pool Company Program, visit http://www.cdnx.com/Listing/MarketingPubs/CPCBrochure.pdf

36. Source: PriceWaterhouseCoopers, Survey of IPOs in Canada in 2001 http://www.pwcglobal.com/

37. The Conference Board of Canada, Going to Market: The Cost of IPOs in Canada and the United States, June 2000. back

38. E. Wayne Clendenning & Associates, Issues Surrounding Venture Capital, Initial Public Offering (IPO) and Post-IPO Equity Financing for Canadian SMEs, 2001, commissioned by Industry Canada.

39. According to the recent survey of IPOs by PriceWaterhouseCoopers, in 2000, two Canadian companies listed exclusively on the NASDAQ, down from three in 1999.

40. According The Conference Board of Canada and Canadian IPO Environment in the 1990s (Jog, 2001), underpricing of IPOs is a characteristic of all financial markets. Underpricing means that the initial issue price of the shares does not equal the full book value of the company – at least as perceived by the current owners.

41. Vijay Jog, Canadian IPO Environment in the 1990s, March 2001.

42. E. Wayne Clendenning & Associates, Issues Surrounding Venture Capital, Initial Public Offering (IPO) and Post-IPO Equity Financing for Canadian SMEs, 2001, commissioned by Industry Canada.