Gaps in SME Financing: An Analytical Framework

Equity Markets for Canadian SMEs

The equity markets that are of interest to SMEs have three distinctmajor segments, each of which is reviewed below.

The Canadian Market for Informal Capital

The informal venture capital market comprises individuals who provide risk capital directly to new and growing businesses with which they had no previous relationship. ^{Footnote 9} In the US, this market has been identified as the single most important source of risk capital for SMEs. Data for the importance of the informal market in the Canadian context are scarce; however, four studies suggest that the informal market in Canada is at least as important as the institutional venture capital market.

The first estimate (Short and Riding, 1989) used capture-recapture statistical methods to estimate the population of angels in the Ottawa region. Extrapolation of their data suggested an informal market that was at least as large as the then institutional market. More recently, estimates by Farrell (1999), the CBA (1998), and the Global Entrepreneurship Monitor (GEM, 2001) estimate an annual rate of investment excess of one billion dollars, a rate that is of the same order of magnitude as that of the institutional market. Moreover, because the average size of private investments (approximately $100,000) is typically less than that of institutional venture capital (in excess of $1 million), informal investors likely finance substantially more firms than do the institutional VCs. The following table is based on the findings reported in the GEM 2000 report and it illustrates the relative sizes of the Canadian market with respect to those of other industrialized countries that participated in the GEM project.

The findings in this table bear further explanation. First, these data show that Canada ranks fourth among these countries in terms of institutional venture capital invested based on 1999 data. All three countries that rank ahead of Canada are substantially larger in terms of population and on a per capital basis, only the US and Israel rank ahead of Canada in terms of venture capital invested per year. Moreover, the data for 2000 may well move Canada into second place overall as well as on a per capita basis.

Table 5: International Comparison of Risk Capital Investment Activity^{Footnote 10}

Country	Institutional Venture Capital Invested in 1999 ($Millions)	Percentage of Population Making Investments in New	Total Non-Institutional Capital Invested in New Firms
US	45,932	7.0	54,333
Germany	2,024	3.9	11,979
UK	1,895	3.1	12,610
Canada	1,489	2.7	3,373
Korea	890	5.5	16,939
Israel	432	3.7	651
Australia	288	2.6	2,803
Sweden	261	2.5	535
Singapore	145	1.3	458
Finland	106	3.6	269
Norway	96	5.1	656
Denmark	75	4.1	1,165
Argentina	n/a	2.5	1,383

Second, investments in new firms, in aggregate, total $3.373 billion US (approximately $ 5.2 billion $Cdn). GEM estimates that approximately 75-80 percent of this total represents investments made by friends and family in new firms. This implies that angels, or private investors, invested between at least $1 billion ($Cdn) during 1999 in new firms and comprise a maximum of 0.5 percent of the population (this is arguably an upper limit because research shows that angel investors usually invest larger amount than do friends and family).

The average size of informal investments is of the order of approximately $100,000 and that such investments tend to be made locally (CBA, 1998; Farrell, 1999; Equinox, 2001). Typically, investments are in sectors and stages that are complimentary to those in which institutional venture capital firms focus and are particularly important for start-ups and early-stage firms (Freear and Wetzel, 1988). Referrals and reference checks tend to be made informally, although an offering memorandum generally governs terms and conditions of the investments, at least for larger investments. Syndicates of informal investors often make such investments, although a substantial fraction remains unsyndicated. More details are available in recent reports produced in conjunction with the FCI (Equinox, 2001a; 2001b).

Sûret and his colleagues (1995), in their study of private investment in Quebec, confirm the importance of private investment stating:

Extrapolation of Sûret's estimations across Canada points to a sizeable informal market.

Attributes of Private Investors

The supply side of the informal market has been widely studied and a consistent picture of informal investors emerges.

• Informal investors are self-made, high income, well educated (normally hold a minimum of a college degree), and middle-aged.
• They are predominantly male (98.1% in Haar, Star and MacMillan, 1988) and have substantial business experience. Most angels have entrepreneurial experience as owners or managers – that is, they do not tend to be wealthy professionals such as physicians, dentists, etc.
• They usually prefer investing within their localities. In Short and Riding (1989), over 85% of the investments by the respondents had been limited to within 50 miles of home or office.
• Business angels are generally experienced investors confident about their ability to appraise investment opportunities and therefore do not typically rely on professionals.
• Their investment decisions are usually opportunistic (based on commercial intuition) rather than scientific (Mason and Harrison, 1996).

Canadian studies (Riding and Short; 1987a; Farrell, 1999; Feeney et al, 1999; Equinox, 2001a) confirm that the characteristics of Canadian angel investors are generally consistent with the wider literature. However, Canadian investors display higher rates of activity (investment), lower rates of participation in the management of the investee firm, and higher rejection rates of possible investment opportunities than their counterparts in the US. They also commit higher amounts of capital to individual investments than their US counterparts^{Footnote 11}, though the usually assume minority roles in the investee firms.

The Marketplace for Informal Capital

In most countries, the operation of the informal venture capital market is usually characterized as inefficient and the market has even been described as inchoate. According to Sherid (1997), "if stock markets are an extremely efficient capital market, angel investing is at the other end of the spectrum". The inefficiency has been attributed to three (3) main factors:

1. invisibility of informal investors: for fear of being pestered by unwanted calls from desperate entrepreneurs, most angels prefer to remain anonymous.
2. the fragmented nature of the market: the reliance of informal investors on 'primitive' (Prowse, 1998) informal networks of trusted friends and business associates in the referral/search process has led to the proliferation of several (highly invisible) networks.
3. poor communication channels: there are no clearly defined channels of communication between entrepreneurs and business angels. This leads to high search costs and frustrations for both investors and entrepreneurs.

In the Canadian context, these problems are being addressed by a variety of public sector and private sector initiatives. All three levels of government have established mechanisms to address the fragmented nature of the market.^{Footnote 12} However, attempts to improve the informal marketplace in Canada must still contend with securities regulations. As MacIntosh (1995) notes, compliance with securities acts generally entails a high cost and that it is likely than many deals are not in full compliance. MacIntosh argues that securities regulations are particularly troublesome for knowledge-based firms, an assertion with the contention of a knowledge-based gap.

Mobilizing New Angels

Freer et al, (1994) have found that a high proportion of individuals with the financial resources to be angels are willing to invest some amount of their portfolio (between 1% and 14%) in the informal venture capital market. This implies that the potential size of the informal venture capital market is far bigger than its present size. Short and Riding (1989) estimate that the potential size of the informal market in Canada may be ten (10) to twenty (20) times the size of the institutional venture capital market.

According to Mason and Harrison (1993), a high proportion of prospective angels cited the inability to identify suitable firms requiring finance as the major reason why they have not invested in entrepreneurial companies. Other considerations included the high risks involved, concerns about exit routes and lack of expertise in investment appraisal. Mason and Harrison state that the factors most frequently-cited needs were personal knowledge of the management team, information on companies seeking finance from a trustworthy source (these two factors essentially relate to concerns about risk) and tax incentives.

These findings coincide with those of Feeney and her colleagues (2001) who asked private investors to identify factors that they considered essential in an investment opportunity and those that they regarded as detractors. The management ability of the entrepreneurial team was regarded as the most important element. Other key aspects of "suitable" investments included the business potential of the service or product idea and the integrity of the founders. Detracting factors included unrealistic projections and elevated valuations of the founders' share of the business.

Given a sense of their investment criteria, a trusted referral service might assist private investors with identification of investment opportunities; workshops could help equip them with the necessary skills and information; and, mentors ('archangels') could assist new angels until they gain roots. These activities have been conducted under the auspices of the Canadian Community Investment Program (CCIP) with measurable success. Prior screening of enlisted projects by referral services would also give prospective investors an additional level of comfort. However, screening implies that market facilitators would be "advising" prospective investors and may be a questionable practice according to Canadian Securities Acts.

Lerner (1998) advances a caveat with respect to enticing more angels. SMEs, particularly startups, are inherently more risky than large firms. There is considerable uncertainty regarding their survival and growth. On this basis, Lerner cautions that amateur individual investors should not be encouraged; rather, he argues that care should be taken to ensure that the prime targets should be value-adding investors. The targeted investor should, on average, be able to withstand the loss of their investment in the informal capital market. In recognition of the importance of this factor, the OSC^{Footnote 13} argues that even though education and experience should count towards the definition of a sophisticated or accredited investor, ability to withstand financial loss of the investment in the informal market should be an overriding criterion.

These findings suggest that knowledge-based firms, because of securities regulations, may face disproportionate difficulty accessing informal capital. In addition, the BDC states that an early stage gap exists such that small early-stage companies are not the strategic focus of most private investors. While this perception may have related primarily to institutional venture capitalists, it is worth exploring in the context of informal investment. Expressed as testable hypotheses, these perceived gap could be phrased as follows:

Hypothesis:
Private investors do not focus on small early stage companies.

Hypothesis:
Private investors do not focus on knowledge-based businesses.

Mason and Harrison (2001) note that barriers to informal investment may not rest with the supply side of the market. They find that in the UK, many business angels are willing to allocate a higher proportion of their investment portfolios to investments in private companies. Most informal investors in their study were looking to make additional investments. Three factors, according to Mason and Harrison, constrained their ability to invest: they did not see enough deals that met their investment criteria; the majority of proposals they received were of poor quality; and they were often unable to negotiate mutually acceptable terms with entrepreneurs. Mason and Harrison state that the need for intervention should be centred on the demand side and in the market-making process so that more SMEs could access what Mason and Harrison found to be "a substantial pool of angel finance that is available". These findings are consistent with those reported by the CBA (1998) and Equinox (2001). Both studies found that Canadian informal investors report having substantial capital available for investments in small firms and they often cite the lack of management skills on the part of entrepreneurs as the primary barrier to investment.

These findings suggest the following testable hypothesis because it implies that informal capital is accessible to entrepreneurs with growth opportunities and management skills or experience.

Hypothesis:
Firms that have accessed informal capital are those with experienced and capable management and that report growth histories and growth opportunities.

The Canadian Market for Institutional Venture Capital

Overview

The Canadian Venture Capital Association recognizes five categories of venture capital firms (categories are based on firms' respective sources of investment capital) that comprise the Canadian market:

• private independent funds which obtain capitalization from a small number of individuals or organizations;
• labour-sponsored venture capital companies (LSVCCs) which raise their capital by means of public solicitations to individuals and which are able to offer substantial tax incentives;
• corporate subsidiaries which are fu nded by parent organizations;
• funds that derive their initial funding from government-related sources, and
• other funds.

According to Clendenning and Associates (2001) the marketplace has been dominated by LSVCCs; however, private independent venture capital firms have recently become relatively more important. According to data for the year 2000, these two categories of funds accounted for 86 percent of the $18.8 billion in assets under management. Labour sponsored funds accounted for 42 percent of capital under management in 2000 and private independent funds accounted for 42% (up from 21 percent of the $12.1 billion of funds under management 1999). This has largely been the result of a recent proliferation of new private sector funds. According to Bloom (2001), the number of active venture capital firms in Canada has increased from 67 in 1995 to 326 in 2000.

The last few years have reflected an unprecedented level of activity in the Canadian venture capital sector. Bloom (2001) provides the following comparison between 1995 and 2000.

Table 6: Canadian Venture Capital Activity, 1995 vs 2000^{Footnote 14}

Indicator	1995	2000
Number of Active VC firms	67	326
Capital under management	$6.0 billion	$18.8 billion
Number of companies financed during year	502	1,089
Number of Investments	610	2,566
Disbursements during year	$699 million	$6.3 billion

The table that follows presents a comparison of the US and Canadian venture capital industries.

Table 7: Venture Capital Activity in Canada and the US^{Footnote 15}

Measure	Canada	US	Ratio
Population (1999)	30.5 million	273.1 million	1:9
Number of Households (1999)	10.8 million	100.3 million	1:9
GDP ($ Cdn)	$1.0 Trillion	$14.9 Trillion	1:14
Number of VC Investments	2,566	5,380	1:2.1
Total Investment (2000)	$6.3 billion	$103 billion (US)	1:25
Proportion of VC to KBI	89%	97%
Average Size of Investment	$4.4 million	$16.4 million ($US)	1:5.6
Pension Fund Commitments to VC Pools	$441 million	$55.5 billion ($US)	1:189

This table reveals several differences.

1. Canadian venture capitalists invested in a disproportionately large number of ventures (compared to the US). This is partly, but not fully, accounted for the finding that 45% of Canadian VC investments are to "early-stage" firms whereas only 23% of US VC investments go to early-stage companies.

Hypothesis
Investment by institutional venture capitalists is complimentary to that of private investors. Institutional VCs invest in later stages of development and in larger amounts than do private investors.

2. In general, investments by US VCs are substantively larger. This poses a competitiveness issue because firms financed by US VCs are evidently better capitalized than are Canadian investee firms (see Bloom (2001) and Clendenning and Associates (2001)).

3. The average size of investments has been increasing in both countries, but at a much more rapid rate in the US than in Canada. These data reveal that the average size of Canadian VC investments has increased from approximately $1 million in 1995 to $4.4 million last year. In part, this is a consequence of increased activity among US investors in Canada.

Hypothesis
As the pool of institutional venture capital expands, the average size of investments increases and earlier stage firms face greater difficulty raising venture capital.

4. The US industry relies largely on pension and other investment funds as sources of capital. In Canada, labour sponsored venture capital firms are among the largest venture investors but they derive their capital largely from individuals' tax-incented investments. Relatively little capital is supplied to venture funds by Canadian institutions. However, several Canadian pension funds have recently been active as direct or syndicated partners in venture investments in Canada.

It should be noted that the larger average deal sizes characteristic of US VC financings is relatively recent, as depicted in Figure 2.

Figure 2: US Venture Capital Activity Since 1994

D

Through the first half of 2001, the rate of VC investing in the US has declined considerably: from $54 billion invested during the first half of 2000 to $23 billion during the first half of 2001. Conversely, the rate of venture capital investment in Canada has continued near the 2000 pace, in no small part due to investments being made here by US venture capital firms (at least as of the first half od 2001). During the first half of 2001, Canadian venture capital firms invested approximately $2.5 billion in 521 financings; for the comparable period of 2000, the Canadian investment was $2.36 billion across 683 investments.

Theory and Evidence of Gaps in the Venture Capital Market

The BDC noted three perceived "gaps" associated with the Canadian venture capital industry.

• an early stage gap, which reflects the belief that small early-stage companies are not the strategic focus of most private investors.
• a dollar gap, according to which Canada was said to rank tenth among developed countries in terms of venture capital funds raised per capita.
• an institutional gap that reflects the lack of involvement in the venture capital sector of pension funds, mutual funds, and other such institutions in Canada.

These assertions may be re-phrased as three separate hypotheses to be tested against the literature and investigated under the terms of the FCI. These hypotheses are:

Hypothesis:
Institution venture capital companies do not focus on early-stage entrepreneurial enterprises.

Hypothesis:
The Canadian venture capital industry, in terms of funds raised per capita, ranks low among developed countries.

Hypothesis:
Institutional investors such as pension funds, mutual funds, and other such institutions are not substantive participants in the Canadian venture capital sector.

From the overview of the Canadian industry, it would appear that the second of these hypotheses is not tenable. Table 5, 6 and 7 all speak to a venture capital sector in Canada that is disproportionately large on a world scale. In some respects (e.g., the number of investments per capita) the industry is more active than that in the US. If comparisons are restricted to the US, it is true that the aggregated volume of venture capital investment is low and that this is at least partially attributable to the lack of participation from pension funds, mutual funds, etc. However, in comparison with other almost any other country in the world, Canada appears to be a leader in terms of venture capital activity and availability.

This discussion raises the question of how much venture capital is sufficient. Mason, Cooper, and Harrison (2001) investigated the development of the venture capital market in Ottawa. As they note, the saturation of the US market is among the reasons that US venture capital firms were investing in Canada. According to the US Small Business Administration (SBA), it is not entirely clear that a larger venture capital market is necessarily a benefit. According to the SBA (1998), the amount of capital under management by US venture capital funds has increased substantially during the 1990s, as has average venture capital fund size. Ordinarily, growth of the pool of venture capital would be viewed as good news for the SME sector. However, the SBA suggests that the organized venture capital industry may have become a victim of its own success. With the rapid growth in the amount of available funds, the average value of individual investments has also experienced rapid growth. According to the SBA, large funds now prefer to invest not less than US$10m in any given venture capital partnership and prefer to represent less than 10% of that partnership capital. The 10/10 rule tends to drive venture capital funds to the US$100m+ range leading VC fund managers to make increasingly large investments. The SBA report indicates that venture capitalists rarely fund deals of less than US$3m to US$4m.

This discussion begs the question of the extent to which the supply of venture capital in Canada is sufficient to meet the needs of those firms that require venture capital or whether there is a gap (in the shortage sense) of venture financing.

Hypothesis:
There is a sufficient supply of venture capital for Canadian firms.

The theory of gaps in the venture capital market also derives from the work on information asymmetries. As noted in a previous section, an agency problem occurs when the goals of the principal (e.g., bank, investor) and of the agent (owner(s) of entrepreneurial firm) differ and the principal lacks salient information possessed by the agent. However, as described so far, the theory of information asymmetry relates exclusively to the interface between the lender or investor and the owner(s) of the entrepreneurial firm seeking capital. In the case of institutional venture capital, the investor also acts as an agent — on behalf of the original source of funding: pension funds, individuals, parent firms, etc. The responsibility to achieve the investment goals of the funds supply is superimposed on the VC's decision process.

Agency problems are, in theory, particularly relevant for the institutional venture capital investor. First, the goals of the VC investor and the business owner arguably differ. The VC is primarily interested in growth of the investee firm and the firm is one of several in the VC portfolio. The business owner shares an interest in the growth of the firm, but also faces consumption needs. Second, the VC investor and the firm owner may hold different attitudes towards risk and may therefore respond differently towards the same situation.^{Footnote 16}

The problems associated with informational asymmetry, however, are arguably mitigated in the context of equity investment relative to that of lending relationships. De Clerq and Sapienza (2000), for example, show that it is in the best interests of investor and entrepreneur to cooperate to achieve their mutual goals. Shepherd and Zacharakis (2000) and Manigart et al. (2001) contend that trust and confidence lead to cooperative behaviour for mutual benefit. This type of behaviour is more likely in a VC relationship than is a banking relationship for several reasons. Thus, recent academic research suggests that the entrepreneur-venture capitalist interface is much more cooperative in nature than that of the lender entrepreneur. Three reasons for this have been advanced.

First, the VC (unlike the bank) stands to participate in future performance of the venture: the bank would only get the loan repaid with interest; the VC stands to share in appreciation of firm value. Second, the development of trust and confidence is engendered by a substantial due diligence process and a time-consuming process of negotiation and communication: this is not economic for small amounts of capital such as those normally encountere d in bank loans. This is also why VCs prefer to invest relatively large sums. Third, it is argued that the size (in terms of the number of firms) of a VC portfolio tends to be much smaller than that typically managed by a bank loans account manager (see, for example, Wynant and Hatch, 1991) allowing the manager more time per investment.

This literature, therefore, is consistent with the previously stated hypothesis that VCs' are less interested in small investments and, by extension, early-stage investments.

Mason, Cooper, and Harrison (2001), in their investigation of the development of the venture capital market in Ottawa, addressed a 'chicken and egg' problem. Specifically, they asked which comes first: high technology firms or venture capital? Their study deals directly with (and in a Canadian context) two relevant issues to this work. The first is the geographic dispersion of venture capital.

Hypothesis
Investments by Canadian venture capital companies are limited in terms of geographic scope.

Second, they also studied the extent to which technology firms (and other types of high growth companies) are constrained by limited access to local risk capital. Through a series of interviews with business owners, VC managers, and private investors, Mason and his colleagues traced the development of both the Ottawa technology cluster and the investment patterns of risk capital in firms in the cluster. They note that between 1990 and 1995 the number of technology-based firms had doubled to approximately 600 and employment in technology-based firms had increased substantively. Yet, prior to 1995, there were no local private-sector sources of institutional venture capital in the Ottawa region even though the Ottawa cluster had experienced at least a decade of technology based development. Between 1995 and 2001, however, the success of a number of Ottawa firms spawned significant VC interest in the regions. The result was that, 14 institutional VC firms had been established in Ottawa and approximately $1.2 billion of VC was invested in Ottawa in the year 2000. This level of investment was approximately 25 percent of the national total.

Mason and his colleagues conclude that four factors led to the development of an active VC market in the Ottawa region. First, they note that the character of venture capital was changing "with the emergence of funds focused on specific technology spaces and weaker geographical ties". Second, they suggest that the history of development in the Ottawa region has led to the "development of a supply of experienced managers willing to take jobs in start-up companies". Third, they maintain that the "spectacular" returns earned on some early investments caught the attention of the VC community. Finally, they find that VC funds located in the Northeastern USA as well as funds located in Silicon Valley exceeded the opportunities available locally, "prompting a wider geographic search for investment opportunities". These findings are not consistent with the contention that the supply of institutional VC is limited for Canadian firms with strong growth prospects. Nor are these findings consistent with the hypothesis that the scope of venture capital investments is limited. According to Sohl (2001), US managers of VC funds are willing to travel – including travel to Canada – to explore investment opportunities.

Determinants of Venture Capital Decisions

There is a substantial literature on determinants of venture capitalists' decisions. An important seminal article was that by Tyebjee and Bruno (1984) outlined the evaluation steps in the decision process. Subsequent work (Dixon, 1991; Fried and Hisrich, 1994; Hall and Hofer, 1993; Knight, 1990, 1994; Macmillan, Siegel, and Narasimha, 1985; Manigart, Wright, Robbie, Desbrieres, Philippe; and De Waele, 1997; Sandberg, Schweiger, and Hofer, 1988; Wright and Robbie, 1996; and Zacharakis and Meyer 1998), are examples, among many others, of ongoing work that attempts to identify the parameters of the venture capital decision process.

The literature examining the nature of the decision-making process used by venture capital firms can be classified in four categories. A first stream examines the stages of the decision making process (Tyebjee and Bruno, 1984; MacMillan, Siegel, Narasimha, 1985; Fried and Hisrich, 1994). These authors identified the following stages: initiation of the proposal, pre-screening, valuation (includes due diligence), structuring of the transaction, post-investment monitoring, and valuation of the investment.

A second stream tries to identify the selection criteria used by venture capital investors and their decision tree. The criteria identified fall under a number of categories such as the specificity of the product or service offered, the potential market size, the management team abilities (in particular the entrepreneurial experience and personality traits) or financial-related considerations (required return, exit potential, etc.). Some studies highlight the key role of the management team in investment selection (MacMillan, Siegel and Narasimha, 1985; Dixon, 1991; Knight, 1994) or the perception of the project risk (Tyebjee and Bruno, 1984).

In a related stream of research, the methods used to gather data during the studies mentioned above have been called into question. There is a fairly large potential for bias when the VCs are asked to give a retrospective account of the criteria used and their importance. They tend to place the criteria in the wrong order and list more of them than they actually use. Therefore, researchers suggest the use of verbal protocol analysis instead (Sanberg, Schweiger, Hoffer, 1990; Hall and Hoffer, 1993) or the simulation of decisions from certain cases (Zacharakis and Meyer, 1998) to infer the actual criteria used. Although they offer interesting leads, these studies offer sketchy results for the moment. Hall and Hoffer (1993) was exploratory in nature and analyzeds the criteria used only during the first two stages of the decision- making process. Zacharakis and Meyer (1998) examined the power of introspection of the VCs in relation to their own decision-making process, obtaining mixed results, some supporting the poor capacity of the VCs to understand the way in which they operate and others showing some form of consistency in the application of their decision-making criteria.

Finally, another stream examines the valuation methods and techniques used by VCs (as in Wright and Robbie (1996) in the United Kingdom and Manigart, Wright, Robbie, Desbrières and De Waele, 1997 in France, the Netherlands and Belgium). The methods most commonly used appear to differ across countries. In France and the United Kingdom the most commonly used methods are those based on multiples (net profits, profits before historical or projected interest and tax), followed by recent transactions multiples and discounted cash flows. In Belgium and The Netherlands, discounted cash flows predominate, followed by multiples and comparisons with recent transactions. No work appears to have been conducted in a Canadian context on these issues.

The Canadian Market for IPOs

The market for initial public offerings is highly cyclical. Figure 3 charts the number of IPOs issued in the US annually since 1960 (the pattern for Canada has been very similar). For 2001, fewer than 70 IPOs have been issued in the US, although there is current speculation in the popular media that the frequency of IPO financing is increasing. The cyclicality is emphasized in Figure 3 by the average initial-day returns (gain or loss during the initial day of trading as a percentage of the initial listing price). It can be seen that several periods can be identified as "hot markets", including the 1998-2000 period. "Hot markets are evidenced by both a high number of IPOs and a high demand for the newly-issued shares of IPOs.

Figure 3: Historical Patterns of IPO Issuances and Initial-Day Returns

D

It is generally understood that regulatory requirements that pertain to IPOs are less severe in Canada than in the US (Clendenning and Associates, 2001). Moreover, it is also understood that the costs of going public – both direct costs and underpricing — are also lower in Canada. The hypothesis, articulated by the BDC (2001) that there is a "smaller appetite for IPOs in Canada" apparently stems from remarks made in a speech by The Honourable Paul Martin (speech to the Toronto Board of Trade: September 14, 2000) to the effect that the "per capita dollar value of IPOs done by Canadian enterprises in Canada was only half the level raised by American enterprises in the US". The comment is bound to be true. As noted by Clendenning and Associates (2001), listing requirements on the NYSE, AMEX, and NASDAQ are all higher than those on the TSE. Firms that list on US exchanges are inevitably bigger; hence, the dollar value of IPO capital raised per capita is bound to be higher on US exchanges. Moreover, the BDC's interpretation of the Minister's comment does not take account of the Canadian firms that also raised capital by IPOs on US exchanges, many of which did so for reasons unrelated to a perceived lack of capacity on Canadian markets (Foerster, Karolyi, and Mavrinac, 1998).

Clendenning and Associates (2001) echo the concerns raised by the Minister, and ask if

In a related question, Clendenning and Associates (2001, p.45) ask:

These questions prompt the following testable hypothesis.

Hypothesis
It is relatively more difficult for Canadian firms to raise capital from the public markets in Canada than in the US.

Canadian IPO Activity: 1990-2000

The data show that between January 1, 1990 and December 31, 1999 approximately 179 Canadian firms undertook an IPO exclusively on the TSE (Jog and Hitsman, 2000). Jog and Hitsman documented the yearly frequency and average underpricing of Canadian IPOs. Their findings are reproduced in Table 8, below. As noted by Shutt and Williams (2000), going public in Canada is generally less expensive than doing so in the US. Updating Jog and Hitsman's figure to include 2000, approximately 210 firms have gone public on the TSE alone during the 1990-2000 period.

Table 8: Canadian IPOs, 1990-1999

Year	Number of IPOs	Underpricing
		Minimum	Maximum	Average
Source: Jog and Hitsman (2000).
1990	1	-0.70%	-0.70%	-0.70%
1991	3	0.96%	20.69%	8.55%
1992	6	0.00%	20.63%	9.46%
1993	50	-11.36%	200.00%	17.98%
1994	19	-7.75%	45.83%	5.60%
1990-94	79			13.76%
1995	8	-4.00%	83.33%	14.88%
1996	26	-5.33%	62.50%	11.63%
1997	32	-11.11%	84.21%	18.84%
1998	17	-33.33%	61.76%	9.43%
1999	17	-33.33%	54.05%	9.05%
1995-99	100			14.00%
1990-99	179			13.55%

In addition, between January 1, 1994 and December 31, 2000, 46 Canadian companies made an IPO exclusively on NASDAQ or an IPO interlisted on NASDAQ and another exchange (usually the TSE). That these firms chose to issue their IPOs in the US begs the question of why they did so in spite of the findings that (a) 210 firms were able to go public and raise capital from Canadian markets with (b) lower levels of underpricing, and (c) at lower issuance costs (Shutt and Williams, 2000).

It is therefore worth investigating why these 46 Canadian firms listed on NASDAQ. In fact, Foerster, Karolyi, and Mavrinac (1998) have already been examined why Canadian firms list on US markets. They interviewed the CEOs of 45 Canadian companies whose shares listed on US exchanges between 1990 and 1997. They found that Canadian firms chose to list on US exchanges for a multiplicity of reason.

To be sure, the CEOs recognized the greater access to capital, greater liquidity and higher degrees of institutional investment and analyst coverage associated with a US listing. However, the CEOs also recognized that American exchanges were more user-friendly, provided helpful marketing material and had more frequent contact with issuers. More specifically, reasons for listing on US exchanges include the following.

Size and liquidity of US markets. The US capital markets are the deepest in the world. This affords firms the ability to issue stock or debt securities more easily. The enhanced liquidity of the securities in the aftermarket can translate into a lower cost of capital because no liquidity premium is necessary. By comparison, many shares listed on Canadian markets, including the TSE, are subject to infrequent trades. Many securities do not trade daily and others trade even less frequently.

Better IPO valuations(?). It has been claimed (Business Council on National Issues, 2000) that IPOs command a higher price in the US. This claim, however, is at variance with the finding that there is less underpricing in Canadian IPO markets. Underpricing is an important element of cost because high levels of underpricing mean that founders must dilute their holdings of equity to raise the funds the firm is seeking. Thus, it is not clear that CEOs' perceptions of better IPO valuations are consistent with research findings.

Access to US Institutional Investors. CEOs believe that US investment institutions are reluctant to invest in stocks on Canadian exchanges but that country of origin is irrelevant to US investment institutions if the shares are listed on US stock markets. While Canadian investment institutions actively invest on US markets, US institutions are less likely to invest on Canadian markets. Moreover, firms that are cross-listed gain better visibility by means of a larger analyst following. In particular, CEOs of companies in non-traditional or emerging industries believed that listing on US exchanges affords a higher level of institutional following than if they had not cross listed.

Global Image. Foerster and his co-workers found that 76 percent of CEO respondents ranked the improved corporate image associated with listing on a US exchange ahead of other outcomes of interlisting. The respondents noted that listing in the US confers enhanced credibility for their companies and potentially facilitates strategic alliances and mergers.

"Be with your peers". CEO respondents inferred that when many companies in the same industry listed on a particular exchange that there is much to be gained from also doing so. CEOs believed that they would not be taken seriously if their firms were not listed on the same exchange as their competitors and not to do so may put the company at a competitive disadvantage. This belief is witnessed by the proliferation of Internet-related companies on NASDAQ, considered the exchange of choice for Internet firms. As of early 2001, 32 Canadian Internet companies had listed exclusively on NASDAQ.

In addition, Jog and Hitsman (2000) speculate on other reasons that may prompt Canadian firms to list in the US. They argue that with freer trade, many of the Canadian firm's suppliers and customers may be located in the US and that they would be "more inclined to do business with firms having a presence in their own country". If so, Canadian firms could benefit from the visibility that attends having its stock traded on a US stock exchange even if it keeps its operations in Canada. However, they also note that if this were were the only reason for an IPO on a US exchange, then the domestic firm could simply create a foreign address or seek a cross-country listing after raising IPO capital in the domestic market.

Jog and Hitsman also note that differences in the exchange rules and policies, and the taxation and regulatory regimes may make the US a more attractive alternative for IPO listing. The exchange policies with respect to insider trading, escrow requirements, and disclosure rules may result in preference for a US financing. The difference in tax regimes, for example in the taxation of capital gains, may benefit investors from one country over another. Given the same expected after tax returns demanded by investors from their investment in an IPO, valuations will be higher in a country with a lower degree of capital gains taxation.

These arguments raise the question of the degree to which the Canadian and US markets are integrated. In general, two markets are integrated if the securities that trade on them provide the same risk-adjusted returns. Foerster, and Karolyi (1999) identify several potential barriers to integration. For example, segmentation is furthered by foreign content rules on RRSP portfolios and the definition of "Canadian" firms that are eligible for RRSP investment. Foerster and Karolyi document differences in liquidity between Canadian and US markets and different levels of information asymmetry that suggest segmentation. However, they also note that North American markets are becoming increasingly integrated over time as globalization and free trade lead to elimination of barriers. For example, discussion regarding the formation of a global equity market have been initiated, a market in which the TSE would join with other international markets to form a global 24-hour-trading exchange.

Overall, the work of Foerster and his colleagues suggests that enhanced liquidity, credibility, and global image are the main reasons that Canadian firms list their shares on US markets. The importance of corporate image and credibility were found to be particularly important determinants of listing location. That a substantial number of Canadian firms also undertook IPOs within Canada questions the hypothesis that the capacity of the Canadian market is limited. On the other hand, it is also true that the shares of many Canadian companies are relatively illiquid.

The SME FDI is not likely to provide the data to fully resolve this debate. To do so will likely entail a specialized study of Canadian IPOs; however, given the work already published by Foerster and his colleagues, it is not clear that an additional study would add to our understanding of these issues. Moreover, it is seen that a lack of capacity could be interpreted in two ways: a lack of ability of the marketplace to purchase the IPO issues or a lack of liquidity in the aftermarket.

Valuation of IPOs, Underpricing, Post-Issuance Performance

Several hundreds of academic papers that relate to IPOs have been published.^{Footnote 17} Generally, these papers deal with one of three aspects: valuation of the shares (setting the offering price), underpricing (the change in the share price during the time immediately following the offer), or performance (returns to investors for a sustained period following the offer). Loo and Riding (2001) offer concise summary of this research, the salient conclusions of which follow.

Valuation of IPOs is usually accomplished by means of the comparable firms approach is typically implemented by capitalizing the earnings per share (EPS) of the firm under consideration at a price-earnings (P/E) ratio representative of comparable publicly traded firms. Other market multiples, such as market-to-book, price-sales, and price-operating earnings ratios, are sometimes employed among other alternative market multiples that can be used in this approach. According to Kim and Ritter (1999), however, multiples based on comparable firms have only modest predictive power without adjustments for differences in growth and profitability.

IPOs are, on average, underpriced. Loughran, Ritter and Rydqvist (2000) summarized studies of IPO underpricing across 36 countries. Most countries experienced positive initial returns. In other words, all had shown underpricing phenomena. China experienced the highest average initial returns (388%) and France the lowest (4.2%). Jog and Riding (1987) and Jog (1997) compared underpricing of IPOs on the Toronto Stock Exchange (TSE) in Canada with underpricing reported for the United States. According to Clendenning and Associates (2001) underpricing on the TSE averaged 5.8% (this value differs from the 14 percent reported by Jog and Hitsman, 2000) compared with 10.9% on the NYSE and 49.6% on NASDAQ. Loo and Riding (2001) also show that underpricing on NASDAQ is more severe for technology-based firms than for traditional enterprises.

Assessment of post-issuance stock market performance has been reported by Ritter (1991) using US data and by Jog (1994), using Canadian data. Both found that the long-term performance of IPOs was disappointing and that IPOs underperformed, on average, stock market indices. Young and Zaima (1987) examined potential industry effects on IPO underpricing and performance. The aftermarket performance did not show any statistically significant differences across traditional industry groupings.

These results may provide background for future specialized studies related to the SME FDI as it pertains to IPOs.

^{Footnote 9} The Center for Venture Economics (1995), in a report for the Office of Advocacy of the US Small Business Administration, estimated that approximately 250,000 angel investors were investing about US$20b in 30,000 small companies each year. That is approximately twice the value of annual investment by US institutional venture capital funds and about fifteen (15) times the number of companies receiving investment (Freer, Sohl and Wetzel, 1996 in Acs and Tarpley, 1998).

^{Footnote 10} Source: GEM (2001)

^{Footnote 11} Feeney et al (1999) attribute this to Canadian Securities laws that limit smaller deals.

^{Footnote 12} For example, Industry Canada has implemented the Canadian Community Investment Program (CCIP), a program that assists smaller municipalities to establish intermediaries to help businesses become ready for investment, to assist with locating suitable investors, and to provide post-investment counsel. Provincial and municipal governments have also established mechanisms to help address the issues listed by Mason and Harrison.

^{Footnote 13} "Revamping the Regulation of the Exempt Market" (www.osc.gov.on.ca).

^{Footnote 14} Source: Bloom (2001); Clendenning & Associates (2001).

^{Footnote 15} Source: Bloom (2001); Clendenning & Associates (2001).

^{Footnote 16} For a full explanation of these issues, see De Clerq and Sapienza (2000).

^{Footnote 17} See, for example, http://www.iporesources.org/iporefs.html