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Capitalizing small firms takes finesse

Monday, March 19, 2001

The market for fresh equity financing, or initial public offerings (IPOs), is in suspended animation.

In the past 12 months, huge technology firms' stock prices have crumbled. Shares in Internet-hardware maker Cisco Systems Inc. have been down 67 per cent, and Yahoo! Inc. stock's been down 88 per cent. Tech investors are getting out of the market and, when they go back in, they will see these abandoned stocks as bargains screaming to be snatched up.

The severity of the downturn is evident in the extent of the closing of the startup markets that usually finance junior enterprises. "Even the CDNX [Canadian Venture Exchange] is closed to new offerings," says Michael Cohen, managing director at Vengrowth Capital Management Inc. a Toronto-based venture investor with nearly $1-billion under administration.

"It's not just junior equity markets that are not interested in new offerings, it's the pre-IPO market that is closed," he says.

It's a vast change from the situation in the markets that, until last March's rupture of the Nasdaq Stock Market, was receptive even to dot-coms that bragged not of their ability to generate capital but to burn it off. Now there's a new reserve about jumping into new deals.

"Only the best deals are getting financed these days," Cohen says. He notes that the selectivity of the market can be expected to last until the Nasdaq recovers, which may happen by early 2002.

In the meantime, there are other options to public offerings, says Earl Lande, senior vice-president for Merchant Banking at RoyNat Inc., a subsidiary of Bank of Nova Scotia.

Mezzanine financings -- with combinations of loans against cash flow and equity participation for the investor -- are taking the place of IPOs, Lande says. "The mezzanine investor may take 5 per cent to 15 per cent of the stock of a firm, and loans may be made repayable mainly at the end of a loan period," he says.

This is the middle range of risk for investments, one in which eight of 10 investments should pay off. Yet it is a far riskier environment than that in which secured lenders such as banks operate. Secured lenders expect 99 of 100 loans to perform well, Lande says.

Yet even in the relatively risk-tolerant world of cash-flow lending and venture participation, there are clear trends. "You don't want to be called a dot-com any more. Instead, you need a good business plan. Today, we want to see what makes a good company, just as we did in the past," says Tim Bowman, president of Techbanc Inc., a venture investor in Toronto. "We are looking for proprietary technology developed by the firm that has real value. Just licensing technology isn't enough for us. We like to invest in companies that have globally scaleable products that can be sold around the world and in which an existing business model can be leveraged internationally.

"The firm need not have cash flow for our own investments, but we want them at least to understand their markets and customers."

Bowman operates at a relatively risk-tolerant level of the venture market. "The majority of the venture market has come to focus on firms that are much farther along in the development cycle and closer to break-even or even profitability," he says. "The capital is not there to support companies struggling to achieve profitability over an extended period of time."

The current moribund state of venture markets is having a profound effect on the technology-development cycle, he adds. "Development of new technology customarily takes two to three years. So in this market, there are a lot of ideas that just won't happen."

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