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Mike McDerment is co-founder and CEO of Toronto tech start-up FreshBooks, which provides cloud-based accounting software for small businesses. (Rosa Park for The Globe and Mail)
Mike McDerment is co-founder and CEO of Toronto tech start-up FreshBooks, which provides cloud-based accounting software for small businesses. (Rosa Park for The Globe and Mail)

Staying Private

Flood of private capital helps fill financing void Add to ...

Last September, Kitchener, Ont.-based e-learning provider Desire2Learn secured $80-million in venture capital, making it the largest funding round by a Canadian software company, according to the firm. The move highlights the growing willingness of private equity markets to inject cash into emerging companies, and offers companies considerable growth opportunities while staying private.

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Not too long ago, the intial public offering (IPO) was seen as the holy grail for entrepreneurs. Its lure, however, has diminished in recent years as companies, facing more cautiousness among large underwriters, are turning to other sources of capital. As well, the rising cost of mounting an IPO has raised the entry bar.

“You used to need a valuation of about $100-million dollars,” says Douglas Cumming, professor of finance at York University’s Schulich School of Business. “Today, you are looking for a valuation in the neighbourhood of about $1-billion.”

A flood of private money is serendipitously filling the void, offering alternatives for firms that otherwise would have seen public financing as the only viable option.

“There is so much capital sitting around these days that it’s not necessary,” says Mike McDerment, co-founder and CEO of Toronto tech start-up FreshBooks, which provides cloud-based accounting software for small businesses, and currently boasts 110 employees and more than five million users worldwide. “It’s a growing trend among companies like ours that the multiples in the private markets are better than those in public,” Mr. McDerment says.

This increased willingness to lend is due in part to a massive overhang. According to research and consultancy firm Preqin, the North American private equity industry is sitting on roughly $500-billion in cash reserves, also known as dry powder. A large proportion of this money accumulated during the global recession, when very little transaction activity took place.

Private equity firms often have the added incentive of a ticking clock, in that they hold funds on the condition that these be invested within an allotted time frame – typically five to seven years. Failure to invest within the given window could mean return of the funds to the original investor, or renegotiation of the agreement to extend the time frame.

The increase in available capital for private financing has been fuelled in part by a willingness of large institutional funds, such as pension funds, to take a more aggressive stand in search of better returns. “There is a fair amount of public money from the pension funds, which is devoted to venture capital,” says Mike Lipkin, an investment adviser at RBC Dominion Securities. “The key reasons are that they are seeking returns, and are having a lot of problems making returns on fixed incomes, so they’ve become more adventurous in their investments.”

Another trend is that venture capital firms, which had all but disappeared from the scene following the dot-com bubble at the turn of the millennium, have shown signs of a resurgence in the past two years. While Canadian VCs have a reputation for being more conservative than their U.S. counterparts, VCs here made $1.5-billion in investments in 2011, according to Canada’s Venture Capital and Private Equity Association (CVCA).

“Private equity deal-making has remained steady on a year-over-year basis in 2012, but strong investment activity in the normally quieter third quarter suggests that the market is poised to surpass 2011 activity levels,” says Peter van der Velden, president of the CVCA, in a press release.

All of these factors have likely contributed to the flurry of Canadian investment activity in the past year. Aside from Desire2Learn, Montreal-based life science company Thrasos Therapeutics, for example, secured $35-million in private financing last year. The blockbuster deals, unsurprisingly, happened in energy; Vancouver’s Ivanhoe Mines (now called Turquoise Hills Resources) secured $426-million in investments, while Alberta’s Seven Generations Energy Ltd. locked down $200-million.

Availability of money, however, is not the only factor driving companies to private investors. As many television viewers are aware from watching the popular CBC reality show Dragon’s Den, private investors can add value as partners by bringing in their expertise and connections.

Getting the right partner, however, is critical. “You need two things in business to be successful,” Mr. McDerment says. “You need people who share values, and you need alignment with what you’re trying to achieve. If you have those two things, you’re going to figure everything else out.”

Some entrepreneurs are also adamant about keeping a tight rein on the management of their company. “Companies stay private, because they don’t need the equity financing, and frankly they don’t want to give up control,” says James Scarlett, a partner at Torys LLP law firm, “because when you go public, you give up control.”

While the availability of private capital can’t be taken for granted, there is reason for optimism that the positive trend will continue in the near-term. Canada continues to be attractive to investors – the 2012 Global Venture Capital and Private Equity Country Attractiveness Index, conducted by University of Navarra’s IESE Business School, ranked Canada second globally, behind the United States. As well, the federal government announced a $400-million Venture Capital Action Plan last month to encourage private sector equity funding of emerging businesses.

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