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The Research In Motion Ltd. company logo in front of one of their many buildings, in Waterloo, Ont. (DAVE CHIDLEY/THE CANADIAN PRESS)
The Research In Motion Ltd. company logo in front of one of their many buildings, in Waterloo, Ont. (DAVE CHIDLEY/THE CANADIAN PRESS)

Canada’s vanishing tech sector Add to ...

If Research in Motion Ltd. is no longer Canada’s most valuable publicly-traded high tech company, what is?

The answer may surprise you. You won’t find it in the S&P/TSX information technology index. Except for its stock market listing in Toronto and the fact that it’s registered in the Yukon, it is barely Canadian at all. But in the past few years, SXC Health Solutions Corp. – which uprooted its head office from Milton, Ont., to the Chicago area a decade ago – has mushroomed into a world-beater, on the back of software its sells to firms that manage prescription drug claims for employers and governments mostly in the United States.

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SXC became so successful, it began buying its customers, and now manages many drug benefits programs itself. The stock has increased sixfold in value on the Toronto Stock Exchange in the past three years, giving SXC a stock market valuation of close to $10-billion – more than double the size of RIM.

That may be great news for SXC shareholders, but in a sense, it’s deeply troubling for the Canadian high-tech sector. One of the country’s great homegrown successes has all but shed its Canadian roots (SXC has just 35 employees left in Canada). Meanwhile, the other, RIM, which has been Canada’s top tech name for much of the past decade, is trying to arrest a steep decline. The BlackBerry maker’s rapid reversal of fortune means that, for the first time in at least a generation, Canada lacks a single, healthy large-capitalization tech champion.

In fact, the air is quickly coming out of Canada’s high tech sector – or what’s left of it. High-tech companies now account for a razor-thin 1.6 per cent of Canada’s benchmark stock index, the TSX composite (excluding SXC, which is now counted as a health care stock). That’s down from a staggering 41 per cent in July, 2000, near the peak of the tech bubble, when Nortel Networks Corp. accounted for more than one-third of the index. That steep decline isn’t just due to Nortel’s demise: High-tech names have been vanishing from the radar in Canada at an alarming rate. Last year, 45 Canadian tech firms were snapped up by foreign buyers, up from 32 the year before and less than 15 per year in the mid-2000s, according to Branham Group, an Ottawa market research firm.

Worse, most of those companies are selling out too early, before they have a chance to grow into larger, global businesses that could fuel further innovation and success in the tech sector, say industry insiders and observers. The blame is squarely pointed at what they call a “broken” financing system, starting with wary, previously burned angel investors, a timid, underfunded and inexperienced venture capital industry, and moving up to institutional investors who are still smarting from their experience with Nortel stock. Many Bay Street investment dealers have lost all interest in the sector, content with the flow of deals in mining and oil and gas. Equity offerings from technology companies represented less than 4 per cent of deals on the TSX in each of the past four years, down from more than 20 per cent a decade ago. That means investment banks are cutting back on technology research. “The amount of resources the major firms on the Street have dedicated to following tech has been rationalized significantly,” says Tom Astle, a former Merrill Lynch analyst who is now director of research with Byron Capital Markets, a boutique tech-focused investment banking firm.

Without big companies at the top of the high-tech food chain – and increasingly, with mid-market companies vanishing as well – it’s like cutting off oxygen to the rest of the sector. “You need a whole ecosystem, from big anchor companies down to entrepreneurial shops,” said Adam Chowaniec, one of Canada’s most successful high-tech entrepreneurs and chairman of Startup Canada, an organization that helps foster entrepreneurs. “If you strip off big chunks of that, you’re in trouble.” It is the large companies that develop the sector’s infrastructure, spin off companies, recruit the big-name talent from abroad, tap the services of other local companies and feed startups when their own entrepreneurial employees leave.

But the continued decline of the sector – with its high-paid, knowledge-based jobs, intellectual property and pursuit of innovation – also has real implications for a resource-based economy coming off an extended bull run in commodity prices. The federal government has taken notice. In its recent budget, the government announced it will pour $400-million into Canadian venture capital, and Finance Minister Jim Flaherty has tapped Sam Duboc, one of Canada’s most successful venture capital investors, to provide advice on how best to deploy the money. But is that enough to create an environment that will produce the next RIM, the next SXC?

“My estimate is we need $1-billion of new risk capital per year,” Mr. Chowaniec said. “Four hundred million on a one-time basis isn’t going to do it. We have a lot of stuff going for us in Canada, but we have some broken pieces. If we don’t fix them, our chances of building new billion-dollar companies are going to be slim.”

The money issue

Ask anyone on the Ottawa tech scene which company is the sector’s next great hope, and you will get one answer: Shopify Inc.

The private firm, founded and led by a 31-year-old transplanted German software developer named Tobias Lutke, started out six years ago as an online snowboard seller before other companies began asking to license its homemade e-commerce software. Now, after ditching its snowboard business, Shopify boasts more than 25,000 customers, ranging from General Electric to dance band LMFAO, which use the software to set up online storefronts in minutes.

Shopify’s revenue is increasing by more than 100 per cent a year and is in the tens of millions of dollars. Mr. Lutke has had little trouble raising money from investors, closing a $15-million round of financing last fall, and is hoping to take his company public in four to five years. But when you talk to him, he makes it clear that the company’s success is almost in spite of its location, not because of it. (Had he not married a Canadian, he likely would have ended up in Berlin or San Francisco, he said.)

Mr. Lutke set up his company in the city’s Byward Market nightclub zone, far from the old-guard techies out in the suburb of Kanata, with whom he has little in common. “You can’t get them to talk anything but doom and gloom,” he said. Most of his financing comes from sophisticated U.S. venture capital firms, including one Silicon Valley VC firm that backed LinkedIn, and is one of the few early-stage companies in a position to turn away Canadian investors. When he went looking for money, his criteria was: Would you pay money to have dinner with that person? “If the answer was yes, we would want them to invest,” he said. “The answer ended up being ‘No’ fairly frequently, looking at the Canadians. I wouldn’t pay money to have dinner with them. It’s the difference between money and smart money.”

The problem in Canada’s high-tech sector isn’t a lack of ideas: Entrepreneurship is alive and well. Bruce Lazenby, president and CEO of Invest Ottawa, a publicly funded economic stimulus agency, said there are close to 2,000 tech companies now in the Ottawa region, about four times as many as there were a decade ago.

Rather, the issue is money, or lack thereof, due to a lack of investor interest in Canada. It’s a pattern that manifests itself at all levels in Canada, and can best be explained as a Nortel hangover. Until the late 1990s, Canada had a healthy, if not flashy, high-tech sector, centred in the Ottawa region around telecommunications, dating back decades. With the rise of the Internet, “at a time when the world said ‘We need connectivity,’ Ottawa said, ‘We can do that,’ and it took off” led by Nortel, Mr. Lazenby said. “We were in the right place at the right time.”

But unlike the U.S., there was almost no risk capital to support the growth of the tech industry here. The first experience many investors had with tech here was Nortel’s outstanding stock market success, and that of other shooting stars that briefly sported inflated valuations during the Internet bubble. Nortel’s massive size at its peak was also unnaturally high, meaning many ordinary Canadians felt the pain – either through their portfolios or their Canadian mutual funds – when it melted down.

That helped to create an aversion to the tech sector as a whole, and it also meant Canadians didn’t recover as quickly as Americans, who were more accustomed to the ups and downs of technology investments. “There are a lot of people in Canada still smarting from the dot-com bust, and that’s a real problem,” Mr. Lutke said. “They are still thinking about the money they lost 10 years ago. That’s a bad state of mind to be in.”

Worse, according to a damning 2009 study by Impact Group of 18 early-stage tech companies that died or were bought out, the few Canadian venture capital firms that do take on tech investments tend to lack the experience, appetite for risk and know-how to help their portfolio companies – unlike U.S. venture capital firms, which typically employ one or more successful entrepreneurs. Canadian VCs also lack the financing to help take their companies through the full investing “life-cycle” until they become self-sustaining. “In Canada we don’t have the ability to take companies from the beginning to the end,” said Scott Clark, managing partner with Covington Funds, one of Canada’s more successful VC firms. “The biggest challenge companies have is getting a second round of funds.”

As a result, Canadian tech startups typically raise only about one-third of what their American counterparts do, and are often pushed by risk-averse investors to sell out just when they could be making the investment to become something much bigger, Mr. Chowaniec said. He has experienced that first-hand as chairman of Belair Networks, a Kanata Wifi technology developer that grew to about $50-million in annual revenue.

“Belair was at the point of taking off and had potential to be an anchor, and needed $20-million to $40-million to get to the next level,” he said. That proved hard to find from private investors, and when the company approached Bay Street investment bankers to go public, it got a valuation of $80-million for the entire company – unacceptable, given that the company had already raised $70-million privately. Meanwhile, the company was too small for a U.S. listing.

So instead, the board sold the company to telecom giant Ericsson for $250-million earlier this year.

And if Belair had gone public? It likely would have encountered what Byron Capital’s Tom Astle calls “the Canuck Tech Discount.” Earlier this year, he calculated that Canadian software firms trade at a 23 per cent discount to U.S. peers, on average. The discount for hardware firms was 34 per cent – making them undervalued targets for acquisitive foreign rivals.

“The only real option for Canadian tech companies in the last few years has been to sell themselves to American competitors,” Mr. Lutke said. “I’m not sure how you’re supposed to create a billion-dollar company in such an environment.”

A reason for hope

Canada’s dwindling tech titans may be worried, but they haven’t given up. And there are a few signs of hope.

One is Code Cubitt. Earlier this year, the oddly-named Canadian-born venture capitalist was taking a year off from a successful career in the U.S. high-tech sector, including a stint managing venture capital money for Motorola, when he got a call from Invest Ottawa’s Mr. Lazenby. The two had never met, but Mr. Lazenby was looking for a Canadian who had made it in Silicon Valley to come up to Ottawa and start a venture capital fund.

The 40-year-old Mr. Cubitt was intrigued, came to the capital in April on a scouting mission and decided there was ample opportunity to launch a successful Ottawa-based VC fund. He has raised $2-million after two weeks, on his way to an initial goal of $10-million by fall.

“There’s no question there’s a lot of good, underfunded, talented companies in the region,” he said. “What I observed was clear underfunding of good talented companies, as good as anything I’d seen in the U.S. I’m getting a lot of serious interest from people who’ve made money in technology, and they’re telling me this is something we absolutely need more than anything else.”

In Waterloo, where about 9,000 people work for RIM, 300 companies have started up in the past year; typically, there are at least 1,000 unfulfilled tech positions in the region at any time. Even if RIM were to be broken up or to fail, the entrepreneurial kick-start provided to the city by the University of Waterloo would remain. Meanwhile, the steady flow of talent out of RIM has already started to populate many of the area’s startups, suggesting the region could yet launch new technology stars.

But fixing the financing chain is crucial for Canada, if those companies are to grow – before the entrepreneurs behind them decide to move to the U.S. to put their ideas into motion, or just sell out. “It would be a tragedy if the only way we could grow our companies is to move them to Chicago,” Mr. Chowaniec said.

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