The Phoenix Report by McRock Capital

THE PHOENIX REPORT

Canadian Entrepreneurship and Venture Capital 2013

At McRock Capital we care about the entrepreneurial spirit and believe it will have a profound impact on Canada’s future. Entrepreneurship and Technology Innovation is more important than it has ever been in the history of Canada. After decades of being venture capitalists and investing in companies across North America and Europe, we have made a few observations to fuel the Canadian ecosystem.

Scott MacDonald

Whitney Rockley

www.McRockCapital.com

Climbing The Next Peak

• To understand Canada’s innovation crisis we need to move beyond the numbers. Most VC studies over the past decade have drawn conclusions based on capital supply numbers without further analysis of the core cause. • In order for a country to be a leader in innovation and entrepreneurship, three fundamental requirements must occur. There must be a motivation, a culture and an infrastructure in place. • Canada’s innovation era was born at the same time and with the same motivation as the US but we have had set backs that have impeded the development of a deep seeded culture of innovation and entrepreneurism. • There is hope – more so today than ever before. Our motivation has never been greater, our infrastructure has new government support and our culture of innovation is taking shape.

Entrepreneurship & Venture Capital

For Canadian entrepreneurs, accessing venture capital remains one of many challenges. The Canadian Government is once again stepping up to help the local venture capital industry find its equilibrium. In January 2013, Prime Minister Stephen Harper announced Canadaâ&#x20AC;&#x2122;s Venture Capital Action Plan aimed at putting the private sector venture capital industry on a path to sustainability and success. Now is the to time to reflect on the past and make a long-term commitment to a prosperous entrepreneurial future.

Technology has been rapidly changing and expanding in every industry and field imaginable. If Canada is going to make the most out of entrepreneurship and the massive opportunities that technology innovation creates, we need to better understand how we got to our situation today. We have concluded that the act of starting and rapidly scaling a new business requires three fundamental elements:

This threat was met with the creation of the Harvard Radio Research Lab (HRRL) manned with 800 technicians in Boston. HRRL developed military technology innovations that were deployed during the latter years of WWII and contributed to the end of the war and victory for the allies.

♦ There must be a motivation to innovate; ♦There must be a culture of innovation; and ♦There must be infrastructure in place to enable innovation. WHY SILICON VALLEY? One of the individuals responsible for the HRRL was Fred Terman. He was a professor at Stanford and upon the end of WWII, he returned to Stanford with a mission to build Stanford into a Centre of Excellence in microwave technology. As Canadians, we generalize and envy the success of Silicon Valley and have attempted to replicate the model as both entrepreneurs and VCs. We worship its results without understanding why that ecosystem works and how it got started.

By 1950, Stanford was regarded as the MIT of the West and Silicon Valley was becoming first known as Microwave Valley. It was also at this time that the first family office, J.H. Whitney, started investing in risk capital (and yes we love the name).

Early entrepreneurial motivation was driven by crisis. The creation of Silicon Valley stemmed from the events of World War II.

The 1950s was also the start of the Cold War and Terman was once again recruited to help protect the US. This time the CIA wanted him to help read the Soviet Union’s nuclear, naval and air telemetry. They also needed to equip their military with technology so the Soviet’s could not detect American activity. It was an electronic game of cat-and-mouse with Stanford designing military equipment and Microwave Valley building it.

The Germans had built the world’s most advanced electronic defense system and the allied forces needed to take out their critical infrastructure . The allied forces were losing the war and life as we knew it was at risk.

Terman was credited with leading war-time technological innovation in the US but an equally important accomplishment during this era was his significant entrepreneurial influence. He encouraged graduate students at Stanford to start their own companies.

Sherman Fairchild financed Fairchild Semiconductor and, at the time, was also the largest shareholder of IBM. Arthur Rock, one of the greatest venture capitalists ever, also helped to arrange the financing. Rock said it best, “If you can find good people, they can always change the product. Nearly every mistake I’ve made has been in picking the wrong people, not the wrong idea...Most entrepreneurs have no problem coming up with a good strategy, but they usually need all the help they can get in developing and implementing the tactics that will make them successful in the long run.”

He encouraged university professors to consult to industry and he also made IP licensing between Stanford, its students and industry easy. But Terman was not alone in building the foundation for Silicon Valley. William Shockley, the Head of Radar and Ground Training during the Cold War, worked alongside of Terman and was also from the Bay Area. Shockley’s legacy was truly the pivot from Microwave Valley into Silicon Valley.

Fred Terman Stanford Professor

William Shockley Fairchild Semiconductor

Shockley founded Shockley Semiconductor and in 1957, he recruited seven others from his company to form Fairchild Semiconductor. The group was known as the Shockley Eight. Shockley was linked to the creation of 65 chip companies including Intel, National Semiconductor and Advanced Micro Devices (AMD).

THE VALLEY`S INFRASTRUCTURE

pension fund managers to allow for higher risk investments;

In 1958, the US Government initiated its Small Business Investment Company (SBIC) program to kick start private sector investment in risk capital. By the mid 1960’s, the SBIC introduced an attractive matching program where every dollar of venture funding raised was matched with two dollars from the government. Venture capital firms such as Draper Gaither and Anderson (circa 1958), TA Associates (circa 1968), Mayfield (circa 1969) and Sequoia (circa 1972) were founded.

♦ The 1980 Small Business Investment Act redefined venture capital firms as business development companies thereby reducing reporting requirements and removing the risk of violating investment advisor regulations; ♦ The 1980 ERISA “Safe Harbour” Regulation which gave venture capitalists more freedom and removed a serious risk in accepting pension funds as limited partners; and

The matching program of the SBIC and five other pieces of legislation, profiled below, helped the US Venture Capital industry jump by a factor of 10.

♦ The 1981 Economic Recovery Tax Act which further lowered the capital gains tax rate paid by individuals from 28% to 20%.

♦ The 1978 Revenue Act reduced the capital gains tax rate from 49.5% to 28%;

As the industry matured, Silicon Valley evolved from being a region that was required to innovate out of necessity, or crisis, to a region that innovated in search of profit.

♦ The 1979 “Prudent Man” Rule which revised and clarified the guidelines for

From Business Week, Oct 29, 1960 General Partners H. Rowan Gaither, Jr., Frederick L. Anderson, Laurence G. Duerig, William H. Draper, Jr. Pictured from left to right.

LOST: Canada`s “Aviation Alley”

Canadian entrepreneurs were also motivated by crisis. Post-Second World War, the Soviet Union began developing a fleet of long-range bombers. The main threat was principally from high-speed, high-altitude bombing runs launched from the Soviet Union travelling over the Arctic. To counter this threat, Western countries engaged in the development of interceptors that could engage and destroy these bombers before they reached their targets.

The Arrow was, and still is, considered to be one of the most advanced technical and aerodynamic achievements ever in aviation. The jet demonstrated near Mach 3 speeds at altitudes exceeding 60,000 feet. The design, parts and assembly of the Arrow’s were 100% Canadian. The performance and onboard electronics were the most sophisticated in the world and the jet consisted of 38,000 Canadian made parts including the engine.

V. Roe Canada Limited had been set up as a subsidiary of the Hawker Siddeley Group in 1945, initially handling repair and maintenance work for aircraft at what is today known as Pearson International Airport. The next year the company began the design of Canada's first fighter jet, the Avro Canada CF-105 Arrow (the “Arrow”).

Not long after the 1958 start of the Arrow’s flight test program, the program was abruptly and controversially halted by the Canadian government.

On Black Friday (February 20, 1959) Avro terminated the employment of 14,000 people in Malton, Ontario after Prime Minister Diefenbaker stood up in the House of Commons and announced that the Avro Arrow and Iroquois Engine Programs would be cancelled. It has been estimated that a further 35,000 jobs in supporting industries were also lost once Avro was shut down.

Division with a team of 33 Avro engineers. He helped spearhead the Gemini and Apollo manned space programs and helped the US take a man to the moon. ♦ James Ford (key design engineer at Avro), born in the UK, went back to the UK and helped to build the Concorde. The magnitude of the brain-drain effect from the Nortel collapse is difficult to quantify but the negative impact on Canada is certain. Nortel’s assets and IP were purchased by companies such as Ericsson (Sweden), Apple (US), Microsoft (US), Sony (Japan), Avaya (US), Ciena Corporation (US), Hitachi (Japan), Kapsch (Austria), and Genband (US).

This decision profoundly impacted the future of Canadian innovation. All of the planes, engines and blueprints were destroyed. Canada essentially gave away 30 years of global aviation supremacy. We also lost the talent. For entirely different reasons, Nortel Networks is also a blemish in the history of Canadian innovation. At its height, Nortel accounted for more than a third of the total valuation of all the companies listed on the Toronto Stock Exchange, employing 94,500 worldwide, with 25,900 in Canada alone. In September 2000, Nortel's market capitalization fell from C$398 billion to less than C$5 billion by August 2002. Over this same period, Nortel's stock price plunged from C$124 to C$0.47. When Nortel's stock crashed, it took with it a wide swath of Canadian investors and pension funds and left 60,000 Nortel employees unemployed.

CANADIAN VENTURE CAPITAL

Venture Capital

Canadian venture capital as an industry made a small debut in the 1970s and 1980s. The industry was mostly development capital for traditional industries with a sprinkling of tech investing. The investors were financial institutions, insurance companies, pension funds and some large corporations. A number of government funds were also created in the ‘80s such as the venture capital division of the Business Development Bank of Canada (circa 1985),

CANADA: TALENT IS LOST It is well documented the talent that Canada lost through the dismantling of Avro. ♦ Jim Champerlin (Chief Aerodynamicist at Avro), born in Kamloops, went to NASA. He was the Head of NASA’s Engineering

Vencap in Alberta (circa 1983), Discovery Capital in BC (circa 1986) and Innovation Ontario (circa 1986). Of all these initiatives, only the Business Development Bank remains active and committed to the VC industry today.

THE BIRTH OF RETAIL VC In 1983, the first Labour Sponsored Venture Capital Corporation (LSVCC) was created. The Fonds de solidarité des travailleurs du Québec (FSTQ) was created and was able to raise investment capital from individuals (this is why they are called “retail VC funds”).

There were very few private independent venture capital fund managers at that time. The list includes Helix Investments (circa 1968), Ventures West (circa 1972), Innocan Investments (circa 1973), Novacap (circa 1981). Novacap stands on its own as one of the few independent Canadian firms that is still active today. Ventures West, who’s web site describes itself as one of “Canada’s oldest, largest and most established venture capital firms” pulled out of the market after raising its 8th fund and significantly reduced its team in 2008.

In 1989, the federal government announced the creation of a national retail VC fund program. The first fund established outside of Quebec was Working Ventures. That fund began raising capital in modest amounts in 1990. Gradually, as the federal legislation was enacted several years later, eight provinces established labour-sponsored programs. MARCH, 1999 " Too often in the past in Canada there has been either insufficient risk capital or it has been volatile and entrepreneurs have faced a feast-orfamine situation. This is an apprenticeship business. We have rebuilt this industry, which, in the late 1980s and early 1990s, was called by some the nuclear winter of venture capital." - Mr. Ron Begg, President of the CVCA, reporting to the Federal Government

The retail VC Fund program gained momentum and substantial capital was raised in 1996. By 1999 there were 23 retail VC funds accounting for approximately half of all venture capital in Canada.

FEELS LIKE THAT MOVIE – GROUNDHOG DAY

In the beginning of the 1990s, the entire venture capital industry in Canada had a total of $3 billion in assets under administration. At the end of 1997, total assets under administration by venture capital companies had ballooned to $8.4 billion. In March of 1999, Mr. Begg, the President of both the Canadian Venture Capital Association and Working Ventures, reported to The Federal Standing Senate Committee on Banking, Trade and Commerce on the state of the venture capital in Canada. In his report, Mr. Begg acknowledged that "more capital was raised than was anticipated and it was considered to have been excessive -certainly in one year it was ".

It didn’t take long after the peaks of 1996 for the VC nuclear winter to return. According to a 2012 Canadian Venture Capital Association study, post 2000 another crises in the supply of venture capital was upon the country.

With the assistance of the governments retail VC fund tax credits, The VC industry managed to swing from the “nuclear winter” of the late 1980s and early 1990s to reports of too much venture capital chasing too few deals in the late 90s.

HOLD THE PHONE! It wasn’t all doom and gloom in the 2000’s. On the downside, many retail VC funds were fading due to changes to the tax treatment. Ventures West was winding down and experienced LPs such as pension funds, banks and insurance companies were abandoning the Canadian market due to poor historical VC performance. However new LPs, backed by governments and FSTQ, such as Teralys Capital, OVCF and Alberta Enterprise Corporation emerged and the Federal Government`s BDC and Export Development Corporation held strong.

In 2005, the Ontario government announced it would phase out the provincial tax credits for retail VC funds by 2011. Subsequently, the 2013 Federal Budget announced plans to eliminate all federal retail VC fund tax credits by 2017. This change will strip billions of dollars of capital from the innovation ecosystem in the coming years.

be fair they also mentioned the angel network was not well developed and that exits have been mediocre.

A handful of new private independent VC funds were raised during this time: Rho Canada Ventures, Georgian Capital Partners, and Lumira Capital. iNovia Capital and Celtic House successfully raised successor funds. Extreme and Mantella Venture Partners were born with entirely different business models. All groups successfully raised capital and some have already demonstrated attractive exits.

This is what we think: ♦ The angel network has always been strong in Canada. It’s just quiet or some would say, private. ♦ Canada has had a number of recent venture-backed successes. We just don’t herald them from the rafters like we should. We also struggle with building billion dollar companies.

Yet when consultants like McKinsey & Company examined this country’s VC ecosystem in 2011, they reached conclusions that we fundamentally disagree with.

♦ As Canadians, we are still afraid to fail yet we are starting to see the tides change. Do you recognize the guy below? I bet McKinsey doesn’t.

In essence, their conclusion was that Canadian entrepreneurs and VCs are both subpar. The management teams are inexperienced and the VCs don’t bring much to the table except small cheques. To

Ryan Holmes, CEO of HootSuite

CANADA HAS BUILT INNOVATIVE COMPANIES

Pure Technologies and Q9 Networks. Canada has made a great start but we need to continue to build a stronger culture of entrepreneurship.

Over the last decade, entrepreneurs backed by venture capitalists have grown spectacularly innovative companies. A handful of the acquired companies are profiled below. The return metrics are venture-grade. The acquirers are predominantly US companies.

We also need a long-term commitment from government and the Canadian securities regulators to ensure infrastructure and guidelines enable and encourage Canadian entrepreneurs to build billion dollar companies.

Other proudly Canadian venture-backed companies include Sandvine, HootSuite,

Investment Multiple

IRR

Acquirer

Acquisition Price

22.8x

142%

Salesforce. com

$320 million

18x

117%

Novell

$205 million

18x

49%

Siemens

$440 million

13.3x

38.7%

Catalyst Health

$4.4 billion

32.8%

IBM

7.5x

54%

The Hershey Company

$175 million

5.4x

68%

Vertex

$375 million

Alexion Pharma

$1.08 billion

THE PUNCHLINE There is hope. Out of sheer necessity (crisis, sound familiar?) a new breed of entrepreneur and venture capitalist has emerged over the past decade. People are playing to win with a new intensity. They are willing to sacrifice everything and have an unhealthy level of commitment.

Entrepreneurship and Technology Innovation is more important than it has ever been in the history of Canada. At McRock Capital, we challenged the many reports that simply concluded that too little capital was being put to work or too much capital was chasing too few deals. It’s an over simplified conclusion and is not the root cause of the challenges that the Canadian VC ecosystem faces. It goes much deeper. The problem in Canada is cultural.

On one hand, the Government is slowly abandoning the Retail VC fund industry. On the other hand, its stepping up with its Venture Capital Action Plan to kick-start the private sector VC industry. It also remains committed to initiatives through the BDC.

We have tried to replicate the innovation model of Silicon Valley without fully understanding all aspects of its success. At the heart of this model are 3 ingredients that must co-exist: motivation, culture and infrastructure.

In just the last decade alone we have grown exceptional technology companies such as Radian6, Q1 Labs, RuggedCom, Q9 Networks, Pure Technologies, Brookside Foods, Sandvine, PlateSpin, and Enobia Pharma, just to name a few.

Like the US, Canada’s innovation era was born at the same time (WWII) and out of the same motivation (crisis) . But Canada has had set backs. A culture of Innovation was not woven into the fabric of our society because we lost leaders, mostly to the US. Canada lost its versions of Terman and Shockley, which, as a result, impeded the development of Canada’s culture of risk taking and entrepreneurialism.

Like a phoenix rising from the ashes, Canada‘s entrepreneurial and VC ecosystem has new life. Our motivation has never been greater, our infrastructure has support and a profound culture of innovation is taking flight.

ABOUT MCROCK CAPITAL McRock Capital is the first dedicated iNtelligent iNfrastructure venture capital fund. McRock is investing in companies that are developing industrial data solutions to help established industries operate more efficiently. These companies provide advanced computing, analytics and low-cost sensing to the water, electric power, oil & gas, transportation and building efficiency industries. www.McRockCapital.com

@McRockCapital

ACKNOWLEDGEMENT ♦ We are grateful to the CVCA for providing historical information and statistics www.cvca.ca ♦ Venture Capital at the Crossroads, William Bygrave and Jeffry Timmons, 1992