The University of Toronto Capital Markets Institute 1 and the Centre for Innovation Law and Policy 2 have jointly sponsored a series of roundtables entitled "Financing Innovative Ventures in Canada: Issues of Law and Policy." The roundtable series aims at bringing together academics who study Canadian capital markets and expert participants in those markets in a series of structured discussions intended to help shape the direction of academic research and government policy related to the effective provision of capital to innovative Canadian enterprise.

The first roundtable in the series was held on June 8, 2000 on the topic of angel investment in Canada. Angel investors are individuals who invest their own capital in fledgling businesses, both in the technology and non- technology areas. Research by Allan Riding at Carleton University (a member of our panel) shows that such individuals typically have run their own small businesses, have significant net worth and income, tend to be college-educated, and are extremely discerning in the projects that they will invest in (rejecting, on average, approximately 97% of the proposals submitted to them). Angel investors typically invest in a business after the entrepreneur's "love capital" (capital from relatives and friends) has been exhausted, but before the firm has reached a stage at which it will be eligible for venture capital investment. Angel investments typically range from about $10,000 to $150,000, although investments may range upwards of $500,000. Professor Riding's research also indicates that, historically, most angel investors seek to invest close to home-within a 200-mile radius of where they live.

The roundtable discussion focused on the nature and importance of angel investment in Canada, the level of Canadian angel investment activity, particularly compared to the United States, the factors currently inhibiting angel investment in Canada, and policy initiatives that would strengthen Canadian capital markets in this area. The following is an edited transcript of the roundtable, beginning with a list of the roundtable participants. Moderator: Jeff MacIntosh - Toronto Stock Exchange Professor of Capital Markets, University of Toronto Faculty of Law, and Associate Director, University of Toronto Capital Markets Institute.

Participants: Borys Chabursky - CEO, Toronto Biotechnology Commercialization Centre; Gordon Gow - President, Gordon W. Gow & Associates; Richard Nathan - Principal, Brightspark; Jim Orgill - Managing Director for Venture Capital, Business Develpment Bank of Canada; Dennis Peterson - President, Peterson & Company; Allan Riding - Professor, Carleton University; Gordon Sharwood - President, Sharwood & Company; Greg Warren - Executive Director, Centre for Innovation Law and Policy; Doug Welwood - Manager, Economic Development Strategy Branch, Ministry of Economic Development and Trade; Rob Wildeboer - Partner, Wildeboer Rand Thomson Apps & Dellelce; Doug Wright - President Emeritus of University of Waterloo; Paul Harris-Lowe - President, International Angel Investors, Toronto

Jeff MacIntosh: I want to start with a basic question that will set up our discussion today, namely, what is the importance of angel capital in financing technology enterprises in Canada?

Allan Riding: In the course of my research, I have spent some time considering why it is that angels are important, and the first item, of course, is money. Angels fill the capital gap between "family and friends" financing and venture capital. But, more than that, angels provide money to the sectors in the business landscape where the need is the greatest. It used to be said that, in Canada, technology firms could not access capital, that new firms could not access capital, and that new technology firms had a terrible time. It is in this context that angels are crucial. They have had, and will continue to have, a fundamentally important role in identifying and financing business in the highest growth sectors.

Rob Wildeboer: Effective early-stage investors also bring expertise. The best angels bring contacts and experience to help technology companies identify customers, get the professional services they require, prepare for later rounds of financing and so on.

Doug Wright: I know a number of cases where angels are on the phone two and three times a day to the CEOs of the companies in which the angels have invested. The angel provides frequent and valuable advice. That, it seems to me, is what the angel stage is all about. It is a lot more than money.

Allan Riding: Our understanding of who becomes an angel investor certainly underscores the points made by Rob and Doug. Angels are not well represented among wealthy professionals such as doctors and lawyers, but they are well represented among business owners who have succeeded. Research done by Professor Ellen Farrell at Dalhousie University showed that, in Atlantic Canada, one in five business owners had acted as an angel investor. Doug Wright: Yes, and successful technology entrepreneurs then become successful technology angels, because they are confident, knowledgeable investors.

Jeff MacIntosh: Okay, so angels provide capital at a critical stage to ventures in important, emerging sectors. They also bring the expertise associated with their own business success. Given the importance of angels, do we have enough angel investment going on in Canada?

Allan Riding: Strictly speaking, there is no shortage of angel capital available in Canada, and in certain regions, such as Ottawa, angel investment is very strong. However, it is true to say that there is not enough angel investment in Canada, and I think this reflects four factors. First, angels strongly lament the lack of management ability in Canada. We have talked to hundreds of angels across Canada and this comes up again and again. Angels reject 97% of the business proposals that come their way, and lack of management is the number 1 reason. We have done a good job in Canada of fostering invention. Government programs, such as the Industrial Research Assistance Program and Centres of Excellence, have created success in university labs, government labs and in the private sector. However, we struggle in our ability to take invention and commercialize it, to make that jump between an idea and a business. This hampers angel investment. Second, the market in Canada is somewhat fragmented. There are a limited number of entrepreneurs in Canada who are sufficiently growth-oriented to represent viable investment opportunities for angels, who typically look for 30% compound annual returns. Of the 552,000 small businesses that exist in Canada, only about 15% have owners who plan to grow the business aggressively. On the other side of the market are the angels, who are a diverse bunch. Some never invest more than $10,000, others never invest less than $500,000. We have angels who prefer high-tech, or will only invest in high-tech, or those who will only invest in their geographic region. Finally, we have geography: limited investment opportunities and limited and diverse investors are spread across a big country. The other two factors are ones that I am sure we will talk about today: tax laws and regulation of investment transactions.

Jeff MacIntosh: Yes, we will talk about tax and securities laws. But staying with the issue of the level of angel investment in Canada, how does the situation in Canada compare to that in the United States?

Richard Nathan: I am familiar with the Toronto market and I think that it has made great strides recently with respect to providing early-stage financing to technology companies. Nevertheless, at both the angel investment and the venture capital stage, we lag behind the United States, even ignoring a unique phenomenon such as Silicon Valley and looking at comparable metropolitan areas like Boston, Washington, and Austin, Texas.

Gordon Sharwood: In Boston, there are about 15 professionally run "bands of angels." The market is so well covered that venture capital firms there will not look at any financing under US$3 million. That is certainly not the case here.

Jeff MacIntosh: For many years it has been said that Canada has a less entrepreneurial culture than the United States, that Canadians are more risk-averse. Do these cultural differences persist, and do they affect the level of angel investment in Canada?

Jim Orgill: Angel investors typically are entrepreneurs who have been successful, and it is that success that breeds their desire to invest further. So, it is not a question of risk aversion, it is a question of experience. The more experience they have with successful companies and investing, the more they are going to do.

Gordon Sharwood: My son graduated recently from Babson College in Boston. I was present at a speech given in November to the graduating class by Maribeth Rahe, the Vice-Chairman of U.S. Trust Corporation. She asked how many members of the class (about 100 people) had already started their own business, or planned to do so within six months of graduation. Three-quarters of the class put up their hands. I addressed the graduating class at the Schulich School of Business at York University a month ago, and I asked the same question. Three of 60 put up their hands. This underlines a major cultural difference that has a profound effect on the level of entrepreneurial activity and angel investment in Canada.

Paul Harris-Lowe: The difference in culture extends to investors, as well. I recently had two conversations, one with a U.S. angel investor and one with a Canadian angel investor, which illustrate this point. The U.S. angel investor told me enthusiastically about his experience at a boot camp for start-ups run by garage.com. He said it was great because there were 800 people there, deals going on all over the place, entrepreneurs and investors were mixing with each other, and it was absolutely fabulous. In my view, that type of event is something we need to see more of in Canada. A half-hour later, I mentioned the boot camp concept to a Canadian angel investor. He expressed a preference for a matching process that was relatively quiet and subtle and did not lead to a lot of publicity. He wanted anonymity. This is a problem when there is a smaller, more geographically dispersed market for business and capital in Canada than in the United States.

Jeff MacIntosh: So if there is more angel investment in the United States, and a culture that better supports entrepreneurial ventures and angel investment, are Canadians heading there for capital? If they are, is that a good thing or a bad thing?

Rob Wildeboer: Certainly at the venture capital stage you are seeing a lot of very good Canadian companies looking to the United States. I think that is a tragedy. Americans are often more willing to invest in Canadian companies than Canadians.

Richard Nathan: I am not concerned about Canadian companies seeking venture capital in the United States. I think that is the way financing a growth company works. Initially, you find local investment: angels and perhaps very early venture capital. You find the people who are going to be there to keep an eye on you. Then, as your business grows, and you need more money, you access the bigger capital pools on Wall Street, Silicon Valley-wherever you find them. It is natural for a Canadian company based in Toronto to want to try to access U.S. venture capital firms as they grow, because those give them business contacts in the other markets.

Borys Chabursky: I think it's great if Canadian companies can choose to go to the U.S. to accelerate their growth and access new markets. However, if they are being forced to do so in order to access capital and expertise, then I think there is a problem. It is an even bigger problem if, because of the local nature of angel investment, Canadian companies cannot reach the stage at which they can seek U.S. venture capital. My sense is that we still have a problem in Canada at the early, local stage.

Jeff MacIntosh: The local nature of angel investment means that the U.S. money is not as readily available at the pre-venture capital stage. This makes a healthy local angel investment market even more important. But is angel investment truly a local phenomenon? What about organizations like garage.com, a U.S. for-profit Internet-based company, or ACE-Net, a U.S. government-sponsored service, which purport to facilitate angel investment nationally?

Doug Welwood: As part of our work at the Ministry of Economic Development and Trade, we have looked at angel investor organizations, not only in Silicon Valley, but also in places like Seattle, Texas, Maryland and Boston. What we found was that successful angel investor organizations were very much locally focused. And, if you think of the dynamics of early-stage investment, that makes sense. It must be a local phenomenon, given the personal and interactive nature of the relationship between the investor and the entrepreneur. Although we did not look specifically at ACE-Net, we certainly heard secondhand from American angel investors that it has not lived up to expectations.

Gordon Gow: Angel investment is also very much a local phenomenon because of the fact that success creates success. Ottawa started with the Mitels, the Newbridges, the Bell Northern Labs, and other successes. These have created a number of wealthy, technology-savvy angel investors, who are now financing another generation of technology companies. We are seeing the same thing in Waterloo to a lesser extent.

Jeff MacIntosh: I would like to turn now to specific areas of law and regulation that affect angel investment in Canada, beginning with securities laws. As you well know, angels invest only by means of exemptions from the prospectus requirement applicable under provincial securities law. The main exemptions currently used by angels are: (1) the $150,000 exemption, which covers those investing at least $150,000; (2) the so-called seed capital exemption, which includes investors who are "rich and smart" or well advised, in addition to directors and officers; (3) the "private company" exemption, covering sales of securities of a private company, as defined in the Securities Act; and (4) the government incentive security exemption, which is broadly similar to the seed capital exemption. The Ontario Securities Commission (OSC) has issued a "concept release" which proposes to revamp the exemptions along the lines suggested by the Task Force on Small Business. The exemptions that I just mentioned would be replaced by two new exemptions- the closely held issuer exemption, and the accredited investor exemption. Under the former, up to $3 million could be raised via sales to up to 35 investors, including employees, with essentially no regulatory requirements. Under the latter, individuals would qualify as accredited investors if they have income in excess of $200,000 in each of the two preceding years (or $300,000 with spouse), or an individual who, together with spouse, has a net worth of $2.5 million, excluding one-half of the personal residence. I would appreciate your views on the current Ontario regime, on the OSC proposal, or on the comparative securities laws in other provinces.

Allan Riding: Well, it is very clear to me that the current principal private placement exemption in Ontario, which requires each investor to invest a minimum of $150,000, simply does not work in the angel investment context. My research indicates that the average angel investment is well below this threshold.

Paul Harris-Lowe: I agree. The current $150,000 exemption doesn't work from the perspective of risk management. It is not unreasonable for wealthy, sophisticated investors to decide that they should not be risking more than 2% of their capital on any given investment. So if you take that logic and then throw in the $150,000 minimum investment, we are restricting the angel investment market to people with a net worth of $7.5 million.

Gordon Sharwood: I agree with Paul on the issue of risk management. I see angels doing what is called "sprinkling." The concept of sprinkling takes me back to the days of the mining boom in Montreal, where I grew up, where you would give 10 prospectors $10,000 and a pick axe and send them out into the bush and one hit gold and the rest came back with nothing. Similarly, today, you do not want to put $150,000 in the hands of one dot-com, you want to put $10,000 into 15 dot-coms. That is what is going on in the U.S. In Ontario, that type of sprinkling is only permitted if a portfolio manager or an investment advisor is managing the funds used to sprinkle. I have no doubt that the current securities law regime is a barrier to effective capital formation in Ontario. I am pleased to see the OSC contemplating a change, although their proposal does not go far enough. In the United States, accredited investors need only have a net worth of $1 million, including the principal residence, or an annual income of $200,000. Given the way capital flows across the border these days, we should be considering a regime no more restrictive than the one in the U.S., and, given the nature of our market, we should perhaps consider adopting lower thresholds.

Jeff MacIntosh: In terms of evaluating the OSC's proposal on the accredited investor criteria, I think it is essential to look at the annual income and net worth of the median angel investor in Canada. Allan, I believe your 1993 study showed that the average annual income of Canadian angels was $177,000 and the average net worth was $1.36 million. The net worth figure included the angel's principal residence. The OSC's proposal excludes half the principal residence, so that might take the median number down to about $1 million. As I said, the OSC is proposing $2.5 million. How many of those currently supplying angel capital would that cut out? Would it be 90%? I don't know. But I suggest that you want to set your threshold significantly lower than the median, because if you put it at the median, you cut out half your investors. Rob Wildeboer: If I recall correctly, the Kimber Report, which is the original 1960s policy document on which much of the securities regulation in this province is premised, stated that the purpose of securities regulation is to encourage efficient capital markets and capital formation. Investor protection is important because it creates confidence in the market necessary for its efficiency. In other words, investor protection is a tool in order to ensure efficient capital markets. Over the years, I think that we have forgotten this in terms of regulation of early-stage investment. Investor protection has been seen by the OSC as the end, not the means to the end. In terms of specific regulatory initiatives, I would make three comments. First, echoing some of the views already expressed, I think that the OSC's proposal for the exempt market should include more realistic tests for the accredited investor exemption. Secondly, I think the proposal should include non-financial criteria for accredited investors that can also establish sophistication. If you are a business school professor, for example, you might not meet the income test or the earnings test, but you would probably meet a sophistication test. The problem with the $150,000 exemption is that it confuses wealth with sophistication. The OSC proposal continues this confusion by setting the accredited investor financial tests too high, and not providing for other measures of sophistication. Finally, I think that it is imperative that the OSC act more swiftly on this issue. Their preoccupation with investor protection has meant that reform of the exempt market, first put forward in 1996, has still not been introduced. Meanwhile, the current rules force market players to avoid certain investments or contravene the rules.

Dennis Peterson: Another important point regarding the Ontario securities rules relates to the disclosure requirements tied to private placements. If an investor information document is prepared, it must conform to the rules regarding offering memoranda. These rules require a certificate to the effect that the document does not contain a misrepresentation. However, the rules do not provide any specific content guidelines. I think it would help lawyers, and therefore reduce transaction costs, if there were content guidelines, as is the case in Alberta. The guidelines should require only the important disclosure, such as GAAP financials, and not a lot of the less useful information currently required in prospectuses.

Jeff MacIntosh: My understanding is that the difficulty in putting an offering memorandum together is the definition of "misrepresentation" in the Ontario Securities Act. Misrepresentation is defined to include an omission to state a material fact that is required to make a statement not misleading in the light of the circumstances in which it was made. So lawyers feel compelled to advise their clients to try to cover all bases to avoid later allegations that something material was left out of the prospectus. As a result, you end up with a document that is essentially a prospectus. So, Dennis, I like your idea of actually prescribing what goes into an offering memorandum, because that could provide a "safe harbour" in a sense. You put in the prescribed content and you are arguably protected from that part of the definition of misrepresentation.

Allan Riding: Any reform of current Ontario securities laws that would reduce the cost of preparing investor disclosure documents would be welcome. I believe the cost of compliance provides a real deterrent to capital formation at the early stage. That a business has to pay $8,000 in fees to create an offering memorandum so they can raise $20,000 just doesn't make a lot of sense. Jeff, has there been any consideration in Ontario of mandating a condensed form of prospectus for early-stage financings?

Jeff MacIntosh: Well, the Task Force on Small Business Financing recommended adoption of the SCOR format of prospectus, which is used by issuers that are exempt from the U.S. federal registration requirements pursuant to Rule 504 of Regulation D to the Securities Act of 1933. The U.S. rules permit up to $1 million to be raised in any 12-month period using the SCOR format document. In addition, there are other exemptions in the U.S. which, in some respects, are even more flexible than Regulation D. It is fair to say that U.S. securities regulation, which is generally seen as the most sophisticated system in the world, does a better job than Canadian regulation in accommodating early-stage investment.

Richard Nathan: I think there is a disconnect between our discussion on what should be in the disclosure and the nature of the angel investment stage. Typically the deals that we see at Brightspark, which are similar to the kind that angels would see, are, in essence, merely ideas. They are often not businesses yet. There is hardly anything to disclose. When we evaluate a company, we evaluate two things. We evaluate the idea. Do we like the concept and the competitive environment? And we evaluate the people. And there isn't anything else to perform due diligence on most of the time. And I think that is what the angel round of investment is all about. If you start mandating a detailed legal form that people are going to have to fill out, I don't think you're going to improve anybody's disclosure, but you are going to increase their costs.

Dennis Peterson: Another area of securities regulation that impacts angel investment is regulation of market intermediaries-limited market dealers and others who broker early-stage investment transactions. If the OSC's reluctance to liberalize the private placement exemptions stems from a concern over investor protection, one way to compensate for less onerous prospectus exemptions is to more effectively regulate the intermediaries.

Jeff MacIntosh: I would like to move to another area of law that affects angel investment: tax law. In the February budget, provisions were introduced that allow for a tax-free rollover of investment in early-stage businesses, subject to certain conditions and restrictions. These new provisions were aimed directly at encouraging angel investment, and are modelled in part on laws in the United States. Will the provisions work? Do they go far enough? Gordon Sharwood: I think the provisions are a very important step and will encourage angel investment in Canada. I am also inclined to allow them to operate for a period of time before trying to fine-tune them. Nevertheless I see some shortcomings and anticipate some modifications down the road. First, there are many details regarding how the provision will work that remain unresolved, such as the way in which the rules deal with investment losses. These details need to be properly addressed in regulations and guidelines. Second, the rules only apply to individuals. Corporate and fund-based investing, which often makes sense for angels, is not included.

Richard Nathan: The application of the rules only to individuals is a significant shortcoming. Angel investment is becoming more organized and more sophisticated. Corporate and fund vehicles are more often being used. These vehicles must qualify for the rollover treatment, or the provisions will not have the desired impact. I feel even more strongly that the best way to encourage angel investment in Canada is to simply reduce the level of capital gains tax. I suspect that if you added up all the forgone tax revenue inherent in the rollover provisions we have been discussing, the $500,000 capital gains exemption, and various other initiatives, and scrapped those in favour of a straight reduction in the level of capital gains tax that resulted in the same amount of forgone tax revenue, the impact on angel investment would be much greater.

Allan Riding: I agree. I recently interviewed a group of 12 angel investors in Alberta and we discussed the Canadian tax situation. All they wanted to see was a reduction in the capital gains tax. The new roll-over provisions inspired a lot less enthusiasm than a straight capital gains tax reduction.

Richard Nathan: One other aspect of tax that hasn't been mentioned relates to the ability of non-Canadian investors, particularly U.S. and international investment funds, to put money into Canadian investment funds. American non-taxable investors-pension funds, people like that-are permitted to invest directly in Canadian companies. The Canada-United States tax treaty works just fine in that regard. But they can't invest in Canadian funds, limited partnerships, that kind of thing. We have had offshore investors tell Brightspark that they would love to invest in our fund, but cannot. And that is because of the tax laws.

Jeff MacIntosh: Are there any final points to be made on the issues we have discussed today?

Borys Chabursky: I would like to come back to the cultural point. Through education and an adjustment to the business culture, I think we need to eliminate the stigma attached to failure that underlies a lot of the risk aversion observable in Canada.

Allan Riding: Borys' point is a good one, and it reminds me of a course that is offered at the University of Texas at Austin called Failure 101. Early in the course, the professor asks his students to make a list of their five greatest failures. A couple of weeks later, he asks the students to make a list of their five greatest successes. Invariably, those successes are rooted in failures. That is the nature of entrepreneurial enterprise. We don't teach that in Canada.

Gordon Sharwood: I am with Allan here. We don't teach people how to be effective entrepreneurs in Canada. In our business schools we teach people how to work for large organizations.

Rob Wildeboer: I also agree. The standard Harvard Business School model of teaching has to be revisited. From a business culture perspective, we have to celebrate our entrepreneurs in Canada, as they do in the United States, rather than waiting for them to fail.

Jeff MacIntosh: This has been a very successful session. Thank you to all participants.

Endnotes
1. The University of Toronto Capital Markets Institute sponsors various types of events, research, and debate relating to the structure and performance of Canadian capital markets. For more information, visit www.mgmt.utoronto.ca/cmi.

2. The Centre for Innovation Law and Policy is a multifaceted academic centre devoted to the study of laws, institutions and policies that affect, or are affected by, innovation or technological change.