Category Archives: Money

How Good is Business Advice?

CASE STUDY #1 – RECENT MBA

A few years ago I watched as a young colleague with an MBA took it upon himself to advise the proprietor of a crepe stand about operations and business strategy – in exchange for a free crepe.  As a former journeyman chef I was amused by the exchange.

My MBA colleague had no idea how long it would take – and how expensive it would be – to train someone to make crepes, unsupervised. It was clear to me that my colleague’s advice was vastly overpriced.

CASE STUDY #2 – ENTREPRENEUR IN RESIDENCE

A few years ago I served on an advisory panel for early stage companies at Innovation Island on Vancouver Island.

One of the participants seemed to be struggling with too much advice. The presenter had stopped working “in the business” in favour of working “on the business”. When I heard that I couldn’t help thinking that an advisor had lifted that line verbatim from an introductory management consulting textbook.

In the past year or so the company had successfully sold their services to at least 3 large government organizations – which isn’t trivial for a small startup on northern Vancouver Island. They apparently had taken the advice of the “entrepreneur in residence”.

Just a note here. Successful entrepreneurs don’t usually work for goverrnment incubators. It is most often failed entrepreneurs looking for a regular pay cheque – and maybe a pension – who work with incubators. Most successful entrepreneurs keep working in their own businesses, become investors – or simply retire.

CASE STUDY #3 – IP LAWYER

Many years ago I read an opinion piece by an intellectual property lawyer. He recommended that a startup developing IP should keep it close to the chest until they secured investment. He didn’t like the idea of using the IP in services in order to prove out the technology. Maybe that works for an IP lawyer who gets paid when the IP is protected – but it sounds like bad advice to me. How does a startup know whether their IP is worth protecting until they established that it’s useful?

How do you know that a minimum viable product is viable unless a customer has tried it out?

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If you’re getting advice, you really have to consider the source. Remember above all, that there is no one size fits all answer to your question. Your business, jurisdiction and personal circumstances are unique.

CPAs who have provided tax, accounting and structuring advice for years, understand this implicitly. Our challenge is to get our clients to ask us first….

 

The Evolution of the Business Plan

Management science used to tell us that we needed to plan carefully and intelligently for any new business venture, document our assumptions clearly – and then execute.
As a professional accountant I’ve always been leery of projections – or as we like to refer to them “FOFI” (i.e. future-oriented financial information). The thing is, accountants built their reputation for honesty on the accurate reporting of historical information. What’s more we’re pretty good at that.

Steve Blank – the well-respected academic and entrepreneur out of California said it very eloquently:

No business plan survives first contact with customers

 

The thing about projections is that, especially in the case of a new business, they’re almost always wrong. For a startup trying to commercialize a new technology in a new market space, projections are almost always wildly over-optimistic.

In fact most investors in early stage companies discount projections heavily – or more likely just ignore them.

Some years ago I watched a video put out by Sequoia Capital. In it Jim Goetz (the founder) said essentially that you may be wasting your time writing a 120 page business plan – since the projections are almost always wrong…

If you like what you’ve heard here is a link to the complete Youtube video…

But in spite of the fact that they are inaccurate – and most experienced investors discount or ignore them – sometimes my clients still need to prepare them. So what is the answer?

From my perspective at least, the answer is STRATPAD™.

Originally developed for the iPad – StratPad is a web-based business planning tool that most entrepreneurs can learn to use in the course of a one day workshop. Which means it costs lest than having your CPA or your management consultant write it for you – and more important, keeps the entrepreneur at the centre of the process. Since is a business plan is really a living document, management needs to keep it up-to-date, or at least re-visit it on a regular basis. If you outsource your business plan that means you always have to outsource your plan….

And you’ll never own it!

 

Asset Sale vs Share Sale

Technology companies – in fact most small businesses – often have difficulty taking advantage of the recently enriched lifetime capital gains deduction. When first introduced the capital gains deduction was targeted the first $500,000 of capital gains on family farms and qualified small business corporation shares (“QSBCs”). Since then the lifetime capital gains limit has been increased to $806,800 for QSBCs and $1 million for family farms.

However it is always difficult for sellers to sell shares. Buyers prefer to buy assets for 2 reasons:

  1. The cost of shares is not deductible by the buyer against income – while most assets are at least partially deductible
  2. Shares of small business corporations are much more complex beasts to acquire and may include undisclosed  liabilities or other “surprises” that buyers are understandably nervous about acquiring

Buyers and their legal representatives will typically discount the purchase price if the vendor insists on selling shares. In some cases buyers simply won’t consider acquiring shares.

Many small, private corporations have at least a few skeletons in their closets. Closely-held companies often operate a little too close to the line and sophisticated buyers will often engage professionals to uncover at least some of these.

As a former senior manager with PwC LLP in Vancouver I was seconded to a due diligence team looking at the potential acquisition of a technology company. As it happened, the target company was one of a number of companies owned by the same entrepreneur. The entrepreneur had separate accounting firms handling each of his companies.

The problem was that he never informed his accountants of the existence of the other companies. Each year he filed for refundable SR&ED tax credits with one of his companies. Presumably his accountants were unaware of the existence of these other companies, since they were not disclosed on the tax returns as “associated” corporations.

Because of the amount of taxable income of the associated group, the corporation would not have been entitled to high-rate refundable tax credits. Thus any purchaser could be on the hook for undisclosed tax liabilities – and penalties – in the millions of dollars.

Of course it isn’t only undisclosed tax liabilities that could surface after an acquisition. There could be problems with employees, former employees, customers or suppliers. With small corporations eligible for the lifetime capital gains exemption, financial statements are often merely compiled with little or no assurance from the public accountants drafting the statements.

For that reason most accounting and legal professionals will advise buyers of QSBCs to purchase assets – or to discount the purchase price and conduct significant due diligence before determining that price.

CAPITAL DIVIDENDS AS AN ALTERNATIVE STRATEGY

Technology entrepreneurs looking to sell their companies should understand that the value of their companies is most often determined by the value of their IP.

Selling intellectual property developed by a technology company now results in a capital gain. With capital gains, only 1/2 of the gain is taxable. The remaining un-taxed half  can be distributed tax-free to shareholders via an amount paid out of the capital dividend account (“CDA”).

So rather than selling shares – typically at a discount – the entrepreneur keeps the company and sells the IP within the company. So the sale price is higher, the sale is only partially taxable and may even be shielded by non-capital losses, SR&ED ITCs or SR&ED expenditure pools within the company. When the proceeds are distributed, the company can elect to pay dividends from the CDA account.

While this works well for technology companies that have IP, it can also work for any corporation selling goodwill as well. Usually buyers will attempt to structure their purchase so that proceeds are allocated more to tangible assets which can be depreciated more quickly. This may result in fully taxable “recaptured” depreciation.

For entrepreneurs that have done this before, be aware that the rules around gains on the sale of what used to be “eligible capital property” have changed in the last few years. Clearly each company’s particular circumstances will be unique. So it pays to get advice from a tax professional that you trust.

 

 

The Cost of Going (and Being) Public

Recently I spoke to one of the founders of a medical device company who was looking to go public in order to fund the development and regulatory approvals for their new products. Assuming that the company accurately projects their capital needs at $4 million I thought it would be a useful exercise to look at the impact of the decision to go public on the company’s burn rate.

To begin with I looked at a study published by PwC in 2014 –

 

According to PwC estimates:

How much can the costs of going public add up to?

Underwriter costs for an IPO – up to 10% of the proceeds.

Legal, audit and accounting costs – from $200K to $500K for a smaller offering

Marketing and road show costs ?

Miscellaneous costs (eg. printing costs, filing and transfer agent fees)?

What’s more many of these additional costs are ongoing.

 

 

Based on this analysis at least half of the cost is directly attributable to going public too early in the life of the company.  Given that this is a medical device company, the cost of foregone SR&ED refunds could easily exceed the IPO and maintenance costs.

Ideally going public should be seen as a possible exit for Series A or Series B investors instead of a strategy for raising money for a development stage company.

VCC Tax Credit Is Not “Government Assistance”

British Columbia’s Small Business Venture Capital Act provides a 30% tax credit to eligible investors in corporations involved in a “prescribed business activity” within BC. For individuals the tax credit is fully refundable and isn’t considered taxable under paragraph 12(1)(x) of the Income Tax Act:

SUBSECTION 12)(1) – INCOME INCLUSIONS

(x) Inducement, reimbursement, etc. — any particular

amount (other than a prescribed amount) received by the tax –

payer in the year, in the course of earning in come from a busi –

ness or property, from

(i) a person or partnership (in this paragraph referred to as the

“payer”) who pays the particular amount

(A) in the course of earning in come from a business or prop –

erty,

(B) in order to achieve a benefit or advantage for the payer or

for persons with whom the payer does not deal at arm’s

length, or

(C) in circumstances where it is reasonable to conclude that

the payer would not have paid the amount but for the receipt

by the payer of amounts from a payer, government, munici –

pality or public authority described in this sub paragraph or

in sub paragraph (ii), or

(ii) a government, municipality or other public authority,

where the particular amount can reasonably be considered to

have been received

(iii) as an inducement, whether as a grant, subsidy, forgivable

loan, deduction from tax, allowance or any other form of in –

ducement, or

(iv) as a refund, reimbursement, contribution or allowance or

as assistance, whether as a grant, subsidy, forgivable loan, de –

duction from tax, allowance or any other form of assistance, in

respect of

(A) an amount included in, or deducted as, the cost of prop –

erty, or

(B) an outlay or expense,

to the extent that the particular amount

(v) was not otherwise included in computing the taxpayer’s in –

come, or deducted in computing, for the purposes of this Act,

any balance of undeducted outlays, expenses or other

amounts, for the year or a preceding taxation year,

(v.1) is not an amount received by the tax payer in respect of a

restrictive covenant, as de fined by sub sec tion 56.4(1), that was

in cluded, under subsection 56.4(2), in computing the income

of a person related to the taxpayer,

(vi) except as provided by subsection 127(11.1), (11.5) or

(11.6), does not reduce, for the purpose of an assessment made

or that may be made under this Act, the cost or capital cost of

the property or the amount of the outlay or expense, as the case

may be,

(vii) does not reduce, under subsection (2.2) or 13(7.4) or

paragraph 53(2)(s), the cost or capital cost of the property or

the amount of the outlay or expense, as the case may be, and

(viii) may not reasonably be considered to be a payment made

in respect of the acquisition by the payer or the public author –

ity of an interest in the taxpayer, an interest in, or for civil law a

right in, the taxpayer’s business or an interest in, or for civil

law a real right in, the taxpayer’s property;

The key wording here is:

(other than a prescribed amount)

VCC tax credits are prescribed by Regulation 7300 of the Income Tax Act to be “prescribed amounts” for the purposes of paragraph 12(1)(x). Not only do recipients not have to include the tax credit in income, they don’t have to reduce the Adjusted Cost Base of the underlying shares after receiving the tax credit (Regulation 6700)

This is a good deal for investors – to extent that investments in such companies can ever be considered “good” for investors. It also means that friends and family can invest in eligible shares and obtain a full deduction for the share when transferring to a self-directed RRSP.

Importance of Startups in Job Creation

As a part of their “The Startup Revolution” series, the Compass Blog published “The Rise of the Startup“. It makes for fascinating reading.

In particular they point to a study by the Kauffman Foundating in 2010. That study revealed that:

over the past 28 years – startups were responsible for all net new jobs in the United States. In 21 of those 28 years, startups was the only class of business to create net new jobs.

According to their blog there are 4 key reasons for the rise of the startup:

  1. startups can be built for thousands, rather than millions of dollars
  2. emergence of new types of investors:  angels, accelerators and micro-VCs
  3. entrepreneurship developing its own management science
  4. speed of consumer adoption of new technology

Of course the Kauffman study shows that startups have been important in job creation for at least 28 years. If that’s true then those 4 factors may not explain the rise of startups, but rather how our economy is adapting to their importance.

Silicon Valley

Local Startup Sues Incubator in Dispute Over IP

Pixsel Sues Invoke Labs for Allegedly Stealing Code to Create a Competitor

This story got coverage in the main stream press today.

Perhaps it is a good thing that the local CBC station is beginning to cover the startup / high tech scene. Certainly this sector is becoming a major source of new economic activity. Before we rush to take sides, it is important that we keep things in perspective. Firms involved in incubating startups have their own economic interests. Sometimes economic self interest pushes people – and organizations are just people working together – to cross the line.

At the same time, startup companies are an important source of creativity and energy – but most fail. It is all too common for people who fail to find someone else to blame.

Unless Pixsel or Invoke Labs (both?) can successfully commercialize their IP and create wealth and economic activity locally, we may never hear of this again. In the mean time we can celebrate the fact that activity in the local startup scene is starting to get our attention.

 

Young Entrepreneurs More Likely to Fail

In spite of Silicon Valley’s apparent fixation on youth – see How Tech Investors are Failing on Due Diligence – a recent academic study has shown that older entrepreneurs are less likely to fail.5 Year Survival by Age

The study spanned 5 years and looked at founders in 5 different age groups by decade (20s – 30s – 40s – 50s – 60s).

Given that the study covers 5 years – about half of the people in their 40s would be in their 50s by the time the study ended.

Note that entrepreneurs in their 30s are marginally more likely to exit by way of M&A transaction than their older colleagues.

How Tech Investors are Failing on Due Diligence

This last couple of weeks I’ve been working on a due diligence team looking at a potential investment. As the only accountant on the team it can get pretty lonely.

In September Noam Scheiber of the New Republic published an interesting article on how due diligence really works for a great many early stage investors.

Noam Scheiber article

According to Mr. Scheiber, Seth Bannon was in his late 20s, had the requisite beard…and raised $3 million for his startup from Y Combinator and a number of angel investors. Somehow – when no-one was looking, he managed to rack up liabilities for $500,000 in unpaid employee source deductions, $100,000 in legal fees and a $90,000 penalty to the IRS.

Seth Bannon with requisite beard
Seth Bannon with requisite beard

For the most part my colleagues don’t get the idea of financial due diligence. First, they don’t seem to think there is any point in getting financial statements reviewed by a professional accountant. A good deal of the information investors should be looking at is contained in a properly prepared set of financial statements.

Even if you’re going to end up valuing the IP, and ignoring the operations for the most part, it is comforting to know that someone has done some work to substantiate assets and liabilities – so investors aren’t later ambushed by undisclosed liabilities or option agreements that might put the corporation’s status as a CCPC or an eligible business corporation at risk.

The last 2 companies I’ve looked at have had financial statements prepared by the same firm of public “accountants”. In spite of a fairly complex (for a startup) capital structure, neither company had even prepared notes to the financial statements. As a professional, I typically find as much of interest in the notes as I do in the financials.

In both cases there were operations in 2 or more countries and the accountant was really a bookkeeper with little or no training in accounting. Admittedly he is a university graduate and has a Phd from Cambridge in something or other – if his website can be believed.

My point is, if I am performing due diligence on an early stage company I don’t really have time to perform due diligence on the financial statements as well.