Undervalued and ignored: Why young Canadian firms are looking to foreign investors and buyers

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From the start, ZS2 Technologies Ltd. was built to go public. The Calgary-based business was founded by stock market veterans who put in place the building blocks of a publicly traded company: governance, oversight and financial reporting. When the time was right, an initial public offering would provide the exposure and capital to take it to the next level.

But the plan has changed. ZS2 is no longer destined for the Toronto Stock Exchange.

ZS2 specializes in high-tech, sustainable building materials. Demand comes mostly from the U.S. construction industry. There is talk of manufacturing stateside, where ZS2 recently incorporated. There are tax advantages to consider. And calls are coming in from U.S. investors hunting for promising growth stories.

“They have an appetite for risk and they see the potential of what we’re doing,” said Scott Jenkins, ZS2′s co-founder and chief executive officer. By contrast, “access to capital in Canada has been challenging, which is shocking.”

It is hard to make sense of that disparity. ZS2 is fast-growing, technology-driven and sells a cleaner product to a huge industry. It checks many boxes that investors are looking for. Its flagship product is a low-carbon cement – the traditional limestone variety is one of the world’s most emissions-intensive products. ZS2 even uses waste water from Alberta mining and energy industries in its manufacturing process.

Yet ZS2 appears fated to join the ranks of young businesses that find better growth opportunities outside Canadian capital markets. “I want to build an amazing Canadian technology company in the world’s largest industry,” Mr. Jenkins said. “I’m bullish on Canadian talent and ideas. The problem is with the ecosystem meant to support these companies.”

The framework for nurturing junior companies through Canadian stock markets has been largely gutted. Gone are many of the boutique brokerages and small-cap investment funds that once provided lifeblood to the sector. Investor interest has petered out. Seventeen years after the S&P/TSX Venture Composite Index hit a record high, the index is down 83 per cent. Valuations have collapsed. Trading volumes are near 20-year lows.

Things are no better for small stocks on the senior exchange. The number of TSX-listed operating companies has shrunk by 40 per cent since 2008, according to TMX Group Ltd., parent of the TSX and TSX Venture Exchange. There hasn’t been an IPO on the TSX in 18 months. In fact, companies have been streaming in the opposite direction.

A burst of 20 tech IPOs on the TSX during the COVID-19 pandemic looked like the start of a new paradigm for a sector that had produced, on average, just one IPO on the exchange a year since the 2000s. But that 18-month explosion ended in late 2021 and now looks like an anomaly driven by the same gold-rush mindset of the original dot-com boom.

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Almost half of those 20 issuers have now gone private, delisted or been taken over. Copperleaf Technologies Inc. was the latest. In June, the Vancouver capital budget planning and analytics software company agreed to be acquired by a Swedish multinational for $1-billion. “Canadian public investors lose out on a compelling small-cap software growth story,” Royal Bank of Canada analyst Paul Treiber said in a note.

There was a time when Canada’s public markets did a marvellous job of turning startups into billion-dollar companies. The country’s early-stage financing markets were the envy of the world, centred around capitalizing on its vast natural resources. The best names graduated to the TSX, creating a pipeline of new listings.

Among the hundreds of companies that followed this route was Canadian Natural Resources Ltd.CNQ-T, now Canada’s fifth-largest public company, with a market capitalization exceeding $100-billion. Other tech companies made their public debuts on the TSX proper, including Research in Motion Ltd. and Constellation Software Inc.

Other countries, including the United States, have also seen steady declines in the number of public listings. But the trend arguably matters more to Canada’s stock market, which has been uniquely rooted in its prolific small-cap roster. These days, the junior contingent of Canada’s public markets is largely undervalued and ignored.

So, capital-constrained companies from Canada such as ZS2 look instead to foreign investors and acquirers.

“It’s just not a long-term solution for the country,” said Bryce Tingle, a University of Calgary corporate finance expert who for years has warned of the dangers of a diminishing small-cap market.

How did we get to this point? Much had to go wrong.

The long fall

In the commodity boom years of the 1990s and early 2000s, the real action went through boutique brokerages. There were dozens, flush with money from retail investors eager to get in on the frenzy.

Deals happened quickly, typically through a vehicle now called a capital pool company (CPC). Entrepreneurs would list a shell company, raise cash and use it to buy a private business.

“It was quick, efficient and cheap,” said Darrin Hopkins, a senior wealth adviser at iA Private Wealth in Calgary who estimates he took 130 companies public this way over the past 30 years. “The prospectus was maybe 12 pages long. You did a qualifying transaction in a month, drilled a couple of oil wells and you’re off to the races.”

It wasn’t just resources. Boardwalk Real Estate Investment Trust BEI-UN-T, the sixth-largest REIT on the TSX, started as a CPC. So did Well Health Technologies Corp., Canada’s largest owner of outpatient health clinics.

When the commodity supercycle fizzled in the early 2010s, it took with it the underlying force that sustained the Canadian small-cap mosaic. Dozens of small brokerages that had financed junior energy and mining plays failed or were bought by big banks.

As the banks consolidated their grip over the Canadian wealth management business, the appetite for small caps withered. The crash soured a generation of investors who were overexposed to resource plays. Regulatory changes made it difficult for advisers, especially those working for banks, to recommend junior names to clients. “They’re making so much money on structured products and mutual funds,” Mr. Hopkins said. “The banks don’t need that hassle.”

At the same time, domestic pension funds drastically cut their exposure to Canadian stocks, from 28 per cent of assets in 2000 to about 4 per cent today, after federal budget changes in 2005 that scrapped foreign investment limits.

Beyond traditional industries such as banking, utilities and railroads, Canada is a country of small- and medium-sized enterprises. Outside the S&P/TSX 60 Index, pretty much every listed company is small cap by global standards. But our pension funds now stalk bigger game, preferring to write nine-figure cheques to foreign companies such as Elon Musk’s Space Exploration Technologies Corp., as Ontario Teachers’ Pension Plan did in 2019, that would overwhelm the capital needs of many young companies here.

“We have a disconnect,” said Alison Nankivell, CEO of Toronto’s MaRS Discovery District, which supports startups. “Our capital is tied up in groups that are too large to deal with the reality of our economy.”

The pension retreat has resulted in an extraction of capital from Canadian stocks to the tune of $1-trillion. “That’s one-quarter of the Canadian market – gone,” said Dan Daviau, CEO of Canaccord Genuity Group Inc., the country’s largest independent investment dealer. “We’ve lost so much money out of our public markets that it just becomes a supply-demand imbalance.”

Valuations reflect that imbalance. The average stock on the S&P/TSX Composite Index trades at about 14 times forward earnings. The S&P 500 Index, meanwhile, trades at 21 times. The gap between the two indexes is about as large as it has ever been and reflects the fact that highly valued technology companies account for a third of the U.S. index, about four times that sector’s share of its Canadian counterpart.

There is also a lack of domestic growth capital for companies that evolve past the startup stage, says Ms. Nankivell, who previously led fund investments and global scaling for Business Development Bank of Canada’s venture capital unit.

The estrangement of the small-cap sector from mainstream investing can’t be pinned on the commodity crash alone. Retail investors returned to the space with enthusiasm with the legalization of recreational cannabis in 2018 and when tech valuations vaulted in 2020-21. The buzz was short lived, however, as many new issues cratered in value.

“We hollowed out oil and gas, we hollowed out mining, and then investors got burned on cannabis and speculative technology,” said Neil Selfe, CEO of Toronto mergers and acquisitions advisory firm Infor Financial Group.

With that, the small-cap alienation was complete. Just seven CPCs have started trading on the TSX Venture so far this year. Last year there were 30. In 2007, there were 180.

The investing world came to demand size and profitability above all. U.S. Big Tech owns the moment. Nobody is paying attention to our small caps. That is, except foreign acquirers.

“A lot of the good companies are just saying, ‘Enough is enough, let’s go private,’ ” says Rob Laidlaw, CEO of Toronto digital media company VerticalScope Holdings Inc., which went public on the TSX in 2021.

The ones that got away

It’s hard to witness the ascendance of Silicon Valley giant Nvidia Corp. without wondering what might have been. There was a time when ATI Technologies Inc. ran neck and neck with Nvidia in the graphics chip market. The difference was that ATI was Canadian. It lacked investor support and became a takeover target.

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ATI was swallowed by U.S.-based Advanced Micro Devices Inc. in 2006 and forgotten. Nvidia, meanwhile, became one of the world’s most valuable companies, worth US$3-trillion, equal to the combined value of all TSX-listed companies.

The most recent crop of Canadian tech stocks, meanwhile, are also finding themselves in the sights of foreign acquisitors. During the pandemic, they cashed in on furious demand by public investors for young, fast-growing tech companies. That didn’t last. Every one of the 20 that went public on the TSX from mid-2020 to late 2021 eventually traded below their issue prices. Some collapsed to pennies a share in the selloff that began in the fall of 2021.

Many were too underdeveloped to matter to public markets investors unwilling to fund continued losses of young firms with illiquid floats. “A whole bunch of companies went public that shouldn’t have,” said Ian Giffen, lead director of education software vendor D2L Inc., which went public in 2021. “They weren’t ready.” (Then again, risk-taking venture capitalists also got nervous, prompting widespread cost cuts by private and public tech companies in 2022 and 2023.)

Most spent their brief time as listed companies underappreciated by Canadian investors. U.S. private investors, on the other hand, saw value. Magnet Forensics Inc., Nuvei Corp. and Q4 Inc. have all been bought or taken off the market by U.S. private equity firms. Other, more seasoned Canadian-listed software companies, including Absolute Software Corp., mdf commerce Inc. and TrueContext Corp., have also recently agreed to buyouts.

The trend is likely to continue. Private equity and venture capital firms are sitting on a record US$2.6-trillion in dry powder, according to S&P Global Market Intelligence and market research firm Preqin. “They are crawling all over each other, looking for Canadian deal flow,” said Mark Borkowski, president of Mercantile Mergers & Acquisitions Corp. “They call every day.”

A U.S. private equity buyout doesn’t mean those companies are lost. Most of the recent deals don’t involve physical relocation, though many redomicile in Delaware. Some could go public again when the funds exit their investments.

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But that doesn’t mean there isn’t a cost. “Every time one of these Canadian success stories gets bought by U.S. private equity, the big high-paying jobs start to move to the U.S.,” says VerticalScope’s Mr. Laidlaw. “There’s an incredible brain drain going on, whether it’s crypto, AI, software.”

That drain is a bigger concern when a company is scooped up by a strategic acquirer, as was the case for Copperleaf. That offer, from past suitor IFS AB, landed when Copperleaf stock was trading more than 30 per cent below its 2021 IPO price. “Public markets didn’t see the value that we saw,” IFS CEO Mark Moffat said. “It created an opportunity for us.”

Copperleaf had hoped to raise awareness with the IPO, “but the Canadian market doesn’t give you the same exposure” as a U.S. listing would, former CEO Judi Hess said.

Instead, Copperleaf was punished by a market that suddenly turned against money-losing, illiquid early-stage companies, a cruel twist given that Copperleaf had been profitable for years until increasing spending pre-IPO to accelerate growth. “To do the right thing from a business perspective, they had to be investing. That simply wasn’t rewarded in the short term,” says Maria Pacella, managing partner with Pender Ventures, an arm of Vancouver’s PenderFund Capital Management Ltd., Copperleaf’s largest outside investor.

There are lots of other small Canadian tech companies trading at discounts. RBC’s Mr. Treiber noted two other potential takeout candidates: Coveo Solutions Inc., which trades at less than half its IPO price, and D2L Inc., off by more than 20 per cent.

It defeats the purpose of being listed publicly if a company cannot maintain a reasonable valuation. It makes you a takeover target. It raises your cost of capital. It weakens your ability to use your stock as currency to acquire companies, which for some was a key reason to go public. And it makes it hard to justify the huge time and expense, not to mention meeting the ever-expanding list of governance best practices and regulatory requirements involved with running a listed company.

“It’s frustrating,” said Mr. Laidlaw, who has seen Verticalscope shares drop 60 per cent since the IPO. “We’re paying $1-million to $2-million a year to be public. You do that to access capital and investors, and it’s really not there.”

Extraordinary regulatory requirements mean everything takes longer and costs more. It takes an average of 18 years to bring a Canadian mine from first drill to production. And the CPC program is no longer a fast, efficient and cheap back door to public markets, says Mr. Hopkins, who has facilitated just one CPC listing in the past year-and-a-half.

The latest irritant in entrepreneurial circles was the federal government’s increase to the taxable portion of capital gains this year. The fear is that the tax hike may discourage investing in Canadian public companies at a time when capital is scarce for most small companies.

“Every time you make an adjustment like that, you start to change that dynamic of where companies want to grow up,” said Tom Liston, a tech investor who sits on the board of Well Health. “The costs have gone up and most of the advantages of being a public company have disappeared.”

The fallout

Canada’s innovation and productivity gap is one of our biggest public policy issues. The Canadian economy is smaller than it was in 2019, after adjusting for inflation and immigration, according to RBC Economics.

There are many reasons Canada has fallen behind most other major economies. One culprit is the failure to produce giant, world-class publicly traded technology companies. No other Canadian company has come close to Shopify Inc., which went public in 2015 and last week sported a $125-billion market capitalization. That is about 50 times the value of Lightspeed Commerce Inc., the next most valuable Canadian tech company to go public since.

“Canadians come up with the ideas, they start companies, but few large-scale innovative firms exist in the country,” the University of Calgary’s Mr. Tingle wrote in a recent research paper.

Many of the most promising companies leave before they have a chance to attain scale. One study found that of 164 acquisitions of Canadian technology firms between 2004 and 2012, just one featured a Canadian buyer (domestic-buying-domestic activity has picked up moderately since then). Each year there is attrition from the public markets and not enough junior companies in the pipeline replacing them. Canada’s public exchanges lose around 60 operating companies on average each year.

Once a company is taken private, chances are it won’t return to the public markets. When it comes time for that investor to exit, it is almost always through a sale to a strategic acquirer or another private equity firm. Over the past five calendar years, IPOs accounted for just 5 per cent of U.S. private equity exits, according to S&P Global Market Intelligence. An IPO is never a clean exit for private equity, which usually requires another year or two after issue to sell their stakes in an orderly fashion, leaving their gains at the mercy of market swings.

Companies that remain public, meanwhile, are limited in growth options if they lack access to reasonably priced capital. “Companies won’t take the risk, won’t start that new factory, or develop that new product, unless they’re comfortable that they will have enough money,” Mr. Daviau says.

Canada has a poor track record in business investment. In the 15 years up to 2021, capital investment for each worker declined by 20 per cent, Statistics Canada reported this year. A study last July from Boston Consulting Group’s Centre for Canada’s Future ranked Canada second to last in research and development spending among 15 developed economies, and one-third of U.S. levels per capita.

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The trends are reversible, insists John McKenzie, CEO of TMX Group. There is a pipeline of 2,000 private Canadian companies that could scale up on Canadian exchanges and the entire small-cap ecosystem will revitalize if there’s money to be made, he said he believes. “Once you’ve got a very robust market again, you will start to get new startup dealers, and you will get expansion again.”

But it will only happen with regulatory and policy changes, he adds. And with the world’s biggest, most liquid market next door, just levelling the playing field won’t cut it. “We need to be more competitive on tax policy, more competitive in terms of how fast we can permit new mining companies and things like that. We can’t just be designing our market to tie.”