Everyone into the pool

Call it the .P boom. Even as the conventional IPO market languishes, the TSX Venture Exchange’s capital pool program is bringing a steady stream of companies to market
By Robert Thompson

Ron Schmeichel shouldn’t have been restless, but he was. Though only in his 20s, and busy with the demands of law school at the University of Western Ontario, Schmeichel was already pondering ways of involving himself in Canada’s public markets. When he wasn’t completing his class work, Schmeichel spent evenings in the school’s business library looking up financing structures and studying their nuances. Some fathers pass on worldly wisdom. In Schmeichel’s case his father, an economist and broker, told his son of a financing structure—the Junior Capital Pool Program, then run by the Alberta Stock Exchange, now thriving as the Capital Pool Companies (CPC) program at the TSX Venture Exchange—that allowed a company to hit the public markets without breaking the bank. It didn’t matter much; as a student, Schmeichel was only able to dream of high finance. To top it off there wasn’t much in the university library to guide him on his financing concept. Yet he wasn’t deterred, and even as he graduated from law school, he plunged straight into the seemingly nebulous world of capital pools.

“I borrowed $100,000 and set up a company,” Schmeichel says. “I probably would have been disbarred, but I wasn’t even called to the bar yet. There was a moment there where I could really screw up my career or make a lot of money. As it happened it worked out—very well.”

Capital pool companies have a two-stage existence. They go public as shells with several primary shareholders, a few million dollars in the kitty and some management and/or acquisition expertise at the helm. They then have 24 months to buy a real business (typically a private growth-stage business) in a “qualifying transaction” and then the latter gets on with conventional public company life. Schmeichel’s first pool company found its target in a Canadian online retailing and website development startup called Cyberplex. The deal, completed in 1997, saw Cyberplex’s subsequent market cap soar to nearly $1 billion. It also made Schmeichel, in his own words, “millions and millions,” and convinced him of the benefits of the CPC structure. Today, he is president and CEO of JJR Capital Corp. in Toronto, spending a good deal of his time on CPCs. “All that stuff is funny in hindsight, but it was heady times. I’ve done three or four iterations since then and I’ve always done CPCs.”

He’s not alone. Quietly, CPCs have emerged as a key, relatively cheap method of launching public companies in Canada. More than 2,300 CPCs have been listed since the program started in 1986. But in the past four years, as many traditional IPOs have struggled, the capital pool route has taken on greater prominence. Last year, 50% of all public transactions on the TSX were “qualifying transactions” involving CPCs. “I joke it is the best-kept secret in Canadian capital markets,” says Robert Peterman, director of business development for the TSX and TSX-Venture.

Though there can be hurdles—liquidity issues and inexperience on behalf of some CPC creators—for many Canadian investors and small and mid-size business operators, they are cleaner and easier than standard reverse takeovers. In this instance, according to Schmeichel, Canada is out in front. “My practice has evolved into doing $100-million transactions using CPCs,” he explains. “I’ve looked all over the world and there really isn’t anything like it.”

Despite the program’s roots in junior oil and gas sectors, today it has broader appeal and plays a more integral role in stoking the market. Robert Munro, chief executive of the Chrysalis Capital Group of Toronto, a full-time CPC financier, says the reasons for the TSX’s enthusiasm are obvious. “The more listings they have, the more money they generate,” says Munro. But clearly, listed companies themselves attach a lot of value to the process. So much so that, in the past year, CPCs were responsible for bringing two of the country’s more high-profile private businesses—former Biovail chairman and CEO Eugene Melnyk’s Trimel Pharmaceuticals Corp. (TSX:TRL) and former Newcourt Credit Group founder Steve Hudson’s Element Financial Corp. (TSX:EFN)—to the public market.

Not every CPC attains its goal of a qualifying transaction. And the program does have naysayers. Most point to the fact some companies are unprepared for being publicly listed, while others struggle with liquidity issues. There have also been issues with some CPCs being run by individuals without the experience or connections to find a target, or selling the shell and doing a disservice to their shareholders. In cases where CPC operators allow costs to get out of hand, they limit any upside for investors. According to Munro, the market refers to those CPCs as “burned out shells.”

The TSX’s Peterman cautions that the CPC concept is simply another structure for raising capital.“We try to provide as many structuring tools as possible,” he says. “There are pluses and minuses with each of them, depending on how big you are and so forth. But for innovation sectors like technology, clean tech and life sciences, [CPCs] are the most popular method of going public.”

Munro, along with Chrysalis partner Marc Lavine, has launched 10 CPCs since 2005. By now, they have the process down cold. A former executive at Rogers Wireless, Munro connected with Lavine, a former Cyberplex creator, while he was still working for the telecom giant. He says in his experience most CPCs are developed by entrepreneurs who are occupied in full-time jobs, but are intrigued by the opportunity to make a longer-term investment. While that’s how they started, it wasn’t long before they wanted more. “After we did a couple, Markand I had a heart-to-heart and realized we couldn’t just do it part-time. We said, ‘Let’s look at the possibility of doing it full-time.’”

Munro says Lavine’s experience with the CPC structure at Cyberplex is what attracted them to the financing vehicle in the first place. It is a structure that is well established. At the start, a small group of investors, all with what the TSX characterizes as “an appropriate combination of business and public company experience,” put in at least $100,000 of seed capital to create the shell company. Each entrepreneur will put in a different amount, but the figure must be the greater of the minimum of $100,000 and 5% of total funds raised.

The group then incorporates that shell company—the capital pool company—and issues shares in exchange for seed capital at a minimum price of 5¢, before preparing a prospectus that details the company’s intent to raise up to $4.75 million and use the proceeds to move forward with finding a target company and complete a reverse takeover. At that point the shell must find 200 shareholders who can hold no more than 2%. Once that distribution has closed, the company receives its TSX-V listing as a .P company identifying it as a CPC.

Supporters of the financing model agree the low cost of completing a CPC transaction and getting a public listing make it attractive for smaller target companies. Traditional IPOs are tricky, especially in the current market, because a company can spend months and hundreds of thousands of dollars on the legal work needed to create a prospectus only to have the markets shift, halting the process entirely. CPCs typically use the money already raised by initial investors to cover the legal work needed to complete the reverse takeover. Costs can still rise, experts say, but those more experienced with the CPC structure can usually keep fees in hand.

Legal costs aside, the other key hurdle is finding those 200 shareholders before the TSX-V allows it to be taken public. These shareholders are typically investors looking for more speculative options that have a higher degree of risk, but also a much higher potential payoff. Investors in CPCs are usually interested in the track record of the management team, since they won’t know what the actual target company will do.“It is one of those things where it has to be part of a portfolio effect,” Schmeichel says. “It gives them first look at a deal and they can get two or three deals a year.”

Peterman says CPCs are forced to have at least 200 shareholders to give the target company some liquidity and distribution as soon as the the takeover is completed and it is listed, a factor that is a struggle for many smaller businesses. It also provides some much-needed cash on the balance sheet. “If you are trying to raise $10 million to start a business and $1 million is there—your job got a little bit easier,” he explains, referring to the point where the target company assumes the shell.

Not everyone feels the process is simple. David Hanick, a partner at law firm Osler, Hoskin & Harcourt and co-chair of the company’s mining practice, has been watching and advising on CPCs for years. He says while creating a CPC may be less expensive than an IPO, many still underestimate the complexity and costs. “I think people get ahead of themselves and don’t think of the public company element and the liquidity issue,” he says. “They are counting their money before they’ve added up the costs.”

Hanick adds the small pool of shareholders can be problematic as well. “The biggest outcome that is negative I’ve seen is lack of liquidity post-closing,” he says. “What you end up with is a target that is a tier-2 TSX issuer. But that means you have a float of 200 shareholders. And one trade in that situation can be material to the share price. So for a CPC holder who is now looking at 3¢ on the table per share and 10,000 shares and needs to get out, that change can cause material weakness in the stock.”

One of the biggest questions for CPC investors and directors is where does the deal flow come from? Once the shell is created, the CPC has 24 months to find a target company to merge with and complete a qualifying transaction. When Schmeichel did his first CPC, he says that was a big challenge. He recalls having failed discussions with several businesses, including a battery retailer, before setting his sights on Cyberplex. “It sounds ridiculous now, but these were the days of Netscape going public,” he says. “I figured I could sell shovels to miners instead of doing the mining. I didn’t know the difference between a good deal and a bad deal and I had my share of false starts.”

When he was introduced to the founders of Cyberplex he says, “I knew they were winners. You don’t always get that right, but my whole CPC process is to focus on the people.”

Munro faced similar difficulties in finding the right target when Chrysalis started. Eventually it settled on PharmEng International, and that company’s initial success after listing (though it later ended up in receivership well after they took their profits) led to more deals. “Over time we’ve developed relationships with guys—and now we go into a meeting and someone will say, ‘I’ve heard of you guys,’” Munro explains.

Officially each CPC deal is supposed to involve a so-called “blind pool,” which essentially means the creator of the capital pool company can’t have a pre-existing deal in place with a target. That doesn’t mean the focus of some CPCs isn’t apparent from the start, Peterman says. “You can look at the board of some CPC companies and say, ‘There’s a lot of expertise in oil and gas in their founders,’” he explains. “But for others it isn’t that clear.”

Schmeichel says he relies on extensive relationships with various financial sources to connect him to target companies. He sees dozens of potential deals for each of his CPCs—“I get two or three deals coming through each week”—and therefore always has two CPCs active. “Mine are all true blind pools. I keep them in inventory and am always on the lookout for deals and circling through my dealer relationships.”

As in all deals, each target company negotiation involves a discussion of valuation. CPCs have both seed and shareholder investments that are then balanced against the valuation of the target company. Munro says there’s a premium on the CPC as they are bringing a clean shell company to the transaction. On the other hand, a target company will have a greater enterprise value. The resulting combination of the CPC and the target company provides an ownership ratio for shareholders and the creators of the CPC. On top of this, private placements are often done concurrently—and are key to the overall success of many early-stage businesses. Shares held by creators of the CPC are kept in escrow after the transaction is completed, often for as long as 36 months. Often a member of the team that created the CPC will take a board seat on the target company for a short period of time to remain involved with their investment.

Lately, thanks to the rocky IPO market, CPC creators say they’ve been able to access deals that might have been out of reach in the past. And those targets, in turn, are grateful. Don Cameron, chief financial officer of Alexander Nubia Inc. (TSX-V:AAN), a mining exploration company that went public in connection with Chrysalis in 2009, simply couldn’t raise money through private means. Cameron says mining exploration companies need the liquidity that comes from the investors willing to speculate on the public markets, something unheard of in private capital.“It was a tough time and when you’re an early-stage exploration company going public is tough without a history of earnings,” he says. “That’s what you’re getting here—credibility and history that you can take to the market.”

Taking Alexander Nubia through the CPC process wasn’t initially easy though. When meeting prospective CPCs, Cameron ran into what he calls “vulture capitalists,” who wanted a big piece of the action but couldn’t necessarily deliver additional investor support during the critical private placement phase of the CPC.

He says some CPCs wanted as much as a 20% stake in Alexander Nubia, while Chrysalis settled for 6%. More critically, Chrysalis’ network of investors in the CPC were more than willing to put more money into Alexander Nubia during the private placement stage—$3.5 million in fact—something other CPC creators couldn’t offer.

That said, CPCs are not just for small deals—as the recent transactions involving Element Financial and Trimel Pharmaceuticals, both done by Schmeichel, indicate. Element, an equipment financing business, raised $175 million in 2011 while going through the CPC structure. Schmeichel says Trimel, which had a non-offering prospectus, was a different type of success because it allowed Melynk’s company to go public while the Ottawa Senators owner and Biovail founder was in the midst of negotiating a deal with the Ontario Securities Commission that eventually found the businessman’s conduct was “contrary to the public’s interest.” Says Schmeichel: “The CPC structure offered an obvious and efficient route for Trimel to go public given the obvious challenges at the time.”

Meanwhile, the payoff for the creators of the CPC varies, depending on the agreement on the valuation. CPCs typically have a greater valuation than the capital in the company because the founders are being rewarded for doing the advance legwork that will allow the target to go public quickly. Often, the initial investment for the CPC founders will rise if a successful financing round is included in the process. Though many CPC founders can’t sell their stake for up to 36 months, the most successful transactions can be significantly lucrative.

Most people involved with CPCs acknowledge that traditional IPOs will eventually regain their attractiveness, especially for larger businesses. Regardless, Schmeichel, nearing two decades since he created his first CPC, says there is an ongoing place for the capital pool program in either positive or declining markets. He’s done big and small deals using the structure and doesn’t envision that changing any time soon. “I always have a CPC or two in inventory—always have and always will,” he says emphatically. “At the end of the day the financial industry will always need well-structured CPCs.”

Slider photo: Evan Dion

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