Private financing of entrepreneurships: sources of private financing; guarantees (required personal or otherwise); when to go public (pros and cons); rights of financing parties; defaults; capital formation for entrepreneurial ventures; tax considerations.

• Author: Cohen, Morton A.
• Position: Canada-United States Law Institute Annual Conference on Comparative Legal Aspects of Entrepreneurship in Canada and the United States

INTRODUCTION

Michael Robinson

MR. ROBINSON: I am Michael Robinson. I am pleased to preside here, which means I do not have to do any hard work. I asked to do this because I represent the last of entrepreneurial financing lawyers.

When I started practicing in 1966, I did two things: Non-recourse project financing, mostly for mines, which was inventive in Canada, and IPOs, for what was then an unusual thing, for the service industry such as radio broadcasting and insurance brokerages that had no bricks and mortars. In other words, they were businesses that did not make "things."

Now, our two speakers today represent the present and the future of entrepreneurial business financing, and I will briefly introduce them. Mr. Cohen is going first.

Morton A. Cohen is a closet Canadian born in Montreal, but not as Canadians are said to be, particularly shy. His bio of many achievements in Canada and U.S. in finance is almost a page and-a-half, but I am going to distill it for you. He owns Clarion Capital, which is a small business investment company, which does private placements in public companies. He founded Clarion Capital Corporation, which runs several domestic and offshore hedge funds, achieving a 15 percent overall return since its inception in 1994. That's not quite up to Warren Buffet's return rate I don't think, but if you go to the last paragraph of his bio in which he details his healthcare and life sciences investment activities over the last eight years, and you will see that he achieved an internal rate of return of over 200 percent. Now, Warren Buffet has never done that and rarely has any investor that I know of. His background is a B.A. in Economics from Concordia University in Montreal, an M.B.A. in Finance from Wharton, and he is a certified financial analyst.

I hope Mr. Cohen will tell us something about how the local medical research establishment in Cleveland, which is so well known and primarily led by The Cleveland Clinic, contributes to his entrepreneurial activities in this field.

Mr. David Woolford is a closet Yank. He was born in the U.S. and ended up in Canada. He is a partner at Cassels, Brock & Blackwell LLP, a major Toronto firm and one of the sponsors of this organization, the Canada-U.S. Law Institute. He specializes in business law, corporate finance, e-business, privacy law, and securities law, and especially the development and financing of high tech companies, including many startups in Canada and abroad.

Indeed, David just returned from closing a deal in Germany between a Canadian technology company and a major German partner. He has published extensively on the subject of emerging developments in technology law. He is also an angel investor and a member of the Toronto Angel Group. So he puts his dollars where his legal advice is obviously, and he knows the entrepreneurial game from the inside out as well as just the legal aspect thereof. He is also Chairman and a director of Virox Technologies Inc., and holds various other private directorships and advisory board positions.

So without further ado, Morton, would you care to begin?

UNITED STATES SPEAKER

Morton A. Cohen *

MR. COHEN: Good afternoon. I really cannot thank you enough for the opportunity to follow Mal Mixon. It is like following Warren Buffet. Let me just say it is just nice to be here.

I walked in here, and the first couple of words I heard were "disputes," and at lunch I heard "conflicts," and that reminded me of an old story about a lawyer who goes hunting in rural Tennessee. The lawyer is duck hunting, and sure enough he shoots a duck, and the duck falls in the farmer's field. The lawyer goes up over the fence to get the duck.

The farmer appears, and gets off his tractor and says, "this duck belongs to me; it is on my land." The lawyer is absolutely indignant and he says, "I am going to sue you. I am a very famous lawyer, and I will sue you and take everything you have." The farmer looks at him, says, "You know, we have a way of settling disputes in Tennessee. We have this three-step rule." The lawyer looks at him and thinks, "I can take on this old cogger." So the farmer then proceeds, and he takes his steel boot and rams it right into the lawyer's groin. And then he turns and rams his boot again into the lawyer's mid drift. The farmer kicks him in the rear and the lawyer falls into a bunch of cow pod. The lawyer is absolutely shocked, and he manages to stagger to his feet and wipes his face on his sleeve, and he says, "So now it is my turn," at which point the farmer says, "Yeah, but you can have the duck."

I want to give you a panorama of American financing that is emerging today. First of all, let me say that we have financed private companies, and we spent about ten years in financing startups and developing companies before we got into private placements. Let me just start with the banking system.

The first place you go if you are an entrepreneur is a banking institution. The banking system is different in the United States than in Canada. Canada has major banks that really control the environment, whereas the United States has multiple banks and has a variety of loans, and recently a lot of them have bad credits.

But banks are all the same: they want your right arm and sign. The one difference in Canada is, if you default, if you screw the bank, you do not get any more loans. In the United States, if you screw a bank, you can always move to Wyoming, Florida, or Southern California and start all over again.

So there is a difference in the way banks tend to treat entrepreneurial investors.

When you get to angel investors--and when I say this, I want you to know that I have the benefit of being in finance on both sides of the border, probably equal time in my business career--this country has a tremendous benefit. Perhaps one of the reasons why it is more entrepreneurial is because the angel investors have larger pools of capital, (1) they are high net worth investors, (2) and the angel investing area is more pronounced and has more experience. (3) This country has a legacy of speculation. Canada does not have the same legacy of speculation. This is a country of the J. Goulds, the Fisks, the Mellons and the Carnegies.

Angel investing is changing. Groups are becoming more sophisticated. You have family offices. You have, to some degree, even ethnic partnerships that are emerging. For instance, in California, there is a strong ethnic partnership among ex-Indians--I don't mean Native Indians, I mean Indians who have immigrated--who tend to finance other Indians.

So you have the emergence of a professional angel class here, whereas in Canada, I am not sure if it exists, other than Calgary and the far west, where you have a large number of oil people who deal with finance companies.

In the United States we have less Government intervention that sustains entrepreneurship than in Canada, (4) but we do have something called the Small Business Association ("SBA"), which guarantees bank loans. (5)

The SBA provides guaranteed loans to corporations, (6) the government carries the banks 85 percent or 50 percent, (7) the latter being the norm because there is too much red tape to try to get the 85 percent loan. But the SBA program has been very good in terms of financing small entrepreneurs. (8)

How did the venture capital start in the United States? It started with the Small Business Investment Company ("SBIC") program in 1958. (9) It nurtured venture capital, and produced the original venture capitalists. Today SBIC has made approximately 3,674 investments and has raised approximately $2,797 billion in equity and debt capital investments. (10)

SBICs either pay interest to the Government, (11) or alternatively, the SBICs partner with the Government. (12) I was involved in writing the legislation for it. Up until this legislation, 44 percent of all the SBICs failed.

The Government supports entrepreneurship, but entrepreneurship does not necessarily ensure success. Venture capitalism in this country has a stellar, but varied record. If you go back to 2000, there were 7,812 venture capital deals and these deals raised approximately $104,379 billion. (13) This number is staggering.

The year 2000 was absolutely a stellar year. Since then, we have had a decline, but recently, there has been a turn around. In 2004, we had approximately 3,072 venture capital deals with the average deal amounting to $7 million. (14) The total amount of investment was short of the record set in the year 2000, but it is growing recently. The number of venture capital deals in existence has grown. (15) Currently, you have approximately 915 venture capital firms, (16 the number of first-time venture capital funds is approximately 40,17 and capital assets under management is approximately $285 billion. (18) So we raised a lot of money. You can see 2000 was one heck of a vintage year.

And because of what happened, because so much money went in to venture capital, the rates of return went down. So as a consequence, we had a number of years where it just took the industry a long time to build up.

Consequently, early stage investing has diminished dramatically, and alternatively, expansion development and later stage investment has become more popular. (19) It has become harder to raise early stage money, even in the technology sector. (20) It has become more onerous. On the whole, venture capitalists are seen as more professional than angels, as we said here before, and to some extent angels are regarded as dumb money and venture capitalists as smart money. Venture capitalists, as we all know, tend to want more corporate governance and control in certain cases. (21) There are always constraints, but nevertheless, the venture capital industry has expanded over the years.

The number of dollars going into various segments of the industry has not changed significantly. In 2005, computer software was invested in significantly, (22) while...