Canada's Missing Internet Wave

The idea sounded so simple and yet so revolutionary: use the Internet to exploit the buying power of far-flung individual consumers, allowing them to sign up for bulk orders on a Web site that would drive down the price of everything from video games to hand-held computers.

Canada's Missing Internet Wave

The idea sounded so simple and yet so revolutionary: use the Internet to exploit the buying power of far-flung individual consumers, allowing them to sign up for bulk orders on a Web site that would drive down the price of everything from video games to hand-held computers. Convinced that it would work, the two Canadians and their American partner eagerly presented their proposal to a Toronto investment firm in the summer of 1998. No one shared their vision. "It's pretty conservative in Canada when it comes to venture capital," observes Jonathan Ehrlich, the 31-year-old co-founder of Accompany Inc., from his San Francisco headquarters. "We knew we needed to be in a place where we had access to the right type of money and the right type of network to create the space that we could play in."

So he and co-founder Selim Teja, 26, moved to California last January - and have played - big time. Accompany's early investors include Marc Andreessen, co-founder of the widely used Web browser Netscape Communications - and it has attracted backing from top U.S. institutional investors. In the past five months, revenues, which come largely from transaction fees paid by suppliers, have at least tripled each month. Its customer base is in the "tens of thousands." And, alas, it is providing jobs for 50 San Francisco employees - and that number will triple by year's end. Accompany still has a 25-person development centre in Toronto. But its big action - and the spinoff economic returns that it generates - have gone south. "Canada has to realize," says Ehrlich, "that it has the ability and the talent to compete."

That message will come through loud and clear this week as the Canadian E-Business Opportunities Roundtable - a voluntary group of high-level business, education and government leaders - unveils its disturbing and compelling 48-page report, "Fast Forward: Accelerating Canada's Leadership in the Internet Economy." The report, which Maclean's has obtained, notes that the Canadian Internet economy represented 95,000 jobs and $28.5 billion in revenues in 1998. And it estimates that this presence could climb to a staggering $155 billion in revenues and 180,000 additional high-value jobs by 2003 - "if Canada moves aggressively."

But Roundtable co-chairmen John Roth, chief executive officer of Nortel Networks, and David Pecaut, senior vice-president of The Boston Consulting Group of Canada (BCG), warn that the nation faces daunting obstacles in that quest, ranging from deeply conservative investors to high capital gains taxes to complacent business executives. In the face of such obstacles, Canadian entrepreneurs like Ehrlich are opting to generate the jobs and the wealth in the United States.

The central message to governments, investors and all businesses is clear: e-commerce is not business as usual. Canada must move fast to adapt to this revolutionary way of doing business - or its economic vitality and its very standard of living could falter. "Canadian companies need to move quickly and decisively to protect their home markets and expand into new markets," the report warns. "We have already seen too many Canadian consumers and businesses relying on U.S. Internet sites, too few Canadian businesses migrating online and too many Canadian Internet entrepreneurs taking their ideas, talents and businesses to more dynamic, congenial markets."

The report - prepared by BCG's Toronto office - makes it clear that the problem lies with the business community rather than consumers. Individual Canadians have quickly adopted the new technology: the report estimates 40 per cent of Canadians use the Internet - compared with 32 per cent of Americans. The problem is the paucity of sites: "Many Canadian retailers have been slow to move," chides the report. As a result, only 12 per cent of Canadian Internet users made at least one online purchase in 1998 - compared with 39 per cent of U.S. users. Worse, in the vital business-to-business e-commerce area, where the value of the activity is five times the size of the flashier business-to-consumer market, Canada may be slipping increasingly behind its fast-growing rival: the report warns that the value of this market may actually decline to 7.7 per cent of U.S. levels by 2003 - from 10 per cent in 1998.

The fallout could be severe. The Canadian Imperial Bank of Commerce now spends about $250,000 per week on goods and services that are purchased online, such as office supplies. (Eventually, it hopes to cut $40 million from its $1.3-billion operating expenses - because the purchasing power of its branches and departments will be consolidated and its invoicing system will be simplified due to Internet ordering.) Senior vice-president Jack Miles says the bank has seven suppliers, including Grand & Toy, that it now deals with online. And it is taking "a very strong look" at smaller suppliers, coaxing them on to the Internet. But it is a brutal fact of life that firms that simply refuse to do business on the Internet or that are too small to service the bank's cross-country needs may eventually lose their customer.

To ease such plights, and to reverse the brain drain of enterprising youth and fledgling firms, the report outlines a series of detailed recommendations. It calls for a two-year tax incentive to encourage investment by all Canadian companies in e-business technology. It advocates revisions in the federal tax regime, including lower capital gains taxes - and the deferment of those taxes on e-business venture capital that is rolled over into other e-business investments.

The report also asks Canadian securities regulators to change the rules that require investors who acquire shares before a public stock offering to retain their shares for up to six years after an initial public offering. Because U.S. rules are far less stringent - generally around six months instead of six years - many investors opt to take their firms public in the United States. "People are coming across the border and eating our lunch," notes Roundtable co-chairman Pecaut, "and we don't even know it because there are no employees and they never even announced they were coming. This report is a huge wake-up call."

It is a Canadian success story - with a bittersweet twist. Vancouver-based Pivotal Corp. has devised a software program called eRelationship, which allows companies to manage their sales, marketing and customer service on the Internet. Revenues have grown by about 100 per cent each year for the past three years. There are 360 employees at 14 offices around the globe. Its market capitalization in the wake of a stock offering on New York's Nasdaq exchange last summer is more than $1.5 billion.

In 1997, however, because senior information technology managers are in short supply in Canada, president Norm Francis had to move his sales and marketing divisions to Seattle to attract U.S. executives. While his product development and administrative staff remain in Vancouver, 40 jobs - and all of the associated economic spinoffs such as printing contracts - are now south of the border. "It is virtually impossible to bring a senior person from the United States into Canada," says Francis. "These people are trying to make their fortune. They are not going to give up potentially millions of dollars in capital gains taxes, personal income taxes and the taxation of options. Nobody in their right mind would come: it's a one-way talent valve south."

Last summer, in an exasperated outburst, Prime Minister Jean Chrétien said that young Canadians were free to go to the United States if they felt overtaxed. The Roundtable report makes it clear that they are overtaxed - compared with the United States. Stock options - which are a common means of payment for many cash-starved start-up Internet firms - are taxed when they are exercised in Canada: employees must pay capital gains on the difference between the preferred price they pay and the market value of the stock. Many struggling employees have to sell shares simply to pay their taxes. In the United States, the benefit is taxed only when the shares are sold. Worse, capital gains taxes are almost double north of the border: up to 38.5 per cent in Canada, compared with about 20 per cent in the United States. And although Finance Minister Paul Martin is likely to change the treatment of stock options in his forthcoming budget, he is resisting calls for a decrease in the capital gains tax.

There are other taxation issues that tilt the playing field in favour of the United States. Foreign investors who pool their funds as part of a limited liability company are not protected under the Canada-U.S. tax treaty - so they have to pay Canadian taxes on their capital gains. In late 1996, Toronto-based McLean Watson Capital Inc. struggled to get U.S. pension and university endowment funds to invest in its fledgling venture capital pool for information technology and Internet software firms. It was a lost cause. "Those investors would be paying higher Canadian tax rates," says managing partner John Eckert, "so right away, they have no interest."

As well, when a Canadian company merges with a foreign firm, swapping its shares for those in the foreign firm or a new entity, its shareholders have to pay capital gains taxes immediately - even though they did not receive any cash. "This puts the Canadian entrepreneur and start-up management at a disadvantage in their growth and development," the report warns. "It is easier for many new companies to move south and establish themselves initially as U.S. companies."

Each of those taxation disadvantages works against the report's central aim of developing so-called clusters: communities in which there are Internet-smart venture capital funds, strong research and educational institutions with active ties to technology firms, large anchor companies such as Nortel that foster spinoff firms, savvy media publications, strong industry associations - and talented pools of entrepreneurs and technology workers. Each reinforces the other. "Once established, cluster development becomes a self-perpetuating cycle," the report says, adding glumly that there are few examples of healthy clusters in Canada, citing only the Ottawa region's Silicon Valley North.

Founded in 1997, WebHosting.Com is doing everything right. The Toronto-based firm provides more than 150,000 clients in 127 countries with the tools to run a small business Web site. President Jesse Rasch obtained a so-called generic domain name: 100,000 people every month reach his site, simply because they type "WebHosting" into their browser. He is profitable - "an eight-figure annual revenue stream" - because he collects monthly fees. But he became a Roundtable member because he believes that governments must quickly change the tax system. "I am not moving," he says firmly. "But I am a bit upset: Canadians view the U.S. market as increasing so quickly that they just give up."

Perhaps the greatest obstacle lies in Canadians' innate caution. In 1994, Dean Hopkins left his Toronto job as a business analyst - and hatched Cyberplex Inc. out of his solarium at home. His dream was to design and develop applications so that companies could transact business on the Internet. But it was almost a year before any business executive even returned his telephone calls. His first client, the Shaw Festival in Niagara-on-the-Lake, Ont., was highly dubious of his scheme - even though he worked for free. Now, Toronto-based Cyberplex has 250 employees in three Canadian and five U.S. offices. Revenues for the first three quarters of last year were almost $14 million - up 118 per cent over the same period in 1998.

Hopkins is trying to make the cross-border difference work to his advantage: he solicits large contracts for Internet site development from U.S. and Canadian firms - and then employs Canadian technology developers who command lower salaries in lower-value Canadian dollars to produce the work. "We are dragging U.S. work up to Canada," he says. "We have to take the wet blanket off the economy by changing the tax regime. And we have to change our perception of our own self-worth. It seems that risk-aversion is woven into Canadians' DNA."

In a way, it is almost amazing that Canadians have done as well as they have - despite the cards stacked against them. Chapters Online Inc. has fought a tough, expensive battle against the gigantic and well-established U.S. book retailer Amazon.com, emerging as the most popular Canadian online shopping site last Christmas.

And Canadian Internet venture capitalists are starting to flourish. Although McLean Watson could not get access to U.S. pension funds, Eckert persisted, and he now has the support of large Canadian players such as the Ontario Teachers' Pension Plan Board. His firm now has $40 million invested in eight companies - and it has started another $100-million fund. McLean Watson's successes include FloNetwork Inc., which does direct e-mail marketing for firms such as Barnes & Noble Inc., sending out millions of e-mails and providing near-instant tracking of the response. "Internet space is like dog years: it is changing very quickly," warns Eckert. "The winner is the one who gets known. To get known, you have to spend on marketing and sales. And in Canada, there is just less money."

To concentrate scarce resources, the Roundtable report identifies five key areas where Canada could become a global leader. They are technology for network infrastructure; animation and Web-based graphics; customer service centres that provide both online and telephone assistance; the remote delivery of health and education programs; and a wide range of Internet tools such as My Virtual Model, devised by Montreal-based Public Technologies Multimédia Inc., which allows online shoppers to use a three-dimensional model with their measurements to try on clothing.

The Roundtable is also working with key players to change attitudes. Officials in Industry Canada's electronic commerce task force, who participated in the Roundtable's working group, have become e-commerce evangelists. Legislation that protects privacy on the Internet and provides legal recognition for digital signatures used in Internet transactions is expected to pass early this year. And Finance Minister Martin is seriously considering the Roundtable's call for tax incentives for all businesses that adopt e-business technologies. Even business organizations have been swept into the e-commerce movement. "We are very gung-ho to promote its further development," says Catherine Swift, president of the 97,000-member Canadian Federation of Independent Business. "We are helping our members through courses on e-business and the Internet itself on our Web site."

In the end, the future lies in places like The NRG Factory, an Internet e-business "incubator," which fosters budding entrepreneurs in a sprawling, art-bedecked loft in downtown Toronto where the desks are on wheels - and some of the businessmen are teenagers. The brainchild of an Internet production and consulting firm, The NRG Group Inc., the Factory now provides five fledgling entrepreneurs with up to $250,000 in seed money each, coaching, infrastructure and marketing and legal services - in return for a large minority stake in the firm.

One fledgling operation, BuyBuddy.Com, acts as a personal online shopping assistant for technology products: it provides product reviews, feature and price comparisons, real-time support - and linkages to merchant sites. "Canada is really behind the times, out of step with the Internet revolution," says The NRG Group's strategic business architect John Rae-Grant, who has added "dotcom midwife" to his business cards. "We have to get rid of the ghetto mentality, this conservative posture. This is a very positive place to do business. Nothing should be holding us back."

A Canadian Model of Innovation

As a fashion-conscious woman also at the cutting edge of software developments, Louise Guay used to reflect on the difficulty of bringing those enthusiasms together. The problem, says Guay, the fortysomething president of Montreal-based Public Technologies Multimédia Inc., is that consumers want items "they can touch and try on." So in November, 1998, her company launched My Virtual Model, software that allows Web surfers to build "electronic mirrors" of themselves online. Now, her clients include retailers Macy's, JC Penney, and Lands' End in the United States, Les Galeries Lafayette in France, and Les Boutiques San Francisco in Canada. Says Guay, whose company does not reveal sales figures: "Our growth is incredible."

The new system was complex to design - but is the essence of simplicity for users. By filling in questions about body type and size - including skin tone and hair colour - users create a model of themselves. The model "tries on" different items and sizes on display in a store's catalogue. Based on those specifications, the virtual model, which comes in 3-D silhouette, also offers fashion advice. The service is free.

It has also made Guay and her 210 employees into hot commodities internationally. She travels extensively in the United States and Europe, and plans to open offices in both. Guay bemoans the fact that keeping talent in the face of high taxes in Canada and higher salaries elsewhere is increasingly difficult, and says that "American people have started to be interested in our staff" - even as the company expects to have more than 300 employees at year's end. In the meantime, Guay says, "it seems logical" to take the company public in the near future. "We would do it in the United States," she adds, "and probably at almost the same time in Canada." But for now, at least, while her virtual models travel the world, most of their real-life creators will continue to make their home in Montreal.

A New Chapter in E-tailing

Anyone who thinks things never change much from one Christmas to the next might want to talk to Larry Stevenson. Chapters Online Inc., the Toronto-based company of which Stevenson is chairman and CEO, recorded $600,000 in sales of the books and other entertainment items it offers in the quarter that ended on Jan. 1, 1999. Now, in the similar quarter just passed, that figure was $12.2 million - an increase of more than 2,000 per cent. One reason for that spectacular growth, says Stevenson, is that "we are Canadian, and Canadians prefer to shop Canadian Web sites."

As the head of what is easily Canada's largest online retailer, Stevenson can afford to say that: by his own estimate, his company is bigger than the next three domestic online competitors combined. But, as he acknowledges himself, Chapters Online has several distinct advantages over such American competitors as Amazon.com and barnesandnoble.com. For one, its core book business includes many Canadian titles not available from foreign retailers. For another, consumers like to deal in their own currency, and avoid uncertainty over such issues as cross-border shipping and customs charges.

Still, Stevenson says those advantages are also at times minimized by government policies that effectively favour foreign competitors. Most U.S. companies do not apply sales taxes to goods shipped into Canada - while Chapters, by contrast, is obliged to charge the Goods and Services Tax. (Provincial sales taxes do not apply to books.) And at a time when most online companies are not profitable, but desperately need new capital to capture market share, tax policies in such areas as stock options and capital gains leave Canadian companies in a far less favourable position than their U.S. rivals. At this point, says Stevenson, American "e-tailers" are "ahead of Canadians by a couple of years" in the scale in which they run online operations. While government intervention cannot cure that, a helpful step, says Stevenson, would be to ensure that "every retailer selling in Canada charges the same tax structure." After the successful Christmas just passed, that would be an ideal follow-up present for Stevenson and other Canadian e-tailers to receive next year.

Maclean's January 24, 2000