The Case for Foreign Acquisition of Rising Stars

In the spring of 2020, just five years after going public, tech giant Shopify Inc. briefly claimed the title of most valuable company in Canada. Today, powered by global demand for its turnkey e-commerce platform, Shopify’s market valuation is still only surpassed on the Toronto Stock Exchange by that of the country’s two largest banks.

The Ottawa-based company is the quintessential startup success story and one of Canada’s few global brands. It has grown from five people trying to sell snowboards from a coffee shop to more than 10,000 employees around the world.

Unfortunately, Shopify is an outlier in Canada, where most young firms fail to scale. Some end up selling to larger foreign companies, and even the few that manage to go public often find themselves acquired within the first few years.

Foreign buyers are often blamed for stripping the Canadian economy of some of its most promising talent and ideas. These large companies (frequently ones based in Silicon Valley) buy successful young firms that have often been nurtured with the support of taxpayers in the form of government research dollars, loan guarantees and tax breaks.

But do foreign buyers deserve the bad reputation? Maybe not. New research suggests they actually boost the domestic economy and entrepreneurial ecosystem — provided there are enough homegrown enterprises scaling up and becoming anchor companies in the future.

The researchers behind the study, Veikko Thiele of Smith School of Business and Thomas Hellmann of Oxford University, based their work on a model that allowed them to assess the balance between foreign acquisitions and small domestic firms that scale up, and to examine the circumstances under which foreign purchasers offer a net benefit to the country.

“In general, having foreign companies acquire smaller domestic companies is not a bad thing,” says Thiele, who is a Distinguished Faculty Fellow of Business Economics at Smith.

By cashing out, he says, entrepreneurs receive money that they can use to start other businesses or inject into existing startups. In addition, their success encourages more aspiring entrepreneurs to launch their own companies.

Buyout prices grow

The researchers’ model showed how foreign buyers drive up acquisition prices in Canada by creating more demand. This has an “unambiguously positive” effect, Thiele says. As buyout prices grow, there is a greater incentive to start more companies, which enlarges the size of the entrepreneurial ecosystem.

Of course, inflated prices make selling a business more attractive to entrepreneurs and can overshadow the domestic benefits of retaining the business and growing it. But Thiele and Hellmann conclude that the benefits of those inflated proceeds flowing into the domestic economy outweigh the negative effects that the entrepreneurs’ decisions have on the domestic ecosystem.

If they are to fuel the domestic entrepreneurial ecosystem, however, there must be a balance in how foreign purchases occur. For starters, if too many early-stage businesses are bought, there will not be enough large, established anchor companies that a strong economy needs, Thiele says. These bigger players have the resources to pour into research and development, sales and marketing and employee development that smaller players lack. 

Equally important, the researchers note, the ecosystem will not thrive if foreign acquisitions lead to a substantial brain drain — what they term an “uncompensated loss.” It is common for a foreign buyer of a Canadian company to require that the founders relocate outside of Canada, making it likely that serial entrepreneurs will start their next company outside of the country. 

“The acquisition price has to compensate for what the purchaser takes out of Canada,” Thiele says.

How that compensation is measured is the tricky part, he admits. It comes down to the amount of money that is re-injected locally and the level of optimism and encouragement the transaction creates for other entrepreneurs in the domestic ecosystem. Seeing some Canadian entrepreneurs succeed in the U.S. and other countries encourages more entrepreneurs to risk starting a business and gives them greater confidence to succeed. In the end, some will leave the country, but many will stay.

Smart policies 

Thiele says governments have an important role to play in maintaining the balance between foreign acquisitions and homegrown stars. They need to be proactive in attracting experienced expatriate talent back to Canada. That includes creating policies and regulations that are in step with U.S. rules for startups. That way, it is equally easy for Canadian entrepreneurs to start a company in Canada as in the U.S.

To soften the effect of a brain drain, policymakers should also construct and implement programs that incentivize entrepreneurs to return, Thiele says. The most effective of these include tax credits and government funding that can be applied to both entrepreneurs and investors. Offering angel investors incentives to invest in nascent companies, for example, improves the access to capital for founders.

In earlier research, Thiele and Hellman found that optimal subsidies are the ones that go to deepen the pool of angel investments, not those directed at entrepreneurs themselves, although Thiele acknowledges that subsidizing wealthy investors is a difficult policy for politicians to sell to the public.

For decades, the federal government has tried with some success to stimulate a thriving entrepreneurial ecosystem. For example, it offers scientific research and experimental development tax incentives in the form of deductions against income or investment tax credits.

In addition, there are a range of government programs providing financial support. Through its Canada Small Business Financing Program, the federal Department of Innovation, Science and Economic Development Canada (ISED) helps small businesses secure loans by sharing the risk with lenders. The Business Development Bank of Canada, meanwhile, assists entrepreneurs with specialized financing and advisory services. In conjunction with ISED, for instance, it currently offers small businesses grants and interest-free loans of up to $100,000 to adopt digital technologies for improving competitiveness.

While fruitful, these initiatives are not going to replicate Silicon Valley in Canada, says Thiele. California’s tech mecca took decades to develop and enjoys a unique blend of resources and culture. It will take time for tax breaks and subsidies to have the desired effect, he says, and policymakers in Canada need to maintain realistic ambitions.