Vanishing act: Where did Canada's mid-sized companies go?

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Canada is in the midst of a chilling mid-sized business mystery.

In just a few short years, hundreds of companies that employ between 100 and 499 people vanished – and no one knows exactly why.

This phenomenon is alarming because mid-sized firms are more productive, hire more Canadians and have more clout on a global scale. Against a backdrop of warring governments, massive sovereign debt loads and a shifting trade picture, their importance to the country's economy has never been higher, their rapid disappearance never more in need of an explanation.

Global competition is fierce not only from Asia and other emerging markets, but increasingly from next door, as the United States lures manufacturers back home. Demographic factors of an aging population, meanwhile, are already set to curb Canada's economic growth in the years ahead, putting pressure on public finances and the country's tax base, making the vibrancy of its private sector all the more essential.

All told, 527 mid-sized companies vanished between 2007 and 2010 – representing a drop of 3.6 per cent compared with a rise of 2.6 per cent of businesses in general, according to numbers compiled by the Business Development Bank of Canada (BDC) and released exclusively to The Globe and Mail. This shrinking pace is all the more worrisome given the outsized importance of mid-sized businesses, which represent 12 per cent of Canada's gross domestic product and 16 per cent of the jobs.

The country now has just over 14,000 firms of that size, compared with almost a million small businesses and nearly 3,000 large ones, leaving Canada overwhelmingly comprised of businesses too small to generate job growth, too small to drive an economic recovery, and ultimately too small to ensure the country can compete for trade with the new global superpowers in this post-crisis world.

The mystery of Canada's disappearing mid-sized firms has even some of Canada's top economic thinkers puzzled – and racing against time to turn clues into a cure.

"Where did they go? Did they become smaller, because of the state of the economy, did they merge with others, get bought up by other [foreign or Canadian]companies? Why is the number decreasing?" asks Pierre Cléroux, BDC's vice-president of economic analysis. "We're trying to understand it better so we can propose a solution."

THE SCENE OF THE CRIME

For Canadian Hydro Developers Inc., a rare mid-sized company in the renewable energy business, the end of life started with a hostile takeover bid from giant TransAlta Corp. in July, 2009.

"It was a massive disappointment" when the offer was made, because the company was in a growth trajectory that was heading it toward big-company status down the road, said former Canadian Hydro chief executive officer Kent Brown. "The hardest thing in my life was the day before we publicly announced [the offer] sitting down with staff and telling them. It was horrible. ... We were just hitting our stride."

Calgary-based Canadian Hydro, founded by brothers John and Ross Keating in the late 1980s, built a diverse portfolio of almost two dozen wind, hydro and biomass plants in four provinces. By the time of the TransAlta takeover, it had annual revenue of more than $80-million and 150 employees.

The company fought the bid, but eventually TransAlta won out with a sweetened offer. Mr. Brown now runs BluEarth Renewables Inc., a tiny green energy startup.

Canadian Hydro's disappearance from the diminishing galaxy of medium-sized companies resulted from a number of specific circumstances. It was widely held and did not have a single strong shareholder to block the offer, and its share price had sunk because of the recession, making it more vulnerable.

But it also reflected broader pressures that make it hard for mid-sized firms to thrive. Part of the problem is that many investors want liquidity and dividends, and that tends to steer equity into large companies instead of mid-sized ones that need capital to fund growth, Mr. Brown said. It also means many mid-sized companies are pressured to prematurely pay dividends, limiting their options and weakening their balance sheets.

Another reason for the current dearth of mid-sized firms in Canada, he said, is that after the recession of 2008-09, investors became leery of investing in companies that have the potential to grow but don't have a wide portfolio of concrete projects on the go. "Nobody is willing to be patient and give you the benefit of the doubt any more, and believe in your story."

The dwindling number of mid-size companies is a problem for the country as a whole, he said, because those firms tend to be more nimble, fast-moving and aggressive than big companies. "You need both, or else you don't have a healthy, working economy."

Mid-sized companies are most exposed to the full force of global competition and the high dollar, and those that don't work hard to develop new products and invest in equipment are at high risk of failure, said Deloitte vice-chairman Bill Currie.

"There's no question there's a cohort [of companies]that we've lost over the past three or four years, and we've lost them because they weren't competitive," he said. "There's competition, not from Asia, but from Indiana at $15 an hour. You can either be massively productive or have low wage rates. If you lose on either one of those metrics, you can no longer compete for those jobs."

Against that backdrop, size matters more than ever. Bigger companies with more employees have more resources to help them export, try out new ideas and study new markets.

And their absence may explain why Canada's export performance has been relatively weak. Exports were still 8 per cent below their pre-recession peak at the end of last year, Bank of Canada Governor Mark Carney said in a recent speech. In fact, Canada's share of world exports has been the second worst in the G20 in the past decade.

THE CHASE

Authorities have a few theories about what's happening, and several possible suspects: Canada's industry base is too concentrated on natural resources, and losing focus on technology. Canadians are reluctant to think outside their borders, or take on risk. Government incentives and economic conditions are hampering growth.

While companies less than three years old tend to grow very rapidly, older ones stagnate and grow very little. And that could be attributed to the Canadian tax system that rewards small, and indirectly dissuades growth. Governments – federal and provincial – love showering preferential tax rates and other benefits on businesses that happen to be small.

"These small-business incentives are a disincentive for businesses trying to make the leap out of the small category," says Andrew Dunn, head of Deloitte Canada's tax practice. "I am not saying that the lack of mid-sized businesses is driven by tax factors, but tax factors provide a current against which these businesses need to swim as they grow."

Staying small to get the lower tax rate makes no sense, but companies seem to do it anyway, said Don Drummond, former banker and top federal finance official.

"It seems to be counter to the corporation's interests, and it's definitely counter to the national economic interest," Mr. Drummond said, pointing out that larger companies are more productive, pay higher wages, are more likely to export and to do research and development.

Deloitte Canada, which is running its own investigation into Canadian companies' growth and its link to poor productivity compared to the United States and other major competitors, has another startling discovery to add to the mix: Six out of 10 Canadian small-business owners are "lifestyle entrepreneurs" who have no interest in growing at all.

Business owner Melissa Orozco, for example, deliberately wants to stay small. The owner of Vancouver-based Yulu Communications, who previously worked for a mid-sized firm in New York, prefers a smaller size that allows for flexibility, and attention on customers.

She acknowledges that it's tougher as a little firm to attract big clients. "We would love to work with some great companies like Lululemon or something like that, but larger corporate clients are going to go to the larger agencies."

The tradeoff, she says, is that she can keep doing what she loves – if she expands to other cities, she will keep the boutique approach. "The bigger the company grows, you have to remove yourself from the work that made you passionate enough to start the business in the first place."

CRACKING THE CASE

If there is a solution to this mystery, officials might consider looking to business owners such as Alexander Fernandes, who knows a thing or two about growing companies. The Vancouver serial entrepreneur has done it four times, most recently as CEO and founder of Avigilon Corp., which makes high-definition surveillance systems used in the Vancouver Olympics, British ports and Saudi airports.

The company officially graduated from small to medium (in number of employees) in 2010 and is one of the fastest-growing in the country. It now has 200 workers, and is hiring several people a week to help it expand in places like Dubai, Mexico and Finland.

The key to growth was thinking globally from the very beginning, says Mr. Fernandes, who began in the Canadian, U.S. and U.K. markets from year one.

"It's always been a global plan," he says. "I could not justify spending $20-million on R&D to develop a product that's just going to be marketed in Canada. It's just not big enough."

Mr. Fernandes, who founded or worked at three prior companies that crossed size thresholds, has several theories for why other firms don't graduate.

First, they don't think globally. Second is risk aversion. "People are probably too complacent and too scared ... or maybe they're just happy to make a nice living with their cottage industry," he says.

In the meantime, one easy fix is to better track trends in company size. The Conference Board of Canada has pointed to a need for more nuanced data. Most research tends to lump small and medium-sized enterprises into one category, as SME, making it difficult to discern, for example, exactly how much medium-sized firms contribute to gross domestic product – and how much support they might require.

For its part, Montreal-based BDC (which crunched the numbers using data from Statistics Canada's business register) is studying why there are fewer mid-size firms by examining the trajectory of medium businesses over a 10-year period to understand their evolution. They plan to publish their findings this summer.

Canada has done a good job of encouraging startups, but it must act swiftly to help them grow, said Mr. Cléroux, the business development agency's vice-president.

"The next step is to understand how we're going to support them or encourage them to get to the next level. The competition is so much greater now than before, so it's more important than ever for our companies to be more solid and be able to export."

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