Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 5 - Evidence - November 24, 2011
OTTAWA, Thursday, November 24, 2011
The Standing Senate Committee on Banking, Trade and Commerce met this day at 10:36 a.m. to examine the present state of the domestic and international financial system (topic: financing growth capital for SMEs).
Senator Céline Hervieux-Payette (Deputy Chair) in the chair.
[Translation]
The Deputy Chair: I call the meeting to order. First, I would like to thank Senator Harb from Ontario, Senator Ringuette from New Brunswick, Senator Massicotte from Quebec and Senator Smith from Quebec for joining us. I am Senator Céline Hervieux-Payette, Deputy Chair of the Standing Senate Committee on Banking, Trade and Commerce.
I want to welcome John Ruffolo, Senior Vice-President of OMERS Ventures, one of the large investment companies in Canada, who will be able to help us take stock of the present state of the domestic and international financial system.
[English]
Mr. Ruffolo, thank you for joining us today. You have helped us in the past with your ideas and experience. Your appearance today is appropriate now that the committee is looking at investment innovation and venture funds. With your expertise and experience, you will likely give us ideas on how we can move forward and create wealth for Canadians in this time of economic turmoil. You have a presentation; please proceed.
John Ruffolo, Chief Executive Officer, OMERS Ventures: Thank you very much for the opportunity to present today. I will go over some prepared remarks, which I have submitted, entitled "Canada: An Innovation Nation, But Not Yet."
As Canadians, we have much to be proud of lately. We have a strong Canadian dollar. Our banking system is one of the strongest in the world. Although the 2008 recession was tough, it has not left us with a crippling debt as we possibly re-enter turbulent times. While Canada's financial house looks in order compared to most countries, we are concerned that Canada is squandering a unique opportunity for our future — a future based on innovation and a knowledge-based economy.
While many Canadian sectors are doing well, the headlines from our knowledge sector are mainly depressing. Large anchor companies are vanishing through acquisition or bankruptcy. Mid-size companies are not stepping in to take their place. Smaller companies are being starved as venture capital hovers at levels not witnessed since the mid-1990s. Our R & D spending at 1 per cent of GDP is declining and leaves us ranked fourteenth in the OECD. A recent Conference Board of Canada report gave us a D on innovation and ranked us fourteenth out of 17 peer countries. A century ago, Canada's economy was based on natural resources and agriculture. We shifted to a manufacturing base in the post-World War II period and then shifted to a service and technology-focused economy in the 1980s and 1990s.
Resources are doing well today and look likely to continue their run for years, but should we turn back time and revert to a solely resource-focused economy again? We are blessed with an abundance of natural resources: minerals, forests, oil and gas and water; but should the extraction and selling of these resources to foreigners be the solitary focus of our industrial strategy for the 21st century and beyond? Our natural resources are not Canada's only competitive advantage. We also have a well-educated workforce, multicultural diversity, technological infrastructure, world-class research capabilities, and proximity to the largest consumer market in the world. These strengths should position Canada as a world-class player in knowledge-based industries. Why have we not leveraged these world class advantages?
Perhaps for too many years Canada has enjoyed a comfortable standard of living fuelled largely by our neighbours to the south. How will Canada fair against the unprecedented economic, geopolitical and competitive forces facing us in the 21st century? We can no longer afford to be complacent and be all things to all people. If so, we risk impairing the standard of living for our children and our children's children. We need a progressive, comprehensive, cohesive and sustainable, innovation-friendly industrial strategy to propel Canada ahead in the 21st century.
Knowledge-based industries cover a wide array of opportunities, such as high technology, digital media, telecommunications, clean tech, life sciences, alternative energies and advanced manufacturing. At the core of each of these knowledge-based industries is intellectual property, which is valuable and can be developed and exported for significant value. In order to develop a globally competitive and innovative knowledge-based industrial economy for Canada, we need to focus and make strategic decisions. We need an effective strategy with both private and public sector collaboration around such areas as education and retraining, research and innovation, commercialization, immigration, productivity and financing, among others.
Strategies in each of these areas need to be identified and linked together to form an ecosystem that extends from the germination of an idea right through to the development of thriving globally competitive companies. We need to determine if each part of the ecosystem is working as intended, and if not, we must actively fix it in order for other parts of the ecosystem to function properly. Over the past 10 years, the one component of the ecosystem hit the hardest is financing. In virtually each growth stage of financing, we see enormous challenges.
Over the past 10 years the song has remained the same. We are all well aware that the financial ecosystem in Canada is broken. Between 2000 and 2010, venture capital invested in Canada decreased over 80 per cent from approximately $5.9 billion to $1.1 billion, with the number of companies receiving venture capital decreasing over 64 per cent from 1,007 to only 357 during that same period.
Given the significant decline in venture capital funding over the past decade, Canadian technology companies have turned to angel investors — generally wealthy individuals who invest in early-stage companies to help fill the funding gap. However, despite bringing individual angel investors together into organized cohesive angel groups capable of pooling resources and making more significant investments, the total angel investment in Canada in 2010 was likely less than $100 million. The problem is not that the various angel groups are not making investments because they are making them. Based on a recent report prepared by the National Angel Capital Organization, angel investors funded approximately 4.5 per cent of all business plans submitted to Canadian angel groups. This is significantly higher than the estimated 0.25 per cent funding rate for business plans submitted to venture capitalists in Canada. Instead, the issue lies in the fact that there simply are not enough non-VC funding resources, angel or otherwise, to bridge the funding gap.
What can we do? We need to act. We need to act now. There are solutions, but there is no magic silver bullet. Rather, there is a series of solutions that can be specifically targeted to address the specific breakage in the link of the financing ecosystem. While there are several addressable solutions, we believe the key solutions to focus on are the following: an angel tax credit; a corporate venture capital tax credit; government direct investment as an investor in angel or venture capital funds; expansion of the scientific research and experimental development program, to include a broader base of qualifying corporations and greater refundability; and formal government procurement policies for domestic enterprises. I will speak to each one of those.
The angel tax credit: With the recent election of the McGuinty Liberals in Ontario, their election platform pledges to implement refundable tax credits for angel investors and certain corporate investors, which holds some promise for kick-starting the innovation economy in Ontario. While the details of these refundable tax credit regimes have not been released, it is anticipated that a 35 per cent refundable tax credit will be available to those angel investors that are making qualified investments in Ontario in the technology, media-telecommunication, life science and clean-tech sectors. This program is largely modeled after the very successful angel tax credit program in British Columbia. Provided the McGuinty Liberals are able to work with a minority government mandate and get these angel tax credit proposals passed into law, more investors should enter the marketplace. Whether it is certain qualifying corporations looking to make strategic investments or high network individuals looking for a greater upside than the stock markets have provided in recent years, many will be enticed to take a hard look at early-stage investments now that the inherent risk will be reduced by 35 per cent. This is certainly a move in the right direction. We support a federal angel tax credit in cooperation with any available provincial angel tax credit.
The corporate venture capital tax credit: In order to incent corporations, including financial institutions, to invest in Ontario-based and Ontario-focused venture capital funds, the McGuinty Liberals have also proposed to provide a corporate venture capital tax credit. It is expected that the corporate venture capital tax credit will be a tax credit available to qualifying corporations that invest in venture capital funds managed by professional venture capital firms. We are not aware of any similar programs elsewhere in Canada or the rest of the world, for that matter. Canada needs initiatives such as this to provide a shot of adrenalin to the emaciated venture capital market. Without venture capital, the road to innovation is a long and often difficult journey. We support a federal corporate venture capital tax credit in cooperation with any available provincial corporate venture capital tax credit.
Government direct investment as an investor: We support continued government support as a direct investor in angel or venture capital funds. We know that public and private sector collaboration in the innovation economy works. It has worked in Israel and Taiwan. Examples like Teralys in Quebec, the Ontario Venture Capital Fund, and the Investment Capital Programs of British Columbia show that it can work in Canada too. We support federal government direct investment as an investor in angel or venture capital funds. The recently released Review of Federal Support to Research and Development, otherwise known as the Jenkins report, also supported increased federal government direct investment through the Business Development Bank of Canada.
Expansion of the Scientific Research and Experimental Development program, SR&ED: Another potential government policy-driven solution to help bridge the funding gap and foster innovation in Canada would be to expand the SR&ED program to include a broader base of qualifying corporations and greater refundability. The SR&ED program, a federal tax incentive that encourages research and development activities in Canada, has long been the primary source of funding for early-stage Canadian-controlled private companies in Canada. Very generally, a CCPC can earn a federal investment tax credit of 35 per cent on the first $3 million of qualified expenditures for SR&ED activities performed in Canada and 20 per cent on any excess amount.
For CCPCs, the refundable component of the ITC is significant, particularly when one includes the provincial research and development incentives, and is a crucial component of a start-up company's roadmap. Currently, non-CCPCs can only get non-refundable tax credits. Providing only refundable SR&ED tax credits to CCPCs does not adequately or appropriately compensate companies performing R & D in Canada. It does not make intuitive sense to deny a Canadian corporation refundable SR&ED credits, simply because that corporation is a public or private corporation that does not meet the particular tax or revenue requirements, as defined by the tax legislation. We must not lose sight of the fact that most SR&ED activities in Canada will be performed predominantly by Canadians, irrespective of the country of residence, market status or size of employer. These Canadians will make world-leading innovations in Canada and will eventually take that knowledge, train other Canadians and start new ventures in Canada.
The reality is that we need these large public and private companies and foreign enterprises. Attracting their best-in-class experience to Canada is critical to becoming a leader in innovation.
Finally, I will address formal government procurement policies for domestic enterprises. We support a federal government policy that supports Canadian enterprise procurement. All else being equal, we believe that Canadian enterprises should win any government request for proposals over foreign bidders.
As quoted in the Jenkins report, the federal government spends billions of dollars every year, but it ranks low internationally when it comes to using that purchasing power to encourage Canadian innovation. The encouragement of homegrown innovation, as a part of government procurement, is common sense.
In conclusion, this is a time of high deficits and constrained spending. Building a 21st century innovation strategy need not be expensive. It is not about billion-dollar bailouts or trying to create an industry where none exists today. There is neither a quick fix nor a single magic bullet. Instead, we need to ensure that our various federal, provincial and municipal programs work efficiently and together. We live in the greatest country in the world. We have been blessed with what this country has provided to us. It is now time to think about our long-term future, from an industrial-strategy perspective. We need to allow our children and our children's children to enjoy the same or better quality of life as we have enjoyed. We can make Canada the envy of the world. We can make Canada the innovation nation. Thank you.
[Translation]
The Deputy Chair: Thank you. I am going to take the time to introduce Senator Moore from Nova Scotia, Senator Gerstein from Ontario and Senator Tkachuk from Saskatchewan.
[English]
I would like to thank you for your presentation. It cannot be clearer or more to the point. I am extremely happy that you accepted because I think this is the kind of option that this committee will look at when it is precise, concise and coming from an experienced person like you. I am sure my colleagues will have questions, not only to clarify, but also to maybe go a bit a deeper in your proposal. The fact that you made very specific proposals will be very useful to our committee.
Senator Massicotte: Thank you for being with us. I think you made a presentation to a Toronto audience in the past week or 10 days and repeated largely the same recommendation to take a mid- to long-term approach with venture capital and government purchasing.
I think you will get a sympathetic ear from this committee, but, at the same time, before we spend taxpayers' money, we have to play the devil's advocate role and ask why they should subsidize investment results and whether or not it will make a difference.
In the last 10 years, no one has made any money almost anywhere in the markets, but particularly on the venture capital side. Therefore, one would say that 35 per cent back is good, but zero on 65 per cent is still zero. Why would I invest in venture capital funds if I still get back to zero? On the same note, some highly reputable people have said to us that this is simply a trend. In other words, venture capital has lost money because it goes in a cycle. There is basically too much money chasing poor deals and, as a consequence, you get zero. You also get distortion of the marketplace from a really subsidized labour fund. Get back to the basic free market, flush out the subsidies and let people invest money because they expect to make money. If they cannot expect to make money, it probably does not bear its support. Why would we do this? Could you comment?
Mr. Ruffolo: Many of the points you raise are valid points.
Let me first start off by saying, as a representative of OMERS, one of Canada's largest pension funds, that we have decided, as of January of this year, to form the largest venture capital fund in Canada. We are still in start-up mode, but we have been starting to make some investments. We believe, at OMERS, that we are doing this to make superior returns in the marketplace. We believe that, by learning some of the lessons of the past, we can appropriately de-risk some of these investments and make superior returns. We fundamentally believe that there is an opportunity in Canada.
When you look at the venture capital community in Canada, it started, in essence, in 1995 or thereabouts. We have really only had a history of about 15 years. The greatest venture capital ecosystem in the world, the U.S., has had about 50 years of venture capital cycles. The first 25 to 30 years of those cycles were actually not very good return years, as the ecosystem and the learning of the industry continued to evolve. In the U.S, for example, it really started approximately in the 1960s. You create a class of individuals and an ecosystem of companies and of success where that success breeds new investors who understand the market very well.
In Canada, 1995 is "venture capital 1.0." Canadian venture capital really did not get an opportunity to learn from mistakes, particularly from the crash in 2001, because much of the capital actually disappeared following that crash.
When you also look to see when there were great years of investing, you actually correlate them to massive innovations in the economy. If you go back to 1994-95, funds that actually invested in that time period had outstanding, superior returns. Why did that happen? That was the age when the Internet was really born, through Netscape. A lot of investment went into that, and venture capital firms were very successful.
In 1999-2000, when most capital was raised, you had, as you mentioned, an excess supply of capital chasing a lot of deals, and we were approaching a recession. As a result, the results showing from 1999-2000 funds were extremely poor. As a result of the poor results, very little capital came back in.
Now, venture capital raised in 2004, or thereabouts, is starting to show signs, again, of very significant returns. However, very few funds were raised, particularly in Canada, in 2004. What happened in 2003 or 2004? It was the emergence of Google and search engines. What is so special about 2011-12? You are seeing two of the most powerful forces in the technology world in the last 15 years colliding. You are seeing the impact of mobile, whether it is on handsets, your tablet, et cetera, and cloud computing. This force will change economies all around the world. If we choose not to play right now, which we can very well do, Canada will see itself further behind.
We have an issue around capital in this country. We can either choose to allow completely private forces to dictate where we will head, or make a strategic, government decision to help incent it, though not to replace private incentive and not to completely eliminate the risk because I think that produces subpar results. I use this analogy: There is a reason why Canada is the mining, oil and gas financing capital of the world. It was largely done through a government, strategic decision for flow-through shares. We do have the strongest mining finance centre, yet we continue to support that program. The market understands and accepts that and believes it is absolutely vital. I use that as a parallel for the innovation industry.
Senator Massicotte: If you read the tax credits that we are talking about, they would not apply to you because you are a non-taxable pension plan.
Mr. Ruffolo: That is correct.
Senator Massicotte: Yet, the expected returns are significant enough to warrant your interest.
Mr. Ruffolo: Yes.
Senator Massicotte: If it is good enough for you to do it without government subsidy, or without subsidy by the taxpayers, why do you propose that to others? I know the innovation argument; I know the technology argument. In the 1980s, I was heavily involved in venture capital. When you talk this way, it makes me think of my old days and it gets me all excited. I know nothing about what you are talking about, but it got us all excited to invest quite a bit of money, with very poor results. I hope the future gives you different results. Can you make a comment on that?
Mr. Ruffolo: That is a great question. None of these proposals directly impacts what we are doing at OMERS. I think that the government taxation and economic policy out on pension funds in this country has been extremely favourable. Someone may ask, "What is in it for the pension funds?" We are not asking for anything. What we are asking for is a strong innovation ecosystem. Why is that?
When you are investing in venture capital, you should do it in a very collaborative way. You cannot possibly support companies right across the country. Rather, you co-invest together. It is a very localized investment strategy. For example, if you are based in Vancouver but want to make an investment in Ontario, there is a lot of hand-holding required in this early stage. It is difficult to be very local in helping that particular company. You require other financially strong sources of capital to partner with in those local areas. The problem we see, from an OMERS perspective, is that we need partners, across this country, that are financially strong to help us lift the Canadian industry. All of these proposals are looking at trying to invigorate various stages of capital, through the entire development of these companies.
It helps us, at the end of the day. What is the self-serving interest of a pension fund? We end up with more employment and future pensioners. What is good for the economy is good for the pension funds. It is not a very direct correlation, but we believe that this is the right thing for Canada.
Senator Massicotte: The proof is always in the pudding. I can appreciate that a pension fund must diversify, but, to give us evidence of how convincing you are, how much money are you putting into your venture capital fund? How much money are we talking about here? What percentage of your total funds go to management?
Mr. Ruffolo: OMERS' total funds are $53 billion. The way it works is that we will allocate $200 million right now. That $200 million, based on our investment strategy, will last us approximately three years of new investments. The strategy is to invest in very early-stage companies. We will invest as low as $500,000, which is very unusual for a fund that has $53 billion. It is fundamental to find the early entrepreneurs and to grow with them and be the financial support throughout their entire life cycle.
As you continue to develop the strategy and add some more companies, you go back and you request additional allocations of capital. This is consistent with how OMERS, for example, developed its private equity practice. This is how CPPIB has done it. A number of other pension funds have done it the same way; they stage the allocations.
Where do we think we will end up? We are trying to create an evergreen, sustainable fund that always has a few hundred million dollars of available capital. What that probably means is that the size of our capital will be somewhere between $800 million and $1 billion. That will probably happen in the next five or six years, in which case that will represent approximately 1 per cent of the capital of OMERS. That 1 per cent to 2 per cent range feels like about the right level.
The interesting aspect to this is that it does not take an enormous amount of capital to actually stimulate a lot of these companies because so many of these investments are quite small. I fully expect that we will be somewhere around 1 per cent in about five years time.
Senator Massicotte: Thank you.
Senator Harb: Do you think 1 per cent of the total fund is something that the government should start promoting with other pension funds and financial institutions?
Mr. Ruffolo: That is a good question. The two biggest sources of investors, traditionally, in Canada, have been both financial institutions and pension funds. Specific to the pension funds, there has been a lot of debate on how to encourage the pension funds to kind of come to the table and reinvest in venture capital.
OMERS, for the last 15 years, has been a very active investor in venture capital funds. OMERS has strategically decided that we have a better shot of hitting our financial hurdles by directly investing ourselves, as opposed to investing in the venture capital funds. OMERS has not left the asset class per se; we just decided to do it a bit differently.
The big question that gets raised is this: How do we get the pension fund industry to come back to the asset class? People have talked about whether or not to implement a pension tax. Many people discussed a 1 per cent sort of tax, where you should have this allocation. If you do not, you need to top it up to the extent that you do not have it, into either a government-sponsored or other type of capital fund. We also heard about guaranteeing the minimum level of returns to the pension funds to help de-risk the pension funds and to stimulate them to come back into the sector.
Personally, I hope to see how successful we can be by being careful and learning the lessons of the past. Through our model and behaviour, I hope to encourage the rest of the pension fund players in Canada to see that, properly managed, this is, in fact, a very good asset class. I hope to entice them to come back in that way, as opposed to mandating a particular tax because you start running into the issues of how that impacts pension members, what happens if there are losses, et cetera. I think there is some complexity associated with that, but, certainly, there have been lots of discussion around that topic.
Senator Harb: In your Recommendation No. 5, you talked about formal government procurement possibilities for domestic enterprises, and you said, "We support a federal government policy that supports Canadian enterprise procurement. All being equal, we believe that Canadian enterprise should win any government request for proposals over foreign bidders." Is what you are suggesting here "buy Canadian," just as the Americans are saying "buy American"?
Mr. Ruffolo: No. The problem with Buy American is that it implies that there are no other tests. Certainly, there were. Right now, as far as I understand, there is no tick on the box regarding whether or not you are a Canadian-based company. If you are a Canadian company with an inferior product or non-competitive price, you should not win that bid. We should not be coddling inefficient Canadian companies if they cannot compete globally. When you have two companies bidding that are competitive in all of the various matters on a checklist, that should go to the Canadian company. Currently, I am not aware of any such item on a checklist. We are just asking that that be there and be considered. Of course, we are not looking for anything in contravention of the World Trade Organization or GATT issues, et cetera, but we think there is room for this sort of addition.
Senator Harb: Surely the mere fact of your raising it is a red flag. If I am a foreign company, and I hear that the Government of Canada, or any government in Canada, is thinking of doing something like this, I would be outraged and sue the government. Simply put, under WTO rules, we have to have a level playing field, and you have to have certain criteria. You cannot turn around and say that they are both equal. That will not happen. At some point in time, one will be scoring more than the others. If you are telling me that one of those two companies will win just because it has the Canadian logo on it — both of them being equal — then you are twisting the rules. That is very serious.
Mr. Ruffolo: Once again, when I have seen the procurement rules and the criteria, they tend to be very sophisticated. It is a question of prioritization. If you have gone through the Jenkins report, you will see that there has been an international study looking at this. Canada sits right at the bottom. Virtually every other major industrial economy in the world does this already. Some do it far more aggressively and put the "made locally" at the top. We are suggesting keeping it at the bottom. It currently does not exist. When you look at some of the tremendous areas of growth, where did a lot of these centres grow? Let us use the U.S. as an example and pick San Diego and Los Angeles. It was through U.S. military contracts. In the U.S, for security reasons, they are extremely conscious. In fact, they go over and above on that. What has happened is that the spinoff benefits that have been created in some of these centres have been unbelievable because of the technology that has been developed from a military perspective. Now, most of these technologies can be seen in commercial and consumer goods. I think that is an extreme example, but that is stimulating innovation. I think that, whatever we do, we need to make it in light of any issues that we might come across from a World Trade Organization or a GATT perspective.
I think there is something in the middle there — classically Canadian, the compromise position. I also think that, by not having it in there, we lose an opportunity.
Senator Harb: Thank you for qualifying that. In fact, national defence in the United States — when it comes to national defence for national securities reasons — disqualifies any company from even bidding, never mind qualifying.
I greatly appreciate the fact that you came forward with some pretty good suggestions. Some are very sophisticated and pretty good. One of them is the fact that you are calling for an almost "one-stop shop" mechanism — federal, provincial and municipal. There are some experiments that have already taken place in that field.
That $53 billion is almost like 50 per cent of all the pension funds, actually. You are pretty big. It is true. In 2009, the total amount was $1 billion. You are planning to do 20 per cent of what is out there.
Mr. Ruffolo: Yes.
Senator Harb: That is good.
Mr. Ruffolo: That is very significant.
Senator Harb: That is very good. I think that you, as someone who is from OMERS, should publicize that as much as possible because you are closer to the people, closer to your members; you see it on the ground. That is fantastic.
It is my hope, Mr. Chair, that, if there are any other extra points in this report, our researchers will do some follow-up, in particular on the notion of the 1 per cent that was brought forward here.
The Deputy Chair: Before moving on to Senator Tkachuk, I would like to ask you whether you do in-house analysis or whether you contract out the analysis of the projects that you are planning to invest in. I suppose you have a committee, but, at the same time, who is doing the study to ensure that the investment will be producing and has a good future when it comes to innovation?
Mr. Ruffolo: That is an excellent question. It is completely in-house, but that is not to suggest that, if there is some deep domain expertise we require, we will not hire the appropriate adviser.
We started off, in January, with one person, which was me. We are up to 10 people. We need to scale it to approximately 12 for the $200 million. It is led by five managing directors. Three of the five have been hired and are currently working; two more are in progress. Four of the five managing directors have been CEOs of technology companies. Two of them have been serial CEOs; one of them has been a serial CEO in Silicon Valley and wants to come back home to Canada to be part of this. The remaining one was an operator for 10 years in some of the world's top technology companies.
The theme here is that it is operationally focused. It is being managed by people who have actually done this before and are empathetic to the struggles and trials of these early-stage entrepreneurs.
This is one of the insights that we decided to do from an OMERS perspective. These individuals do not look like most people at OMERS who tend to be far more financially focused. It is a new and different cultural experience, but it is one that is quite exciting. I think this is one of the various issues or rules that we learned in venture capital 1.0: You need entrepreneurs to help build entrepreneurial companies.
Senator Tkachuk: In your presentation, you mentioned angel tax credits and corporate venture capital tax credits. In Canada, we have the labour venture capital tax credit. In testimony here, there has been quite a bit of criticism of them, saying that they have not been profitable. In other words, I put $1 in it in 2000 and I still have $1 today. The only thing I would have gained is my tax credit.
How will those tax credits be different from the ones you are talking about here? The whole purpose of that was to use it for venture capital.
Mr. Ruffolo: On the labour-sponsored venture capital funds, there were a number of challenges with how they were inherently structured. Without going into the various details, they were largely very costly; they had pacing requirements that encouraged investing to occur when, perhaps, it was not opportune to make those investments. It required you to make investments in the precise jurisdiction where you raised the capital and there were a few other inefficiencies.
The time when they raised most of their capital was around 1998, 1999 and 2000, just in time for the big meltdown. Most had significantly underperformed in the marketplace. On top of that, they had significant costs to administer the funds, in addition to your normal management fee.
These angel tax credits, which I will use as an example, are designed not to focus in on the retail investor, where the labour-sponsored fund was trying to attract the $5,000 from people who were otherwise giving it to their broker or putting it into their RRSP. This is designed for sophisticated investors.
When you are making a technology investment, there is a challenge when you are making it on a very early-stage company. You place two bets: You place a technology bet on whether this thing even works, and then you place the normal commercial bet that you bet on every other non-technology based company.
What we were trying to do on this one is help a number of these individuals who are passionate about this sector — perhaps made a bit of money in this sector and want to be part of it. They do not really have the time, resources or inclination to spend lots of time trying to de-risk the technology part of the bet. We were trying to give an incentive, but not remove the risk at the end of the day. We were trying to given enough of an incentive to push them over the goal line to take care of the technology risk part.
That begs the question: How much is enough to get them over the goal line, but not to get them so far over the goal line that we get back into some of the issues that you described? Using the upper end as being the flow-through shares, which give a 45 per cent benefit depending on the province in which you reside, we thought that was the maximum that you should do — probably even a little on the high side. We felt that 20 per cent and less was not enough to change any sort of behaviour. The going-in position was somewhere between 20 per cent and 40 per cent for an incentive.
We do not have the details here, but it was capped on an annual basis. I will explain the capping so that this does not get a bit too unwieldy and expensive for the government. We ended up picking 30 per cent, kind of the halfway mark, as enough to incent the behaviour.
What we also tried to do — "we" being with the Ontario government — was to create a box around this. We said, let us earmark X amount of dollars per year to monitor this program. When the dollars run out at whatever point in the year, you stop for that year and then restart the following year. You can then measure whether this is having the right impact in the economy.
We did that on the basis of careful management and using the example of British Columbia, which had this program in for a number of years and released a study last year showing that the unbelievable benefits and the returns as a result of those companies were far superior to what they had otherwise. We are sort of relying on 10 years of history as a model and benchmark.
Senator Tkachuk: The angel tax credit, corporate venture tax credit, government direct investment and expansion of scientific are all government subsidies, in a way, because each tax credit comes out of the general revenue from other taxpayers.
Mr. Ruffolo: Right.
Senator Tkachuk: I do not know whether it is the culture or what; I have no explanation for the fact that great inventions were made previous to tax credits — the Wright brothers, Pasteur, television, the computer, et cetera. Really, the first 50 years of the 20th century produced probably the greatest inventions in the history of mankind; it has not been matched since. We certainly have not come up with anything as inventive since, and yet we have all this government money being poured into these tax credits.
You mentioned that there was a downturn in 1991. Well, you know what? There is a downturn every decade. In my life experience, it happens every decade. That still does not explain the fact that there were no returns with the venture capital tax credit. We had years in the 1980s, the 1970s and the 1960s where we had recessions. We will always have recessions.
The Deputy Chair: And the question?
Senator Tkachuk: All of this, including procurement, is all government-related. My question is, is there anything we can do outside of government?
Mr. Ruffolo: Absolutely we can.
Senator Tkachuk: Those would be interesting to hear.
Mr. Ruffolo: The focus of these was, what can government do? That was the focus here. This is not what can we do as a nation, from a private perspective. There are many things that are going on. There is the example of OMERS as a private organization with private capital injecting the biggest injection that Canada has seen in at least 10 years. There are lots of things going on.
The question is, is it enough? When you look at Canada right now — this is the fundamental underpinning of this — up until the last 10 years basically, Canada was an economy described as being all things to all people. I compare Canada to Nortel. Nortel was one of our greatest innovation icons. One of the biggest reasons for its downfall was it was all things to all people; the market changed and competition became global and intense. All of a sudden, they needed to select and they needed to bet.
I view this same example in Canada. I think our days of spreading our wealth across a multitude of industries are over. Canada has to make strategic choices, saying no to a bunch of industries that will not define us in the 21st century. The thesis here is that if we are going to have to do that — and I believe we are — we do not compete anywhere.
There are only a few industries that we can pick. This is one that I think we have the natural assets to pick and stimulate and grow, not unlike most other great countries in the world that are doing the exact same thing. When you look at what Israel, China, India and the Nordic countries are doing on the innovation agenda, it saddens me that we sit back and do not get very aggressive back.
They are all supported through government initiatives at the very beginning. Where the challenge comes is that you do not want this to be the ongoing way of how we will compete because this is a short-term opportunity. What we believe and hear is that, unfortunately, whether we like it or not — and my personal view is I do not like it; I do not like subsidies because I think it makes it difficult to make pure economic decisions — I have come to the conclusion we do not have a choice.
All of these ideas, taken either collectively or choosing the one or two that make the most sense, are based on government creating and fertilizing the field, but not picking the seeds on who actually grows — not picking winners or losers. I think that needs to be left to the private sector. This is when Canada gets into trouble.
This is doing the fertilizer and hopefully allowing the seedlings to grow. Let the private sector take those seedlings and grow them. All of these here have that same sort of field underneath.
The Deputy Chair: We started a bit late so I will allow two more questions.
We have someone who was supposed to intervene at 11:30 but we started the committee work after 10:30. I will ask Senator Ringuette to ask a question and Senator Smith, but we have two witnesses afterwards.
Senator Ringuette: I have two short questions. You talked about lessons learned, and we have talked a lot about financing. I would like to know what were the lessons learned in regard to commercialization and the buyout of these Canadian innovations by foreign entities.
My second question is that I find that at least from my perspective, these start-ups lose a lot of time and money chasing after venture capital, making their case here, there and everywhere. I think at least the federal government could have a pool, either under Industry Canada or through the BDC, where all these start-ups that are looking for funds could register. Therefore, it would be easy also for potential investors to look at who are our start-ups that are looking for angel or venture capital. At least it would create a database and hopefully remove a lot of the time and energy these start-ups spend in looking to finance their ventures.
Mr. Ruffolo: You raise a very good point. Many of those start-ups do struggle. If you ask start-ups what are their biggest barriers for success, one of the top two answers is financing capital. It is not always the number one answer but it is always in the top two.
When you look toward the solution — this is kind of a follow on to the previous question — there are only six sources of capital in this country. They are financial institutions, what can we do; pension funds; the corporate sector, for example, the corporate venture capital tax credit; foreign investors — I think I was in front of a few of you a year ago on the section 116 clearance certificate, and it has had the desired effect so there is nothing more to do there; individuals, for example, the angel tax credit; and government. Those are the six pockets you need to address.
When you look at the various solutions, there is not one that underpins just one of those six categories. What it inevitably does is create a myriad of different financing sources, and it does create some confusion. Many of the start-ups we talk to do have some concern about who to go to. That is really the responsibility of the private sector predominantly doing a much better job of making it easier for start-ups to access that capital.
The Deputy Chair: The first question was about companies growing after three years and needing more funds. After having invested and gotten investments of over $20 million, because they need more cash and it is not there, they are being bought and foreigners are walking away with innovations that both Canadians and Canadian taxpayers have financed. I think it is a concern of all of us that many times when we get to the last stage of financing, the money is not there in Canada.
Mr. Ruffolo: That is an absolute concern that we have seen, particularly over the last five or six years. The issue is exactly as you had stated. Due to the lack of capital, many of the traditional funds — and let us just use funds, whether they are venture capital funds or not — have been too small to continue financing the company to its ultimate liquidity, profitability, et cetera.
The thesis that we have of OMERS Ventures is predicative of exactly that issue. This was one of fundamental learnings that we learned over the last 15 years. When you look at the history of venture capital in Canada in particular, the focus of the funds was somewhere around a cheque size of $2 million to $10 million — not too early but also not going late.
Once it hit about $10 million, it forced you as the entrepreneur to go largely to the United States. What would happen, with you being a Canadian investor — particularly if it was a great company — is that either you had no power to take the real profits of the deal when it was ultimately sold, or it would end up being sold far too early.
Our strategy is not only to go earlier, but also to go later. The idea here is come in at the seed stage when angels come in and co-invest with the angels. That is why we have gone to as little as $500,000. However, OMERS is not interested in making an investment for $500,000 and exiting it for $10 million. That does nothing for our pension plan members.
What we are trying to do is do $500,000 to help the business: Is it the right business? Is it pivoting the right place? Is it a business that deserves to survive or not? If it is, hit them with $5 million, then $10 million, then $20 million and $30 million. Our cheque size range is $500,000 to $30 million, which is typically the largest cheque that you will need before you go public.
The idea is that this is the first time, at least in the last 10 years, that any capital pool in this country could match the firepower of any fund in the United States. For the first time, we are trying to tell the entrepreneur that if you want to go and get foreign capital, get it for strategic value reasons, not just because they can cut a bigger cheque. We can cut a cheque that is as big or bigger than any U.S. venture capitalist right now. That is at the core of the strategy.
Senator L. Smith: People always talk about the risk aversion of Canadians. We do have an entrepreneurial base, but I would like your comments on risk.
Having lived through a couple of situations with venture capital, it is like you give your shirt, your home, everything to get a position of support, and as you go forward in time, you try to get to the point where you get your shirt and your house back.
What type of balance do you see in that whole evolution of risk with entrepreneurs? How do you change the culture, if you like?
Mr. Ruffolo: I personally think this is the most difficult issue to address. Let me answer the question in a couple of ways because it is very complex.
There is no question that we have entrepreneurial talent, particularly from an engineering product development perspective, in Canada compared to any place in the world. I would defend it anywhere; there is no question in my mind. Canada looks very similar to the rest of the world, with the exception of the United States.
The United States is an exception, particularly in Silicon Valley. It is very interesting to see how the entrepreneurs there view success. They wear failure as a badge of honour. When entrepreneurs in Silicon Valley introduce themselves, they usually say I had three start-ups; for the first one, I raised a bunch of money and boy did I lose everything and it was crazy. The second one, I thought I got it and I lost it too; but on the third one, I made it.
In Canada, we do view failure as failure and it is something that you shy away from. There are some exceptions, but it is not still a cultural thing.
It is still not cultural when we go to our schools, where people want to be accountants, lawyers, bankers or professionals — and the professional class here is generally viewed as where we want to be as opposed to an entrepreneurial class. There are some exceptions. You are starting to see for the first time, particularly at the University of Waterloo, kids coming out of engineering school saying I will be a start-up guy, and you relish that.
I think that we still need to get the culture moving in that direction. However, on the other side, the interesting question is, is Canada a risk-based culture? Let us go ask our friends out in the oil patch. Americans generally think Canadians are nuts from a risk perspective: You are going to invest $700 million to dig a hole in the ground and you do not know if anything is there? Are you guys crazy? We do it better than anyone in the world does, so for us to say we do not have a risk-taking culture is naive.
Now, what did we do? We created a government system of financing to help de-risk that. It has been a phenomenal partnership. I do like a lot of entrepreneurs in the oil patch. They do wear failure as a badge of honour, and I think the technology sector can learn a bit from that.
The Deputy Chair: I guess we have gone a little bit over time. I would like to thank you. Any other great ideas are most welcome. We will continue our hearings for a couple more weeks. It is very useful.
You came with a very concrete way of doing things, and we congratulate you also for the innovation in your fund, to go ahead with a longer range of investment and at the same time, to really trust Canadian entrepreneurs to accompany them and help the country. Many thanks on our part.
Mr. Ruffolo: Thank you very much for the opportunity.
Senator Michael A. Meighen (Chair) in the chair.
The Chair: Colleagues, welcome back to the second half of our meeting this morning. I want to thank our deputy chair, Senator Hervieux-Payette, for having chaired the meeting so well in the past hour. I hear it went very smoothly. I am sorry I was not here. In this second hour, I will see if I can keep up to her high standard.
We welcome Mr. Iain Klugman, President and CEO, Communitech, which is Waterloo's technology commercialization digital media and economic development cluster. Through the magic of video conferencing, we also have James Brander, Professor, Strategy and Business Economics Division, Sauder School of Business, University of British Columbia. Welcome to you both.
Without further ado, I understand, Mr. Klugman, that you have an opening statement. We will start with you and then go to Professor Brander.
Iain Klugman, President and CEO, Communitech: First, let me thank the committee, the chair and the members for inviting me here today. We view government as being important partners in what we are trying to achieve, and we love the opportunity to comment on this important issue.
I wanted to start by saying that we truly believe this is Canada's opportunity. In many respects, I would echo what Mr. Ruffolo said previously around the need to focus on where we want our economy to grow. We had the fortune of spending the last couple of days with the Kauffman Foundation out of the U.S. It is the largest foundation in the world that focuses on entrepreneurship. They basically said to us every nation is in a race to the top in trying to figure out how to build an innovation economy. Again, to echo the words of Mr. Ruffolo about the investments by China and the Nordic countries and the U.S. under the Startup America campaign led by President Obama, this is a significant race we are in, but one that can produce tremendous results for the future of our country.
This is truly an opportunity for Canada. We have invested significantly in research and development in the past number of years, and that yields tremendous opportunities for us. We also have an unprecedented rate of start-up activity starting across the country. Being an entrepreneur is all of a sudden becoming cool. It is one of the things that people are wanting to become. It is one of the career choices that people are wanting to make. The only thing getting in the way of us being the envy of the world, the next Israel as far as innovation economy perspective, is capital.
As I said, my name is Iain Klugman, and I am from the Waterloo region. In addition to being the CEO of Communitech, I also have the pleasure of chairing the Advisory Committee on Small Business and Entrepreneurship, which provides advice directly to the Minister of State for Small Business and Tourism and the Minister of Industry.
At Communitech, we work at the front lines of Canada's technology industry, serving a network of more than 800 technology companies that generate more than $25 billion in revenue. Our work connects us with companies at all stages of growth, from the more than 350 — in fact, it is actually about 400 — start-ups that employ fewer than five people, through to Canada's largest software company, OpenText, and Canada's largest technology company, Research in Motion. The Waterloo region technology sector employs more than 30,000 Canadians. Increasingly, Waterloo region is rivaling Silicon Valley and Boston as the preferred launch pad for entrepreneurs, based on the strength and the track record of the local technology ecosystem and its ability to accelerate the growth of investment-ready companies. I share this background because it is the vantage point that gives us insight into what business needs to be successful and the challenges faced by Canadian entrepreneurs.
I am very pleased to be able to share this perspective with you today because I think we, government, can make a significant difference for this key driver of the economy through some strategic, cost-effective policy change. There are two key recommendations that I wish to highlight for your consideration today. They are that government should increase access to capital for Canada's small and medium-sized enterprises and fine-tune support for R&D to accelerate the growth of knowledge-based businesses.
The first issue I would like to raise is access to capital. Quite simply, our system is broken. Since it is broken, we are raising a generation of companies that cannot succeed in Canada. The capital crisis hits all companies equally, no matter where they are in their life cycle. Small companies in particular need access to capital to help them grow their business. Government has already taken important steps to help companies raise capital through its commitment to reform section 116 of the tax code. This is an important change that makes U.S. capital more readily available to help Canadian companies grow, but there are three additional steps that government can take to ease Canada's capital crisis and help companies raise capital. These are to implement an angel tax credit, to implement a corporate venture capital tax credit and to invest directly in angel or venture capital funds.
For early-stage companies, angel capital bridges the gap between friends and family, or friends, family and fool financing, and venture capital. The Government of Canada can get this important source of capital off the sidelines by providing a tax credit for angel investors. Off the sidelines is really a way of talking about how to bring the large pool of capital that is sitting with individuals into the game, out of other asset class and into the game. An angel tax credit will put more capital in Canada's tech ecosystem for companies needing $500,000 to $2 million in capital by engaging the wealth that exists in Canada and putting it to work at the community level.
Encouraging greater levels of angel investment has benefits beyond the value of the capital itself. Harnessing the additional value of mentorship to investment is often as valuable to building successful businesses as the money itself. Fixing the life cycle of capital from the start, by focusing on early access to the unique expertise and capital provided by experienced angel investors, will result in better companies with higher valuations of the next tier of financing. Good models exist in British Columbia and throughout the U.S. and are proposed in Ontario. The conditions are right for a credit of this kind, with strong angel networks having emerged across the country to share best practices and streamline a deal. If we look to the south, there are two types of states in the U.S. right now. There are states that have an angel tax credit and states that are in the process of putting an angel tax credit in place. A tax credit of this type would supercharge this activity and make capital more available to early stage companies, leading to increased job creation for Canadians.
Turning to the venture capital tax credit, government can further reinvigorate Canada's capital by bringing large corporate investors back into the asset class. Providing a tax credit to qualifying corporations that invest in venture capital funds that are managed by professional firms will not only catalyze the creation of more capital in Canada but also will attract top management talent to Canadian VCs. Strategic corporate investors from communications and mobile technology companies to big pharma represent potentially huge pools of capital for fund creation.
Without reinvigorating Canada's venture capital market and growing the number of available sources of risk capital, we are simply growing promising start-ups to the point where they are forced to sell. That means we will never create a strong crop of mid-sized businesses in Canada and our companies will never grow into large global powerhouses because they do not have the right capital at the right time.
A recent study by the U.S.-based Kauffman Foundation for the study of entrepreneurship shows the majority of new jobs are created by companies younger than five years old. Unlike more established firms, start-ups do not seek to become more productive by shedding jobs and talent; rather, they add jobs. To meet the objective of job creation in Canada, government can support innovative, high-growth companies by directly investing through public sector vehicles.
Entities such as BDC, EDC, the Ontario Venture Capital Fund and Teralys have significant amounts of unallocated capital that, if utilized strategically, could become a force for building innovative companies in Canada. One estimate is that it could be as much as $1 billion. Early indications signal that these players are keen to partner but need strong leadership that will bring institutional investors to the table. In the words of one entrepreneur, we do not need more money; we need to unlock the existing money.
Currently, entrepreneurs spend a significant amount of time and talent putting together a patchwork of money from every conceivable source. This is inefficient and distracts entrepreneurs from the work of building the company. Active, well-funded funds in strategic sectors of the economy can help address this inefficiency and get managers back to building their businesses. The idea is that combined capital and a fund of funds could seed 10 to 15 funds across Canada led by seasoned, top-tier performers. Provincial considerations could be negotiated as required. A consensus is already emerging as who the top fund managers and up-and-comers are. In this model, public capital gets out of the firms rather than languishing allocated and leverages private sector capital in the process. The result is a smart, elegant solution that gets capital in the hands of early-stage companies quickly and efficiently.
Fine tuning support for R & D: My second major recommendation for your consideration today is that Canada should fine-tune its support for research and development undertaken by private companies. It can do this by expanding the scientific research and experimental development credit, the SR&ED credit, to include a broader base of qualifying corporations and by allocating a portion of government R & D funding to support innovative SMEs. The SR&ED program is widely recognized as a strong instrument for encouraging private sector research and development.
More than that, I firmly believe the SR&ED program is the largest single reason why Canada has a technology industry. It has long been the means for mitigating the access to capital issue for small business. The recent Jenkins panel report on federal investment proposes the simplification of the SR&ED program to make it easier for companies to access, which I endorse. The current practice of limiting eligibility to early-stage Canadian-controlled companies does not adequately or appropriately motivate all companies interested in performing R & D in Canada, be they Canadian, foreign, public or private.
For Canada to realize much needed productivity gains, the SR&ED program must be broadened to encourage innovation and job creation.
Expanding SR&ED eligibility to a broader base of corporations will result in more R & D being done in Canada, creating more jobs, spinning off more innovations and starting more companies. It is a virtuous cycle that benefits our knowledge economy.
More immediately, government can encourage greater levels of R & D by acting as a customer for Canadian innovation. Consider the U.S.-style Small Business Innovation Research program, SBIR, which provides full funding for SMEs in conducting research towards delivering a real solution for government. The program is enshrined in legislation and gives small companies a real customer that can provide real feedback on their products. Government ministries could invest in R & D solutions and leverage government purchasing power to encourage Canadian innovation.
In conclusion, we invest heavily in research and innovation in this country, but as a country we struggle to see these investments translated into commercial success. By increasing access to Canada, capital for Canada's small and medium-sized enterprises and fine-tuning our support of R & D, government can have an immediate, positive and direct impact on our ability to produce more companies, jobs and wealth for Canadians.
Ladies and gentlemen thank you for your time this morning.
The Chair: Thank you, Mr. Klugman; that was straightforward and to the point. We appreciate your practical ideas for our consideration.
James Brander, Professor, Strategy and Business Economics Division, Sauder School of Business, University of British Columbia, as an individual: Thank you for inviting me. I am not sure I can be very helpful to this committee, but I have prepared some general comments on financing innovation, and the financial sector more broadly. I would be happy to respond to questions. I think the tone of my comments will be different from the last two witnesses you heard.
The first thing I would like to observe is that the recent financial crisis in the United States — arising from an under-regulated or deregulated mortgage finance sector — has reinforced the general acceptance of prudential regulation in the financial sector. The role of prudential regulation, capital adequacy, leverage restrictions, separation of financial activities across institutions, disclosure requirements is widely accepted and the Canadian model is well regarded. I feel confident in saying we would all be much better off today if the Europeans and Americans had a model closer to the Canadian model. The point I am making here is it is not obvious to me that the Canadian model is broken, relevant to other financial models out there.
Prudential regulation is very important. It is less clear if it is a good idea for governments to become involved in actively promoting or encouraging certain types of finance. We know the tools: tax subsidies, loan guarantees, provisions of funds directly by governments, preferential regulation, and so on. These tools are all subject to debate. Also subject to debate is whether SMEs, start-ups or other categories of firms deserve special treatment from a financial point of view.
I do not pretend to have a broader knowledge than I do of the answer to these questions — or of the financial sector generally — but I have done a fair amount of research on venture capital finance and related types of finance such as angel finance.
The first point to emphasize is that most finance for the SME sector is not venture capital finance, with banks and ordinary equity investors being much more important. Let me talk about overall job creation in the SME sector, which is important. Most of that is not derived from venture capital; most is derived more from bank finance and conventional equity finance.
These are important for innovation, which in turn is important for economic growth and productivity improvement.
I have a series of arguments I would like to put forward. First, we do not know as much as we would like. We do not know a lot. When we go for advice within the sector, there is a lot of self-interest and strong opinion — which is not necessarily self-interest — but we do not know as much as we would like about what creates good performance and innovation.
I would think that the Canadian financial system has performed relatively well by international standards. I am reminded of the adage, "If it ain't broke don't fix it." One of the two main jobs of the financial sector is to provide safe and prudent investments for investors, such as pension funds, other institutions and individuals. Canada has a good record in this area. No major banks have failed in all that time, and investors have enjoyed reasonable rates of return by international standards. They would like high returns over the past decade, but it is not as though anyone else has done well. I think the decision to prevent major Canadian banks from merging and the decision that prevented absorption of the TSX by one or more international stock market conglomerates were good decisions. Those mergers might have generated small economies of scale and large bonuses for a few executives, but at the cost of reduced safety and accountability in the system, in my view. My basic point here is the prudential aspect of the financial system is absolutely fundamental.
The second major job of the financial sector is to channel money from investors to firms or other users of finance who can use it most effectively. The Canadian financial markets have also performed relatively well. The one area of concern sometimes raised about Canada is in financing innovation. The normal comparison is with the United States, which appears on a pro rata basis to generate more financial capital or innovation, and simply seems to generate more innovation by any reasonable measure. In addition, Canadian labour productivity has fallen in relation to the United States over the past 30 years.
The question comes up: Does this relatively disappointing performance in innovation and productivity, relative to the United States, arise from a failure of innovation finance or something else? Is it actually a problem? Does it call for public policy to generate more innovation finance?
My answers are along the following lines. First, there are various measurement issues. I am not an expert in measurement, but there are various issues that should make us somewhat skeptical about the size of the advantages of the U.S. over Canada. If we end up comparing standards of living, Canada does pretty well.
It is certainly true that the U.S. does have a comparative and absolute advantage in innovation. It does innovate more than Canada on a pro rata basis. This has been important, especially in the information and communications technology sectors.
This is the one thing the U.S. does well, much better than anyone. I think a big part of the reason is the close connection between the innovation sector in the United States and the top research universities in the United States. I believe Canada should have an active innovative sector and continue to improve connections between, for example, major universities and business innovation. Until recently, we were a lot further behind the United States. I think we have closed the gap.
Relying to a large extent on technology transfer from the U.S. is not a bad thing. We hear a lot about China and China's economic growth. There is some innovation in China, but most of its economic growth is based on technology transfer, which is basically technology developed in the United States.
I am skeptical about expanding the role of publicly supported innovation finance in Canada. I do not believe the problem — if there is a problem — is actually a lack of finance.
If we talk to entrepreneurs of start-up companies they will always say they would like more finance. If you talk to venture capitalists, they will complain about the lack of quality enterprises in which to invest.
Canada actually already has a high level of government activity in the venture capital sector. This is something I have studied quite a lot. From the government's point of view, Canada is one of the most active supporters of venture capital, certainly much higher on a prorated basis than in the United States. At the government level, Canada is doing a lot. This includes the Business Development Bank of Canada, the Labour Sponsored Investment Funds, various provincial programs, tax credits, and so on.
My co-authors and I have studied government activity in venture capital finance. This surprises quite a few economists, but what we have concluded is that if we look at the world as a whole, government provision of venture capital has been awful. However, it does best when it is channeled through the private sector. When funding for a given enterprise is mixed — it includes government and private sector finance — the companies supported primarily by governments for its finance is actually poor.
We do observe that the level of so-called driving out is not that high. "Driving out" refers to the problem that if you are worried that you provide an extra dollar of government-based finance, are you simply pushing out a dollar of private venture finance? There is some driving out, but we have convinced ourselves that most government finance for innovation is additional finance rather than displacing private investment.
Canada already has a high level of government support for venture capital finance. It is not clear that Canada should go much further. In fact, the record of finance for Canadian government-supported venture capital finance is not as good as many other countries. To me, there is no obvious room for significant expansion.
Of course, we need to improve what we currently do. For example, there is the Labour Sponsored Investment Funds. I guess there is a widespread agreement in the academic community that it is not well-structured. There is no reason why venture capital subsidies should be tied to organized labour in the first place. Various other restrictions associated with that program are inefficient and raise the cost of raising money. That is an issue.
I think there is widespread support in the academic community — and this is certainly consistent with my research — that government should not use investment in venture capital to directly promote social objectives, regional expansion or employment creation. Employment creation and other desirable social objectives will be generated by successful innovation, but it is important to focus on getting good investments first. It is not obvious to me that by pushing on the string — pushing more finance into the system — that we will create more good investments.
I think the real answers are bottom-up answers. We need to focus more on improving the underlying available technology and human capital — both for entrepreneurship and in the scientific and engineering disciplines — that create the basis for this innovation. That wraps up my introductory comments. Thank you.
The Chair: Thank you, Mr. Brander. That gives us food for thought. We may have a slight difference of opinion here, which is always good for debate.
Mr. Klugman, do you have any comments before I turn to the list of questioners? There seems to be a slightly different approach suggested by Mr. Brander.
Mr. Klugman: There are a couple of things. First, I am not an academic so I defer the kind of analysis that was just presented. I am a guy on the ground, working with hundreds of entrepreneurs who are trying to build businesses. My perspective is one of what I hear and see every day within one region in Canada, which is the Waterloo region.
The question comes down fundamentally to whether or not we want a piece of the high-growth innovation-based economy in the future or not. If we want that, we will have to be in the game. If we are comfortable being a resource-based economy with a strong banking system, that is a decision as well. The sad part is that if we decide to go down that path, I think are missing out on a huge opportunity. We have tremendous research in this country. We have a great new crop of entrepreneurs who want to build world-beating businesses. That is such an advantage over so many countries that are trying to think about how they build an innovation economy.
Going back to the last comment, this was not about trying to push a string. This was about trying to respond to what we see as an emerging industry in the country. There is a tremendous amount of new venture that is being created and a tremendous thirst for entrepreneurialism and company creation. That is what we are trying to respond to. We are trying to say, "How do we fuel what we see is happening already?"
The advantage we have over others — and we had Singaporeans in visiting us, who are tremendous at doing managed economies and high levels of intentionality — is that they do not have the entrepreneurial culture. The fact we see this emerging within our country is our great opportunity. They have to try to manufacture an entrepreneurial culture, which I think would be a difficult thing to do.
Senator Harb: Professor, I want to thank you. I want to quote something from Canada's venture capital industry. They appeared before our committee in 2010 and they said that the venture capital industry is in crisis today. I suppose you disagree with them.
Mr. Brander: Yes I do. If you talk to venture capitalists and ask them if they want help from government, what will the answer be? Of course it will be yes. That comment does not surprise me.
Obviously economies throughout the world are not performing as well as they would like them to perform right now. As I mentioned, the performance of innovation in Canada is not as strong as we would like. I strongly agree that we need to work hard to improve innovation in Canada. My question is what is the right way to do it? Is the right way to do it to force money into the system? Having studied it, I am skeptical about that. I am also skeptical about the ability of governments to pick winners and particular industries. That is something I have studied. If you look at the record, it is not good. The economy — and for all its problems — does continue to lead in the innovation world in the United States. Most of that innovation is not driven by government decisions. It might indirectly come about by government actions in certain areas, especially defence. However, it is basically driven by private sector initiative and incentives, not by government support for the venture capital sector. It is lower in the United States than in Canada, although it does exist.
My concern is that pushing may do more harm than good.
Senator Harb: Professor, you have to be at the table. We have organizations such as the Organisation for Economic Co-operation and Development, the OECD, saying that Canada was in the bottom half of selected OECD countries when ranked according to venture capital investment as a percentage of GDP. In fact, we are way down. Come on, professor. How would you want us to move along when all of these people who are in the industries, organizations such as Communitech, the organization that represents venture capitalists, OECD and others are telling us that we have a crisis. Yet you are telling us we do not have a problem?
Mr. Brander: I think it cheapens the word "crisis." It is not a crisis. It is true that we have less venture capital money per capita, or per units of GDP, than the United States and some other countries. That is not in question. Our economy is more focused in other areas; that is true. We obviously have much bigger resources in energy sectors than those other countries. Countries differ, and not every country will be like Israel or the United States. We should not expect to be exactly like those countries.
In the case of venture capital finance, the big difference between Canada and the United States is that there is more pension fund money that goes into venture capital in the United States than in Canada. The reason pension funds do not put money into venture capital in Canada is that the returns and investments are not there. As I said, technology is a good thing to invest in rather than trying to force the investment into areas that cannot support it right now.
Senator Harb: What you are saying is let to the market decide. If there is a market there, money will come; if there is no market, money will not go.
Mr. Brander: Government has an important role to play. The question is, what is that role? Having a sound financial system is extremely important. Having a sound tax policy with low corporate tax rates and low capital gains tax breaks are important. I think that is a better way to spend money than to try to pick winners here and there, and push money into the venture capital system.
The Chair: Professor, what would your feeling be about the principle of matching funds? Does that attract you at all?
Mr. Brander: In the research we have done, we found that governments actually do add something. I am not proposing scaling back current Canadian investment in venture capital, which is significant, but structuring it so that it is matched is a good idea. Our research would support that. Getting investments in enterprises that are good enough to attract the private sector and the public sector provides money to help get them over the top. In our research, that is the best model. That is absolutely the right way to go.
Senator Oliver: My question is for Mr. Klugman.
A number of witnesses have told us, as you have told us, that one of the things we have to do — if we decide that we really want to promote high-growth innovative-based economies here in Canada — is find ways of getting angels to give more money and finding more angels. You have suggested one way to do it is to have an angel tax credit and a corporate venture capital tax credit. Several people have recommended that, but I want to probe a bit more into it.
How will it work? What percentage will it be? What triggers it? Let us say there is an angel that is prepared to give $500,000 to a start-up. What kind of tax treatment would you suggest for that $500,000 and how would it be triggered?
Mr. Klugman: The good news about an angel tax credit is that it is something being deployed across the U.S. and Canada as well. There are lots of models we can look at and learn from. The other interesting thing with the angel tax credits is there is a significant amount of consistency in how it is done. It is a relatively simple type of program. It does rely on the fact that there must be some sort of removal from personal types of investing. I cannot invest in my mother's start-up. The second thing is the notion of accredited investors. We have mechanisms in Canada already at the provincial level to determine what an accredited investor is.
Traditionally what happens — and what we would be proposing — would be that the individual would make the investment and be eligible for the tax credit. The range is anywhere from 25 per cent to 40 per cent, as far as what other jurisdictions have done.
Senator Oliver: What has been the most effective, 25 per cent, 40 per cent, or something in-between? What are you recommending?
Mr. Klugman: To follow on what we heard from Mr. Ruffolo this morning, there is a sense that 20 per cent is not enough and 40 per cent is probably too much. Somewhere between 25 and 30 per cent seems to be what is most common and effective in other jurisdictions.
The other thing we see with the angel tax credit is that it is not only large-net-worth individuals who are super angels themselves. There is a lot of money sidelined, which are smaller angel investors. What we see emerging in the U.S. with angel tax credits is not-for-profit angel funds. People can buy into a fund that does investment in entrepreneurs and early-stage companies, without a fragment type of approach. I am interested in doing angel investing and I have $100,000. I am not big enough to be an angel myself, but I can pool my capital in the form of an angel fund that will make the level of investments necessary.
Senator Oliver: If that person put $100,000 in an angel fund would they be eligible, under your scheme, for the 25 to 40 per cent credit?
Mr. Klugman: Yes.
Senator Oliver: What about corporate venture capital? Is there any difference?
Mr. Klugman: I think one of the trends that will happen is that investors will be demanding that large corporations get some of the cash off their balance sheets. We are already starting to hear that from the shareholder community around Microsoft and Sysco. There is a significant amount of money that is being pushed on to the balance sheets. We see the opportunity as that money will have to move off. We think if there is a mechanism or an opportunity for these large corporations to invest in venture capital, it might be a great opportunity for us to provide input to the venture capital industry in the country.
There are two problems. I am not a venture capitalist; I am a not-for-profit, which my father never understood. A strong venture capital ecosystem and venture capital industry is only important because of the fact that it is a necessity in having a strong innovation economy.
To do that, you must have the big players involved, such as institutional partners and the government. You have to have enough funds across the country so there is the right venture capitalist for the right company at any given time.
Mr. Ruffolo mentioned the notion of syndication. Part of the problem with matching programs is there is no one to match with. We think of how many programs there are that are able to make investments in Ontario companies. There are a couple. Part of what we need to look at is not just the success of the individual funds, but the fact that we need more individual funds. We do not have enough. There are partners with whom Mr. Ruffolo can syndicate.
The Chair: Professor Brander, do you have any comment on that exchange?
Mr. Brander: No, I do not.
Senator Tkachuk: I have two questions and they will be to both of you.
Mr. Klugman, you and Mr. Ruffolo both recommended tax credit programs — both corporations and otherwise — and an angel tax credit. We have heard quite a bit of criticism here on the labour venture capital funds, which is a tax credit system. In my province of Saskatchewan it is quite generous, as it was in Ontario and I think it is in British Columbia. It is not only federally; you also get it provincially.
The criticism was that this program did not return, or the returns are very low. If you invested $1 in 2000, you would have $1 today.
Could you both comment on the labour venture fund which is a tax credit program that was supposed to be used for this very purpose?
Mr. Klugman: There are three factors that led to the outcome of the labour sponsor fund experience that we had in this country. The first was the timing around when the funds were created. The technology industry is cyclical and the timing was off. At the time the funds were launched, there was not the kind of entrepreneurial start-up community that there needed to be. There was not the deal flow.
The second thing was a requirement that they actually pace the investment. They needed to make the investments within specific and limited periods of time, which meant that they had to push money out the door even in the absence of really good deals.
The third thing was that there was some question around whether or not the management of the funds had the allocations in the right places — were the expense ratios too high and those types of questions.
If you look at it from an asset class, it was a failure. The good news was that from a company perspective, it provided cash to some very successful companies at a time when there was not a lot of other venture capital around. Those companies have gone on to become very successful and in many cases go public.
The other thing that was good about the LSIFs was the fact that they had deep enough pockets to do the follow-on investment. They could do the $2 million, $5 million, $10 million and $20 million investments. That was beneficial and allowed a lot of companies not to go to the U.S., when otherwise they would have had to do so.
While it was not the kind of success that we hoped for, there were lessons we took from it, and there was some good that came from it.
Mr. Brander: My co-authors and I have studied the labour-sponsored funds. To summarize, their performance overall is poor. It is not just timing. The performance is poor not just in absolute terms but relative to other types of investments and private venture capitalists. The labour funds did not do well as a group. As you pointed out, the returns to investors were low and the performance of the enterprises they invested in was poor. Of course there is variation. Some of the labour-sponsored funds did much better than others and some of the enterprises they invested in did well. I am not saying there are no successes, but fewer than there should have been. I agree with the comments that some of the specific regulations were harmful.
As I mentioned before, I think there is no reason to connect it to organized labour per se. It did not have that big an impact. In addition, because labour-sponsored funds ended up focusing on the retail sector, picking up small investments of $5,000 or $10,000, it turned out to be very expensive to manage and raise the money. Focusing on the angel sector where you have relatively high-net-worth individuals who might be investing $100,000 or $500,000 makes more sense and would be a better use of the tax credit. My bottom line is that the labour-sponsored funds have not performed that well, and I think we can understand why.
I would favour relaxing some of the restrictions on the funds, including the connection to organized labour. I actually prefer placing more emphasis on the angel sector rather than the retail sector, where you can actually get significant-sized investments and you are not burning up a tax credit just managing the fund.
The Chair: It sounds like we have one area of agreement and the angel sector is where we should be concentrating.
Senator Tkachuk: There was a point I wish to clarify. Both witnesses referred to the venture tax credit system program they have in the province of British Columbia, which I am not really aware of. However, both had talked about it as success stories. Since Professor Brander is from the University of British Columbia, perhaps you can both comment and explain what that program is. I would like to know whether it has been as successful as people say.
Mr. Brander: I have actually studied the B.C. programs to some extent. First, with the labour-sponsored funds, the basic tax credit is 15 per cent. Provinces could add more and double it. In B.C. they did double it. The effective tax credit in B.C. was 30 per cent. In addition to matching the labour-sponsored funds, the government also provides tax incentives and tax credits for other funds not necessarily tied to organized labour. When we look at the record of the B.C. funds, they have actually done better than in the rest of Canada. If you look at the so-called venture capital corporations — which are not necessarily tied to labour — and the labour-sponsored funds together, the performance is better than the rest of Canada. I am not saying it is wonderful, but it has been pretty good performance. The B.C. program has worked. The B.C. government worked hard on getting the program designed properly. The actual companies have done a reasonable job. It is not a roaring success, but relative to the rest of Canada it is pretty good.
Mr. Klugman: Our analysis of the angel tax credit system includes looking at the jurisdictions in the U.S. Since these are government programs, for most of them there is a requirement to have a review and analysis done looking at the impact of this policy initiative. There was one that was done in B.C. about six or eight months ago, I think, that pointed to what the ROI was for the government's investment in this type of policy instrument. There are similar studies in many U.S. states that have undergone the tax credit. I cannot remember the specifics of the ROIs of these studies, but I can make available to the committee the research we have done in identifying the various jurisdictions have the angel tax credit and the analysis of the tax credits.
Senator Tkachuk: That would be a comparison for us because in Saskatchewan they have a double-up program with provincial and federal money. Ontario decided to pull theirs because it was not successful. They are just going with the federal program. If we have someone who has a national study on why it succeeded in B.C — and I do not know, but it may have succeeded in Saskatchewan — we need witnesses from there to tell us. That is something we should know before we proceed.
The Chair: Our help from the Library of Parliament has taken note of that and perhaps we will see if that is useful. We are technically out of time, but I know Senator Massicotte has a question.
Senator Massicotte: I will address my questions to the professor from B.C. I think you made a comment that said labour funds did not perform very well. We had previous testimony here saying they did not perform very well, but performed equally as well as other venture capital funds. Are you saying something different?
Mr. Brander: That is correct. It is not easy to collect the data, but in our data the labour-sponsored funds have underperformed the rest of the industry.
Senator Massicotte: Waterloo seems to be getting good press. I have not done an analysis, but it seems to be doing very good work. The whole world talks about the Silicon Valley and the Boston area. The whole world tries to duplicate that success, because it is significant. I think you referred to the Kauffman Foundation, saying most of the employment group comes from small firms. The Brookings Institute said most of it comes from a small number of small firms that grow immensely. Is it a worthwhile dream? Many countries spend money trying to create the environment of this great innovation. Is it worthwhile to pursue or will we accept that no one has achieved the success and save taxpayers' money?
Mr. Brander: There is one Silicon Valley and hundreds of wannabes. The Route 128 region outside of Massachusetts is also very successful. The Silicon Valley experience is connected closely to the universities, Stanford and Berkeley. The Route 128 success is connected to the research coming out of MIT and Harvard. In addition, they are nice places to live and they have a lot of human capital there. It has been very hard to replicate that experience. My view is that no one will replicate it. It is easier to be first than third.
We can learn from Silicon Valley and a Route 128 experience. Getting a good connection between high-quality, high-research-output universities and business activity is important. Having other kinds of human capital in place is important. Having money is important. There is a lot of money in both areas that goes into innovation support. Having a good tax and regulatory system is important. We will not replicate Silicon Valley, but I think we can learn from them.
Senator Massicotte: What can we learn from Israel, which is doing well in innovation?
Mr. Brander: I have looked at the Israeli case. You cannot pretend the standard of living is anywhere near the Canadian economy, so we are talking about another level. It is doing well on the innovation side. Israel does have very good universities and a very high level of human capital in both the entrepreneurial area and the scientific area. Israel is better positioned than anyone else to do a Silicon Valley kind of thing.
The conditions are more suitable in Israel than probably anywhere else. It is not easy for them. They have had some success, but it is not easily imitated. As I indicated before, we can learn and improve. We are making progress here. The Southern Ontario region, Ottawa, Toronto and the Vancouver region have made a lot of strides in innovation finance and in the development of the high-tech sector.
The Chair: Thank you very much Mr. Klugman and Professor Brander. The video conference offers a wonderful alternative for bridging vast distances. We hear you loud and clear.
Mr. Brander: Technology in action. It is great.
The Chair: We reiterate our thanks to our guests and declare this meeting adjourned.
(The committee adjourned.)