Proceedings of the Standing Senate Committee on Banking, Trade and
Issue 47 - Evidence, March 16, 1999
OTTAWA, Tuesday, March 16, 1999
The Standing Senate Committee on Banking, Trade and Commerce met this day at
9:30 a.m. to examine the state of the financial system in Canada (Equity
Senator David Tkachuk (Deputy Chairman) in the Chair.
The Deputy Chairman: Senators, this morning we welcome Mr. Begg, President of
Working Ventures Canadian Fund Inc. and Canadian Venture Capital Association,
and Mr. Allan Riding from Carleton University. Please proceed, gentlemen.
Mr. Ron Begg, President, Working Ventures Canadian Fund Inc. and Canadian
Venture Capital Association: Thank you for the opportunity to appear before
this committee to brief you on the recent developments in the venture capital
industry and to throw out some ideas for discussion.
I am the President of the Canadian Venture Capital Association and it is
primarily in this capacity that I am here today.
My day job is as President and CEO of Working Ventures Canadian Fund, which is a
labour-sponsored venture capital corporation. Working Ventures is the second
largest venture capital fund in Canada and the largest venture capital fund
which operates on a national basis.
My submission will be largely in English.
The venture capital industry in Canada has come of age in this decade. In the
beginning of the 1990s, the entire venture capital industry in Canada had a
total of $3 billion in assets under administration. That has grown steadily. At
the end of 1997, total assets under administration by venture capital companies
had grown from $3 billion to $8.4 billion. More important is the fact that the
amount of capital being deployed to small and medium-sized businesses increased
dramatically during this period.
In the early 1990s, from $200 million to $300 million a year was being invested
by venture capital funds in all of Canada. By 1997, that had grown to $1.8
billion. It is now an $8.4 billion industry, most recently investing at a rate
of $1.8 billion. This is good news for small business in Canada and for the
impact that that has on the economy.
The higher plateau that was established in 1997 appears to have been largely
consolidated in 1998. In the first nine months of 1998, total investments by
venture capital funds amounted to $1.1 billion, which was quite close to the
record established during the first nine months of the previous year of $1.2
billion. Details of this are provided in the briefing packages that were
circulated to honourable senators last week.
We will have final numbers in April. They will be included in our annual report.
These will be prepared for the Canadian Venture Capital Association, as in the
past, by MacDonald and Associates, and we will be happy to bring you up to date
at that time.
This has represented a sea change in the availability of true risk equity
capital for small business in Canada. In the early 1990s, the pace of
investment activity in Canada was low in absolute terms and also relative to
investment activity in the U.S. Relatively new capital was coming into the
industry at that time. The traditional sources of venture capital, the large
financial institutions, had largely withdrawn from the market following the
poor performance of the industry in the late 1980s.
This is changing. In this decade, there have been three important developments
that I should like to draw to the attention of this committee. The first and
one of the most significant events has been the significance of
labour-sponsored funds. This is a uniquely Canadian institution. I am not aware
of anywhere else in the world where average investors can pick up their daily
newspapers and check on the progress of venture capital funds in which they can
The original labour-sponsored venture capital corporation (LSVCC) was the
Solidarity Fund in Quebec. It was established in 1984 and operates exclusively
in the province of Quebec. It is the largest venture capital company of any
kind in Canada.
In 1989, the federal government announced the creation of a national LSVCC
program. The first fund established outside of Quebec was my fund, Working
Ventures. We began raising capital in modest amounts in 1990.
Gradually, as the federal legislation was enacted several years later, eight
provinces established labour-sponsored programs. Today, there are 23 LSVCCs,
accounting for approximately half of all venture capital in Canada. The program
gained momentum and substantial capital was raised in 1996. More capital was
raised than was anticipated and it was considered to have been excessive --
certainly in one year it was.
At that time, the federal and provincial governments enacted some amendments to
the program with the objective of moderating the amount of capital raised. This
appears to have been successful.
In 1995-1996, LSVCCs raised over $1.2 billion, representing 80 per cent of all
new venture capital raised from all sources in that year.
The measures that were generated federally and provincially to moderate the
amount of capital were introduced and, in fact, reduced the amount of capital
raised during that period.
Following two years of substantial reduction in the amount of capital raised by
LSVCCs, and during a period when more capital was being introduced by LSVCCs
than was being raised, the federal government and many provincial governments
enacted further refinements to the program to attempt to fine-tune the program
to restore at least some of the ability to raise significant amounts of
capital. Early indications are that this has been successful. The numbers will
be published later this month and will be included in our report in April.
Early indications are that the amount of capital raised outside Ontario is
consistent with that which has been raised in previous years. In Ontario, the
amount of capital, while approximately one-half of what was raised in the peak
1995-1996 year, is substantially higher than the capital that was raised during
the two previous years after the federal reductions had been incorporated. That
was the first major development.
The second positive development, and a quite recent one, is that there appears
to be, at least to some extent, a return to the market of some of the
traditional institutional sources of venture capital. The increase shown in the
table in the briefing materials provided in non-labour sponsored capital
reflects a commitment of over $400 million by corporate investors, including the
chartered banks. In addition, there have been significant new commitments from
pension funds and life insurance companies to private traditional venture
funds. This amounts to over $.5 billion, which is a level we have not seen in a
decade in Canada.
You will notice in the table that labour-sponsored funds raised $1.2 billion in
the 1995 year. That amount declined to $647 million the following year; and in
1997 it amount to $500 million, of which over 60 per cent was raised by one
fund in Quebec. This year, we estimate that that number nationally will be in
the $800 million to $900 million range. These are preliminary estimates only.
As you can see from the table, other sources of capital were at a low in 1995 of
$317 million, increasing to $500 million and then to $946 million. We do not
have numbers for 1998 yet. However, indications are that this return to the
market is being sustained. A sustained flow of new risk capital from one source
is a healthy development that increases the total pool of true risk equity
capital available for entrepreneurs. This is an important development. Too
often in the past in Canada there has been either insufficient risk capital or
it has been volatile and entrepreneurs have faced a feast-or-famine situation.
The third development I should like to draw to your attention is that, as the
venture capital industry has matured in the past few years, we have seen the
emergence of more seed capital funds, that is, funds that are dedicated to
making early investments pre-start-up. In the past, the formal venture capital
industry in Canada has made relatively small commitments to pre-start-up or seed
capital investments. We think this is really a part of the maturing process in
the industry. There are a number of funds participating in the development of
these new funds. They include funds that are sponsored by the Bank of Montreal
and the Royal Bank of Canada. Very active in this regard is Ventures West, the
Business Development Corporation and the Canadian Medical Discoveries Fund. The
Solidarity Fund has been doing some very interesting things in this regard. My
own fund, Working Ventures, has established three of these seed capital funds.
The point we would like to make is that as we approach the new century our
industry is coming of age. We have a good environment in which we can operate.
The level of capital under administration and the rate of deployment to small
and medium-sized businesses has begun to rival that of the more mature venture
capital industry in the United States. We are not there yet. This is an
apprenticeship business. We have rebuilt this industry, which, in the late
1980s and early 1990s, was called by some the "nuclear winter of venture
capital." We have a strong infrastructure in place. We have a healthy
balance sheet with substantial assets to deploy for the first time for small and
There is substantial evidence that small and medium-sized businesses that are
backed by venture capital companies grow faster than other companies. The study
that is done each year for the Business Development Bank of Canada by Macdonald
& Associates demonstrates the impact. A copy of that study is included in
our briefing materials; it demonstrates that venture-backed companies grow very
quickly. Over the past five years, their average growth in employment has been
23 per cent, compared with 1.7 per cent nationally during the same period.
These companies are strongly export-oriented. Exports accounted for some 34 per
cent of these companies' sales during this period. Their investment in research
and development was over 10 per cent of revenue.
Canada needs more of these venture-backed small and medium-sized companies. The
industry is well-positioned to continue to provide them.
As your committee is reviewing the availability and the effectiveness of
deployment of risk capital in Canada, we urge you to consider several ideas
that we have included in our briefing book. These items are really quite
technical. I do not propose to take the committee's time in going through each
of the measures that have been provided in the briefing materials. I will simply
In particular, on the page entitled, "Summary of Proposals," I draw
your attention to the first item, the proposal for a national escrow regime,
which has been proposed by the securities regulators. While this is not a
matter under federal jurisdiction, our membership is quite alarmed about the
proposals included in this national escrow regime that is under consideration.
We are concerned that this will have a serious effect on the availability of
capital, not only for venture capital funds but also, more important, for small
and medium-sized businesses.
While we have made submissions, and continue to do so, with securities
regulators, this is an event that is of interest to anyone who is concerned
with the supply of equity capital to small and medium-sized businesses.
This escrow regime contemplates increasing escrow periods up to six years for
companies going public for the first time. This is on top of a long holding
period. Typically, venture capital funds are invested for a three- to
eight-year period. Under this proposal, we would be held, potentially, for up to
a further six years. We have proposed that venture capital organizations be
exempted from this provision so that we can recycle this money and continue to
raise capital from a variety of sources to serve the small and medium-sized
Quite apart from the narrow interests of the Canadian Venture Capital
Association and venture capital funds, we are concerned that this may affect
the operation of the capital markets in Canada. It may lead firms to go
directly to U.S. exchanges or to sell their companies rather than to accept this
rather onerous escrow regime. We propose that the policy be modified to be no
more stringent than the escrow regime that is in place in the United States.
The other five measures that we have brought to your attention include the
following: vehicles to facilitate increased investment by pension funds in
venture capital funds; measures to strengthen the ability of small businesses
to recruit qualified directors; some technical suggestions with respect to how
associated companies are treated in our industry; and a few suggestions on
capital gains taxation and withholding tax provisions. These are presented in
some detail in our submission.
I would be happy to attempt to answer any questions you might have.
The Deputy Chairman: We will go to the second presenter and then proceed to
questions for both of you.
Professor Allan Riding, Carleton University: Honourable senators, I will be
speaking about a much less spectacular segment of the equity markets in which
small firms operate, but a segment that is no less important than the
institutional venture capital part of that marketplace. I will be talking about
private investors, sometimes called informal investors, sometimes called angels.
Ten years ago, policy makers knew nothing about angels. They did not know they
existed. It was very difficult even to talk about the concept and demonstrate
its importance. Over the last ten years, there has been quite a lot of research
about angels, about their importance and their preferences. I should like to
spend a few moments just talking about that. I will begin by talking about it in
some basic terms. If it seems like I am lecturing you, please forgive me; I am,
after all, an academic and I just cannot get out of the classroom sometimes.
These private investors are one of the major sources of external equity capital,
particularly for early-stage firms and even more particularly for firms in the
I will begin with some stylized Canadian facts, or at least my perception of
those facts. There is no shortage of innovation. There are all kinds of labs
and private companies turning out new ideas, technological wizardry and many
things I do not understand. The fact is that few of them grow. From work done
by Arend, colleagues at UBC, Statistics Canada, and other work in the U.S., we
know that approximately 4 per cent of the firms that begin with some
technological ideas really grow substantively. Those 4 per cent provide much of
the employment in the economy. Why they do not grow is often attributed to a
lack of capital, but there are other reasons that are often lost.
Part of it has to do with the choice of the owner of that firm. Many firms
simply do not grow because their owners do not want them to grow. Rena Blatt
conducted a survey in 1992 in which she asked owners of new companies whether
they wanted their firms to grow or not. Half said no. Barbara Orser in the last
couple of years has done quite a lot of work on the reasons behind the growth
decisions of Canadian business owners, and she has found that growth depends
very much on the conscious and unconscious tradeoffs made by business owners.
So, on the one hand, growth is rare.
On the other hand, we have small businesses facing all kinds of difficulty,
according to the media, in raising the capital they need. They need that money
for different reasons. The money people need to start their businesses is a
different kind of money from what they need to grow and a different kind of
money from what they need when they are in trouble. Sometimes those motives for
raising capital get lost in the policy making.
We see that sometimes in the way we try to impose, in my impression, a
one-size-fits-all solution. We get on the banks and tell them to make more
money available. In fact, if we look at Canadian small businesses and compare
them with small firms in other countries, we can see important differences. Ray
Petersen at York and his colleague Joel Shulman in the U.S. compared the
dependence on banks among small businesses in the U.S., Canada and ten other
countries, and found that Canadian small businesses depended on their banks
much more highly than did the others. That can be a problem. Overuse of debt
capital makes those companies more vulnerable in times of recession and
There is much to be said for equity capital. Where do we get equity? Banks are
not venture capitalists, so banks are usually not the solution, although they
are becoming much more active, as my colleague mentioned earlier, in the
venture capital arena.
Venture capital institutions have preferences that are clear. Much of venture
capital is invested in technology-based firms, and much of it is invested in
firms at the expansion stage. Venture capitalists, as a rule -- although there
are obviously many departures from that -- prefer not to invest in amounts of
less than $1 million.
Where can firms get early-stage capital? The two major sources, of course, are
retention of earnings, but that becomes limited, and informal investors, also
known as angels or private investors.
We are not talking about love money. That is there, too. We are defining private
investors as people who make arm's length investments of their own money in
other people's businesses.
It is a very local, very personal marketplace, and it is very different from the
institutional venture capital marketplace.
People who work for institutional venture capitalists are agents. They are, in a
sense, paid employees. They do not invest their own funds; angels do. Agents
earn salaries; angels' payoffs are determined by the success of the firm. The
professional venture capitalists do not suffer losses personally, unless, of
course, they have a long record of losses; private investors suffer those losses
entirely personally, losing their own cash.
Venture capital funds manage relatively large portfolios; they are diversified,
much more so than the portfolios managed by angels. Institutional venture
capitalists have the resources of the firm to do the due diligence; private
investors do it themselves.
The difference is summed up in the "agent" versus "principal"
name applied to those two. Nevertheless, angels are the single largest source
of early-stage -- and I emphasize early stage -- equity capital in Canada. At
those early stages, they invest at rates of two to four times, in terms of the
number of businesses in which they invest, not in terms of the amount of
capital. The size of that market is difficult to estimate. Angels do not wish
to be on mailing lists, so to do a survey of angels is not straightforward.
Ellen Farrell, in some work funded by ACOA in Nova Scotia, surveyed business
owners of firms that had just registered in the Province of Nova Scotia and
asked whether or not those owners had made investments in other people's small
businesses, people who were not related in a family way to those owners. She
found that one in four of those business owners had acted as an angel. If that
result holds true across Canada, then we are talking about a marketplace of
more than $10 billion available for small businesses. That is certainly more
than the $1 billion that I estimated for my studies. Her work is very revealing
and surprising. The potential of the market is truly vast.
Angels have a profile that looks something like the following. They tend to be
about my age. Unlike me, they have high incomes and high net worth, in the six
or seven figure range. They are well educated. They have business experience.
Many angels are people who have succeeded at building a business in the past.
They are not in it for tax reasons; they will take tax benefits if they are
available, but they are not motivated to be angels because of tax benefits.
They become quite engaged in the business, very often acting in a day-to-day
role. They tend to syndicate, usually with each other. They will occasionally
syndicate with an investment fund but almost always they will syndicate in
groups of five or seven or fewer angels. The networks are local and personal;
they operate by word of mouth, by referral.
When they invest, the angels contribute more than money. They bring to the table
their experience, their contacts, their energy and their knowledge of how to
mentor a small firm. They also bring the attributes of their syndicate. Hence,
the viability of small firms with angel investments is typically higher than
that of other small firms.
Most angel investments are at very early stages. Approximately 60 per cent of
investments made by angels come before the firm's product hits the market.
Typically, venture capitalists invest in a complementary way and tend to invest
at the expansion stage although, as Mr. Begg mentioned, more and more funds are
investing earlier. When we talk about small amounts of capital, the angels
provide much of that equity for early-stage companies.
The amount they invest varies. There is, of course, a distribution of investment
amounts. The median investment is approximately $100,000. In other words, about
half of the investments are less than $100,000 and half are more than $100,000.
Those are early-stage, small investments.
It is interesting that in Canada the average investment is approximately
$100,000, but in the U.S., Britain and Sweden, where angels have also been
studied, the average investment is less than $50,000. We attribute that in part
to different legislative regimes.
Angels typically seek the same rate of return as institutional venture
capitalists. My pure economist friends give me trouble over that point. When we
asked angels what rate of return they wanted, that is what they told us. By and
large, 30 per cent is the benchmark. It is sometimes less and sometimes much
more, but 30 per cent is a typical rate of return required by angels. That is in
the same order as the rate of return for venture capitalists. Yet, angels are
investing at arguably riskier stages of the business. That prompts the
question: If they are taking more risk, should they not get more return? What
is the nature of that return? We could argue that part of that return comes from
the excitement and experience of building and creating a viable business.
Angels are patient. They are not looking to flip their capital. Five to seven
years is an expected holding period. They understand that it will take some
time for the firm to grow and to create the wealth. That leads to what I call
the 7-7 rule. Typically, an angel will want to take $7 out of the firm seven
years after investing. If the average investment is $100,000 and if after seven
years the angel wants to take out $700,000, the angel has just used up the
entire capital gains exemption for his or her life on that first success.
Angels are not frightened by the new economy. Typically, they invest in
high-growth companies. They are looking for high-growth companies, and they
have a particular bent for technology-based firms. In the Region of
Ottawa-Carleton, one-half of the investments occurred in what we call
Some research done on Cambridge, U.S., investors found that companies have a
problem because the angels keep chasing them. Bill Wetzel will speak about that
being a "Silicon Valley phenomenon" where people in the area who
become angels have a sympathy for or a comfort level with the nature of the
industry in that area.
Canadian angels typically invest more, on average, than U.S. angels, but they
are also more discriminating. Canadian angels turn down 97 per cent of the
proposals that arrive on their desks. They reject three-quarters of those
before they read the business plan on the basis of the referral, on the basis
of the first look at the business plan, or on the basis of their first meeting
with the principals of the firm.
Greig Clark, the founder of College Pro Painters Limited and recently a private
venture capitalist, said that he would rather invest in an A person with a B
idea than a B person with an A idea. However, what is an A person? What is a B
Last year, we spoke to almost 200 angels across Canada and asked them what it
was about businesses that turned them off and what were the shortcomings of the
businesses they had inspected. There was a high degree of consensus. The most
frequently cited reason was their perception that the management skills were
not in place.
At the beginning of this presentation, I spoke about the innovation occurring in
Canada. However, when we asked the angels about what is missing, they said that
the skills to take those ideas to market are missing. We spoke about a capital
market gap. In the view of the angels, those commercialization skills are the
Another turnoff they mentioned was a lack of realism. Many entrepreneurs are
rather optimistic, which I guess they ought to be. As well, there was a lack of
commitment. They do not have their own money in the project. They also
mentioned a lack of integrity. The word "integrity" turned up over
In terms of that gap, there are two sides to the coin. It is a reality that
business owners often have trouble raising capital. When we asked angels about
the gap, the other reality is that they have trouble finding the reassurance of
fiscally responsible management in the companies to which they are entrusting
their personal funds.
The market has a great deal of untapped potential. We did some work about 10
years ago in the Ottawa area, and we found that of the people with the
financial wherewithal to be angels, only 1 in 20 were actually acting as
angels. Why so few? We still do not know the answer to that question.
Last year, we asked angels how much money they had available for investments in
small firms. As I mentioned, we talked to almost 200 angels. We were told, on
average, that they had $500,000 each.
If we take Ellen Farrell's result of a quarter of the firms having made angel
investments, and if we superimpose on that the $500,000 amount of available
money, we come up with an impressive amount of money out there. It is on par
with the banks lending to small firms.
How do we mobilize that money? One solution is matchmaking. About 10 years ago
we tried an experiment in this country called COIN, which was a computerized
database matchmaking service. It failed. However, out of that we learned some
COIN was national and impersonal. We learned from that. We created the Canada
Community Investment Plan, which is sponsored by Industry Canada. It has
created local marketplaces based on local economic development infrastructures
to mobilize angel capital. They must be able to attract a cadre of investors
and provide those investors with value-added. They need to vet the lemons, but
that is illegal.
Investors continue to face legal barriers. Securities acts make it very
difficult to invest small amounts of capital. The costs of compliance are high.
I know the committee spoke to Jeff MacIntosh, and I hope that you raised that
with him. He is certainly much more of an authority on these issues than I.
Colin Mason and Richard Harrison do a lot of research on angels in the U.K. They
recently wrote a book based on the experience of matchmaking services across
the world. We wrote about the COIN experience in Canada. They took some lessons
from the best practices, the successes and failures of matchmaking services
around the world. They came up with four aspects that make for successful ways
of mobilizing angel capital.
The first was to establish a critical mass of clients. By that, they mean
investor clients. They see their successful matchmakers and see their clients
as the investors.
They must be properly resourced. These services are not self-sustaining. As with
the CCIP, we require that matchmaking services be self-sustaining. That drives
them to larger deal sizes, which is not what we want.
They must be active. They must beat the bushes to find the angels. They cannot
simply be passive and wait for them to arrive. They must be respected within
the community. They cannot be seen to have vested interest.
In summation, we can look for angels to become more important. As the baby
boomers pay off their houses and get their kids through college, and as their
disposable incomes and RRSPs become larger, we can look for more of them to
become investors. There is still a gap between the angels, who typically invest
$100,000 or, atypically, seldom more than $400,000, and the institutional
venture capitalists, who seldom invest less than $800,000 or $1 million.
How do we close that gap? One possibility might be alliances between the
institutions and the angels. CCIP sites will, I hope, establish angel
communities and act as advocates on behalf of angels. It makes sense for
institutional venture capitalists to work with those angels. The angels have the
interests of the firm in their own pocketbooks and hearts, as do the venture
There needs to be a coordination of those matchmaking services. We have 22 CCIP
sites operating across Canada. In addition, we have many municipal development
offices trying to mobilize angel capital. However, they are reinventing each
other's wheels and they are not learning from each other's mistakes.
If we are to encourage more investment, we must encourage the management skills
of the owners of many of our country's small businesses.
Senator Callbeck: My question relates to venture capital in the Atlantic area.
In Mr. Begg's brief there is a chart that shows the amount of venture capital
investment activity by region. It puts Atlantic Canada at 3 per cent in 1996
and at 1 per cent in 1997. In another document, I see that for 1998 it is still
at 1 per cent.
How much of the money comes from Atlantic Canada?
Mr. Begg: As discouraging as that may be in terms of the amount of capital being
committed to Atlantic Canada, that is actually a significant improvement. Until
a few years ago, Atlantic Canada was not even on the screen. There were a few
years running when the capital committed by the venture capital industry to
Atlantic Canada was 0 per cent.
There has been an increase in activity in Atlantic Canada, and that is a
function of a couple of things. A study done a few years ago showed that
approximately 90 per cent of capital invested in a region is a function not of
the source of capital but of the location of the venture capitalist office. They
do 90 per cent to 95 per cent of their investing within a 90-minute to two-hour
drive of where they are located, and offices have historically been in
Montreal, Toronto and Vancouver.
The increase that we have seen in Atlantic Canada has been a function of some
new offices being opened in Atlantic Canada by venture capital companies and
the Atlantic investment program established by the provinces. That capital was
raised and committed by the provinces to form ACF Equity Atlantic Inc., run by
In addition, Working Ventures now has established an office in Nova Scotia,
although still very little capital is raised directly in Atlantic Canada. The
only measures for tracking we have are the publicly available numbers that
relate to the labour-sponsored funds plus the capital in the Atlantic Canada
While the amount of capital being raised is increasing, a more significant fact
is that the venture capital funds are beginning to establish offices and are
becoming more active in the province. They attract other capital by virtue of
co-investment as well.
Senator Callbeck: In other words, we have figures by regions on investment
activity, but we do not have figures to show what percentage of that capital
was actually raised in Atlantic Canada.
Mr. Begg: I would be happy to produce what we have available, but there are
really only two sources, those being the labour-sponsored capital that is
raised locally and identified by region and the new Atlantic Canada fund
established by the provinces.
The other sources of capital are fungible. It is hard to identify the origins of
capital from banks and their subsidiary venture capital companies.
Senator Callbeck: I see that only 1 per cent is being put into investment
activity. I am wondering whether we are raising 5 per cent in Atlantic Canada
and investing only 1 per cent.
Mr. Begg: I would say definitely not.
Senator Callbeck: Those are the figures I should like to get.
You say that offices have been opened. Are there other things that the
government should be doing?
Mr. Begg: The role of government in our industry has been changing. It has been
making the environment more welcoming for sources of risk capital because the
government has had less activity in this area.
One of the important issues is the extent to which capital is easily available
from government sources. An entrepreneur will not easily take capital from a
venture capital fund if they can get the money with either no repayment
requirements or low interest payments. If that is an equity capital risk, the
entrepreneur will take the free money before they will take a partner.
Senator Oliver: Mr. Begg, I have a question relating to your recommendations
dealing with capital gains. You recommend reducing capital gains taxes on
founders' shares and employee share ownership plans. When I look at the details
of that, it seems to me that your recommendations on capital gains changes are
quite narrow and confined to your own business. A Senate committee looking at
the development of public policy must paint with a much broader brush. Have you
looked at anything broader in terms of capital gains improvements?
Second, your final recommendation is that the Department of Finance conduct a
comprehensive survey. Have you spoken to them about some of your suggestions
for changing and improving capital gains legislation? If so, how have they
reacted? What studies have you yourself done? Why give it to government to do
Mr. Begg: We have not worked on those matters with the Department of Finance.
Your suggestion is a good one. I will discuss with the executive the
possibility of becoming more active in that area.
I take your point. We are narrowly focused on the issues that concern us. It
would be interesting to ask my colleague, too, how these changes to capital
gains taxation would be received by angels. Angels are an important part of our
business as well, to the extent that angels are prepared to work with us
investing in the companies in which we are committing capital.
Senator Oliver: Do you have any examples of where angels have invested where you
Mr. Begg: Definitely. As a matter of fact, we have a program by which we attempt
to recruit individuals both to invest alongside us and to bring their
experience to bear on boards of directors as well.
As you may understand, in our business we are not passive investors. Typically,
we take a minority interest in the company. We are not a sliver but a
significant minority interest.
Senator Oliver: Would that be over 30 per cent?
Mr. Begg: It would range anywhere from 10 per cent to 50 per cent. Occasionally,
as necessary, it would be to take a control position. Typically, that would
entitle us to one or more seats on the board of directors. It is there that we
hope to add value and to work our investment toward an exit strategy.
Where we have only one director on the board, usually it will be a member of our
professional investment team. Quite often, we will have two or more boards of
directors. In that case, we have a program to recruit individuals who can add
value. In some cases, they will also invest capital. We recruit those
individuals to put them on the board.
When we first began, we would use our own relationships in the community to
identify people who could add value on the boards. As our company grew, we
brought a more professional approach to it. Now, when a recommendation comes
forward to me from the investment department and it is contemplated that there
will be an opportunity to recruit a new director, the profile of that director
will already have been identified, that is, a person who can add value. We then
use professional recruiters to search out the best person. As a matter of fact,
we will have negotiated the transaction with the entrepreneur and we will have
obtained an agreement that we have two or three directors. Even before the
transaction is closed, in many cases, the recruiter will show up to meet with
the owner-manager to say, "Working Ventures has the opportunity to place
an independent director on your board and they have hired me to find the person
who will add value." Of course, the owner manager is a little astonished
and usually replies to the effect, "That is terrific. I thought they were
going to stuff someone on me."
The entrepreneur is well served, and so are we, when those angels, particularly
when they have what we call skin in the game, can sit on the board of directors
and also have an investment in the company.
Senator Oliver: I should like you to tell me a little about Working Ventures and
how much capital they have deployed. I should like to know why they have not
got more capital deployed. What are the reasons for holding back? In addition
to taking equity, what other security do you take?
Mr. Riding, in your mind, what is the difference between private investors,
angels and informal investors? I did not see the distinction in your
Mr. Begg: First, we now have $700 million under administration. When we started
in the early 1990s, the average size of a venture capital fund in Canada was
$25 million. A big one was $50 million. The entire industry would invest $200
million in one year.
Since inception, we have invested over $500 million in small and medium-sized
businesses. I challenge anyone to find another example of a venture capital
company outside the one fund in Quebec that has ever invested in that base.
Senator Oliver: You are sitting on $200 million.
Mr. Begg: No. We have had exits. We have met the federal pacing requirement,
which is to have at all times 60 per cent of our capital, according to their
calculations, invested in capital. Currently, approximately one-half of our
capital is invested in small and medium-sized businesses. The balance we have
in liquid capital for follow-on investments and deployment.
This is not a business where you can turn the tap on and off. Typically, it
takes about three months to make an investment. We have invested in almost 180
companies since inception.
The other question you asked had to do with typical instruments. At the end of
the day, we are equity investors. We do not take a fixed charge on assets. We
do not take personal guarantees. We use a combination of instruments. In some
cases, it will be pure equity, while in others it will be a combination of debt
On our balance sheet, debentures for small businesses do not mean security as
most people would normally think when they see debenture. We will have a
debenture because it gives us a possible exit strategy. It may earn a coupon
along the way. It is there as a possible exit strategy and also to represent
our interest. However, it varies.
It makes no sense to have a debt instrument in an early-stage company. We have
done over two dozen raw start-ups, for example, and debt instruments make
little sense. In more mature companies, that is usually a consideration.
Mr. Riding: We use the terms angel, private investor and informal investor
interchangeably. That being said, the terms are proliferating. We now see
archangels, people like Denny Doyle in Ottawa who will marshal a group of
investors around a particular opportunity. We are seeing corporate angels,
companies like Newbridge, who are fostering the growth of small firms within
their organization as well as external to their organization.
The terms continue to evolve. We have a lot of fun thinking up titles for
Senator Angus: As I think you are both aware, the study we are doing has been
driven by certain elements of folklore which were highlighted in the 1997-98
debate concerning bank mergers and the way that small and medium-sized business
gets the short end of the stick.
In listening to you, however, I have the impression at least that the venture
capital business is coming of age as we reach the millennium. Mr. Begg stated
that specifically in his paper. It would appear from what you both say that
there is a lot of money available. That concurs with what we have heard from
other witnesses and from what I have heard personally in my comings and goings.
It is not so much a question of the money being available but the terms on
which it is available.
Is it fair to say that there is an adequate amount of money available to the
entrepreneur in starting up a small business? Is it correct to believe that,
unfortunately, that money comes at too high a price for the businesses and the
investor wants too big a piece of the action or imposes other conditions that
basically neutralise that money or make it unavailable?
Mr. Begg: With respect to the volume of capital available, there has been a sea
change in professionally managed venture capital in that it has come up to a
level which we hope will be sustained. That is the important point. In the
study set out in the book you have before you, you will notice that the total
capital available in the industry at the end of 1997 was $2.3 billion. The
industry was investing at the rate of $1.8 billion. It is okay, as long as that
In the past, the problem has been feast or famine. Institutions are either in or
out. When the results are good, more money comes in. Then, when the results are
not too good for a few years, money leaves the industry.
Continuity and certainty of this program are important, not only so that
entrepreneurs have a continuous supply of risk capital that they can depend
upon, but also so that you have the infrastructure in the industry to serve
those small and medium-sized businesses. Venture capital is all about adding
value, not just providing capital. Venture capital funds sit on those boards.
They provide advice in a number of different ways. They network. They help them
to grow internationally. Having continuity of capital is, I think, very
In terms of the pricing of venture capital, certainly as the industry matures
and more capital becomes available, there will be more competition among
venture capitalists and other financial institutions for the very best
transactions. The market will work, and that will drive down the pricing on any
A part of the folklore is that venture capital is expensive money. There is a
great deal of misunderstanding about that. I wish I had a dollar for every time
I had a conversation that went something like this: "Ron, we would like $1
million and we will give you 10 per cent of our company." I say, "So
you reckon that your company is worth $10 million today, but you do not have
any sales and you do not have a prototype." The other person will respond, "I
did not say that. I did not say my company was worth $10 million." I will
say, "Oh, yes you did." It is a matter of understanding and
As the industry comes of age, there are many more venture capital funds, more
professionals, all out there competing for business, talking to accountants and
lawyers. We speak to manufacturers' associations, at technology conferences and
so on. How to work with sources of risk capital and how to price your
transactions are becoming better understood.
As the industry grows, the representatives of the small and medium-sized
businesses are becoming more sophisticated. We are also being kept very
disciplined by the availability of venture capital from the U.S. We see
increasing forays into the Canadian market by U.S. venture capitalists, and that
is a healthy thing.
Mr. Riding: This gives me an opportunity to talk about some research that we
have done recently but have not completely written. We spoke to 200 randomly
selected business owners across Canada. That is not a big number, but we
interviewed them in depth. We asked them to tell us about their expansion
plans, if any. We asked them to tell us about how they planned to finance their
businesses. We taped the interviews, transcribed them and analyzed the
transcripts with sophisticated software for the analysis of qualitative data.
We saw three themes emerge clearly. The first was awareness. In our interview,
they would tell us about their financing plans. Typically, that would involve a
bank. Then we would say, "You have not said anything about equity
financing. Why is that?" There would be silence and then a question: "Do
you mean bricks and mortar? Do you mean the mortgage on my house?" There
was a lack of awareness of financing sources beyond the banks.
The second theme was that those business owners value autonomy. That is
consistent with why many people are in small business in the first place. Many
of them would rather keep control of their firm than grow, if growth means
taking on a partner of any type. Those potential partners, investors, venture
capitalists, in their perception, are a threat to their autonomy and control.
They do not want them.
The third theme was access. However, we are talking now about a minority of
people. Very few people mentioned problems with access to non-bank capital. Is
the price too high? If we expand the nature of price to say that part of that
price might be giving up some control, then apparently it is too high.
In terms of financial measures, when we consider that you or I could put our
money in the Toronto Stock Exchange and get double-digit rates of return over
the last couple of years, 30 per cent on a brand new start-up business with no
sales and no contracts does not seem out of line. That is all I can say on
Mr. Begg: On the question of pricing, my colleague is quite right in saying that
the threshold that both venture capitalists and angels look for in true
risk-equity financing is 25 per cent, 30 per cent or more, depending on the
transaction. However, one must consider the results of the industry, in terms of
what returns are actually generated, given that this is very high-risk
investing. We expect that out of every ten investments, two will go bankrupt.
From six, we hope to get our money back and perhaps make a little money. We are
really in business for those two out of ten that have potential for
The best statistics in terms of returns for venture capital are produced in the
United States by Venture Economics. They will show a return for venture capital
funds over the long haul of about 15 per cent. Again, you can compare that with
the public markets, for an investment program that is of substantially higher
risk. Anecdotally, our returns in Canada have been much lower.
Senator Angus: I should now like to move on to a related point: the corporate
governance of these start-up small businesses. My experience -- and I think we
have heard evidence to this effect -- is similar to what you were saying,
Professor Riding. The owner or innovator or entrepreneur or principal decides
he does not want to play with these sources of funds because the price is too
high. There seems to be a significant amount of evidence that they are unable
to attract good directors to the board.
I keep hearing that they are afraid of the costs of holding board meetings, of
doing all the things that one might find in the TSE guidelines on corporate
governance for public companies. As a result, an angel will come along to one
of those companies and find all sorts of bad practices going on because
compliance is not without cost. Do you have any statistics or comments on that?
Mr. Begg: One of the principal contributions that venture capitalists make to
small and medium-sized businesses is being active on their boards of directors.
Sometimes that is imposed as a condition of providing the capital.
I can tell you that when we are making the investment in a company, I really
know I am on to something when the principal in the company, the entrepreneur,
negotiates with me not so much on the price but on who will sit on the board.
That is what he wants to know. He will say, "Yes, you will have two seats
or three seats," but he will want to know that the person going on the
board will be adding value.
Because we think this is so important, even though every venture capital in our
association has a different way of handling it, we insist that they take
seriously the subject of corporate governance and require a certain structure
and a certain participation. Frankly, corporate governance is almost a fad
these days. You cannot find a company that is not introducing corporate
Senator Angus: They have all been reading the Banking Committee report.
Mr. Begg: Exactly. In small business, the principles and fundamentals are the
same. However, the practice or the art of implementing them is different. When
you are starting, you do not have the infrastructure and the organization. You
do not have the professional advice. You do not have the history in the
We recruited a professional to write a manual, if you like, on good corporate
governance, according to the revealed wisdom at Working Ventures as it relates
to small and medium-sized businesses. We hold seminars. We have trained our own
people. We have put them through this very practical, hands-on program that
addresses the questions: What does an audit committee agenda look like? What
should you require of your CFO? What role should the auditor play?
We have begun also to invite our investee company directors to go through that
seminar. Increasingly, we will be inviting the CEOs of these small companies to
participate in that process as well. It is healthy and well-regarded.
Your last question had to do with the cost of this. The barrier is that initial
reluctance to report to a board. That is the price, as my colleague was saying.
The cost is typically small. One thing that I think can be done to strengthen
that is to have a better environment for rewarding and compensating directors
for serving on small boards. Typically, the fees are modest relative to, say,
the Conference Board benchmarks for retainers and meeting fees. Increasingly,
we think that the use of options should be an important element to attract
angels and people of experience who can add value to those boards.
Senator Angus: You mentioned the reticence of the entrepreneur to make that step
of reporting to the board. A fundamental characteristic of people with good
ideas is secrecy or a reticence to disclose, and not only to a small board of
interested investors or angels. They are uncomfortable generally with the
disclosure that is inherent in the new concept of corporate governance. Have you
found that that is something that they need to overcome? I believe that it is
an inhibition to raising capital or equity.
Mr. Begg: Secrecy is an issue, but it is not as important as the discomfort of
having disciplines imposed in terms of reporting. There must be a briefing
package and it must go out a week before the board meeting. That is more
Can you imagine how indignant an owner-manager who has always run a personal
fiefdom would feel to show up at the first audit committee meeting to find out
that it is inappropriate for him to chair that meeting?
Senator Angus: And to have to account for his experiences and his last lunch at
the Rideau Club.
Mr. Begg: Exactly.
Senator Angus: Senator Oliver was moving into the area of directors. In your
report, Mr. Begg, you outline some of the issues regarding liability.
Do either of you have statistics on the difficulties encountered in recruiting
directors? What other incentives might you be able to suggest, other than
generous stock options at the start-up phase or a good, clear, due diligence
defence with respect to directors' liability?
Mr. Riding: We have no data on that. That issue came up in our 1993 study where
we interviewed angels and asked them about some of the barriers to investing.
At that time, the Ontario government proposed legislation that would make
directors personally liable for a number of things. It was in the newspapers.
Because of that, hazarding statistics is not something I would really be
prepared to do, but it certainly was an issue. Liability issues discourage
angels from investing and from being on boards.
Senator Angus: You indicated, Mr. Begg, that you hire headhunters for Working
Ventures. If you have two or three slots on the board of a company in which you
are investing, you will hire Caldwell or Spencer or another firm of that type.
They would give you feedback on whether or not it is difficult to find those
Mr. Begg: The issue of director liability is a showstopper for many people. A
chill goes over people when they contemplate serving on the board of a
high-risk business, particularly a business that may go international. They are
very frightened of that. Venture capital funds have a variety of ways of
addressing that, and some are better able than others to deal with it.
Senator Oliver: Insurance?
Senator Angus: Indemnity?
Mr. Begg: In our case, we indemnify directors whom we ask to serve on boards.
Given that we have a fund with deep pockets, that assurance provides comfort.
That typically is not a barrier with the people we are trying to recruit.
Companies try to buy indemnity insurance for directors' liability. It is very
expensive and sometimes impossible to buy for companies on their own. Some
smaller funds will indemnify the directors they offer to serve on a board, but
it is more onerous on a small board.
Senator Austin: I wish to move to the area of your exit strategy and to look at
the considerations you use once the investment has been made and has perhaps
Professor Riding, I was rather intrigued by the disclosure that an angel is not
motivated by tax. Why do you think that is? What does motivate the angel?
Mr. Riding: In making their investments, their emphasis is on the fundamentals
of the firm. They are looking for a company that will succeed and will pay them
that 30 per cent after-tax rate of return over that seven-year period. They
will certainly accept a tax benefit if it is available, as would anyone else,
but they are not in it for tax-loss reasons. Some groups of investors will
choose tax havens, but angels, generally speaking, are not among those.
Senator Austin: Archangels are different from angels in that respect; is that
Mr. Riding: No.
Senator Austin: A gathering of angels has a tax-motivated plan. Or are they
angels in a flock?
Mr. Riding: No. The gathering is just to create a syndicate.
Senator Austin: You can see that venture capital groups, such as the one Mr.
Begg heads, are tax-sensitive groups because they report a return to their
investors. That is the fundamental issue on which capital can be raised. Why
Mr. Riding: I am not sure there is one. The angels we spoke to are looking for
that 30 per cent rate of return. They take a lot of risk. Part of what they get
for doing that is the involvement and the creativity of building a new company.
We asked them a number of questions about why they do what they do.
Senator Austin: I could give angels a lot of excitement if they were interested
just in creativity and capital did not matter.
Mr. Riding: No one said that. They want a 30 per cent rate of return.
Senator Austin: When the Mulroney government, under Finance Minister Wilson,
introduced the $100,000 capital gains free zone and the $500,000 total, did
that increase the activity of angels with respect to investing in small
enterprises? Do you have any numbers to show whether that tax system was
Mr. Riding: Our interview data indicate that it had a perverse effect. We
changed those kinds of tax measures relatively frequently compared with the
frequency of changes in the U.S. Some of the angels we spoke to told us that
because they could count on that tax benefit being available now, they wanted
to cash out.
Senator Austin: Before it was taken away.
Mr. Riding: Before it was taken away.
Senator Angus: By the new government, which is more perverse.
Senator Austin: I did not use the word "perverse." The witness used
the word "perverse," and I found it rather intriguing.
I do not wish to be goaded by my colleagues, sir, because I think that what you
have to say is more important than what they have to say.
I want to ask you about the U.S. capital gains structure in which a "long
hold" reduces the capital cost of the investment. That is where I was
going when I mentioned the motivation of your angels. I take it that angels can
be motivated by a lower cost tax structure. Would you find that type of tax
structure of interest to capital focused on SME risk?
Mr. Riding: The answer is an unequivocal yes. I have advocated that since the
first work I did on angels.
Senator Austin: Mr. Begg, on the issue of the tax structure, in your paper you
address the problem of an exit strategy and the cost of a long hold. You
discussed the escrow share system and focused on an IPO as an exit strategy.
The investors in your own fund would be much more patient and much more
encouraged if the capital gains tax were reduced by the length of the hold,
would they not?
Mr. Begg: This is rather a complex minefield. Different types of funds are
treated differently. The labour-sponsored funds are treated uniquely and they
represent a certain part of the market. Many of the members of our association
are structured as limited partnerships. The gains produced by those funds flow
through to the institutions providing the capital, which was one of the points
we identified. In order to facilitate that, it is important that the pensions
have confidence that they can obtain that flow-through without becoming
associated or denied the treatment.
In terms of capital gains treatment for entrepreneurs, I noted that when the IDA
appeared before you a few weeks ago, they made recommendations to lower the
inclusion rates and to exempt certain types of gains on initial public
offerings of small companies, for small founders and others. We support that
type of initiative.
With respect to the labour-sponsored funds, the capital gains do flow through to
shareholders. However, the other income produced by investment does not.
Senator Austin: The point I am almost advocating is that, in encouraging the
fund flow and, more than that, a culture favourable to investment in Canada in
small and medium enterprise, it strikes me that the longer the hold, the lower
the tax costs should be in a high-risk environment such as the one both of you
have been discussing. Is there any research indicating that the capital gains
tax structure in the U.S., which is not small and medium enterprise sensitive,
but just capital hold sensitive, has encouraged their SME activity or has it
just remained neutral?
Mr. Begg: I have no information on that.
Mr. Riding: That is an interesting question on the angels. We have seen an
increase in angel activity in the U.S. However, attributing the cause is more
difficult because, not only have those taxes become more favourable over the
last 10 years, but there have been more steps taken by municipalities and
governments to mobilize angel capital. It is difficult to say what is
responsible for what.
Mr. Begg: I would make two points with respect to exit strategies as they relate
to professionally managed venture capital funds. First, there has been a lot of
focus on IPOs. Historically, that has been not been a rich source of exits for
venture capitalists, although it is becoming more important. Increasingly, we
are seeing companies bypassing the Canadian exchanges and going directly to
Nasdaq, but that is still not a rich source of exits. Other exit strategies
include sale to a strategic partner, buy-back by management, retirement of
debt, and a longer-term hold.
The other point with respect to exits from professionally managed venture
capital companies is that quite often we do not drive the exit at all. We are
minority shareholders. The principals, the owner-managers, will drive that. We
will be there, encouraging and supporting it or, sometimes, opposing it because
we think it is too early, but we will be taken along on an exit driven by the
Senator Austin: I appreciate that answer and it anticipated the question I was
pursuing. To finish the IPO aspect of it, I hope that the reorganization of the
Canadian stock exchange system will provide for a junior stock exchange that
will be focused on taking your clients into initial public offerings.
Do you think that is so or is it of no particular significance to venture
Mr. Begg: I will have to reflect on the structure that is being proposed,
particularly for the consolidation of the junior exchange in the west. However,
in our experience historically, our fund has not seen many companies make their
initial offering on the junior exchanges.
Senator Austin: Therefore, this section on escrow regime is not particularly
significant to the reality of the business.
Mr. Begg: I was differentiating among the different exchanges. I think this
escrow regime is vitally important to small businesses. We are quite alarmed
about this, whether it relates to a junior or a senior exchange. An
entrepreneur who is raising capital for the first time is looking at a very long
exit horizon. Other investors, such as venture capital funds, may have been in
that fund for three to eight years. The possibility of being locked in for
another six years is of great concern. From a policy standpoint, it means that
that capital, which would otherwise be recycled into new opportunities, would
be locked in for a longer period of time. It will also discourage major
institutions from putting money into professionally managed venture capital
funds because, in addition to this three-to-eight-year hold period, the money
will be locked in for up to another six years. That is a very serious matter.
Senator Austin: In your presentation, you are arguing for a healthy IPO market
in Canada, stating that the alternative is a transfer into the U.S., where the
rules may be more attractive. Yet you also say that the IPO is not that
significant to you, although it may be very significant to the entrepreneurial
shareholders and the angels who have supported them.
Mr. Begg: I did not mean to make that distinction. It is an increasingly
important exit strategy, but it is only one of several.
Senator Austin: How do we foster the idea of entrepreneurship at an early stage?
One of the complaints about Canadians, which I think is totally untrue, is that
they are not brought up to be entrepreneurs; they are brought up to be risk
adverse. I have seen a great deal of entrepreneurial activity.
Can we change our educational system? Is there enough entrepreneurial juice
around or are we a risk-adverse society? Can we do more in secondary schools to
incorporate the idea of business as one of the disciplines of education?
Mr. Riding: I believe that more must be done, but it is somewhat of a challenge.
I am familiar with the community of people who do research on entrepreneurship
in Canada, and it is fragmented.
There are one or two people at one university and maybe one at another. I think
perhaps only at Calgary and UBC is there a critical mass of people doing
research. There is a need to foster that. I spoke earlier about the way we
fostered innovation with the centres of excellence and the other initiatives
that are truly paying off.
We did not at the time, and perhaps we ought to have done, create a national
centre of excellence that could bring together people who work in
entrepreneurship and who could then disseminate that work through the
Senator Austin: I am not thinking so much of research in disciplines that
ultimately give rise to ideas, but of giving our young people a framework for
understanding the role of business and entrepreneurship in society.
Mr. Riding: That is part of it.
Senator Austin: This is a responsibility of the provincial governments of this
country. Is it something the Council of Ministers of Education should look at?
Mr. Begg: I grew up in a branch-plant economy, but that has changed.
Entrepreneurship is alive and well in this country and is very exciting. That
has come about partly because of the importance of the multinationals and their
changing role in Canada. I was trained at a multinational, where we moved the
chess pieces around the board in Canada. Did we ever fashion a chess piece and
think about establishing the business in another country? Never. That has
changed. People are growing up learning how to fashion the pieces, and not just
move them around the board.
I noticed in a newspaper a couple of months ago, a report on a study that ranked
the esteem in which the public held various occupations. Number one was the
small-business owner. What a change from 30 years ago. I think that is really
What we can do, more than anything else, is celebrate our heroes. Let us point
to the people who have actually built businesses and who have succeeded in a
number of ways, including raising money. Let us honour these people with
entrepreneur of the year awards. Our association has an entrepreneur of the
year award, as do The Financial Post, The National Post, and Ernst & Young.
They are good opportunities to celebrate these people.
The maturing of the venture capital industry can also contribute to the issue.
We are putting much more money into the community than we ever have before.
People are starting to understand that it is not just a question of what you
can borrow from a bank, but that the rules have changed. Capital is available
from other sources. It is honourable to have partners, to have linkages with
people like venture capital companies, and to create other forms of venture
companies that can compete internationally in many cases. I think it is a very
exciting environment. Most of all, I would say, let us celebrate our heroes.
Senator Kroft: I come from Manitoba where, until very recently, the venture
capital industry was certainly a deprived industry. My colleague Senator
Callbeck was illustrating that, and it would be the same across the Prairies.
Canada is not well served in an even-handed way in terms of the venture capital
industry. In your report, you state that the stimuli you are looking for to
provide for venture capital investors is in terms of organized venture capital
vehicles, and appropriately so, because that is your job.
I really want to make more of a plea for getting the angel, the private
investor, the one-off, the local investor -- whatever term we use -- to
participate and gain some of the same advantages that you are trying to
advance, quite properly, for the organized industry. There is a significant
amount of data showing that the organized industry does not reach the whole
country now. In many places in Canada, it is difficult to find access to that.
Yet the private investors do not have a voice in the same way that the
organized industry has.
In terms of escrow conditions, tax issues, et cetera, my point is that they
should apply equally to the investor who does not have an opportunity to work
in an organized venture capital environment. I am requesting that you not make
your club too exclusive.
Do you have any statistics on the number of public offerings of Canadian
companies that are going to the United States, specifically through Nasdaq? Is
it a significant number?
Mr. Begg: I would be happy to try to compile some information in response to
that question, senator. We are conscious of them anecdotally, but I could not
give you the percentage that goes directly to Nasdaq. Certainly there are
Senator Kroft: Do you have any information on the number of companies who find
their financing from U.S. sources?
Mr. Begg: That would be much more difficult to come by because so much is done
privately. I will see what might be available.
With regard to your point about this not being an exclusive club, it is very
much in our interest to develop the kind of initiatives you were speaking about
as a feeder system for investment opportunities. We live and die by deal flow.
We need to see good opportunities. If we could create a feeder system, it would
be very much in our interests. It is one of the reasons my colleague mentioned
earlier the federal Canada Community Investment Plan. The minister asked me to
chair the national program that selected the 22 communities. I am a very strong
supporter of that program because it focuses on creating an environment in
which small regional companies can be made investment ready. These local groups
are not making the investment decisions, they are making these companies
investment ready for angel investors and beyond. That sort of initiative has
To date, we have not seen much deal flow being generated out of the CCIP, but I
am hoping that as it matures, we will see more.
Senator Kroft: Winnipeg, for example, has always traditionally had an active
investment market, certainly on the private investor side. I do not know if any
of the major capital investment firms have offices in Winnipeg, or if they have
even attempted to cover that market. I do not know if they have working or
agency relationships with these companies. I do not know whether there is any
systematic effort to identify and monitor deal flow. However, if you follow what
has been happening, you will know that there has been a substantial number of
very interesting new company developments, particularly in the high-tech area.
I am amazed that the established firms are not making an effort, on any basis at
all, to go in and find those deals. The community-based investment firms and
other types of initiatives are fine, but I continue to be surprised, when I see
the deals that are being done, that people in the comfortable fortresses of
Toronto are not more aggressive in going out and looking for them, or even
establishing agency relationships with people on the ground. Mr. Desmarais has
found that to be a fertile investment area for a couple of significant
companies. That is not a bad example.
Mr. Begg: I am not aware of any of the large funds having an office in Manitoba,
other than the ones that are already established there. I am aware of two,
however, that have direct relationships with other funds. The largest Manitoba
fund has a relationship with the B.C. fund, and another, new fund has a formal
relationship with a Toronto fund. Our fund does have an office in Saskatoon but
not in Manitoba.
Senator Kelleher: I want to go back to a point that Senator Austin was starting
to explore, but perhaps not in sufficient detail. I work in a law firm, besides
being a senator. We are a fairly large firm, where there are several hundred of
us. We seem to attract a lot of people who come in looking for money, wanting
to get started. We get the collective feeling that they have no clue about what
is involved. They have no idea whatsoever that it will cost them 30 per cent of
their company to raise this money. They are shocked when you tell them that,
and also when you start explaining to them the strictures that will be put on
them by someone willing to invest, in order to protect that investment. We are
not teachers; we are lawyers. We are not really trained or set up to teach.
Are we wrong in this feeling? I do not think we are, so assuming it is correct
that people coming in really do not know what they are facing when they ask for
this money, are there any courses or seminars available? I am not talking about
sending them to community college for a year. We seem to have all sorts of
other courses available. I am not aware of anyone setting up courses where I
could say to these would-be entrepreneurs, "You will have to sit down and
learn a few things here. There is a great one-day or two-day course available."
You do not want to discourage them by making it too difficult, but I find this
to be a real problem. We seem to be in the educational business, which we are
not cut out for.
Mr. Begg: This is a very common problem, and it varies according to the region
of the country as well. In some of the major cities, the financial advisers,
the lawyers, and the accountants have a sophisticated understanding of venture
capital and share this in their advice to their clients. That makes the
potential for completing a transaction much greater and faster. You cut through
the kind of resistance you are talking about.
In other parts of the country, it is anathema to consider giving up part of your
company at all, let alone a substantial stake in it. It is a matter of
education. I know that a number of members of our organization have programs to
put on presentations regarding how to structure a transaction, how to value a
business, how to implement a corporate governance program. At our fund, we
certainly do that.
There is a handbook on venture capital investing by David Gladstone, which is
the bible of the industry, and it goes through chapter and verse on how to
structure and value a company, and what to expect when dealing with a venture
capitalist. There are two versions of this book, one written for the venture
capitalist and one for the entrepreneur.
Senator Kelleher: I know that various organizations put on seminars from time to
time. They may occur every three to six months, depending on what part of the
country you are in. It is not very helpful to someone who is in your office now
to say, "Well, look, you wait around for three or six months and there
will be a seminar on and I think you should go to that." He wants to get
going. Is there a role for government or the educational institutions in this?
Mr. Begg: The experience you mention is certainly consistent with everything we
have seen. We felt so strongly about that lack of awareness that I mentioned
earlier that we decided to write a book and then sell it. We have made so much
money on the book that we can now go out for lunch.
The Deputy Chairman: And deduct it.
Mr. Riding: The reviews of the book are very good. As the author, what can I
say? Industry Canada has adopted parts of it for its Web site on strategies, to
teach people about different types of capital.
In hindsight, as I look back on that process, I realize that many entrepreneurs
are so busy running their companies, that until they need particular knowledge
about raising this or that kind of capital, they will not go to a course or
read a book. We need to provide them with the information at their point of
requirement, but it is very difficult to forecast or identify where that is. Of
course, the cast of characters is changing a great deal, as there are so many
new businesses being created. I do not quite know what the solution is,
although I certainly recognize the problem. I can relate an anecdote, if I may.
In doing some of our research, we talked to a woman who ran a motorcycle repair
shop, and we asked her if she had thought about angels for financing.
Senator Kelleher: You need not go any further with that. I guess the answer is,
there really is nothing readily available to which you can refer people when
they actually land in your office and have this need.
Senator Oliver: The professor's textbook.
Senator Angus: You can refer them to Stikeman, Elliott.
Senator Kelleher: I do not think the average small entrepreneur could afford
The Deputy Chairman: Motivation is the reason people invest. I know that the
Alberta Stock Exchange started some small venture capital funds. Everything is
about attracting money. I also know there are special tax considerations that
make it easier for Working Ventures to get capital into the fund itself. Some
provinces have unusual tax credit systems that, along with the federal system
and RRSPs, basically give you back all the money you put in. Is that unfair to
other venture capitalists who are trying to attract capital? Why are people
putting money into the fund? Are they putting money in because they want to
invest in small business, or because they want to get the tax credits, much
like the MURBs?
Mr. Begg: There is little doubt that without tax credits, the labour-sponsored
funds would not have raised the capital that they did. That tax credit was
designed as a matter of public policy, in order to create a larger pool of
capital that would focus on small and medium-sized businesses. That pool had
essentially evaporated in the early 1990s.
The other policy objective was to do this in such a way that, for the first
time, average wage earners would be able to invest in this asset class with the
types of tax incentives that had historically only been able available to high
net worth, sophisticated investors. If one could write a cheque for $150,000,
one could participate in this type of asset class without an incentive. Now the
system is more egalitarian and inclusive. For $50 a month, or a lump sum
payment of $500, one can participate.
It would not have happened without those tax credits, which are intended to
underwrite the additional risk and the time it takes to produce returns in this
business. This is long-term investing.
Much has been made of the J curve. One expects to lose capital on a portfolio
basis for two to three years. It is only in years three to eight that one has
the potential to start deriving returns.
The restrictions under the program also focus on investments that may not always
have the potential of unfettered venture capital because it is channelled to
meet certain policy objectives. Returns are also dampened by the need to
maintain liquid capital to meet redemptions.
This program has been successful. Compared to the situation at the beginning of
the decade, small businesses are much better off now in terms of being able to
raise equity capital.
Is this perceived as unfair competition? At the time the program was
established, there were not many alternatives. The sources of capital had dried
We now have a much healthier industry with some continuity. The amount of
capital being raised by labour-sponsored funds has been moderated by the
refinements to the program and we have seen a return to the market of more
traditional sources. We have a mix of capital that should provide continuity
and adequate supply into the future.
The Deputy Chairman: Both witnesses spoke about the different kinds of
businesses that need venture capital, and the high-tech sector came up quite
often. Do certain companies have difficulty raising money, given the types of
businesses they operate? I am thinking, for example, of the restaurant
business, the fishing business, or grain processing and the production of canola
Mr. Riding: The angels we spoke to indicated that it is not a question of
industry sector as much as it is one of growth potential. I mentioned some of
the things that turned angel investors off a particular opportunity.
The things that turn an investor on, and prompt an investment decision, are
focused on growth and the ability of the business owner to demonstrate the
potential of the product and his own potential to make that product a viable
business. Sometimes it is easier to demonstrate that potential in the more
That being said, there are industries where growth is relatively harder to
obtain. As a consequence of the growth aspect, there is an industry overflow.
However, investors are looking at the growth issue.
Mr. Begg: I agree with that. About two-thirds of investments in the venture
capital industry are what might be characterized as high-tech. A third of them
are in traditional industries. The growth factor is what drives this business.
Equity capital can then be levered against traditional sources of financing.
That is when one needs equity capital.
Senator Oliver: Are there areas that you will not finance, such as real estate?
Mr. Begg: It is fair to say that the industry as a whole does not place any
restrictions at all. They certainly favour certain industries, as is shown in
the industry report. There are restrictions when it comes to labour-sponsored
funds, such as no real estate investments and no money-out deals. There must be
capital going in to grow the businesses.
Traditional venture capital is not restricted as to region or industrial sector.
Senator Kroft: I wish to return in a very general way to the tax question. You
addressed technical structural elements related to limited partnerships. I
would like to put a more general question to you, one that preoccupies me and
much of this committee in a broad sense, beyond merely the question of
financing smaller business. It relates to the capital gains tax regime in this
Is there a possibility of fundamentally altering the capital gains tax regime,
both quantitatively and by the stimulation of risk-taking, as represented in
the financing of a small business? I do not want to get into types of
structure. If the potential reward could be enhanced by way of the capital gains
structure, a regime could be constructed in a way that would invite investment.
Do you see that as being particularly productive? To the extent to which
financing a small business is favoured over other investment avenues, one could
then distort the investment flow in that direction. Can you make any helpful
Mr. Riding: The position I have taken, on the basis of our research, is that
investors are looking for that 30 per cent after-tax return. The first time an
informal investor gets a hit, he or she has used up the capital gains tax
As we look into the future and watch the borders between countries disappear --
which is happening at an ever-increasing rate -- there is much to be said for
harmonizing tax regimes internationally. If informal investors in the U.S. can
get a better rate of return by investing there than Canadians can by investing
in Canada, as those borders disappear, money will become more fungible.
Mr. Begg: In our submission, we identified the specific structural changes that
would be of interest to our industry. Quite apart from that, the health of the
entrepreneurial community is largely driven by taxation. The ability to
generate retained earnings as a source of risk capital to grow a business is
vitally important. Whether it is capital gains or regular corporate tax, it is a
tremendous source of equity capital to grow those businesses. In the U.S., we
are seeing that successful entrepreneurs who have exited are taking that money
and recycling it into the next venture.
The final point to be made relates to personal taxes, in terms of retaining the
brightest and the best in this country. Attracting individuals with expertise
in certain industrial sectors to Canada to help build these companies is very
important. It is very much a question of fertilizing the ground as opposed to
plucking out the odd weed.
Senator Kroft: You have emphasized the building-up of internally generated
funds. For instance, the small business preferred tax threshold could be raised
from 200 to some other level. Could this have a significant impact on that
Mr. Begg: Yes, very much so. In a paper released a few weeks ago, the IDA
proposed lowering the exclusion rates, increasing the limit for small business,
or perhaps reducing the rate for small business, and we generally support those
suggestions. If you would like chapter and verse on the ones we do and do not
support, I would be happy to leave that with the committee.
Senator Kroft: I appreciate that.
The Deputy Chairman: There being no further questions, I will thank the
witnesses for appearing today.