Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue 51 - Evidence


TORONTO, Thursday, April 29, 1999

The Standing Senate Committee on Banking, Trade and Commerce met this day at 9:00 a.m. to consider the present state of the financial system in Canada (equity financing).

Senator Michael Kirby (Chairman) in the Chair.

[English]

The Chairman: Our first witness this morning is Mr. Loudon Owen, a managing partner of McLean Watson Capital Inc. You will notice that your agenda for today indicates that Mr. John Eckert, who is Mr. Owen's partner, was scheduled due to appear and indeed, Mr. Eckert was in the audience for most of yesterday. Unfortunately, he is not feeling well this morning, so he conscripted his partner to replace him.

Thank you very much for coming, Mr. Owen. We appreciate your taking the time to be with us, particularly on such short notice.

Perhaps you would start by making some opening comments and then we will ask you questions to explore, in detail, some of your views.

Mr. Loudon F. Owen, Managing Partner, McLean Watson Capital Inc.: Mr. Chairman and honourable senators, Mr. Eckert does apologize for not being here. He is not feeling ill because of the content of yesterday's discussions. His is a legitimate illness.

I am the co-managing partner of McLean Watson. Last night, in thinking about this presentation, I organized my remarks into four categories. First I will cover our philosophical underpinnings, that is, how we think, or where we are coming from. Second, I will tell you a little bit about us so you understand our credentials. Third, I will share some views about the venture capital industry, particularly in an international context. I spent some time last year travelling around Asia, particularly in Taiwan, Hong Kong and Singapore. I also spent some time in Australia and in the Nordic countries, Norway, Sweden and Finland, looking at the venture capital industry and opportunities, so I will be able to give you my perspective as to where Canada fits in. Fourth, we have a couple of recommendations which I do not think will shock you. They are fairly consistent with what you would have heard elsewhere, but they are sincere.

Venture capitalists are on the streets, our sleeves are rolled up, and we are independent. Although there has certainly been a growth in venture capital, there are not many independent venture capital firms in Canada. Most of that venture capital is associated with the larger organizations, the banks in particular, and of course, the labour-sponsored funds. However, we come from the category of raw independents.

Our job is pretty simple: It is to achieve an above-average return for our investors. Historically, that is what we have been able to do, and that is what drives us. Basically, our pension plan is how we make a living.

Our investors do not receive any tax breaks. Of course, they would love to get any and the all tax breaks that are available. We elected not to go down the path of the labour-sponsored funds because of the constraints those placed on running a venture capital group, so we chose a different path. We started the business with our own money, and we still own it 100 per cent.

The way we make our profits is fairly consistent with other groups in the venture capital industry. We take 20 per cent of the profits we generate, and we share that among our partners.

I am sure everybody in the room recognized what an exciting future there is ahead of us, particularly in view of the new technologies. Having travelled extensively over the past year, I must say that the Canadian technology market is adequate, but moving at a slow pace compared to the rest of the world.

Our role is to try to find some world class companies. We try to achieve a superior rate of return not by getting 14 per cent as opposed to 13 per cent on individual transactions and adding them together; we are trying to chose some enormous winners. We are in the "hits" business, sort of like Hollywood moviemakers. We are looking for companies that can dramatically expand, and we have had some good luck in that category in the past.

We do not have any simple answers to what we call "innovation drivers." I know there will be discussions, as there have been in the past, about seed financing and how to change cultures. However, we really speak to the primary factors, that is the financing and the risk assumed by those who put up the money. There are two principles to keep in mind: one, people should be rewarded for performance, not just for participating; and two, for the most part, markets work very well and, if there is excessive intervention, that is highly disruptive.

In terms of credentials, from a highly personal perspective, my family came here in the 1950s by boat. We came seeking opportunities. I was educated here and in France. I have lived about a third of my life in Europe.

Historically, McLean Watson was a trading company. It was based in Indonesia. Our assets were nationalized by the Indonesian government, so you will see that our perspective is a somewhat cautious view of government intervention in business.

I watch the capital markets in two contexts. One is wearing the McLean Watson hat. I am also on the board of BPI Capital Management Corporation, a mutual fund company with $4 billion in assets. However, I am wearing my McLean Watson hat as I speak.

In the next 18 months, McLean Watson will be deciding whether it will continue to be based in Canada. There has been fairly serious discussions within our organization about moving to the U.S., and about being an American venture capital firm that has a long and proud history with Canada. Some of my comments here will be derived from those discussions.

We have been investing informally for the last 10 years, and formally for the last five. We started with a few thousand dollars of our own capital and we now have $125 million under management. I suspect that, within the next four months, we will have $150 million under management.

We have six partners. We have invested across Canada. We have investments in Victoria and Vancouver as well as at that the other end of the country, Halifax, Nova Scotia. We have also invested in Montreal, Ottawa and Toronto. In addition, we have invested outside Canada, in the U.S., and in the U.K. and are actively looking at investing in Asia. All of the members of McLean Watson, all the partners, are entrepreneurs. We have all had to hire and fire people.

When we started, we were trying to raise money for a company in Montreal called Softimage. We were carrying around our little flip books but nobody wanted to give us money. We were quite astonished because we thought it was an exciting opportunity. We spoke to American venture capital firms, we spoke to Canadian venture capital firms and we decided there was an opportunity for a highly specialized venture group, so that is what we set up. We invest exclusively in software companies. We were highly focused, driven by what we perceived to be a market need. That was quite a few years ago and I think the market has changed dramatically in the last five years. However, that was what gave us the impetus to go forward.

I do not know if you have heard about Softimage. It is an animation software company. If you have seen Titanic, Jurassic Park, Death Becomes Her or most of the commercials on the television, you will have seen Softimage's technology. The company was funded with $350,000. The shares which we receive from Microsoft are today worth $2.2 billion. It has 400 employees in Montreal and it was instrumental in building the animation industry in Montreal. There have been a variety of spinoff companies such as Discreet Logic and other companies in Montreal, so the company grew pretty dramatically. The only venture capital that went in was $350,000. After that it went public on the NASDAQ.

Our role was to invest. John Eckert and I share the duties of chief operating officer, and took it public on the NASDAQ. It was the first Quebec company to make its initial public offering on the NASDAQ. We considered the Canadian markets and elected not to go public here. We then sold it to Microsoft. We took the company from the initial point of investment, with its four employees, including the founder, Daniel Langois, to over 200 when we sold it to Microsoft.

The venture capital industry in Canada is quite young. It had a bit of a false start in the 1970s and 1980s when performance was not good, but there has been a real surge of activity in the last five or six years. The number of financial institutions that invest in venture capital is not large, and if you were to invite them into this room, you would have a lot of empty seats.

If you speak with any of the institutions that do invest in venture capital, you will find that they estimate that between 10 and 12 institutions in Canada would seriously consider investing material amounts in venture capital managers. More would invest directly.

I think Canada has a long way to go to impress international investors, and I know a lot of you gentlemen have travelled the globe extensively and have confronted some of the issues that raise about Canada. I will give you some indication of the questions I am often asked.

I believe that anything that can push the scales one way or the other in terms of either international interest or domestic interest is good. Obviously, people are always concerned with a range of issues ranging from taxes, to bureaucracy, to red tape.

If you read any high-technology publication, go to a technology meeting in Ottawa, or speak with a young company of people in their early 20s but who all know about stock options and public offerings, you will realize that the real attraction and the real excitement is south of the border. Everybody wants to be financed by an American venture capital firm; everybody wants to go public on NASDAQ; and people want to relocate in California. The ability of Canada's venture capital firms is limited, and American venture capital firms are not very active here in Canada, notwithstanding some protests to the contrary. For the most part, the Canadian firms that are being funded by venture capital, are being funded independently and domestically.

Another important point is that many of the best people I know have left Canada and will not come back. This includes developers, marketers, CEOs. A major difficulty for business in Canada is finding qualified people because some of the most successful entrepreneurs have made their money and left. They do not return, in large part because of the tax environment. My comments are anecdotal, not based on statistics, but it is something we certainly noticed.

In Canada's favour, and on the plus side, is good education, attractive R&D tax credits, a stable work force, unlike California where they park a Porsche in the parking lot and hand the keys to someone they hire as they walk out of the building at night, which does happen. Canadians tend to be much more stable. We are close to the U.S. which is probably the major consideration when businesses are considering basing themselves in Canada or investing in Canadian companies. It is an enormous market and relatively safe, we hope, on an ongoing basis, from the geopolitical risks.

In respect of challenges we face, there is an international perception of very high taxes and of a very complex tax regime. It is difficult to spend more than one or two days talking about Canada without being asked about the threat of Quebec separation and the disruption to Canada that would result. There is a perception of antibusiness legislation, particularly employment legislation.

I asked a group of Taiwanese delegates who were travelling across Canada whether they would consider investing in Canada. After a pretty long silence, they responded, "Why would we? Taxes are high, employment legislation is outrageous, people do not work that hard, but it is a beautiful country." I think it is a real challenge to get people to invest in Canada.

We also face a couple of other challenges. Canadians are relatively weak in sales and marketing. If we knew of a panacea, we would certainly share that with you. We would advise you how to improve the sales and marketing of our organizations and our companies. The most important point is that we should try to keep our good people and give them incentives to stay in the country.

The GDP growth anticipated in Canada is relatively modest. It amazes me that, when I speak to businessmen in Hong Kong or in Singapore, they know that, based on estimates, Canada is looking at a 2 per cent, and perhaps a 2.2 per cent growth in GDP in the next year. They are looking forward to much higher rates. That is a significant issue.

I believe that the complexity of the legislation that influences investors cannot be overstated. For example, when we sold Softimage to Microsoft, some of the filings that were technically required, arguably, would have required American investors to file not only returns related to what they had made on Softimage shares, but their entire tax filings in Canada. That was a literal interpretation. It was appalling. You can imagine what the American institutions who confronted that concluded when they were subsequently considering investing in Canada.

I do have a couple of recommendations. The first is that we support what the CVCA has put forward as their recommendations. They seem cogent; they are well-argued; and they are well-presented by the venture capital association. However, in some cases, they do not go far enough.

We would point out, however, that we think that the proposed escrow rules are shocking, counterproductive, and that they will send a cold chill across the venture capital community in Canada such that you will not have a single, credible venture capital firm taking a company public in Canada, nor will you have many entrepreneurs seeking, as their end game, public listing in Canada.

My wording could be much stronger, but I think the rules are a complete non-starter and should not even be considered. The fact that the rules have been put forward has added fuel to the fire, certainly within our company, about discussing whether we should stay in the country and whether we should continue to be based here.

As with many people in the room, we work long hours and we invest our own capital. We are trying to build a future for ourselves and for our families. What will the next legislation bring? What will happen in one year, in three years? Why are these sorts of rules even being considered? Do we have a better chance of making extraordinary returns in the U.S., or do we have a better chance of making returns here? Obviously I am being fairly candid about the reaction to this.

I would point out that if the rules were adopted as they are stated or in a watered-down basis -- and by the way, we do not think that it makes sense to exempt venture capital firms exclusively from them -- we think they are, in and of themselves, totally unacceptable. If they were adopted, they would play into the hands of people who do not respect or adhere to rules, and that would allow those who control the market to wreak havoc in Canadian stock exchanges.

Of course, everybody wants lower taxes and better incentives. We are no different. However, we would suggest that rewards are for people who succeed, and that the current tax regime and the benefits put forward for investing venture capital should encourage people to participate. A much simpler regime which would create a much more level playing field would be to lower capital gains tax for those who make money. There are all sorts of ways of fine tuning that and, of course, we are not tax experts. However, we are enthusiastic about encouraging success and rewarding it.

As a principle, in looking at any prospective legislation or in analyzing any ongoing regulation of our industry or related industries, we have a standard to suggest. We compete with Route 128, the Boston firms and the Silicon Valley firms, and they have enormous advantages. They have a bigger market, more money, more experienced companies, more experienced senior officers, and a very exciting environment in which to take companies public. Canada does not have that. We also have to compete with one hand tied behind our back because of our excessive legislation. The complexity of the legislation makes it all the more difficult.

As a baseline, we would suggest that the applicable legislation should be consistent with and similar to the American legislation, that is, more "business friendly," whatever that means. Why not start at that point? We already have enough disadvantages. I think we should try to copy what our American neighbours do and do very well.

One point I would make may actually surprise people. It is not often that people in the venture capital industry sing the praises of the government. However, I would like to sing the praises of our Department of Foreign Affairs and International Trade. Last November, when we set up an office in Singapore, the departmental officials and other individuals working there as well as in Taiwan, Hong Kong, and the Nordic countries, did an absolutely fantastic job.

Their job is to try to help small businesses in Canada find markets externally. Most Canadian companies that we deal with will sell between 60 and 100 per cent of their products outside of Canada. Our market is too small to grow a company indigenously. In Singapore, David Wynne our trade commissioner worked tirelessly to help us. As well, Handol Kim and Stewart Beck in Taiwan, Michael Fine and Amy Yung in Hong Kong, all worked very hard to assist us. Even in Ottawa some people really helped us drive our international strategy, particularly Mr. Michael Farley and Mr. Greg Meredith. I would continue to support the ongoing assistance provided to small and medium-sized companies who are trying to crack the international markets.

Finally, I make a plea to reduce complexity wherever possible. Swing the machete through the jungle of laws and legislation, and rules and regulations.

I would also urge us to be more creative. Why is Nokia the world leader in cellular phones? They are based in Helsinki, a very cold place. Why has that happened over the last five years? There are only 5 million people in Finland. They have done an extraordinary job. Most people assume they are based in Japan. They are also located in Oulu which is 200 kilometres from the Arctic Circle. We visited them in January when it was absolutely freezing cold. We did that because they have been very creative, and anything that could possibly have been done to help that company has been done.

Why is it that in Sweden, a large percentage of employees have home computers and Internet access? That is because, last year, they told their employees that, if they bought a computer for their homes, the company would deduct the cost. It is not a taxable benefit to the individual.

In talking with somebody from Ericsson last week, I was informed that, out of their 45,000 employees, 22,000 bought computers, and they had to contribute some portion of the purchase price. The result is a dynamic group of employees, students and children at home working with very good computers.

There are some obvious examples in Singapore in the tax free zones, the industrial parks, enormous ongoing projects for biotech and software. The same situation applies in Taiwan and in Hong Kong.

TThat concludes my comments on behalf of an independent venture capital firm.

The Chairman: Thank you for your most intriguing staggering comments.

Before I ask Senator Angus to lead off the questions, may I ask you just one question? I am trying to understand what makes Route 128 and the Silicon Valley work in terms of business legislation. Do you know of anyone who has done an analysis of their success? Are there two or three key elements that come to your mind right off the bat that are more favourable in those locations as compared to others and that are not found in Canada? Obviously one relates to taxes.

Mr. Owen: You are right.

The Chairman: Are there certain elements of government legislation or regulation that leap to mind?

Mr. Owen: A study is being done by a Swedish group. They are travelling the world to analyze the best practices within the venture capital firms as they relate to operations and environmental factors. In fact, we will be meeting with them this afternoon and we will be happy to share any results they may have.

The Chairman: That would be very helpful to us.

Senator Angus: Welcome to our Banking Committee. You were certainly very candid. Mr. Eckert missed a good show.

You certainly did not minced your words. You paint such a bleak picture. Why have you stayed in Canada?

Mr. Owen: To use a Californian expression, it is our "power alley." In launching the business, we had our personal affiliations here. I think Canada is at a crossroads in terms of the venture capital industry. Looking at it globally, it could go either way. It is relatively small, and it is relatively fragmented. There are a couple of large players and there are some tax advantages; but the industry could grow, and it is a terrific launch pad because of the state of the industry. The important considerations are personal affiliations, history and the state of the industry.

Senator Angus: As you say, it is a very young industry. As to the crossroads we are at, do we have to do certain things or make certain changes before it is too late? I am reading that into your comments. Is it urgent that something be done?

Mr. Owen: Yes, it is. We are in the IT industry and it is moving at a rapid pace. There are highly specific venture capital industry benefits or investor benefits along with cultural factors that must be considered. You can do is sit around and talk about them, challenge people and do what we are trying to do here.

The Internet adoption rate is 50 per cent throughout the Nordic countries. The cellular phone adoption rate is well over 50 per cent. That will rise to over 100 per cent, that is, more than one phone per person. We must examine why that is so from a cultural perspective.

To be specific, the tax regime is unattractive for venture capital. The regulatory regime is also unattractive.

For the past year we have been travelling around the world telling people that Canada is a great place to invest. We tell them that we are the size of California in population, but we have a fledgling venture capital industry. Imagine having become involved in California 15 or 20 years ago. That is how we position Canada. We have great technology and a stable work force. However, all our potential investors keep trying to drag us down to the U.S., and the reason for that is pretty clear: the tax regulatory web.

Senator Angus: I was interested in your story about Soft Image, but is there another part of that story that involves something called Avid Technologies?

Mr. Owen: It was ultimately bought by Avid from Microsoft. The acquisition was about six months ago.

Senator Angus: How has that affected Canada?

Mr. Owen: On the animation side, the employees are still based in Montreal. However, one has no control over what Avid or any successor purchaser will do in the future.

Senator Angus: They are based in Texas?

Mr. Owen: No, they are based in Tewksbury, Massachusetts.

Senator Angus: Is that in the Route 128 zone?

Mr. Owen: Yes.

Senator Angus: We heard a staggering bit of evidence yesterday, contradicted by only one witness at the end of the day. It was that a great proportion of the graduating classes of the University of Waterloo, in the field of technology, are being hired immediately after graduation day by people like Microsoft. Can you corroborate that?

Mr. Owen: Yes.

Senator Angus: Are all of your comments applicable, mutatis mutandis, to sectors in the emerging economy other than the IT sector, for example, in biotech?

Mr. Owen: I do not know if they are all applicable. I do know they are applicable to the biotech sector. I know of one Canadian company which changed its strategy in the bioinformatics field and, within about two months, every employee was hired by American firms.

Senator Angus: As for our technical graduates, when they commence their studies do they have a foregone conclusion that they will leave Canada? Alternatively, do they see themselves staying in Canada and building their futures here?

Mr. Owen: About a year ago our company employees had a pub night with a group of high school students who were on an exchange program. Of course, being under age, they were not drinking, and they were asking some questions. We expected questions about the kind of cars we drove and so on. But their questions were much more complex. They asked us when they would be eligible for stock options; what the exercise price would be; and what the term of the options would be. These students were 17 years old. I think people seem to be quite aware of where the opportunities are.

Senator Angus: The American dream is alive and well in Canada.

Mr. Owen: I think it is. Young students are reading a lot about the opportunities.

Senator Angus: Thank you. Those are my preliminary questions.

Senator Kroft: I wish you had come later in the day. I would like a cheerier view to open my day, but there are probably at least 75 countries in the world that have a much worse problem than we have here. We are looking at our problem or our challenges in comparison with Boston and Silicon Valley, which are easily accessible to us, and we are feeling more hard done by. In relative global terms, however, I think you would agree that Canada is much better off than most.

Mr. Owen: Yes.

Senator Kroft: Okay. Just so we try to keep some perspective here.

I was interested in the fact that you are in a judgment mode in terms of your own firm and where you are going. You said that you will be making some fundamental decisions over a period of 18 months or so, and that you do have a Canada case and that you are out there selling it. I suppose one of the things that will help you to make a decision in the next 18 months is how effective a response you get to the package that you are offering.

Given the nature of the Canadian society, the Canadian economy, our geography, and our market -- particularly as things have moved with the trade agreements -- many obstacles that we used to face no longer exist. You seem to keep focusing, however -- and I am not surprised because you are not the first to do so -- on the tax and regulatory regimes as the big problem. You see them as the big area of contrast with the U.S., and I would like to get a bit more specific under those two headings, if I could.

First, let us consider the tax regime. Could you please open up another window in your visual display to give us some breakdown of the two or three specific tax elements that you would like to address?

Mr. Owen: Sure.

Senator Kroft: It is tough for us to deal with people just saying "It is a lousy tax environment."

Mr. Owen: Yes.

Senator Kroft: I would invite you to expand on that.

Mr. Owen: I have spent a year as a cheerleader for Canada, so I am putting on a different hat when I point out some of the challenges that I have faced. It is obviously a fantastic country -- we are here, we love it, and we want to see it continue to grow and prosper. No one is saying that Canada as a place is unattractive, but we are trying to identify the problems, and shine some light on them.

The number one issue is capital gains. When we talk about rewarding success, it does not mean simply giving a micro-focused tax break to people who participate in an industry. The capital gains exemption has had a very powerful effect on entrepreneurs in Canada. That has been excellent, as has the $500,000 exception -- it is actually $400,000 plus $100,000.

The continuing uncertainty as to whether or not it is going to be there, of course, is difficult. It has yielded all sorts of practices where people are trying to crystallize the gains, and trying to ensure they are going to be there going forward. I do think that the program has been an enormous boost to people, however, particularly with the smaller companies.

Second, the overall capital gains rates in Canada are relatively high. I am not just comparing this to the U.S., but also to other jurisdictions, and there is a large range of jurisdictions from which to choose.

Third, if we could rewrite the Tax Act -- and I am sure it would be a difficult and lengthy process -- the general level of personal taxation in this country is high. I went to a business school in France called INSEAD, and I have tried to encourage a variety of my colleagues to come to Canada. They all have the economists' analyses of tax regimes and they all have friends in different jurisdictions, including in Canada and in the U.S. It is very hard to get them to come here, and the industry is not built by institutions. It is not built by organizations. It is built by people, and taxes at the individual level are high. It is hard to get people to come here.

Senator Kroft: On the capital gains tax, you have observed the exemption benefits that were built into the system. Focusing on capital gains as the issue relates to venture capital, would you take a macro approach? That is, would you say that the capital gains regime should be made much more attractive to enterprising Canadians in general, or would you propose targeted capital gains incentives in terms of particular types of investments? During the course of yesterday's session, both approaches were advocated.

Mr. Owen: I think they are both legitimate. Philosophically, we are generally in favour of a level playing field -- make it across the board, simplify the process, and share the benefits among all business people.

Senator Kroft: You mentioned the regulatory disadvantages or obstacles that Canada faces in comparison with the U.S. Venture capital investors and those trying to organize venture capital investments both face these obstacles. Could you offer a few examples on the regulatory side?

Mr. Owen: Sure. There have been some improvements on this side, but the securities legislation for relatively small investments can be quite intimidating. The variety of exemptions available and the vagueness in defining some of the exemptions has been difficult for smaller investors and for the angel level and the earlier stage investors.

When it comes to getting institutional investors into Canada, and this again goes back to the tax side, there are withholding tax implications and there are also structural implications as to what vehicle they can use. You cannot have a non-Canadian investor in a Canadian limited partnership, because then it is no longer a Canadian limited partnership. The consequences of that are significant, and it is very difficult to come up with an attractive structure for a co-investment that involves both Canadian investors and a non-Canadian investor.

Non-Canadian investors seek the flow-through benefits of a limited partnership. They do not want to invest in a corporation, and they certainly do not want to invest through a trust. The vehicle just is not there, and I know there have been some suggestions about vehicles in the past.

Senator Kroft: Are you suggesting that the other way around is much easier -- that the Americans are much more benign in their regulations, their tax requirements, and their filings? That has not been my own experience. Alternatively, are you saying that it is more difficult for us to accommodate Americans than it is for Americans to accommodate Canadians? That is, they have so much more of the investment, so we have to be more accommodating than they do?

Mr. Owen: It is more of the latter. They have such a "mind share" and market share that we are in a battle to try and get capital here. We have to try and accommodate them. It would be very positive if we were to have legislation and practices consistent with theirs, but I know that, with the state system, that can be very complex to do.

Senator Kenny: This witness is very helpful, but I have an observation that applies to the previous hearings and to today's hearings. We have all understood the general drift of the concerns, and nobody has any problems with the fact that people are concerned about taxes, the regulatory environment, culture issues, and political instability. I think everybody on the committee is clear about that. However, the more specific we can get on this, the better. Perhaps this witness and future witnesses could focus more on the specifics and less on the general issues, because I think we are all comfortable with the general issues.

The Chairman: Like some of the specifics that Mr. Owen just gave.

Senator Kenny: Exactly. Frankly, it would be helpful if they could give us some insight as to what the costs of their proposed changes might be. For example, they are concerned about the escrow rule, and obviously somebody has a concern somewhere if they want to double the period of time for that. Nobody has come forward and articulated what that is for us yet, however. It is fine for witnesses to come and say, "We think it is a crappy rule and to double it makes it twice as bad," but it would be interesting to have somebody come forward and say, "Well, I think they are doing it because they are worried about X or Y."

The Chairman: We may get some of that.

Senator Kenny: Fair enough, but the more specific we can get, the more helpful it would be to the committee.

Senator Kelleher: I want to move away from taxes and regulations, to what I call the supply and demand topic. I think the supply of money available for venture capital in Canada has probably increased over the last five years. I do not think it is as bad as it used to be.

Mr. Owen: Yes.

Senator Kelleher: Some of the evidence we are hearing, however, is that the people who want the money, who need the money, are having trouble accessing it and finding out where they can get it, or what will they be hit with when they find somebody. For an awful lot of them, it is quite a shock to find out how much equity they have to give up, and I think it is also a problem for people who, let us say, live in northern Saskatchewan as opposed to in Toronto.

Do you agree with that general statement, and do you have any suggestions as to how we might improve access to the money that is now becoming available?

Mr. Owen: Yes, I agree that the amount of venture capital is larger. Yes, first-time entrepreneurs who are facing seeking equity capital are sometimes surprised, and sometimes they are poorly educated and ill-informed about obtaining it. Yes, nobody wants to give up equity. There is always that tension back and forth between are they giving up equity or are the venture capitalists betting their life and the next five years of their existence on an entrepreneur who is untested. I agree with all those points.

I also agree that geographically, in what we would consider to be remote areas that have less of a concentration of economic opportunity, it is much harder to raise capital. I do not have any suggestions in that area, however, because I think that if it is an IT company, notwithstanding the growth of the Internet and ubiquitous telecommunications, the company should be best positioned to serve its customers, and we are a highly focused investor. If they are based in northern Saskatchewan and they are trying to get in the mainstream, we probably would not finance them because they are not in the right place for what they are doing.

The thrust of our business is to focus on the best companies, ones that seek the largest returns and that cater to their customers. We are not really in favour of trying to support companies simply because they are based in a particular location.

The Chairman: I have a question on the tax issue. We have heard two different arguments on the capital gains issue. Let me put them both to you, and we will see where you come out.

One is that generally speaking, capital gains taxes are too high and they ought to be lowered across the board. The second is that it would make more sense to have a targeted capital gains tax cut -- one that would target either by industry type, or more importantly, by company size. Just as corporate income tax is lower below the $200,000 mark than it is above it, one could have a capital gains tax structure where smaller companies paid a lower capital gains tax rate. Where do you stand in terms of across the board tax rates versus targeted rates?

Senator Meighen: What about the rollover?

The Chairman: The other question involves rollovers. If you cash out and then reinvest immediately in a similar business, should you not pay tax until you cash out on the next one?

Mr. Owen: If it were possible to do things on the rollover basis, that would make a huge difference. The number of people who are no longer living in Canada because of the lack of that type of provision is significant.

The Chairman: As I understand it, that provision does exist elsewhere.

Mr. Owen: Yes.

The Chairman: Does it exist in the U.S.?

Mr. Owen: Yes.

The Chairman: That is what I thought.

Mr. Owen: Yes. I do not know if we have strong views on whether or not there should be a dividing line for tax rates, personally or corporately. People who build companies often become experts in tax legislation. This is what happens with a lot of the smaller companies; they become highly expert in tax filings and understanding the IRAP grants and what the different levels are, as opposed to working on the business. If one is trying to stimulate the smaller enterprises, a dividing line -- some enhanced capital gains treatment for smaller businesses -- would be preferable.

The Chairman: And the rollover certainly accomplishes that.

Mr. Owen: Yes.

Senator Meighen: I want to talk about the idea of clusters. Do they come about naturally, or is there some sort of stimulation through government or other entities that accounts for it?

As a sort of a subset to that question, we are aware that Quebec seems to be a hot bed of entrepreneurship right now. Is this is due to a more favourable regulatory and tax climate -- to the extent that the provincial government can influence that -- or is it just because people are more into the culture of entrepreneurship?

Mr. Owen: There is no doubt that doing business in Quebec is a very lively pastime. There is a lot of creativity in the Quebec business force, particularly, in our experience, in Montreal. The growth of the entrepreneurial segment is not restricted to the preferred regulatory regime, the lower taxes or the large amounts of venture capital being invested. I think it is a combination of the two.

However, when one is in Taipei, there is a Quebec trade office representative at the meetings to promote Quebec directly. The other provinces do not tend to be so involved, and I think that Quebec takes a more aggressive approach. I think there is an extremely creative element and dynamic there, but the province itself is certainly a factor.

Do hotbeds of technology or clusters grow naturally because they are sponsored and supported? Again, it is a combination. I think Montreal's animation, post-production and special effects community grew without any government support. For example, neither Softimage nor Discreet Logic had any significant government support or tax breaks. In fact, we tried to sell our first product to the CBC, and they would not buy it. They bought a French product, so we had to go to France and sell our first product there.

These companies grew up indigenously through their own creative efforts. What is happening now to sustain those industries and help them grow with their larger working capital requirements is assisted by government efforts.

Senator Meighen: You would not advocate any particular treatment of Halifax, Ottawa, or Vancouver?

Mr. Owen: No.

Senator Meighen: The critical mass has probably already grown up naturally in those places.

Mr. Owen: I think the critical mass has grown up. I know it can be very frustrating to hear platitudes about lower taxes and less of a regulatory regime, but it is much more at a macro level. Internationally, I know that Canadians face perceptions -- and there is some reality behind them -- about the complexity and the high rates, so it is much more at a macro level. If an entrepreneur in Vancouver can make 30 per cent more in his or her pocket, he or she will fuel the entrepreneurial zeal and the growth of the high-tech business in Vancouver, Montreal, and Ottawa.

Senator Meighen: Speaking of perceptions, it is my perception that federal bureaucrats feel that the government would suffer a net loss of revenue if we were to cut the capital gains. That is not necessarily a terrible thing in itself, but I am not so sure it would happen. The lower capital gains tax might well stimulate additional activity, which would promote higher revenues, et cetera, et cetera. That is the classic theory, and the results in places where it has been done seem to prove the validity of that theory.

I want to echo Senator Kroft's point that any specific examples from within these areas would be very helpful. If you think of any after you have left here, we would appreciate it if you would communicate them to us. Those that make sense to us would be incorporated in our report, and they might even have some effect on our it.

Mr. Owen: I will make my best effort.

Senator Meighen: Thank you very much for taking the time to be here.

Senator Kenny: I would go a step further, and I say this to you and to the other witnesses that are coming before us: One of the issues here is the political dimension, and you understand this as well as we do. We are in Toronto, and right now the main focus in this city has been to set up a task force on homeless people. That is a grabber. People are unhappy seeing so many people out on the streets, and that seems to be something that governments should focus on.

It is a lot tougher to make a case that somebody should become a millionaire. Nobody around this table disputes that there is value in that, but it is difficult to make a political case for it. Your thoughts on that would be of assistance to use, because the burden for making the political case cannot rest entirely with the politicians. We need help, and we need arguments. How do we make the case that this is good for society in the broader sense?

In a general sense, I can see what you are saying, but there are competing demands. It is easy for me to see why the arguments you are putting forward tend to get shuffled down the political food chain over time.

The Chairman: Thank you, Mr. Owen. You have been very helpful to us this morning. Dr. Gerry Goldstein, our committee researcher, would love to get the results of that study that you are going to be briefed on this afternoon. That would be really helpful to us.

Senators, our next witnesses this morning represent the various bank capital corporations. Mr. David Pakrul is the president of the Bank of Montreal Capital Corporation, Mr. Jacques Sayegh is from RBC Capital Corporation, Mr. Ian Kidson is the managing director of CIBC Capital Partners, and Mr. Rod Reynolds is the president and CEO of RoyNat.

Thank you very much for coming. You all know the subject that we are talking about. I will begin with Mr. Pakrul, and perhaps we could go around the table for your opening comments, followed by a discussion with you.

We have an advantage, because we have heard from a lot of people. Our knowledge base in terms of the kinds of issues we would like to explore with you is actually pretty good, which is probably an advantage for us and a disadvantage for you. I am sure, however, that it will make for a delightful dialogue.

Thank you very much for coming. Mr. Pakrul, please begin.

Mr. David Pakrul, President, Bank of Montreal Capital Corporation: Thank you, Mr. Chairman. Good morning, honourable senators.

I will try to be true to what you have asked. I know from reading the transcripts of your previous meetings and from what I have heard today that you have already had some excellent presentations and discussions on this subject. In my opening remarks, I would like to briefly highlight what Bank of Montreal has done in its three-year experience in equity investing in small business under Bank of Montreal Capital Corporation and make some general observations on the subject at hand.

Bank of Montreal Capital Corporation is a relatively new entrant in the venture capital field. It was formed just over three years ago, in January 1996, to act as the venture capital arm for the Bank of Montreal. At the time of our formation, the Canadian venture capital market had under management aggregate capital of about $6 billion, of which more than $2 billion was available for investment. In addition, the labour-sponsored venture capital funds had become a significant presence in the market; they basically dominated investment activity in certain market segments.

Consequently, there was an adequate supply, if not an oversupply, of equity financing available in certain market segments, and intense competition was resulting in decreasing investment returns. Thus, our strategy was to concentrate on segments of the market that seemed to be underserved and where we believed appropriate investment returns could still be obtained. We identified three, namely: early stage, high-technology companies; existing profitable companies requiring temporary equity capital of up to $1 million for expansion; and seed stage investing in commercializing university research together with others.

To-date, over our three-year history, we have made direct investments of about $110 million in 81 companies. In addition, we have invested about $20 million in aggregate in the Western and Eastern Technology Seed Funds, GUARD Inc., which is a seed fund sponsored by the University of Guelph, and ACF Equity Atlantic Inc.

Recognizing that the investments we have made both directly and through the seed funds are not likely to be realized to any significant extent for several years, I cannot report to you that our investment portfolio has yet achieved its targeted rate of return. However, I can tell you that my long-term career prospects, as well as those of today's other witnesses I suspect, are very dependent on our achieving the targeted rate of return in our respective portfolios over time.

Turning to the specific question you wish us to address today, namely, "Are there changes in public policy that would increase the amount of money and the number of sources of money for equity investment in small business in Canada?", let me first make some general observations based on my experience.

First, there is no shortage of equity capital available for investment in good opportunities in Canada, and competition for these opportunities is very high. Secondly, many entrepreneurs do not like the price or the conditions under which equity capital is available to them. Finally, many investment opportunities are declined because of management deficiencies and the inability to create an appropriate rate of return and a viable exit strategy for the investor.

In summary, there is no shortage of equity capital available to finance situations where you combine a good idea for growth opportunity, excellent management skills and expertise, and an entrepreneur who is prepared to accept a transaction structure whereby both he and the outside equity investors can achieve their financial return objectives.

Given the high risk associated with these types of equity investments and the lengthy time period before they can be sold, and therefore realized by an investor, any change to government policy which improves an investor's chance of achieving their targeted after-tax rate of return on their investment should increase the amount of money and the number of sources of equity investment available for small business.

Specifically, as a taxable equity investor and wholly owned subsidiary of a Canadian chartered bank, I support your conclusions in "A Blueprint for Change," in which you, in turn, support recommendation number 44 of the MacKay task force on taxation of the financial services sector to reduce the burden of taxation, especially capital taxes, on the banking sector, one of the most significant job- and wealth-creating sectors in the domestic economy.

I will stop here in order to allow my fellow panelists to make their opening remarks.

The Chairman: Mr. Sayegh, before I ask you to begin, I would ask you not to read your full brief, in order for there to be time for questions.

Mr. Jacques Sayegh, President and Chief Executive Officer, Royal Bank Capital Corporation: Absolutely, Mr. Chairman.

The Chairman: It is several pages in length. I have had a chance both to read it and to look at the recommendations.

Mr. Sayegh: Mr. Chairman and honourable senators, the Royal Bank Financial Group has been involved in the venture capital business for many years. Royal Bank Capital Corporation had its origins in 1983. I have been involved in the organization for the last 15 years, as well as being a director of the Canadian Venture Capital Association.

Royal Bank Financial Group has taken an approach of lifecycle investing in the provision of equity financing to this industry. We have established four operating units that cover the gamut of financing from very seed-stage opportunities right through to the mature, very large companies. The four operating units, in brief summary, are as follows. The first is Royal Bank Growth Corporation, which was established in 1997. Its mandate is to provide seed capital and business expertise to facilitate the commercialization of technologies from various universities and inventive sources.

Secondly, we have established the Small Business Venture Fund. That fund is focused on providing equity financing, in amounts under $1 million, to emerging young companies that traditionally have not been able to access traditional venture capital. We recognize that they have significant different needs than more mature companies.

Royal Bank Capital Corporation, the third entity within this group, has had the longest history, since 1983, as I mentioned. It has evolved into what I call a "fund of funds" structure, which is focused on certain specialized sectors. Where we have chosen to differentiate ourselves is in attracting operating people and entrepreneurs to run these specialized pools of capital.

The three pools of capital have focused on information technology, on the biotech area, and on the industrial technology sector, and collectively there are over 100 companies financed here, emerging technology companies principally.

Finally, the Royal Bank has established a merchant banking group financing very large and more mature companies.

In terms of recommendations, from our perspective, a key element to re-examine and reconsider is in the Bank Act 1993; more precisely, the limit to the amount of capital that the banks can commit to the sector. That limit is capped at 5 per cent of the total regulatory capital that the banks can provide, in terms of equity financing.

The previous Bank Act under which I was operating, previous to 1993, was itself restrictive, in terms of the ability of the banks to provide venture capital. We were very active in advising on the positive changes to the Bank Act, in 1993, the effect of which were to broaden the powers of banks to provide equity financing. The one impediment that still exists is the 5 per cent cap on the amount of capital the bank can commit to equity financing. That is something to consider as well.

In terms of other jurisdictions, in particular, Europe and Asia, there are significantly larger amounts of capital available from the banking sector to the venture capital industry. In many European countries, as much as two-thirds of total venture capital comes from the banking sector. In Canada, it is less than 20 per cent.

We certainly support some of the recommendations of the Canadian Venture Capital Association that were tabled previously. I will not review them. However, in particular, we support the idea of encouraging outside directors to help small companies, the aspect of liabilities around that, and taxation of those outside directors, who are useful in guiding strategically emerging companies.

The Chairman: I now call on Mr. Kidson.

Mr. Ian Kidson, Managing Director, CIBC Capital Partners: I have had a chance to read some of the earlier testimony as well. At this point, there is probably very little I can tell you about the merchant banking or venture capital business that you do not already know. Therefore, I will restrict my remarks, if I may, to giving you a snapshot of what CIBC's portfolio looks like right now.

The merchant bank at CIBC was formed ten years ago as a bridge between the products that the Bank of Commerce would provide as a senior lender and the activities that Wood Gundy could undertake to help companies go to the public markets.

Currently, our portfolio has over $1 billion in what we deem traditional merchant banking investments; that is, outside of what we like to call strategic investments that the bank will make from time to time. That portfolio is split about 60 per cent in Canada, 40 per cent in the United States. As a rule, in our general portfolio we do not do startups. We have 20 professionals split between Toronto, New York, San Francisco, with one in London. Generally, the investment we like to make is $5 million at a minimum. Frankly, it tends to be upwards of $10 million, with $30 million as an upper level on the comfort zone.

We do not target any specific industries. Having said that, I will now contradict myself. There are two units, which we have set up, that are targeted: a mining group and a technology group. We established those small subunits to take advantage of opportunities that we see from time to time that are too small in the ordinary course for our general professionals to look at. Those opportunities are in the range of $500,000 to $3 million. That area is too important for us not to focus on.

I will conclude by echoing strongly Mr. Sayegh's last statement, that one of the biggest problems we encounter when we make an investment in a company is constructing a functional board of directors. Generally, the board of directors will consist of the entrepreneur or the principal in the business, perhaps his chief financial officer, maybe even an operating officer, and the other investment or other venture capital investors. All of the venture capital investors tend to bring the same strength to the table. They all tend to have similar backgrounds. To the extent that we could find a way to incent outside directors to get involved, I would be grateful. I will stop there.

The Chairman: I would like to clarify one thing before moving to Mr. Reynolds.

When your nominees are appointed to the board of the company, are they members of your staff, or do you, in fact, occasionally try to get outside directors from the bank; in other words, not bank directors but outside people who are appointed to the board?

Mr. Kidson: As a rule, when we make a substantial investment in a company, we will request one or more board seats.

The Chairman: Right.

Mr. Kidson: Generally, either my counterpart or myself will take that board seat. There are instances where we look at the composition of the board. For example, there are two instances where I processed the investment, if you will, supported the investment, and do not sit on the board as a board member. I am an observer on the board. We have nominated an individual to take our board seat simply because we saw there were some significant weaknesses in the board. It is not easy to find those people willing to dedicate the time.

The Chairman: Mr. Reynolds, please proceed.

Mr. Rod Reynolds, President and Chief Executive Officer, RoyNat Inc.: Good morning, Mr. Chairman and honourable senators, and thank you for letting us appear before the committee today.

RoyNat is a 100 per cent subsidiary of the Bank of Nova Scotia. In my remarks, I will try to focus on what the request has been and not repeat what my colleagues have said. I will talk a little bit about RoyNat and the other equity investing that the Scotiabank Group does, and then I will turn to a couple of recommendations and try to get to the specifics if I can.

RoyNat was incorporated in 1962 as the only alternative at the time for long-term lending to the predecessor to the BDC. Since then, RoyNat has emerged as the leading Canadian provider of long-term capital to small business in Canada.

Our market, unlike some of the other bank-owned subsidiaries, is in the smaller end. We focus on a range of $250,000 to $10 million in all forms of capital, long-term debt, leasing, subordinated mezzanine and all forms of equity. We operate on a decentralized basis through 22 offices across the country and four regional offices. We have a long culture of trained investment staff who take care to appreciate the concerns of the entrepreneur and look at transactions from their viewpoint.

An important point of ownership for RoyNat is that ownership is only permitted through temporary investment orders by OSFI. It is a non-permitted investment that needs these special clearances to go forward. Certainly, the talk about increased structural flexibility in the banking environment would help us in long-term to continue to provide the types of services we do at RoyNat.

Throughout Scotiabank, we divide the equity market into three groups: seed capital, in the very small end, is provided through a joint venture with BDC; the medium end, which I just explained, is provided through RoyNat; and the large end, which is generally over $10 million, is provided through Scotia Merchant Capital and ScotiaMcLeod. As I mentioned, in RoyNat we try to tailor transactions to whatever financial instruments we can achieve, be it for long-term debt all the way through equity.

In 1998, we completed 56 transactions that are mezzanine or equity, for a total of $83 million. We tend to have a much higher approval rate than the norm in the industry because of the breadth of our instruments.

Our experience and expertise is really in the smaller end. We focus on managed buyouts, expansions, and acquisitions, where we really look to act as a financial partner and mentor. Interestingly, in mid-1998, we launched a specific project targeted at succession financing for small business, which is an important element going forward in the intergenerational transfer of businesses.

If I can turn to some suggestions, I do not believe there are any fundamental changes that we can make quickly to the regulatory structure that will dramatically increase the flow of capital to small business, but I do have a couple of small suggestions.

Let me preface that by saying that, for the right enterprise, there is always capital available. What I mean by the right enterprise is this: good management, a sound business plan, and a well-structured transaction. That is not as easy to achieve as it may sound. We think that the biggest challenge is how to help entrepreneurs with these three tenets. At RoyNat, we try to take transactions that may be weak in one of those elements and work with the entrepreneur to help them develop the area of the gap.

There is not a great deal of published information on private equity transactions, and I think that is an important element of why there is this information asymmetrics that have been referred to before. We certainly agree that that does occur where the suppliers of capital know all about the location of the capital and the entrepreneurs know all about the business, and to bridge that is very difficult.

However, we do not think that is a major constraint in going forward. A plethora of intermediaries in the market have knowledge of both sides of the transaction. Companies like RoyNat and others spend a great deal of time with the intermediaries, educating them on investment criteria.

All of us at the table here spend a great deal of effort on advertising. We all have Web sites that small businessmen can come into and learn about our investment criteria. In addition, through RoyNat's decentralized business gathering, 22 offices in the communities, it certainly helps to inform the small business owner.

The investment appetite at RoyNat is not really limited by the amount of capital, like some of the closed-end funds, but really by finding sound and well-structured transactions. Our biggest hurdle in achieving that is the mind set of the small business owners and the appropriate ownership position for RoyNat.

There seems to be a distinct Canadian psyche that is reluctant to share in the equity of a company. We often see a scenario of an owner being much happier being 100 per cent owner of a small business than 80 per cent owner of a larger business. Interestingly, from our evidence, it seems to be considerably different from the attitude in the United States, where there is more will to give up some of the equity to achieve growth. One of the reasons for that reluctance, we believe, is a fear of venture capitalists, a fear of control, and certainly we need to address how we can overcome that fear.

Let me turn quickly to the tax regime, as it relates to the previous point I just made. At present, financial institutions are taxed fully on capital gains, unlike regular corporations, which receive a more favourable tax rate. Entrepreneurs are motivated to look primarily to debt-related instruments rather than equity, primarily because of the interest deductibility of interest payments versus dividends and, of course, the control issue I just mentioned.

Those two issues together increase the motivation by parties, the investor and the investee, to look at a debt-type instrument versus common equity. If venture capitalists that are financial institutions were treated like other corporations -- that is, that 75 per cent of the gain is taxable -- it would encourage us to look for a lower pre-tax return on our investments. That translates directly into a lower percentage ownership of the company, which may address the problem of the small businessman believing we are asking for too much ownership. Similarly, the many points made about the indexation of capital gains would again lead us to seek a lower percentage ownership of the company.

My last point, which is related to escrow agreements, is that we think that two years would be sufficient to protect the interests of other parties as well as motivation to venture capitalists to take companies public.

The Chairman: TBefore turning to Senator Meighen, if wish to ask you for a clarification on the tax regime. If the bank holding company provisions, which were recommended both by the MacKay task force and in a somewhat different form by this committee, were adopted by the government, would that solve the tax problem in the sense that, presumably, your organization would become a subsidiary of the holding company and thereby be subjected to a different tax scheme? Am I correct on that?

Mr. Reynolds: I would answer yes to those two questions. The first is the ability to continue doing the business that we are doing, which is only done by special order of OSFI and under the non-regulated holding company. If we were taxed at 75 per cent, it would achieve that goal.

The Chairman: Then the first step would be achieved automatically because you would be outside the regulated company, and thereby the OSFI string would disappear. Am I correct?

Mr. Reynolds: From what I understand, OSFI is making representations to have some sort of regulatory powers over the holding company also.

The Chairman: Your understanding is correct. Whether that prevails is a different issue. We are on your side on that one.

Senator Meighen: I will begin by following on from the chairman's question. If you ended up as a subsidiary of a holding company, forget the tax angle for a second, would the way you do business, your culture, change? I confess that I am very interested in what you had to say, and very supportive of what you have done, and I think you are making a great contribution; however, visually you come to me as bankers, and I do not see bankers as venture capitalists, particularly at the front end.

If you were a subsidiary of a holding company, do you think your culture would be different, or do you think it would be the same? Second -- and this may vary from witness to witness -- where do you see yourself coming into the picture? At love money? At an angel level? At the mezzanine level? At the venture capital stage?

The Chairman: And just to piggy-back on that, I noticed that Mr. Kidson made the observation that CIBC does not fund start-up.

Senator Meighen: Where do you fit? Are you a competitor of McLean Watson, for example, or are you positioned differently? I am having trouble seeing you other than a banker and coming in to you and you not making a loan at 12 per cent to me because you guys do not price to risk.

Mr. Pakrul: First, your impression of us as bankers comes because we are owned by a bank. None of us is bankers. I have never been a banker. I have been an investment banker for 20 years, and I am a venture capitalist.

Bankers and their culture basically do not work in the venture capital operation. So while some people may switch between organizations, venture capital and the skills and tools associated with it are very different. Different people are hired to fulfil that role, although we are owned by a bank.

You talked about culture therefore changing. As Mr. Sayegh has said, we now being a specified financing corporation under the Bank Act, we have restrictions, on the 5 per cent of capital rule and our hold period of 10 years. We have to report to OSFI. We have to do many things because we are a subsidiary of a bank.

Senator Meighen: The previous witness, for example, would not have to do.

Mr. Pakrul: Exactly. We would feel a lot better perhaps not having to do some of those things or having some of those restrictions.

By the same token, I would add that the measure of success that we would have to be measured by might be different if it were not directly held by the bank. I would suspect that return on capital or return on equity becomes a far more important objective in a holding-company structure. It may not. However, I think there would be changes, and it would be probably beneficial to all of us.

Mr. Sayegh: The Royal Bank has recognized the importance of differentiating between the cultures of the banking world and the investment world. Our organization is operated as a subsidiary, with its own board of directors. It has a different investment process than the debt process. There are Chinese walls with other parts of the bank. The people we hire come from the investment side of the business, and we do compete with the McLean Watson and the other independent funds.

Having said that, we are constrained by some of the banking rules, as David Pakrul has mentioned, in terms of having some of the regulatory aspects around our business that are specific to banks and yet competing with the other side of the world.

On the tax side, in particular, I would mention the non-level playing field with the labour-sponsored funds, in terms of access to cheap capital and so forth, and that is certainly a situation that differentiates our ability to operate in that marketplace on the same basis.

Mr. Kidson: I wish to make three points. I started at Wood Gundy in 1984 and functionally have never left the business. The days when you had a banker and an investment banker are over, frankly. The banking business itself has changed as well. Ten years ago I would have been insulted by being called a banker. I am over that.

You are right, Mr. Chairman, I did make the remark that we do not do start-ups, but it may be helpful to clarify what I meant.

As you know, any business goes through a multitude of stages during its growth, usually starting with the kernel of an idea. Generally, that kernel will take anywhere from $100,000 to $2 million to establish a credible, well-thought-through business plan. We generally do not get involved during that stage.

Once someone brings to us that plan -- arguably it is still a start-up in the sense that the company might have few, if any, employees and no operating assets -- we do get involved with that stage. Without being an advertisement, companies like Coinstar have recently gone public in the United States. One that is near and dear to our hearts at CIBC is Global Crossing. We made a $40 million investment in that company, as a start-up, in U.S. dollars, which has provided a nice return as you read in the paper.

Therefore, we become involved once we are comfortable that the business can take the capital that we will provide and direct it to achieve a business plan that we can understand and evaluate, and decide that we want to support.

From a regulatory perspective -- and I be wrong here -- the one area that I have always been at loss to understand is that we are restricted to owning 25 per cent of a company. That is correct, is it not?

The Chairman: Yes.

Mr. Kidson: I am at a loss to understand why that is.

The Chairman: Do you wish to add anything, Mr. Reynolds?

Mr. Reynolds: Back to your point, Mr. Chairman, about the bank holding companies. I think that would certainly sustain the independent and the autonomous nature of the corporations you are hearing about here and also address Mr. Kidson's point about the 25 per cent maximum in an unregulated subsidiary. That should not be an issue at all.

Senator Meighen: A final question. It strikes me that, when comparing the four of you to previous witnesses, you are far more restrained in your criticisms of the regulatory and tax environments.

You mentioned the 5 per cent limit and that you wish that were raised. Mr. Pakrul I think has mentioned exit strategy. I assume you feel as strongly as our last witness about the proposed new escrow rules, but I have not heard any of you talk about capital gains.

You may have heard some of the previous testimony this morning. Do you share the view that the capital gains tax regime in the country is counterproductive in terms of venture capital activity? Is the regulatory system too complex? Do you think combining the junior exchange in this country, such as has been proposed with respect to Calgary and Vancouver, would help activity? Do you have any comment in that regard with respect to the proposed or the nascent EASDAQ exchange in Europe?

Mr. Pakrul: Let me try to break it out.

I think I can say on behalf of all of us that we are all members of the Canadian Venture Capital Association and as such strongly support their recommendations to this committee. In our remarks today, we did not want to repeat what has been said.

With respect to ourselves, we mentioned a particular tax situation but, more important, the tax regime and attractiveness to an entrepreneur is paramount. As a country, we are in competition to attract people and keep them here. Anything we can do to make an entrepreneur's tax situation better, from his perspective, to help him achieve his financial objectives, as well as in a business sense from Canada as opposed to some place else, has to be positive.

With respect to the escrow policies, we all feel strongly about that. It certainly will deter investors of all kinds from encouraging companies to go public here in Canada as opposed to other alternatives.

I do not know enough about the exchanges, except to say that the junior exchange program, which is trying to foster an active capital pool and a public market based around Alberta, would again have to be positive.

Mr. Sayegh: We feel passionately about that and obviously have been very involved in helping them draft them.

Regarding the NASDAQ concept, there is a critical need to remove the barriers of these multiple jurisdictions, the provincial barriers for listing and for raising capital. It seems that every province has its own securities rules. The exemptions and legal costs required for a small company to raise small amounts of capital, whether it is from angels, traditional venture groups, or ourselves, are very complex. We would very much support any regime that would simplify access to that capital through a national exchange to junior companies.

Mr. Kidson: From our perspective -- and this is a very parochial comment -- we see lots of companies that have raised in the order of $500,000 or $1 million in a public exchange, have used it are seeking more capital, and they come to us.

It is infinitely more difficult for us to make an investment in a company like that than a private company simply because of the rules, et cetera, that have to be dealt with. To be frank, it is an impediment for me to make an investment in a company that has accessed a very small amount of money on the public exchanges. That does not mean that they are bad. It is just sort of a practical issue that we confront.

Mr. Reynolds: One interesting point from our experience is that about 75 per cent to 80 per cent of our exits are not via the public markets, and that probably has a great deal to do with the inability of these companies, which tend to be smaller, to enter the markets because of regulations and the costs involved. Thus, when we go in we are looking for a greater ownership position.

Senator Kenny: I have questions in two areas: directors' liabilities and capital gains.

We spent some time looking at corporate governance and came to the conclusion that due diligence was perhaps the solution to directors' liabilities.

We have since heard that it is not as good a solution as we think it is and I am interested in comments from the panel on whether the problem is solved, first of all, with an effective due diligence defence. Secondly, do we have to look at other models altogether for directors?

I know that during the course of our hearings on corporate governance, we had at least one witness who talked at some length, for example, about directors getting much better compensation and spending much more time actually functioning as directors.

On the first area, I am interested in your reaction to my comments about the due diligence defence, whether it does or will work, and whether we should be looking at other models.

Mr. Sayegh: If I may respond to that first, I want to say that, for one thing, Canada is way ahead of the United States on this aspect. There is such a litigious environment in the United States that four out of five directors get sued during their tenure.

I do not have precise figures for Canada, but I would be surprised if it is more than one in five. Therefore, I think in that respect we are ahead of the game. We do not live in such a litigious society.

I definitely support the due diligence defence, although I think it has some limitations to it. However, I also take your point about trying to find ways of benefiting directors in a more economic and direct way by assisting companies in terms of stock options, and in particular, the capital gains aspect that we keep coming back to. Almost every speaker has mentioned that, and I think it would be a significant and positive step.

Senator Kenny: Not all of the directors we are talking about here have insurance, I assume.

Mr. Sayegh: Most companies, especially the small ones, cannot afford the insurance premiums for director and officer liabilities.

Mr. Kidson: Just to follow up on that, whether it is the due diligence or some other defence, I think clarity should be the goal, so that a director can understand very clearly that he has fulfilled his obligations.

If it remains as it is today, a very grey area, it will continue to become increasingly scary for someone to be asked to be on the board of a company. From our perspective, we will not sit on a board unless all of the directors are covered by insurance that we view as adequate. Maybe that is because we have made a number of investments in the United States, where I sit on several boards, and we are being sued there but not yet in Canada. However, I do not know if that is because we are better or it simply reflects the nature of Canadians.

Senator Kroft: May I ask a quick supplementary? Is it possible for your corporation or bank, or whatever entity within the bank, to insure you in your roles as directors in companies in which you have invested in order to at least remove the personal aspect?

Senator Kenny: Are you self-insured?

Mr. Kidson: Personally, I am covered by two layers at the board itself. I am also indemnified by my employer, so that if anyone seeks to go after me personally and the insurance is not adequate, or they refuse to pay for whatever reason, I am covered.

Mr. Sayegh: I will confirm that, but I will also add that, because we are viewed as having deep pockets, and in particular because we are banks, we attract litigation.

Mr. Reynolds: One alternative that we have used in cases where we are concerned about potential liability is just to seek observer status. We can exert considerable control just as an observer without even a voting position.

Senator Kenny: Exerting that control does not attract liability?

Mr. Reynolds: It has not yet.

Mr. Pakrul: I want to add, on behalf of the outside directors that we try to attract to these companies, that it is obviously a huge concern for them. They are looking at it from a risk/reward standpoint, and the rewards, even with stock options, et cetera, sometimes do not appear, even under the best of circumstances, to justify the risk. It is a major problem, I agree, and I do not have any magic answers.

Senator Kenny: The second area I wanted to pursue, Mr. Chairman, was capital gains. In terms of the three models we talked about -- across-the-board lower, targeted for size, or the rollover option that they have in the United States -- what are panel members' preferences?

Mr. Pakrul: Certainly the rollover provisions, which I do not think anyone talked about, are very important for Canada with respect to other parts of the world, and I think we would all strongly recommend that.

With respect to across-the-board or targeted, while I am no tax expert and do not pretend to be, I have always found it difficult to design tax structures specifically aimed at one situation. You draw lines and somebody will find a way around them. I bow to tax experts, but certainly we need something that helps us in the small-business end. Under $2 million is where we live and die. That is all we do, and certainly we need something not just for the companies that are at the stage of seeking that kind of capital, but for ourselves as investors, to be selfish about it.

Mr. Sayegh: In my personal opinion -- I do not profess to represent the interests of the Royal Bank in this area -- and from a venture capitalist perspective, I think the rollover mechanism could be the most interesting. There is a lack of good management talent in this country, and my experience has been, if you look around Silicon Valley, Route 128, the companies that have been most successful have been started by people who may have failed a couple of times or who have done extremely well and sold out and reinvested in another company. The experience that comes from having gone through the process of building a business, successfully selling it, and reinvesting, is a most valuable one for a venture capitalist to partner with. In that respect, I think it could be a very attractive mechanism.

Mr. Kidson: I will certainly echo David's statement, in that I am anything but a tax expert, and this is my personal view, not CIBC's.

If I understand it correctly, the suggestion is that if we make a lot of money in a metal-bashing company, and we invest that money in another metal-bashing company, then we will not pay tax on that. That will have the practical effect of rewarding industry-specific funds at the expense of capital pools that are broadly targeted. It is not clear to me why that is a good thing.

The Chairman: Just for clarification, the rollover provision is not industry specific. The way it works is, you can roll it over directly into another investment, but you have to roll the entire amount over and you have to do so immediately.

Senator Kenny: The capital gain is not crystallized when you take the money out of the first company.

The Chairman: All that effectively happens is, the capital gain is delayed. When you sell the second or third time, then you get hit.

Mr. Kidson: If it is not industry specific, then I am a big fan.

Mr. Reynolds: Senator Kenny, I think you asked the previous witness about the political palatability of some of these issues. Certainly I think the latter two, mirrored by the small-business tax, which I do not believe anyone criticizes, would be very acceptable politically. You either target it or you have the rollover and sell it on the basis that it is encouraging small-business growth, versus the former suggestion for just a blanket lowering of the capital gains.

Mr. Kidson: If I may just be a little bold here, there was a suggestion earlier that you wanted our help with ideas on how to sell it politically.

From a very simple businessman's perspective, I do not understand why it is difficult to convey the message -- and this is simplistic -- that businesses that succeed and create a broader tax base are necessarily good. To me, that is a truism and I would have thought that that is something that we should look to politicians to encourage, and frankly, it is up to you guys to sell that hard.

Senator Kenny: With respect, I suggest that politicians are pretty reactive, and if you do not view it as an area where there are different ideas competing, and if you are not prepared to argue your case in a way that is politically palatable, it is unlikely to be successful in Ottawa on its merits alone.

The Chairman: I will make one observation on capital gains changes. Both the rollover and the targeted are a much easier sell than an across-the-board one, only because of the popularity of small business with the Canadian public. It also seems to me that, forgetting about politics, that is where one would want to put the incentive, as straight public policy.

Senator Kroft: I want to turn to an area that I do not think we have really discussed with anybody, but it has been sort of lurking in the background, and my thought was triggered by Mr. Reynolds' observation that RoyNat has a particular interest in management buyouts. We talked a lot about retention of talent in this country and creating an opportunity for companies to build and persuade people to stay. One of the things that can do that is an environment where people feel that they do not have to move in order to achieve an equity position and the rewards that come with that. That it is of interest to those people. It is also of interest in promoting the continuity of business on an ongoing and intergenerational basis and all these other elements.

What obstacles, if any, do you find in regulations or practices in the field of management buyouts in comparison with the U.S.? What is the Canadian environment, both regulatory and cultural, in that area?

Mr. Reynolds: I would rather talk about the cultural aspect of that question. As I said in my earlier comments, some of our main business focuses are MBO, succession financing, and that sort of thing, and our key issue always comes down to management or siblings not having the funds to do it on their own -- therefore, they need a partner -- and their reluctance to give up a share of the business.

I really cannot comment on the regulatory nature in the States as opposed to Canada.

Senator Kroft: Rather than discussing comparisons, are there any particular tax rules that could be changed, or anything else that would facilitate management, whether it is family or otherwise, in these buyouts?

Mr. Reynolds: One of the problems the retiring owner always faces is the capital gains tax on his interest in the company and that tends to be one of the biggest accounting issues that has to be dealt with. The classical approach of using estate-freeze, preferred-share type transactions is really tax driven.

We attempt to help the retiring owner gain some cash in hand, but that instantly generates a capital gains concern, which often causes some difficulty in closing a transaction, as that issue has to be addressed. Now, it can often be structured through trusts and that sort of thing, but it is an obstacle. I cannot give you specific statistics. I do not know how many transactions fall apart because of it, but definitely it is in the forefront of the issues that have to be dealt with.

Senator Kroft: Once again, it is rooted in the capital gains issue.

Mr. Sayegh: There is one other tax issue that is related to the associated company rules, that is, in most of these management buyouts, the management, because it has limited funds, does not always have a controlling interest in the company. Therefore, outside investors who have been attracted may collectively own more than 50 percent of the company. In particular, if they are institutional investors, the company loses its status as a Canadian-controlled, private corporation, and there are other implications of the association rules of the Tax Act that are significant impediments to this company attracting the capital that it needs.

Senator Kroft: I have another question on a different subject. One of the discussions we had yesterday was on the question of geographic access to venture capital funds, or the lack thereof, and the high level of concentration in Toronto in one or two limited areas.

Again, turning to Mr. Reynolds, I think you talked about the number of your branches and how you wanted to use your branch operation to deal with that problem.

I want to ask all of you who come from bank ownership how the branches are being used in this regard.

Mr. Reynolds: Let me tackle that one first. RoyNat, given its long history, has established those geographic centres right across Canada.

The previous question was, how do you serve Ontario north? We have an office in Sudbury that has the geographic responsibility. We support those offices. Not everybody, of course, can be an expert in equity investing. They are the finders. Then we bring our extras in to help them on the specifics of a transaction.

We still recognize, of course, that having just 22 offices is still not sufficient. We attempt to use the 1,400 branches of the bank as an extension of our tentacles in seeking out and establishing potential opportunities, again recognizing that we cannot have experts in all 1,400 branches who can deal with the more complex issues of equity investing.

Mr. Kidson: I will make two observations. One is, the people who administer the capital are concentrated in Toronto. I think that is again just a function of the way the financial system in this country works.

The fact that the managing directors of CIBC work in Toronto though, quite frankly, is irrelevant. I spend, and I am sure my colleagues spend, more time on planes and am a member of more flyer clubs and the like than my wife would prefer to think about.

So where I live has absolutely no impact on the ability of someone in Halifax to get money from me, with possibly one exception, and that is he cannot just walk down the hall and knock on my door, which obviously someone in Toronto could do. That leads to part 2 of the question on the branch network.

We spend a lot of time meeting with our account officers, which we do once a month. We channel people through our training centre and tell them what the merchant bank is all about, the kind of companies in which we want to invest, and the parameters. From my perspective, it is a very selfish thing. The larger the gathering system, and the more informed that system is, the more money we will make.

We absolutely do use our branch network, and frankly, that is how the guy in Halifax usually comes to our notice if he is not large enough to attract the attention of an intermediary.

Mr. Sayegh: I would like to reinforce the need to have a local presence. I think it is very difficult to deliver venture capital from a large urban centre into another regional market. We have recognized that need and have multiple offices across the country, and certainly rely greatly on the Royal Bank's branch network, which is very extensive, in the small-business market.

However, we have also partnered with some small regional funds. We have had success in attracting and identifying regional funds that could provide management expertise in addition to capital. They can work with the entrepreneur and be very hands on. We act as their financial partner, but they also provide the business expertise in some of these smaller centres.

At Royal Bank Financial Group, we think we have a corporate responsibility, in addition to an economic one, in representing our interests across the country, and it makes for good business as well.

Mr. Pakrul: We have a unique situation in my particular subsidiary because we are a start-up. We only have a three-year history and yet we somehow had to have a national presence. So your question is a good one that we debated long and hard.

I cannot agree more with Jacques. Local access is absolutely critical in venture capital, and so we had a conundrum, being a start-up ourselves, on how to provide national coverage, local access.

We attacked that by trying to provide a series of funds under the umbrella of Bank of Montreal Capital that focused all the way from seed stage to mezzanine financing, and where appropriate, we either invested in funds with others -- in other words, had partners who did have local access or specific expertise -- or where we did it ourselves, we tried to co-invest, as Jacques said, with local investors. That way, we have invested virtually all across Canada.

In Atlantic Canada, we are co-investors with, and actually an investor in, the Atlantic fund that you may have already heard about. Also, we are partners with the BDC in running the eastern technology seed fund, where we actually do seed investments directly.

Ontario speaks for itself, as does Quebec.

In the Prairies, we have offices in Calgary and Vancouver, but we are also partners in the western technology seed fund, which covers all of Western Canada, and we have investments in most provinces. I am afraid we have not been able to make one in Manitoba. We had approved two, but local investors competed and won on price.

In our three-year history, we have invested in 81 companies virtually all across Canada. We will continue to do it this way, with local partners, because as Jacques says, it is very important to be there to provide the advice as well as the money.

The Chairman: I have one last question that refers to something Mr. Pakrul said and I think then Mr. Reynolds also made an observation on it.

Mr. Pakrul said that many entrepreneurs do not like the price or conditions under which equity capital is available to them and Mr. Reynolds alluded to exactly the same thing. Do you want to expand on what you mean by that?

Mr. Pakrul: I thought this might come back to haunt me. I think all of us would agree with it, although we might say it a little differently. There is no opportunity with which we have ever been involved that has not been very competitive. We have not only other venture capitalists, we have competing fund sources, all the way from government-assisted funds through IRAP and on up.

An entrepreneur, quite rightly, will be interested in the lowest cost of funds he can find and he will seek government grants and bank financing to the absolute maximum before he will turn to us. He will then be shocked to learn that we want a rate of return similar to his, and it takes a while for him to understand that he wants a 30 per cent to 50 per cent rate of return, if not more.

Once he gets over that, he will shop to find the lowest-cost source of financing, as he should. Sometimes he comes back and then we sit down and negotiate.

One of the other problems we have with the funds is our exit. By current law, as a bank-subsidiary-specified financing corporation, we must exit an investment in 10 years. There is no choice. Like other entrepreneurs, we want to find some way of getting our money back. Therefore there is usually a long discussion about the plans three, four, five years out. No one is in a hurry, but we want to know what we are anticipating. Are we talking about a sale to a strategic partner or an IPO? All these discussions take place. Once again, sometimes the entrepreneur has not thought about that. He just wants to have a nice business to run and does not really want to sell his company. Oftentimes you can structure a buyback, where the company can literally buy back your interests, but then you get into negotiating at what price and how do you determine that?

There is a lot of necessary negotiation for an outside investor on his ability both to get a return and to find a way out that will satisfy both him and the entrepreneur. I turn to my colleagues, who have far more experience.

The Chairman: Are the problems as outlined by Mr. Pakrul more or less the same for everybody?

Mr. Reynolds: Yes.

Mr. Sayegh: Yes. It is very similar. Let me share a little irony with you, as we quite often come across very promising companies who come to our door and we start doing a lot of work on due diligence and negotiations. Then we come up with an offer of financing, only to find that our banking colleagues have all of a sudden woken up to this great opportunity to stretch lend. Of course, the entrepreneur is just thrilled that he does not have to give up any equity and he can simply get a bank loan. Sometimes our competitors are not our peers in the industry, but rather our affiliates.

Mr. Reynolds: I was just looking at some previous testimony provided to this committee, I think by Professor Riding, where he was looking at the particularity of the Canadian small-business person. It speaks to David's point about negotiating with small-business owners and their unwillingness to give up equity or their unrealistic expectations as to the future of the business. Our role, of course, is to be realistic and ask for a reasonable return based on realistic expectations, and bridging that gap is often impossible.

The Chairman: Am I right, though, in assuming that an entrepreneur who was not excessively optimistic and gung-ho about the true brilliance of his idea, would not be a guy you would want to invest in?

It just seems to me that if you have the creative energy to try to start a new company, you had better really believe in your idea. I am in complete agreement with you. Very few of such people would be conservative. Rather, they would be very optimistic. You do not want to invest in a really cautious guy, right?

Mr. Reynolds: No, no. I agree that enthusiasm is very important. However, at the end of the day, if he knows we will take his projections and then deduct 10 per cent, he should be willing to negotiate an acceptable position for the venture capitalist.

Mr. Kidson: Just one observation: The fact that entrepreneurs tend to value their businesses more than we do and do not like to give up equity is definitely not unique to Canada. I have yet to meet an entrepreneur in the United States who thanked me for valuing his company at more than he thought it was worth.

The Chairman: Thank you for that comment, because we have often been led to believe that Americans willingly give up equity and Canadians do not.

Senator Kelleher: Thanks, Mr. Chairman. I just want to go back for the moment to the exit problems or exit strategy, and it is quite obvious that the proposed escrow rules, certainly for Ontario, will cause problems in that area, as does the lack of rollover provisions.

Are there other areas of comparison between Canada and the United States where the Americans have better exit strategies for investors, and if so, what are they?

Mr. Sayegh: Our experience has been that access to the capital markets in the U.S. is substantially different from the Canadian model. We have quite often seen companies that are less than three years old launching IPOs. Whether it is in the Internet area or biotech, they are often concepts that have very little fundamental business already established.

However, I think the key element there is the quality of the sponsors around the table, either the credibility of investors or of the management team that has done this before, and that is one thing that is lacking in Canada. I think it is just the repeat expertise, the repeat experience of those investors or entrepreneurs who have done it once and now going up the second and third time around to do the same thing again.

One other observation is that Canadian entrepreneurs are reluctant to part with their businesses. Some frequently do see this as a lifestyle business rather than a vehicle to create wealth, and I think that is an important distinction. If you see it as a vehicle to create wealth, you will not be as emotionally attached to the business as you might be if you are the founding president of a family business and have that reluctance to exit from the company at some appropriate stage in the future.

Senator Kelleher: I am thinking though, you are talking about something in one's mindset there. I am thinking more in the area of government rules or regulations, for example, like the escrow, the lack of a rollover. I know Canadians have a different mindset, but I am thinking more of the regulatory area.

Are there advantages, exit strategies, in the States that we have to compete with that are impediments for us? Part of our role here is to come back and make recommendations to the government. Sometimes they are receptive, sometimes they are not. We are looking for thoughts and suggestions from you people.

Mr. Sayegh: I repeat, I think the formation of a national stock exchange will be a very positive step, and I cannot say enough about how the escrow provisions are substantial impediments to creating a favourable exit environment.

Senator Kelleher: I guess we are fairly clear in that area.

The Chairman: Gentlemen, thank you very much for coming. I trust you were delighted to find that it is possible for bankers to have a sensible discussion on business issues with parliamentarians from Ottawa.

Honourable senators, our last witness this morning is Mr. Dave Smardon, the Managing Director of Nibiru Investments. I asked Mr. Smardon if "Nibiru" is an acronym and he said that it is not. As an opening, can you tell us where the name comes from?

Mr. Dave Smardon, Managing Director, Nibiru Investments: Sure. Nibiru was formed back in 1990 by three individuals who came out of Apple Computer. We were running Apple Computer's venture capital organization here in Canada. It was called the Strategic Investments Group. When we left Apple we had a number of names that we had thrown onto a white board. We sent our administrator to register one of the four names. She came back empty-handed saying that they were all taken.

"Nibiru" came out of a book that one of us was reading. It is Sumerian from Mesopotamia. The Sumerians are credited with being the first culture to track the stars and planets, the first to invent the wheel and the first to invent irrigation canals.

There was a technology component to the Sumerian organization, and "Nibiru" means "giver of life" in Sumerian. Since we left Apple, what we have done in some respects is give life to technology companies by putting capital and people into those companies. So that is where the name comes from.

The Chairman: I expect that you had no trouble getting that name when you searched the registry, because there was no one close, right?

Senator Kenny: Sumerians also invented the capital gains tax.

The Chairman: Thank you very much for coming. I was genuinely interested in the name. Please go ahead.

Mr. Smardon: Thank you, Mr. Chairman and members of the committee. It is a pleasure to be here.

I have a paper but rather than reading it I will just go over some of the highlights and I will leave it for you to review.

I have already talked a bit about the Apple experience, but our focus is on emerging technology companies. I wanted first to give you our definition of "emerging." From a revenue perspective, we like to see a company that has $1 million or more in revenues. On rare occasions only will we get involved in companies that have less than that.

The reason $1 million is a key mark for us is that a product or a service in the marketplace has to have been proven. There has to be a customer base that says that the product is needed and wanted. That helps us with our due diligence processes.

If you are investing in start-ups, you do not have that track record of revenues and, therefore, you have to make a gut call as to whether or not that product or service will be a viable one. Thus, emerging for us means $1 million in revenues.

We also have a hands-on model, which I will go through in a little more detail. The hands-on model puts capital and people into SME businesses. To us, hands-on does not mean taking a seat on the board of directors and from time to time looking at the business and talking to the president and helping him out as the director may feel is required. Hands-on means being in the business every day or every second day. It means taking responsibility for certain tasks that are required in that company and then taking an approach that allows us to exit from the management tasks over a period of six to twelve months.

I think you have seen from previous presentations that the typical early-stage to emerging-stage company in Canada has fewer than 10 employees. There will be one guy in the business who is a visionary, a jack of all trades. The company will have someone who is probably very technically sound but the management team is missing a great deal of experience. For that reason, they will be turned down by traditional investment organizations and venture capitalists. They will not be able to raise the capital.

We come along and we see that we have an opportunity here to put some money into the business and to add value to that business by putting people in wherever that management team needs to be augmented.

For example, if in a particular stage the company needs to have international sales and marketing agreements put together, we can do that for them. If they are in the process of going public and need a chief financial officer, we can provide one. In other words, we can put people into a variety of areas in those companies to make those businesses stronger.

Let me take a step back for a moment. This model -- putting your capital into the business and taking a look at the corporate structure of a company and saying, "I have a person that knows distribution. I have a person that knows product marketing. I will put them in that business for the next four months on assignment" -- is not new. Newbridge in Ottawa does a variation of that. Apple did that back in the 1980s and it was successful. We invested in about 35 companies in Canada and probably 400 or 500 companies in the U.S., from very small amounts of capital, $100,000 or so, up to several million dollars.

As people left Apple, they took their experience to other venture capital organizations and they are now dispersed amongst the Silicon Valley venture capital organizations. We find that the hands-on model is now being used quite extensively in San José, in Seattle, where there is a new regime of venture capital firms, and to a lesser extent in the Boston area. Boston has not been quite as proactive in getting involved in day-to-day management.

The following are examples of companies in California: Sequoia Capital, Benchmark Capital, Accel Partners, Draper Fisher Jurvetson, and Advanced Technology Ventures, also known as ATV. And there are many more. Those organizations may be doing some later-stage financings as well, but on the earlier-stage financings, they are arranging for people to be put into the businesses.

Kleiner Perkins Caufield and Byers, which is one of the most well-respected and well-known venture capital firms in the United States, has recently signed an agreement with Stanford University. To get early-stage financing from them, you are required as part of the investment to take a series of entrepreneur courses at Stanford University. That is a different way of approaching the same problem.

In the studies that we have done, and they were quite extensive, we looked at the venture capital firms particularly in Seattle and the Silicon Valley. We have found that the newer firms are not managed solely by investment bankers but, rather, they have significant industry expertise amongst the management team. Quite often they are founded and managed by the very entrepreneurs that have run successful, high-tech, start-ups in the past.

As a result, those firms have a greater understanding of the entrepreneurial mentality. They conduct far more intensive due diligence because they have a greater understanding of the markets in which they are investing. They are focused on specific industries. They are not broad-based. They recognize the higher risks but also the greater potential of returns from investing in those sectors in companies in those stages. The most significant fact is probably that those venture capital firms value-add beyond their capital.

At the risk of being taken to task by my compadres in the Canadian venture capital industry, I will say that I think you would have great difficulty putting your finger on a company in Canada that provides that level of expertise in value-adding to their portfolio.

Why is this particular model so important? Well, first, it is highly successful. Again, the studies we have done show that those companies are getting quite significant returns. Second, it provides an environment for investment capital to reach firms that would otherwise have been turned down by traditional investors because of lack of experience or because the company is too early-stage or even because the venture capital firm or investment banker simply does not have the expertise to review and assess the risk and the potential of the business.

The model recognizes the importance of relevant operational experience, particularly at the critical growth stages of the company. Nibiru was formed in part because the model does not particularly exist in Canada, and that is why we are currently out in the marketplace attempting to raise $80 million.

A greater control is placed over these companies from the very outset. Quite often in Canada and in many firms in the United States, a person will be parachuted into a company when that company is in trouble. By that time there are already problems and somebody has to get the company back on track and bailed out.

Instead, it is important to go into those companies at the early stages to prevent problem situations from arising, to control the direction of the company, to control the expenditures of the company, to keep the company on track and to be there when the second and third rounds of financing are required.

There was some talk yesterday about the example that we have heard over and over again in newspapers where a Canadian venture capital firm invests in ten companies; two of them do really well, six of them maintain their level of return and the rest go bankrupt. That is totally unacceptable in these new models.

If you have people in those businesses and you are there to look at the issues that are coming down the pipe, then you are also there to head off the hurdles that are coming at this company and you can change direction with that company. You can change its business. You can have it acquired. You can acquire someone else. The experience in these nouveaux venture capital firms is that one in 25 businesses has a problem.

I should like to talk just briefly about what we call the corporate life cycle, and I have provided a graph. Basically, there are five phases that any company, not just a technology company, goes through. The first phase is the R&D phase, which in Canada is serviced mostly by seed capital. The question has to be raised: Where does the seed capital come from? There are a few seed capital funds in the marketplace but there is not a critical mass of seed capital available.

I believe I heard it mentioned in yesterday's discussions that angel investors are involved heavily in seed capital. I would disagree with that. I would say that only the most progressive angel investors are involved in seed capital. The risk in that business is so very high that most of the sophisticated angel investors that I know would not touch seed capital. They are looking at the same deals that the venture capitalists are looking at.

After you have completed the R&D on your product or service, the next phase is the emerging phase. Now you are out in the marketplace selling your product or service. These are companies that have anywhere from $250,000 in revenues up to $2 million or $3 million in revenues, but they are definitely pre-IPO.

Now, it can be argued truthfully that a number of venture capital firms do invest in this area, but if you were to go back, as we have done in our research, and look at their portfolios, you would find that that is not their focus. It is more the exception than the rule. Most of the organizations prefer to invest in later stages like accelerating which is just pre-IPO and post-IPO opportunities. I am painting with a very broad brush here, and of course there are exceptions. Typically, venture capitalists prefer the pre-IPO opportunities while institutions prefer the post-IPO stage.

There is a gap in the marketplace, the highly underserviced market in the seed capital and emerging marketplace here in Canada. That same gap really does not exist to the same extent in the United States.

Let me make a couple of comments and then I will turn it over to questions. Statistics can be very misleading. I think approximately 46 per cent or 50 per cent of the venture capital dollars in Canada come from Quebec. It is important to realize that the majority of those dollars are reinvested back into Quebec firms. Very little Quebec venture capital goes outside the province. Therefore, it is important to note, while the Quebec capital industry is healthy, that does not necessarily mean that the Canadian venture capital industry is healthy.

The rest of Canadian venture capital is dominated by labour-sponsored funds. Working Ventures is the largest of those outside Quebec.

The majority of the labour-sponsored funds are located in Ontario. That is a problem for you if you are an SME located in Prince Albert, Saskatchewan, or in Halifax. Then where do you get access to the money?

Another point that was recently brought to my attention is that the labour-sponsored funds in Quebec are allowed to invest in other funds, and they have in fact done so. I would suggest that the Senate committee might want to look into that from a legal perspective.

Ron Begg and Jim Hall from Working Ventures and others in the industry have indicated to me that they are prevented from doing that by their corporate structure, their corporate governance. They are not allowed to invest in funds. They are allowed to make only direct investments. They are a logical source of capital for venture capitalists like myself and the others you had here yesterday to go to in order to create new funds for the emerging marketplace. Thus, it is a preventative issue.

The Canadian venture capital community is largely unspecialized, being made up of a large number of broad-based investment bankers. I would say that there is too much investment capital concentrated and too few investment sources, and that does not help the SMEs. My suggestion is not to take money out of those sources but to create new sources.

I think a couple of comments were made yesterday with respect to how labour-sponsored funds have perhaps squeezed other sources of funds out of the marketplace. I think that is true, although it is difficult to prove. We have heard from U.S. organizations that have complained vehemently about labour-sponsored funds in Canada and the tax considerations that they have.

Let me cut to the chase here: I should like to see the committee consider how to get the labour-sponsored funds more readily able to invest outside of their provinces and to invest in funds, and it does not really matter whether those are mezzanine funds or start-up funds or a variety of industries. I think that is an important piece.

The second piece is this: The venture capital community in Canada must have the support of institutional investors, particularly in the private equity side. Currently, insurance companies and pension funds, with very few exceptions, do not invest in private equity deals. They are almost entirely debt-based financing.

Therefore, if we are considering providing tax incentives to the angel community, I think we would be remiss not to look at the institutional investment community as well.

Had you asked the gentlemen yesterday where they got in their funds, how much they raised and how long it took, you would have found that a few high net worth individuals had seeded the fund and that money was leveraged from other institutions. In other words, if you raised $30 million, you might get $5 million from private individuals. It is critically important for the institutions to be involved.

I think there are some things that can be done to augment the creation of new funds. Again, it takes a long time to create a fund. It takes a lot of capital to create a fund, anywhere from $250,000 to $500,000 of private money just to get the fund up and running. That puts that business out of the reach of many very experienced individuals who come out of the venture capital market or the investment banking market. I think there are things the government can do on that fund.

Senator Angus: You have brought yet another focus and perspective to the issues. I did see you sitting here yesterday; you have obviously been following our deliberations with interest.

I was struck by your comment about angels not investing in seed capital. We have really been given a total immersion in this subject, and we may mistakenly be using the term "angels" synonymous with "love money." That may have been why you got that impression.

Let us focus on the love money that, I gather, is available for seed capital. It would be the type of money that the entrepreneurs we heard yesterday would have had recourse to for their start-ups. Could you tell us a bit about love money, so that we get it clear? I believe that it was Mr. Begg on the first day who told about love money being at the first tier.

Mr. Smardon: Love money typically comes from friends, uncles, relatives and professional people with whom you have an association, and you are able to raise the love money because of who you are. If they like Dave Smardon, then they will come to the table with $25,000 a piece and I end up with my first $250,000.

Senator Angus: Would it include your own money, your own savings? We did ask one of the chaps at lunch the question you just suggested about where his money came from. He said that he needed $2.5 million. He put up $1 million and his uncle put up so much.

Mr. Smardon: I think you will find that, generally speaking, the entrepreneurs will put up some capital but the reason they are going for love money is they have limited access to capital.

We tell people, "Never put your house up." In the hard-nosed venture capital model there is a tendency to say, "Well, what have you got in this business? Is your house up on the line for this?" I would never suggest that somebody do that. I think that is naive and ignorant of the situation. However, they will take their lines of credit. They will put in their savings and they will match that with love money.

We do see many people come to the table with no money to put in but they have a great idea. They are at an extreme disadvantage because even their friends will say, "What are you putting in?"

Senator Angus: You mentioned the gap that exists with seed capital and you mentioned early accelerating phases or emerging markets. Could you just define those stages again?

Mr. Smardon: We see a lot of business plans from organizations that have less than $250,000 in revenues. While that is a great start, that could come from one client and that could be the only client that wants this guy's product and maybe he will never sell another one as long as he lives. For that reason, we need to have proof in the marketplace that you have a number of clients and that you have sufficient revenues to warrant our looking at this thing from an investment perspective.

Senator Angus: Do those have to be already established revenues?

Mr. Smardon: Yes. They have to be established revenues.

Senator Angus: There is an earning stream already in place.

Mr. Smardon: Absolutely. One of the best things an entrepreneur does is embellish. We are talking to Microsoft. We are talking to IBM.

The Chairman: Our profession has a similar weakness.

Mr. Smardon: We have to get beyond the embellishments and say, "Show me the contracts."

We have seen situations where a business has no revenues but does have a contract with a large firm that promises to pay $1 million in revenues over a certain period of time. That business could qualify if other criteria are in place.

You can move that $1-million mark either way by $50,000 or $75,000 or $100,000, but the bottom line here is that there has to be a proven track record for the selling of the product in the business.

Senator Angus: You mentioned that the gap that you have described does not exist in the United States. Who fill the gap in the U.S.? That is a key area for us. Hopefully, the result of our deliberations will help to fill that gap.

Mr. Smardon: It does not exist to the same extent because of the proliferation of dollars available, and keep in mind I am talking mostly about high-tech here. That is where our experience is. There is a proliferation of various forms of funding from high net worth individuals. There are so many of them down there who have taken their companies public and who are now dabbling in the marketplace. You may be aware of an organization in California called a Band of Angels.

Senator Angus: They are around on the Internet.

Mr. Smardon: Absolutely. They are the president of Sun Microsystems, the president of Apple, the president of Yahoo -- the who's who of the high-tech industry. When they look at a business, they want to see a potential for $35 million to $50 million in revenue, and these are typically businesses that have no revenue.

Senator Angus: Are they loveable angels, love money angels?

Mr. Smardon: I think the term "angel" is a misnomer, because those people are as hard-nosed as anybody. But they do have the capital available. They have the industry experience to look at business opportunities and they have access to know who in the marketplace is already doing this or, if no one is doing it, why not. If no one is doing it and it is a great opportunity, let us put the money in.

Senator Angus: Are you talking about the seed capital, the emerging stage?

Mr. Smardon: Yes, right at the seed capital stage. I should comment that the Canadian high-tech community is not very old. There are not that many entrepreneurs out there who have been there and done it with very successful firms. The Dennis Bennies of this world who have done it and who have formed a venture capital firm are very unique. Many people who have had that success disappear for a period of time saying, "I worked 18-hour days to get this company up and running. I did it for five years. I want to rest."

I have personal friends who have done so well in a company that they are now each worth about $22 million as a result, and they are under 30. They have no intention of investing in any more high-tech businesses for the next five years. One of them is going back to university. One of them is taking pilot lessons. One of them wants to go to the Caribbean for a couple of years. That is the sort of thing you have to deal with with angels.

It is also important to understand that the different age groups within the angel community have different objectives. My father, who has done well working for Proctor and Gamble for 38 years and who has a nest egg, will never put that nest egg out into the Internet stocks. You have to consider where individual angels grew up, what they are interested in and what their objectives are.

Senator Angus: Does the band of angels and their ilk fill that gap in the United States?

Mr. Smardon: Yes.

Senator Angus: I understand that the model you described is focused on the high-tech and not the biotech, for example.

Mr. Smardon: Not biotech, no. You could do it with biotech, but we do not have that experience.

Senator Angus: In that model that you described so well, you said that there is a value-add beyond putting up the money. Could you itemize the value-add so that we have a clear sense of what it is?

Mr. Smardon: I can give you an example that is fairly close to home. There was a software company here in Canada that was generating about $50,000 a month in revenues on the Internet. They had been trying desperately to get hold of the presidents of Apple, Adobe, Macromedia, Sun Microsystems and a variety of others because they felt that their product could be bundled with those vendors' products.

Senator Angus: We are talking electronic commerce here all the way.

Mr. Smardon: Yes, absolutely. We stepped in; we know people at the high levels at all those firms, just as the venture capitalists in the U.S. would know. In a matter of four or five phone calls in a couple of weeks, we had meetings in front of all of them. We came away with two bundling deals that took the revenues of the company from $750,000 a year up to about $4.5 million.

That is value-add. That is what the entrepreneurs are looking for nowadays. I am talking about more sophisticated entrepreneurs. If you are coming to the table saying, "I want 30 per cent of your company," you had better have more than just capital to put up. And, as I said before, while sitting on the board of directors is of value, it is not enough value.

Senator Angus: Is going to Stanford part of the value-add?

Mr. Smardon: I have not experienced that model but I assume that they must have some very good programs there, although I have not looked to see exactly what they are teaching.

Senator Angus: I take it though that the expression "hands-on" used to describe the model means, as you say, things like contacts that led to that bundling and explaining to them about the availability of different tax plans or government grants or whatever.

Mr. Smardon: Yes, government grants. There is a tremendous education that needs to be done with the SME management. In the example that I gave, those deals were negotiated as a result of us placing two people into that company for about three months from start to finish. Now, the deals did not take three months to put together. But in order for us to appreciate the skill sets of the management team, where the focus should be and also underscore the critical success factors of that business, we have to be in there.

Let me take a step back and talk just briefly about due diligence. Our due diligence process puts an individual into a business for a minimum of two weeks and a maximum of four weeks. He eats, sleeps and breathes with the management of that company. When he comes back, he knows what has been embellished and what has not. He knows what skeletons are in the closet.

Senator Angus: He has seen the contracts.

Mr. Smardon: Absolutely. He also knows the capability of that management team to do what they say they can do. If they say that they can generate $25 million in revenues in three years, we now have a much better appreciation for their skill sets and we know the strengths and weaknesses of that firm. That is critical to being able to make the right decision at those early-stage companies.

Senator Oliver: What is the profile of the people who do that? Do they have an M.B.A. or what?

Mr. Smardon: No. In fact, we have only one MBA in our group. Everyone in our group has 20-plus years in the high-tech industry. There are three of us who have done time in the high-tech industry and have done time in the venture capital industry, but the rest of the group are operating people. They have worked for IBM and Unisys. They have done start-ups. They see the signs. When there is something on the horizon that does not look right, they see that very quickly, and they start to go into a fix-it mode, if you will.

So the model is significantly different and the type of people that you deploy are a little bit different.

Senator Angus: You mentioned the Quebec situation. Senator Hervieux-Payette and I are both from Quebec, so we find it interesting to hear you state that 60 per cent of the venture capital funds of the nature you have been describing come from Quebec.

Mr. Smardon: Did I say 60 per cent? It is 46 per cent.

Senator Angus: I must have misheard, but that is still a high number. You also mentioned le Fonds de solidarité; the labour-sponsored fund from Quebec is not subject to the same restrictions as Working Ventures, for example, which I believe is the biggest one from outside. You mentioned some of them, referring to their ability to invest in funds also outside the province. Are those the two most significant differences?

Mr. Smardon: Yes. Investing outside the province is not a legal restriction.

Senator Angus: But it is a policy one.

Mr. Smardon: But it is a policy one, yes. The investing in other funds, I believe, is a legal restriction. I believe they are prevented from doing so.

Senator Angus: The Working Ventures?

Mr. Smardon: Yes.

Senator Kroft: If I may say so, the discussion becomes more interesting every time we have another witness.

You mentioned that the typical breakdown of a venture capital firm's investment in 10 companies would be that two would do well, six would remain stable and two would go bankrupt. Then you said that the experience of these new venture capital firms is that one in 25 businesses has a problem.

I understand that to limit non-performing investments to something in the range of one in 25 can be very much a consequence of effective assistance and what is brought to the company, but is there another implication? I am wondering what that means about numbers of companies given rigidity of tests, which is perfectly valid from the point of view of the investors; what are the implications for companies that are not being funded? After all, the more demanding the profile, the more demanding the template is, the fewer will qualify. That seems almost axiomatic.

I just wondered if you could comment on that, its being sort of the other side of that coin.

Mr. Smardon: I am not sure I heard the question correctly.

Senator Kroft: Well, it may not be a problem for you, but in the macro picture it is a problem. If the test for funding an investment gets narrowed so much that it is to the very few who will be able to sustain a one-in-25 rate, does that mean that the risk-taking level has been substantially reduced? Are there others, then, who are being passed over, who in a more liberal risk-taking environment should be or would be qualifying for investment?

If you make the test too tough, then nobody will get any money. If you are looking for one in 1,000 only to be bad, nobody would get any money.

Mr. Smardon: I would argue that the exact opposite is true, if you have this model in place, particularly in Canada. For the sake of argument, let us say that an enterprise goes out to raise $3 million and its management team is suspect, in that it does not have the experience that perhaps might be required; then your traditional venture capital community will say, "You need to solve these particular issues before you come back to us; otherwise we will probably not put the money into your business."

They come to an organization like ours, or like one of the groups in the States. and the management issue is not as significant, because we will correct that over the longer period. So it becomes an issue of whether the product stands up on its own; is there a global marketplace for it and is there sustainable growth?

If the answer to those three things is yes, then that venture capital will be put in. So there are more companies that will receive the capital rather than fewer. The criteria are very different from the criteria for the traditional hands-off or passive venture capitalist.

Senator Kroft: Going on from there -- and I may have missed this as you went through or in my quick reading -- what is your approach on exit? What are your terms on exit strategy?

Mr. Smardon: Let me give you some approximate figures: probably 55 to 60 per cent of the firms will be acquired or will acquire someone else.

Senator Kroft: On a non-IPO basis?

Mr. Smardon: Yes, on a non-IPO basis. Probably 25 per cent to 30 per cent will be IPO and the rest will be refinanced in some capacity.

Senator Kroft: Do you set time frames in which you expect your exit to happen?

Mr. Smardon: Yes. Our exit is a little more aggressive, but that is because we are controlling a lot of what is taking place in the company. Typically, we are looking at an exit of over 36 to 48 months.

Senator Oliver: That is a short time.

Mr. Smardon: Yes.

Senator Kroft: That is very much on the fast side, compared to your marketplace.

Mr. Smardon: Yes. That, in fact, has been a major selling point with the institutions we have been approaching, because they are used to seven to 10 years, and they are looking at liquidity after 48 months.

Senator Kroft: Let me ask you a more general question. With the knowledge that you have of the marketplace, and listening to all the discussions, which have been interesting for us but probably have not added to your total knowledge, what is your view as to the adequacy of venture capital funding for SMEs in the Canadian marketplace? There is then the broad question as to whether there is any balance between supply and demand or is there a great imbalance one way or the other?

Mr. Smardon: First of all, there is lots of capital in the marketplace. The problem, as I perceive it, is where that capital is located. We are drastically improving. There are new funds, and new venture capital organizations are springing up across the country; most of them are fairly small, but they are still very important.

I believe that there is an abundance of good investment opportunities. There are more opportunities out there than there are venture capital firms to put money into them.

The biggest issue that I see is that all of the venture capital firms are looking for the same deal and, as mentioned earlier this morning and also yesterday, they are all participating in the same marketplace. Whether it is in high-tech, biotech or something else entirely, they are looking for the management team that is already in place and experienced. They are looking for sales that are already there, and whether they are in the range of $1 million, $2 million, or $3 million, the minimums are somewhere in that range, depending on whom you are talking to.

So the SME, when considering where to raise the money, will go to the same source every time. He will go to Ventures West. He will go to the banks that you saw here earlier today, two of them anyway. He will go to Jefferson Partners, McLean Watson, and the BDC -- obviously, he will go there as well -- and one of the two people we had on earlier, like Mosaic, for example.

So that list is fewer than 10 that you will go to. The criteria of those 10 are somewhat similar, so that, if you get turned down by one, the chances are you will get turned down by the other nine. Then you are back into love money, angel money, and you are also into taking the company public prematurely, because that is the only way you can raise your capital.

Senator Kroft: Just following on that, it seems that in setting your criteria, the most obvious one that you do not set down is that you want to make a ton of money doing it; that is probably the first one.

You have been convinced, educated, seduced -- whatever is the right word -- into believing that the world of high-tech is where your fastest and best payoff will be, whether it is on the IT side, the bioscience side or some other area of new technologies. Presumably, you made that decision, because that is where you are concentrating ,or a subcategory within that.

We have only had one presenter in front of us in two days who suggested that that was not his focus. To me, that is a pretty important contributor to the problem of inadequate distribution of investment opportunities, because, much as the brokers and the Internet would want us to believe otherwise, there are other businesses of different kinds out there that are functioning and worth investing in.

I am kind of struck by the suggestion that all other business in Canada seems suddenly not to be attractive enough to be pursued by the venture capital area. I have been waiting and waiting. Lots of people in this city and across this country have done very well in all kinds of businesses, and they will continue to, and yet here you are saying that there are not many places to go.

If you get turned down in one place, it is probably because you have narrowed the scope to such an extent that you are all looking at the same place. You are all chasing the same deals. You have decided that the profile of the deal that is worth doing is so narrow that there are not that many places to go; that is why you complain about Canada, because there are not many of them, and there you are. Yet we have this whole industrial world; we have this whole service world; we have all these other things and basically you are saying they are not worth investing in.

Mr. Smardon: I am not saying that.

Senator Kroft: I am telling you that I am sort of left with that impression at the end of a couple of days.

Mr. Smardon: I should say the real reason that we are doing technology is that I ended up in the technology marketplace totally by accident. I do not have a high-tech background from a university. I had an investment background, a business degree; but I found myself in the high-tech world in the 1970s and, quite frankly, I could not get out of it. So here I am in my 40s and now I am focusing on the things where I have experience.

I think there are places to go for very specialized activities. There are medical funds out there. There are oil and gas funds. You can go to Abitibi, if you have a paper-product type of venture, or you can go to MacMillan Bloedel. There is a whole host of what we call strategic investors who are already in the industry and are selling products that have venture capital or investment dollars available to them.

We are in this market first and foremost because it is what we know. Secondly, it is also one of the highest growth marketplaces. If you look at the number of investment opportunities that get presented to venture capital firms -- I am talking about broad-based firms at the Working Ventures level or at the level of RoyNat, and even firms in the brokerage community -- you will that a growing percentage of those opportunities is based on high-tech.

Whether it is a high-tech company or a service company, or a company like Federal Express, based on a back-shot system that is automated through high-tech, high-tech is ubiquitous; while there are other opportunities to invest, the euphoria in the marketplace south of the border, and to a certain extent here in Canada, is surrounding these new technology businesses.

I think Brad Ashley, who was here yesterday, has found a very good niche. If you are a manufacturing firm looking for investment dollars, that is the first place you will want to go. But, again, what happens if you go to Brad and, for whatever valid reason, you do not get the money? Then where do you go? That is the situation that exists throughout Canada: you have only a very small number of sources for the capital and, once you have exhausted those, you are forced into a process that is based on desperation. It is a desperation process.

Senator Kroft: I guess the answer to my question as to adequacy of capital is that, given that these narrowly defined, high-potential deals are there, there may be plenty, if not infinite amounts, of capital for them, but for horizontal access the profile of deals in which those funds are interested is rather narrow.

Mr. Smardon: Yes.

The Chairman: In your written text you made the statement that there are no incentives for institutional investors to support private-equity funding; then you went on to talk about the desirability of institutional investors doing private-equity funding. Why should tax policy create an incentive to get private investors, to get institutional investors, to do something that presumably is in their economic interest, if, in fact, the private placement is a good investment? In other words, to what extent do we, in effect, skew the market by putting in place an incentive? Is that what you are saying? Or are you saying that there is actually an impediment to their doing it and we ought to get rid of the impediment?

Mr. Smardon: It is a combination. There are impediments in the marketplace. I think mostly there are cultural impediments. As Mary Macdonald expressed the other day, back in the 1980s pension funds and insurance companies were investing in SMEs in the U.S. and Canada; however, for a variety of reasons, partly because of the newness of the venture capital industry, many of these firms got very poor returns on their investments and they decided that they would no longer be in this business. They got out of it.

The U.S. pension funds and the U.S. insurance companies have come back into the marketplace. The Canadian ones have not. I do not want to name the firms, but in doing our research we spoke to a number of pension companies that said, in essence, "We blew our brains out in the 1980s and we are not going back to technology, and we are not going back to private-equity investments. We need to have liquidity in our funds." So, based on some history, which is now 15 years old in some cases, they are not investing in the marketplace.

Brad Ashley mentioned, and I think a couple of other people mentioned as well, that you need a level playing field. I think there was a good reason to create the labour-sponsored venture capital funds; they have performed a service to the overall venture capital community, but I think it has been to the detriment of the institutional investors, because, again, the labour-sponsored venture capital firms are focused on private individual dollars, not on institutional dollars. So there was no mechanism to prompt them to have a change of strategy or a change of culture.

The Chairman: So it is partly an impediment.

Senator Meighen: Is it your conclusion that the problem of institutional investment will be taken care of by time?

Mr. Smardon: It probably will be, but my question is: How much time will that take?

The Chairman: Well, changing capital gains tax rates particularly targeted at start-up-type or embryonic-type smaller companies would have that impact directly.

Senator Kroft: Not in the pension funds.

Senator Meighen: What would help then -- a rollover?

Mr. Smardon: The other aspect to pension funds and insurance companies is that, like anybody else, you invest in what you know. We are at a disadvantage, in that many of the industries, whether they are in environmental, biotech, medical or information technology, are all fairly new industries. How do you develop the expertise within the investment community to be able to look at these new opportunities and say, "This is a good investment opportunity and that is a bad one?" Until they have that expertise available to them, I do not see them changing their posture.

One way of making this expertise available to them would be by investing in funds that focus on those things because, if you have to wait for them to hire the people and grow their skill sets inside, you have a very long wait.

Senator Hervieux-Payette: The hands-on theory seems to be producing great results, but I have also a sad story of a hands-on Quebec investment where the difference of opinion between the fund and the entrepreneur ended up before the courts; that cost a couple of people a lot of money, but they won their case, and they were fighting a fund, just to tell you that.

How do you solve the problems when you have a difference of opinion? I ask that because the fund went there and wanted to run the show and there was an endless battle; my impression was that the people in the fund at that time did not play the role they should have played, which is to educate people and work with them as a team rather than being confrontational. I think you have to look at the other side of the story, because this case was a very sad event.

Mr. Smardon: One of the biggest issues facing venture capitalists is shareholder discontent and ownership discontent. Certainly, as a passive investor there is very little you can do about that. As an active investor, you have a few more controls, but you cannot prevent it completely.

When we meet with the ownership and the management of an SME, one of the first things that we learn is the short-term and long-term personal agendas of the owners. You hope that they are synchronized, because, if one of the owners is looking for a stock play and wants to get out of the business in 18 months, and the other owner sees this as an $80 million business and wants to ride the wave, then right there you have signs that you will have some issues with respect to decision-making for the company. So we do it; it is part of the due-diligence process that we get involved in to understand both the capabilities of the management team and their mindset. What are the personal and corporate objectives in this business entity?

We have had some experience with shareholders who did not agree, but there are usually ways around it from the standpoint of buying out the shareholder. Keep in mind that quite often a shareholder also happens to be a member of the management team. Therefore, another aspect is that you can move him to the side or give him different functions. There are many of ways of dealing with the issue, but you cannot eliminate it.

Senator Hervieux-Payette: From your own experience, when there are major differences, how do you solve the problem? Going before the courts is certainly not very helpful.

Mr. Smardon: To be honest, we have not had very many of those situations. Perhaps we have not had them because of the amount of work effort that was done up front going into the arrangement. We had one that reached this point, but we were able to deal with that without going into the courts.

The Chairman: Mr. Smardon, thank you very much for coming. I must confess that I am intrigued by your hands-on model.

The committee adjourned.