Proceedings of the Standing Senate Committee on
Banking, Trade and
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
Senator Michael Kirby (Chairman) in the Chair.
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
I really cannot comment on the regulatory nature in the States as opposed to
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
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
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
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
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
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 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
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
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
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
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
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
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
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
"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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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
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'
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
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
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
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
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
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
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
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
The Chairman: Well, changing capital gains tax rates particularly targeted at
start-up-type or embryonic-type smaller companies would have that impact
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.