Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 47 - Evidence, March 18, 1999
OTTAWA, Thursday, March 18, 1999
The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:00 a.m. to examine the present state of the financial system in Canada (Equity Financing).
Senator Michael Kirby (Chairman) in the Chair.
[English]
The Chairman: Senators, we have appearing before us Mr. Michel Ré, Senior Vice-President, Emerging Markets for Business Development Bank of Canada. He is also appearing in his capacity as Chairman of Réseau Capital, which is an organization in Quebec that brings together key players in the Quebec investment industry.
Following our discussion with the witness, we will have a brief in camera session to finalize the letter to the Department of Industry on the subject of joint and several liability.
Mr. Ré, please proceed with your brief. Then we will turn to a series of questions.
Mr. Michel Ré, President, Réseau Capital and Senior Vice-President, Emerging Markets, Business Development Bank of Canada: We have prepared a kit that includes an economic impact study sponsored by the bank on the impact of venture capital in Canada. There are brochures on the activities of the bank, as well as my submission.
Mr. Chairman, it is a pleasure to be here today as the current president of Réseau Capital to discuss venture capital in Canada and, in particular, the market in Quebec. Réseau Capital is an association of Quebec-based venture capital investors and business professionals: lawyers, accountants, brokers and bankers. Our association has 460 individual members and it provides a forum where they can develop mutual connections for investment projects and get access to capital for small business. About half of Réseau Capital's membership comes from the venture capital companies operating in Quebec. Those companies have $4 billion in capital under management.
In my position at the Business Development Bank of Canada, I am responsible for our Venture Capital Division and for our quasi-equity activities. We manage a portfolio of more than $5 million in loans, quasi-equity financing and venture capital for Canadian small business.
The Chairman: Mr. Ré, I normally do not interrupt an opening statement, but in this case you have used a term I do not understand. Can you define for us exactly what you mean by "quasi-equity"?
Mr. Ré: For a long period of time, the financial instruments that you had in the market were term loans and venture capital at the other end of the spectrum. In the mid-1970s, when there was a problem with interest rates, a new kind of instrument was developed called sub-debt. The sub-debt is a debt with no tangible security. Usually, you will have what we call an "equity kicker" with it. It is a loan with a right for the lender to get a certain portion of the company. That is a sub-debt. When we refer to quasi-equity financing, we are referring to all the financial instruments that are not pure venture capital and that are not term loans.
The Chairman: In other words, you are talking about an instrument that is not pure debt and not pure equity and that typically is in the form of a subordinated debt of some kind with a right of conversion to equity, presumably on the option of the lender, not the person who is actually borrowing the money. Is that correct?
Mr. Ré: Yes.
The Chairman: Perhaps you would like to go ahead with your presentation. Then we will come back and ask you questions.
Mr. Ré: To keep my opening remarks brief, I will not repeat all of the national statistics that you have already received or will likely receive from others. However, I should like to mention that Réseau Capital supports the recommendations put forward by the Canadian Venture Capital Association. In particular, we are in full support of their recommendations on the proposed national escrow regime and the associated company rules.
In Quebec, there are at least 94 sources of venture capital. That is the number of venture investment companies represented in Réseau Capital. They provide capital investments ranging from $2,500 to $25 million. The smaller amounts are available principally from various regional investment funds that are sponsored by the Fonds de solidarité des travailleurs du Québec, Caisse de dépôt et placement du Québec or Desjardins.
While investment activity data for last year are not yet available, I do have data that show the growth trend in the capital under management and the capital available for investment. I will refer you to graph number 1. Further, there has been a growth trend in investment in Quebec. I should like to refer you also to graph number 2.
For the first nine months of 1998, there were 303 venture capital investments made in Quebec. They represented 43 per cent of all deals done across Canada. If we look at the amounts of money actually disbursed, Quebec-based companies received $389 million in the first nine months of 1998, representing 36 per cent of all disbursements across Canada.
There is a notable feature to those transactions. Smaller deals account for a significant share of that activity. I mention that because one of your background papers refers to the limited availability of venture capital under $1 million. While that may be the case in other parts of the country, two of every three venture capital investments made in Quebec are for amounts under $1 million. The average size of those investments under $1 million is about $300,000.
Mr. Chairman, these numbers show that, one, the venture capital market in Quebec is one of the most active in the country and, two, smaller Quebec companies requiring less than $1 million do have access to venture capital. I would add that Réseau Capital, in bringing together investors with business professionals representing small business, is playing a positive role in that active market.
I should like now to speak about the impact of the Business Development Bank of Canada's activities in the equity and quasi-equity market. BDC started its venture capital group in 1983 at a time when there were few sources of venture capital in Canada. What did exist then was concentrated mainly in southern Ontario. Senator Kroft, who was a director on BDC's board at that time, played a major role in creating the group. The basic principles he helped establish have been the main reason for BDC's success over the years.
Since 1983, BDC's investment activities have evolved as new sources of venture capital have entered the market, but two characteristics have remained constant. First, BDC has always been a market leader, finding innovative ways to address emerging demands from fast-growing small businesses and enticing others to follow. Second, since inception, the BDC venture capital group has constantly recorded a positive return on capital greater than the government's cost of funds, which is its mandate. That has allowed the group to turn over the government's original $55 million in investment four times, for a total of $228 million worth of investments. Furthermore, BDC's investments have generated over $800 million in co-investments from other investors.
I should like to cite two examples of BDC's role in venture capital, that is, in creating innovative instruments to address emerging market needs.
Until recently, finding seed capital for technology companies in their very early stages was close to impossible. Such companies were simply not on the radar screen for venture capitalists. BDC recognized this need but could not tackle it alone, due to its limited capital resources. Thus, three years ago we worked with others and convinced them to create new, specialized seed capital funds. In Western Canada, Bank of Montreal, B.C. Pension Fund, Ventures West and Cascadia Pacific came together with BDC to establish a $25-million seed capital fund for technology companies. That was quickly followed by a partnership with SOFINOV and Innovatech to establish a $62.5 million seed capital fund in Quebec known as T2C2 and another partnership with the Bank of Montreal to establish another seed capital fund of $25 million covering Ontario and Atlantic Canada.
[Translation]
This is how the bank keeps a front-line position in the risk capital industry, and subscribes proactively to the MacKay task force recommendation that financial institutions continue their initiatives aimed at industry, placing emphasis on seed money and risk capital, and giving preference to a high rate of investment in these innovative industries.
The influence of BDBC in the creation of seed money funding is not limited to the companies with which we have direct involvement. We have paved the way with our partners and are now seeing seed funding being created by other risk capital businesses without BDBC involvement.
BDBC also maintains a lead role in the form of quasi-equity funds for small and medium businesses. Many rapidly expanding SMBs are incapable of generating the rate of return generally associated with risk capital, or more simply refuse to share ownership of their business with outside investors. Because of their rapid growth rate, their financial requirements are far in excess of the conventional financing available to them.
Recognizing that the risk capital industry was not meeting these needs adequately, BDBC created innovative quasi-equity funds instruments to complement the risk capital funding it was providing. Venture loans, patient capital and the CDB working capital for growth fund, products that are better known as junior debts, are leading the market field. Their particular target is the financial needs of small knowledge-based and export industries.
The junior debt market for SMBs is not yet much developed. More than 70% of quasi-equity funds available in Canada come from BDBC, and do not exceed $1 million. This represents less than half of the total market by amount invested, at an average of $300,000.
When the Bank oriented itself toward this type of risk capital four years ago, other suppliers of junior funding were essentially handling only investments in excess of $1 million. Since then, following the BDBC lead, some, including certain chartered banks, have opted for the lower-level junior funding market.
[English]
Being a market leader and encouraging others to enter emerging markets is consistent with our mandate. It is a valid role for government and government-sponsored agencies. That is exactly the role BDC plays in venture capital. It has led to the bank increasing its equity and quasi-equity investments in small business nine-fold over the last five years and to significant developments in available sources on financing in this area.
Now, Mr. Chairman, I should like to turn to some challenges for the industry as a whole. As Canadian technology firms have become more active and successful in international markets, their capital requirements have increased accordingly. A typical venture-backed company now consumes about $14 million of private capital before reaching the stage of an initial public offering. Biotechnology firms consume even more, close to $20 million. With this appetite for capital, the Canadian venture capital industry will be hard pressed to keep up with demand from its own clients unless it continues to attract new funds into the market at the same pace that it did in the mid-1990s. There are signs that that could be a difficult task.
The industry has over $8 billion in capital under management. But only a quarter of that capital is available for new investment. That is enough for slightly more than a year's worth of investment. Recently, the industry has disbursed more funds than it was able to raise. Thus, raising new capital remains a serious challenge.
Other challenges for the industry are related to the rising need for capital in two emerging groups of small business. Many successful businesses are reaching the point where owners want to sell out, whether for lack of family succession or for other reasons. In Canada, management buy-out/management buy-in financing is not as developed as it is in the U.S. or the U.K. As a result, management groups have usually been precluded from purchasing businesses that they already operate. Today, more management groups are pursuing the option of purchasing businesses and the demand for capital for those groups will, in our view, grow.
Another group with rising capital demands is small businesses that have been highly successful in exporting their products. For a number of those companies, the next step is to expand operations abroad to take advantage of even greater market opportunities. As they are relatively unknown to financing sources in foreign country, they will depend on Canadian sources for their capital needs. As more Canadian small businesses become successful in foreign markets, the venture capital industry will start to see more demand for capital from these companies.
Mr. Chairman, I will end my presentation here and will be pleased to answer questions from committee members.
Senator Kroft: It is not very often that we have individual attention drawn to ourselves. I am taken aback.
I continue to be interested in the dynamic venture capital market, particularly in the province of Quebec. I know that, over the years, particularly aggressive and imaginative tax policy has been part of this in terms of the small business sector.
If they still run true, your statistics show that B.C. is the other area that runs numbers on successful venture capital at the smaller end, quite out of sync with the rest of the country.
Would you comment on the elements that, in your judgment, have provided that dynamic in Quebec?
Mr. Ré: Half of the money presently available in Canada is in Quebec. Thus, there is a critical mass, which is important, because it tends to specialize and to go more deeply into the regions. For a long period of time, venture capital activities were mainly concentrated in larger urban areas. Now the venture capital funds are more specialized, for example, in information technology, biotechnology and so forth.
The regional funds are also doing a great job because the funds sponsored by Fonds de solidarité des travailleurs du Québec, Caisse de dépôt et placement du Québec and Desjardins have activities in all regions of Quebec. For deals below $1 million, that certainly helps the kinds of activities that Quebec has presently. There is a long background to those activities in the regions in Quebec. At first, National Bank, Solidarité, Desjardins and Caisse de dépôt all joined together to create regional funds. After four or five years, some decided that the experience was interesting enough that they wanted to launch their own regional funds. The original regional funds more or less broke down. We have ended up with more groups having more regional funds and more transactions.
The provincial government has played a role because they backed the operating expenses of the regional funds sponsored by Solidarité. By doing that, they have encouraged the activities of the regions. That is certainly part of the explanation, along with the critical mass, the fact that there is more specialization, and the fact that the money now is going into all regions in Quebec.
The Chairman: I am curious as to what caused the creation of the critical mass. Senator Kroft used the phrase "aggressive tax policy." Is there something in tax policy or government policy or the Quebec stock savings plan or the fact that you have a Caisse de dépôt and nobody else has a caisse? Given the data, it is obvious that something in the Quebec business environment or public policy environment has led to this critical mass. If we could understand what that was, we could consider whether it ought to be exported to the rest of the country.
Mr. Ré: We have the two most important venture capital firms in Canada, Caisse de dépôt and Solidarité. The political reasons behind it are self-explanatory.
In Quebec, wealth is not really based on individuals like elsewhere in Canada. The wealth of Quebecers is more in institutions. Part of the interpretation could be that there is probably more pressure on institutions in Quebec to get involved in financing. The other point is that Solidarité was the first labour-sponsored fund ever. Once again, there is a tradition behind it.
Over the years, all levels of government have made a great effort to put forward regionalization, to put forward regional policy. There is a background in Quebec that the regions are important. There is a background also that much of the wealth is in the institutions. There is a long tradition in Quebec concerning this type of financing.
Senator Kroft: I should like to turn to the seed capital firms that have been created. You have indicated the groups that have come together on that. Could you tell us a little more about how those operate, what the thresholds are and a little bit about their success?
Mr. Ré: Roughly three years ago we recognized that there was a gap in the market for financing of good science. We were doing some seed financing within our normal operation, but we were reacting to situations instead of being proactive, simply because seed financing addressed companies at their earlier stage of development. Most of the time, those companies consist of only one scientist or one inventor with a product that has no commercial features yet. We need to build a company around science and the scientist.
I can speak only for the BDC, but I would say that all other investors had the same reaction. We were looking for situations where the labour that had to be put in was as low as possible. Many approaches were declined simply because they were too labour intensive.
We talked to many people in the market to say that we should like to be proactive in this type of financing. Obviously, we talked to many other venture capital firms. At that time, some of them also said that it was their intention to start those types of activities, but they were afraid, as we were, that it would consume too much labour.
We launched first the Western Technology Seed Investment Fund in Vancouver with Ventures West and Cascadia Pacific, a company from Seattle doing seed financing. We have limited partners in the Bank of Montreal and the B.C. Pension Fund, too. The way it works is that we get in touch with the NRC, various laboratories, universities and hospitals to find the best science that we think could have a commercial potential. The first round of financing will usually be $100,000 to $150,000.
Senator Kroft: By proactivity, do you mean that you go to the NRC or hospitals and so on as part of your due diligence to a deal that has been brought to you? Or do you actually go into those places looking for opportunities?
Mr. Ré: We are trying to source deals. The people that we have hired in those funds are scientists also, and they know where good science is being developed. Most of the time they know the scientists personally. We do that not for due diligence, but more for sourcing a deal.
Once the good science has been identified, usually there is a first round of financing of $100,000 to $150,000. That money is used to protect the intellectual property and quite often to keep up the research or to bring the development to another stage and also to write the business plan. That money will last between six months and a year. We do realize that today it takes a bit more than a year and a bit more than $150,000; however, after that, once we are at the point where the business plan is written, then we can go for a first real round of venture capital financing.
The objective of these funds across Canada is to take the science, protect the intellectual property, and start building a company so that it can become commercially viable.
Senator Kroft: After the seed has been planted and you are into the first round of real financing, what would the structure be of that kind of a deal? Typically, there is not much there in the way of any real assets.
Mr. Ré: At seed financing, you will have at least two rounds of financing because we realize that $150,000 is not enough. The trend is to have more than a round of financing and maybe between $500,000 to $1 million in seed financing. It is a bit more than the $150,000.
Senator Kroft: Would you be taking equity options?
Mr. Ré: Yes, equity.
Senator Kroft: Would you be taking real equity as you go?
Mr. Ré: Yes, only to picture what it would look like. Usually, the first round of venture capital financing will be for approximately $3 million. The investor will have roughly 60 per cent of the company. The scientist and the NRC or the hospital or the laboratory will have roughly 40 per cent of the company. That is roughly the structure after the first round of financing.
Senator Kroft: I am not sure how much history you have. The Americans have done better than anyone else in the world. Whereas most of the world looks at science as something the governments do, the Americans have understood that good science, as you say, can be good business, and it has produced some extraordinary results.
Let us take another step down into a typical situation, if you have real cases to refer to. You are into another round. Can you keep going with the story as to where you have gotten to next?
Mr. Ré: It is important to establish that there are various business models, especially when you are talking about knowledge-based industries. If you are in information technology with hardware, at that first round of financing you will clearly have a product. Because we started quite early in the development stage, usually that product will have a solid differentiation in the marketplace. But this product, by itself, will not make the company. It is more a technology platform than anything else.
For the first round of financing, for the first year or year and a half, we will work with one or two products and see how the market reacts. Then we adjust the products and look at the next products that will be launched. We will work on that for roughly two years. At that point, we will go for a larger round of financing, maybe $7 million or $8 million. Each time the scientist and the laboratories or the NRC will be diluted. But at the end, the value of the company has increased quite significantly.
If you look at another business model in biotechnology, for example, we will identify a compound or something that is quite far from having a drug. I would say we are almost in fundamental research. So we have identified something that is promising. The first round of financing will be around $3 million. With that $3 million, depending on how efficient you are and what kinds of problems you have, you will have pre-clinical and clinical studies done. Usually that $3 million will show you, as an investor, that you have something really promising. Then you will go with phase 1, phase 2, and clinical trials to bring the product to a large pharmaceutical company that will develop a drug. There will be two or three rounds of financing. Once again, the business model is quite different.
During the various phases, instead of having revenues from sales, you will have revenues from big pharmaceutical companies that will sign alliances with you to get the rights on your discovery. You will get some revenues from outside and usually around clinical trial phase 2 you will be able to go public. Then the venture capital firm will take back the money to invest in another one. Those are the two business models that we work with most frequently.
Senator Kroft: How do you feel about the degree to which new players are coming in to play this patient and long-term role? Is that market developing to your satisfaction?
Mr. Ré: In biotechnology?
Senator Kroft: In the financing of science.
Mr. Ré: If you look at the trends of investment in Canada over the last five years, the knowledge-based companies are gaining a larger and larger share of the investment in Canada. The market is growing. At that level we are financing creativity. What it can generate is almost endless. With the quality of the scientists that we have and the quality of universities that we have, we are not close to seeing an end to that.
Senator Kroft: It is a tremendously significant area of investment.
Senator Austin: Mr. Ré, I should like to understand the impact on your industry of the federal government's new innovation program and the $1 billion that is to be made available over five years. Is your instinct that this will be competitive money, that it will displace the current venture capital industry to some extent or do you see it as a marvellous enhancement in creating new opportunities in the capital markets?
Mr. Ré: Canada is in competition with what happens elsewhere in the world. Therefore, the money that we are putting into knowledge-based industries at whatever level is beneficial for our economy and our future. We sponsored an economic impact study to show the impact of venture capital in the Canadian economy. Considering how fast the knowledge-based industry creates jobs, creates sales and pays taxes, anything that can be done to enhance that industry is a plus. I do not see it as competition because that amount of money brings the science to a level where venture capital can take it and run with it to achieve commercial standing. I hope that that money will help to generate more and more proposals.
We were talking about the Americans a few moments ago. We were talking also about critical mass. This money will increase the critical mass of technology. As venture capitalists, sometimes we take a risk with one or two technologies. Imagine if our companies were able to do more technology bundling, to take a few technologies here and there and build a stronger company. I see it as something positive and appropriate if Canada wants to remain competitive worldwide.
Senator Austin: Just to restate your answer, it will stimulate the venture capital industry because it will create more technology and more entrepreneurs with technology who need to commercialize what they have been doing. We actually need more instruments in the venture capital side of it to assist with what you expect over the next five years to be a larger flow of opportunities.
Mr. Ré: Yes, and the amount of money that the knowledge-based companies are consuming before going to the public market is increasing on a yearly basis. A few years ago it was around $12 million on average. Now we are at $14 million. We do not know how the public market will react. At some points the public market is quite open to support those companies and at other points the public market is not. If the public market is not there, the venture capitalists will need to support those companies a bit longer. Obviously, there are huge needs in terms of investment.
Senator Meighen: Obviously, the need is for more capital and there will be a voracious appetite for an increased amount. Presumably that can come from a combination of foreign venture capitalists and domestic venture capitalists.
In terms of foreign venture capitalists, is it helpful to have the BDC as a lead domestic investor or does it matter? Do you have to have a lead domestic investor in those cases?
In terms of domestic venture capitalists, I know you have supported the recommendations of the Canadian Venture Capital Association. Their recommendations encompassed a number of suggestions, including tax policy changes. Could you elaborate on that area, particularly as to whether our general tax policy in terms of venture capital has had an impact on what is perceived as our inferior position compared to what the Americans are doing? I realize the Americans have economies of scale and they have the size. How do we get more capital from both domestic sources and foreign sources?
Finally, do you see the BDC's role as one that will change as the amount of money and activity in this field increase?
Mr. Ré: Historically, venture capitalists want to invest close to their own simply because they are quite active in developing those companies. The younger the company is, the closer the investor will want to be. That is a rule simply because you need to be hands on to develop it.
Presently, what I see in the market is that the company will be developed, will be at a second or third round of financing with domestic investors, when all of a sudden we will want to be able to have the American channel for distribution, the American network. Then we will go with our companies in the United States to try to attract that kind of money. That is the way things are going because of that background, because of that history.
Will the foreign investor be more active in Canada? I would think yes, because they realize more and more that the quality of the science that we are developing in Canada is certainly world-class technology. We are attracting more attention because they see that our level of activity is comparable to theirs on a per-capita basis.
In terms of taxation, you have looked at the Canadian Venture Capital Association recommendations about what we will do with limited partnership and with capital gain. I should like to stress also that those companies are being built with individuals. There is a significant barrier to attracting Americans to work for us. Yesterday in La Presse there was an article about four or five companies that were unable to penetrate the United States with their software simply because they were not part of the old boys' club. Presently, it is impossible for us to attract foreign managers. That would be quite useful because they know their markets better than most Canadians. Everyone should like to see taxes being dropped. Where it hurts the most is on an individual basis because we are unable to attract the talent that we should like to develop our companies.
Senator Meighen: Does it also have a serious effect on your ability to attract capital? I ask that because surely the area that you are interested in is high risk, high return. However, if you do not get a high return, it is hard to get fired up for the high risk.
Mr. Ré: Everything holds together. When people talk about the criteria of venture capital, everybody talks about management. Obviously, it would be useful in many of the companies that we are developing presently to be able to attract foreigners on a more regular basis. Currently, it is almost impossible. The difficulty is more than taxation, but that is part of the equation.
I would talk about capital gains and various ways of reducing taxes for specific purposes. Maybe we can talk about a seed fund, for example. We know that it is high risk. Would there be ways of giving tax deductions for people or corporations that invest specifically in those types of activities? Taxation can be a tool for development. That has been the case with the labour-sponsored fund.
Senator Kroft: I believe your point, in the context of the tax discussion that Senator Meighen raised, was the difficulty of attracting people to Canada to pursue this work. What is your experience of our inability or failure to hold onto Canadians who leave the country with the so-called "brain drain"? Not only are those people taking with them brains, they are also taking proposals. Do they in fact have to shop in the U.S. for opportunities not only for their own reward, but also for the financing of their ideas or proposals?
Mr. Ré: Obviously, if we are unable to keep our own talented people here because there are many good opportunities in the United States, imagine what it is like to try to bring foreigners here to help manage our firms? I will give you an example. Presently, in order to attract vice-presidents for marketing, most of the small technology firms would almost have to give them a CEO position simply because that talent does not exist. With our dollar and taxation, it is almost impossible to attract foreign human resources.
The last part of your question was regarding the role that the BDC can play. It takes a lot of capital to do investment, because you cannot do investment with borrowed money. When we are doing these types of activities, the bank has always tried to leverage its money. All of our deals are syndicated, unless we are unable to find investors who would like to invest with us, because they find that the risk is too high. However, we have pushed to have syndication.
The role of the bank in venture capital can be expanded. There are not many investors who have a national scope. The experience that we have built over the years and the network that we have make us a valuable instrument. If the money is available, we can do a decent job. We have been in that business officially since 1983, although we started on a pilot project a little before that. Over the years, other players in the market have been there in good times and others disappear. We have been there through the good times and the bad times. It is a matter of having funds. We have the resources needed to deliver, and we have demonstrated that in the past by being profitable.
Senator Meighen: Mr. Ré, is your role essentially to be an ongoing participant or to be a stimulator? Are you in competition with other venture capital organizations or are you there as a promoter of the industry in general?
Mr. Ré: In terms of investment, since 1983, we have been dealing on a national basis with really early-stage, knowledge-based companies. To give you an example, presently 60 per cent of the money is being devoted to technology firms. We have been doing that for the last 15 years. Ninety-five per cent of our portfolio is a technology portfolio.
I talked about seed funds in my submission. Seed funds did not exist in Canada on a proactive basis. We more or less created that market. With quasi-equity, we more or less created a market of $1 million or less.
We have our regular activities: to look at the needs of companies and try to fill them. We work with our partners because, although it is not strictly policy, I exert a lot of pressure to make that happen. We have been an important supplier of funds over the years, and we have been able to be innovative when needed. We can keep on this road. We have identified two other MBO-MBIs. We think that over the next five to ten years there will be huge needs if we do not want our businesses to be under the control of foreigners. We have also identified exporters because we are developing world-class technology firms. We need to support them when they go abroad because we see more and more companies that have more employees abroad than in Canada. However, all of the intellectual property is here, all of the brains are here. Those are important points for the future. The BDC can obviously play a role in that.
Ms Mary Grover-LeBlanc, Director, Government Relations, Ottawa, Business Development Bank of Canada: I should like to add to that a point about other entrants into the venture capital industry. The bank has acted as a catalyst over the years. In fact, for every dollar we invest, we attract $3 more. We would not go solo on any venture capital deal. We welcome many more players in the deal. The bank has acted quite extensively as a catalyst and has been seen as a pretty solid investor over the years.
Senator Meighen: Does the mandate specify that you should break even or not break even? What has in fact been the record?
Mr. Ré: We are being asked to cover the cost of funds for government. Our return since 1983 is approximately 7.1 per cent. Most of the funds, especially in the United States, have a limited life. Having a limited life, they do not carry much cash. They are not evergreen. Therefore, when they need cash they call it and at the end of the period they divest. Ten years after, if the life is ten years, they calculate their return.
We are evergreen, and for a certain period of time we have carried a lot of cash that was not having the kind of return that we were expecting. If we consider only those, the return is over 12 per cent.
Senator Callbeck: I want to come back to the seed capital fund for a minute. That is just for technology companies. Do you have other special seed capital funds?
Mr. Ré: In the market, seed funds are usually quite specialized. There are seed funds for biotechnology, for software, for information technology. That is what happened in the United States because the critical mass is quite large. In Canada, the seed funds that we have pushed forward are simply for technology. We do not have a seed fund for traditional businesses.
Senator Callbeck: You mentioned that there is a $25-million seed capital fund covering Ontario and Atlantic Canada. How is that worked out in Atlantic Canada? I presume that it was set up three years ago. Has it been successful there?
Mr. Ré: The last seed fund that was created is the Eastern Technology Seed Investment Fund in Toronto. It has been in operation for the last 18 months, but I would say in real operation for a year. Presently, out of ten deals, four are in the Atlantic provinces. At the beginning, quite frankly, we never thought that close to half of the deals would come from Atlantic Canada. Once you make the money available, quality science can be anywhere. The Eastern Technology Seed Investment Fund has decent activities in the Atlantic provinces.
Senator Callbeck: Roughly how much money do the four deals represent?
Mr. Ré: I would say that on average they represent around $250,000 by the seed fund. In some cases we have partners.
Senator Callbeck: I was looking at the Business Development Bank of Canada's document entitled Economic Impact of Venture Capital. On the last page, you say that you have 590 companies distributed across Canada. There are 20 companies in Atlantic Canada. They represent 3 per cent of the companies. Do you know what percentage of the dollars Atlantic Canada would represent?
Mr. Ré: I do not have the answer with me, but I could give that to you. My guess would be that it is a little lower than the average because my perception is that the companies in Atlantic Canada are a bit younger than the other companies. Mr. Chairman, I will come back with the information.
Senator Callbeck: On page 7 of your brief, you talk about successful businesses reaching the point where owners may want to sell out. You go on to say that in Canada, management buy-out/management buy-in financing is not as developed as it is in the United States and the U.K. Can you give me an example of that or explain it a little bit?
Mr. Ré: In the United States, the buy-out market is an industry in itself. You have an association of companies that are doing it on a specialized basis. Some funds are totally dedicated to MBO-MBIs. It is the same in the United Kingdom. They focus mainly on management buy-in/management buy-out. Unlike elsewhere, in Canada this industry does not exist by itself.
It is somewhat similar to when we started with our sub-debt activities. We could feel that there was a market but we were unable to put a gauge on it. In terms of the management buy-in/management buy-out, we know that there is a market that will grow, but presently nobody is focusing on it exclusively. They are doing it like the seed funds where they react to proposals instead of being proactive.
In the United States and the United Kingdom, it is an industry. Here we do not have a specialized fund doing it.
Senator Kelleher: On Tuesday we had the Canadian Venture Capital Association in front of us. They told us that the percentage of equity taken for providing the funds ranges from 5 per cent to 50 per cent and seems to average out at about 30 per cent. I know that comes as quite a shock to the poor fellow who has developed some sophisticated software. In light of the fact that Quebec appears to have been in this a little longer than most of the other provinces and has perhaps become a little more sophisticated, what is the so-called equity range that the suppliers in Quebec ask for for these funds?
Mr. Ré: There is really no difference. It is the same range of negotiation. It happens quite often that a venture capital firm from Ontario will invest in Quebec. We need to have a unanimous shareholders' agreement. What is right for Canada is right for Quebec, also. We are in the same ballpark.
Senator Kelleher: I happen to be with a large law firm when I am not being a senator. We are probably the largest firm in Canada dealing in intellectual property. We are across Canada. Because of our background, we attract many people to our firm looking for funds. We have found right across Canada that, while the people who come to see you may be very sophisticated with respect to a biotechnology project or some software, when it comes to business, the kindest thing we can say is that they do not have a clue. They do not know what a business plan is and they are shocked, frankly, when they find out how much equity they will have to give up in many cases in return for the funds.
Law firms and lawyers are not great teachers and we are not in the teaching or educational business. It appears to me and others in our firm that some type of education is needed here for those people. I am not totally convinced that the problem is all a lack of funds. I think part of the problem is trying to source those funds and finding out about those things. There is no sense in saying that we will have a seminar three months from now and you can come to that. They need the money now in order to move ahead.
Are there any organizations or any part of the government or your bank where they can go for a half-day seminar? Are there any booklets to find out what is required? That is part of the problem. They really do not know where to go or where to look. Frankly, I hate to admit this, but we do not know, either.
Mr. Ré: There are various sources of information. Within the bank we have a consulting group and we have people who can do some mentoring to show them how it works. The Canadian Venture Capital Association and Réseau Capital are having many activities to show how it works in the financial markets. The best way we have found within the BDC to tackle this problem is to hire specialists, to hire scientists. Scientists talking to scientists understand better their own way of doing things. Two-thirds of our investment managers have a technical background in life sciences or in information technology. At least the same language is being spoken. The other third of our work force are people with financial and business backgrounds.
People are quite shocked during the negotiation because having an external investor in your company changes everything. Percentage-wise it could be a shock, but it is even more of a shock when you divide their role as a shareholder and an employee. At one point you have to negotiate the shareholders' agreement and you need to put business matters into the agreement.
Obviously, it is a concern, but many venture capitalists know that it will be a long partnership with those people, and they try to make it as clear as possible. It could be shocking, but they try to put it on the table as early as possible to see whether or not there is a business case. Are we losing opportunities because there is a lack of information? Quite frankly, I do not know. You can talk about these subjects for a long time, but it will not strike you until you are faced with the situation. Once again, much depends on the explanation given to the scientists. To have 100 per cent of a patent is one thing. To have even 5 per cent of a company that is worth $200 million is something else.
Senator Austin: On your last point, I, too, have been involved in venture capital and angel-type investment. More important than the money is recognition, ego, reputation, credit for the technology. For some individuals, taking on a partner or responsibilities is very difficult because it feels like surrendering identity. That is a cultural problem. I am sure that you have to assess that when you are dealing with people.
I want to pursue two narrow questions related to the exit strategy part of the performance. Mr. Begg, when he was here, told us that IPOs are not an important part of their exit strategy, that they basically like to live with the investment and then to move it in either takeovers or new pools of private capital. Is it your experience as well that IPOs are not a significant part of the exit strategy for a venture capital investment?
Mr. Ré: I do not have precise figures, but I would say that probably not more than one out of five successful deals will end up being public.
Senator Austin: That was his number also.
Mr. Ré: A study in the United States a few years ago showed that it was 18 per cent. It seems, then, to be a figure between 18 per cent and 22 per cent.
We all aim at bringing the company public because usually that brings the better return. We buy the company with undifferentiated activities and then we try to build the sales volume, the differentiation and the intellectual property. We take a company that is selling $200,000 to $500,000 and try to bring it to $45 million to $50 million. To put it on the stock exchange means that the people who will invest in that company will want to see a $500-million company. It is quite a challenge. All along the way you realize how tough it could be and all the mistakes that you could make.
An IPO is the ultimate objective but reality shows us that we have many other ways to get out of the company.
Senator Austin: Mr. Begg told us that out of ten ventures, two will fail, six will return the capital and two will be a success in the marketplace. Do you agree that that is the model?
Mr. Ré: Yes.
Senator Austin: On that IPO level of exit, is it possible for you to syndicate your equity investments in an equitized package? I am referring not to the two that fail, but to perhaps a basket of the six plus the two that are IPO'd as another way of distributing risk. Can you offer to the market a package of venture capital risks as an IPO of an average of the better part of your portfolio? I know of one case where that was done. A company named Quorum decided that the marketplace was not giving them the multiple in their equity that they believed they deserved; therefore, they went private.
Is it too hard to ask the public to take a little of the risk of building an enterprise by syndicating it? Is there just no market there? Can you develop a market for it? I think that there are two public policy reasons. One is to offer an opportunity for gain in that area of the capital market. Another is to create with investors a culture of accepting that kind of enterprise. Take a look at junk bonds or anything else that nobody would buy for a time until a culture was developed that created recognition. Is it possible to go in that direction here?
Mr. Ré: Are you talking about putting together a limited portfolio that the public could buy?
Senator Austin: Instead of taking one company public, take a package of your equities -- those that you believe have reasonable progress -- and equitize that. That may take ten years to mature. You have a five-year company, a six-year company, almost like a good bottle of scotch, blended and marketed.
The Chairman: Essentially, Senator Austin is proposing a speculative mutual fund. You would take your portfolio of investments and people would buy shares in the portfolio as a whole, not shares in the individual company.
Senator Austin: That is right. That is what Quorum tried to do.
Mr. Ré: Anything is possible. Considering how the various financial tools like options and warrants have been developed over the years, I do not see why it could not be done. However, it would be a recognition that the stock markets are not as efficient as we should like.
Senator Austin: That is the final point. We now see the stock markets looking at a different organization, a specialty. If a venture capital market is talked about as an Alberta-Vancouver-Winnipeg market, there is no reason why it should not be a Montreal-Toronto-Halifax market, given the electronic realities of today.
If there is support for it, I should like to have a recommendation by the committee that in the organization of those markets there be recognition that the product that I have been discussing with you is a legitimate product. Réseau Capital would be the sponsor, the promoter of that package. There would be risk, but at least we know the quality of the people who would be putting the package onto the market. That is more representation than question, I guess.
Mr. Ré: Mr. Chairman, we have looked at a model within Réseau Capital, but we were looking at it more for our own members to see if we could enhance the possibility of exit within our company and to create a smaller market or a smaller stock market almost on a private basis. Obviously, Réseau Capital is an organization with people supplying their time freely, so it is hard to build that. Certainly, however, looking at the various tools that we can have for exit is of concern to venture capitalists. If it can bring money for business development, it would certainly be a plus.
Senator Austin: If it is doable, it has the value of averaging the risk to the investor. Instead of going for a company that fails, you get a basket that averages, and it creates a venture capital culture in the country. Investors begin to say that 5 per cent of their portfolio should be over here where they will get a Ballard or another of Ventures West's successes.
Senator Meighen: The 5 per cent was urged upon us in Vancouver with respect to the Canada Pension Plan. Are you not describing a labour fund?
Senator Austin: I am describing how they are behaving but I am trying to move it into the capital markets as well. At the moment, most of these products are still relatively closely held.
The Chairman: Mr. Ré, your data show that the BDC has played an important role as a catalyst in Quebec. Given that, are there changes to the mandate of the BDC, to the amount of money available to the BDC, or to the organizational structure of the BDC, such as increasing its regional representation, that would enable the BDC to play that same role of catalyst outside of Quebec? I understand, of course, that legally you do play the same role outside of Quebec, but clearly the data show a regional skew. I am not objecting to that. What changes to the BDC would enable it to play that catalytic role elsewhere?
You have a detailed knowledge of the incentives that people respond to in this business. Some of the questions and some of your comments touched on the role of tax policy as an incentive to get people to respond differently. What changes in public policy not now related to the BDC -- the BDC being a separate case -- might work as incentives to get more private-sector money willing to invest in those kinds of ventures? For example, do we have a different capital tax rate structure? As an incentive, does an investor get to keep a lot more of the money and pay a lot less tax if they invest in certain kinds of industries, biotech or knowledge-based, or hold the investment for longer, and so on?
We should like to see this study suggest not that federal and/or provincial government get into the business of investing in equity but that they change the incentive structure to encourage private sector individuals and corporations to do more than they are now doing. What carrots can we hold out to get people to change their behaviour patterns?
If you could think about those two questions and get back to us, we would appreciate that.
Mr. Ré: We will do that.
The Chairman: Senators, we do not need to go in camera with regard to the letter to the deputy minister.
Senator Austin: I take it that the investment value test would distinguish between those who invested below the threshold and those who invested above the threshold? Where is the value point in this? Is it at the time the investment is made?
The Chairman: It is at the time the action begins, which is a long discussion Senator Meighen and I had with the government and with the CICA.
Senator Austin: That is rather puzzling to me.
The Chairman: I am sorry, the valuation day issue is the one issue that is still up in the air.
As you know, we did this study. The government basically bought our proposal completely. Although it is not entirely supported within the bureaucratic structure, the government has accepted it. Justice raised some legal issues regarding our original proposed way of drawing the boundary line.
The proposal that is in the letter now meets the concerns of Justice, is acceptable to the CICA and is acceptable to the Department of Industry. Senator Meighen and I have been going to a series of meetings with the government on the one hand and the CICA on the other. This proposal meets that wonderful Canadian test of equalized unhappiness in the sense that everybody got about 80 per cent of what they wanted and everybody dislikes a different 20 per cent, but there seems to be a consensus that it is a reasonable balance. I should like the authority of the committee to sign that letter on behalf of the committee and send it off to the minister.
Senator Austin: I have no objection to signing the letter, although I do not grasp the objective test you are looking for that distinguishes between the categories.
The Chairman: The objective test will be a $20,000 limit. The ongoing discussion is regarding the exact date: Is it a cost-based test or a market-based test, and if it is a market-based test, what is the date of that market-based test? The lawyers are having technical discussions on that question.
Senator Austin: The cost-based test is easy and objective.
The Chairman: That is exactly why it is our preference. A number of officials in the department prefer a market-based test, which is why that issue is still up in the air.
Senator Austin: If I invested $500,000 in a company and today that investment is worth $5,000, am I covered?
The Chairman: Senator Meighen and I have been at a number of meetings on this issue and we are 100 per cent in agreement with you. That is why some discussions are still going on.
The committee adjourned.