Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 50 - Evidence for the morning meeting of April 28, 1999
TORONTO, Wednesday, April 28, 1999
The Standing Senate Committee on Banking, Trade and Commerce met this day at 9:00 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, to continue our discussion of equity financing for small business, we have with us this morning two panels. On the first panel, we have Professor Jeffrey MacIntosh from the law school of the University of Toronto. Many of you will remember that Professor MacIntosh wrote a paper for us in relation to pension fund governance. Ms Mary Macdonald is president of her own company and has appeared before us on at least two other occasions that I can recall on issues related to small business. Mr. Brien Gray, the senior vice-president of the Canadian Federation of Independent Business, has also appeared before us on other pieces of legislation and other studies. Thank you all very much for coming.
I suggest that each of you to take five or 10 minutes to hit the highlights of your positions and then we will ask you questions collectively. Let us get all of the thoughts out on the table first and then we will go from there.
Mr. Brien Gray, Senior Vice-President, Legislative Policy, Canadian Federation of Independent Business: Honourable Senators, I must say it is a pleasure to be here and I congratulate the committee for undertaking the examination of the equity provision for small firms in Canada. Certainly, this area has been understudied and much ignored by policy-makers in Canada.
As you may recall, in previous appearances before you and others regarding the great debate about bank debt, I made the point that when we are talking about capital in this country, we should really be talking about a two-prong strategy. Bank debt is one part of the equation, but equity capital is the other part. We tend to focus very much on bank debt, but if we do not concentrate on equity capital, we will always be concentrating on bank capital. I think that if we want to grow firms in this country at the rate that we had hoped, we have to realize that we must examine the equity capital provision for the SME market and bring tools to that sector that currently do not exist.
In order to understand the perspective that I bring to the table today, it is important to understand the unique presence and the unique features of the small-business market in the country. I will be talking from the unique point of view of the consumers at the bottom end of what I call the "equity needs continuum."
As you can see in Appendix A, 78 per cent of all firms in the Canadian economy have five or fewer employees. About 94 per cent of firms have 20 or fewer employees, while 97 per cent have 50 or fewer employees. The financial services sector is not Toronto-centric in terms of either our organization or small businesses generally. Small businesses exist in every part of the country. Therefore, I would argue, any policies that you develop have to be built and based on a Canada-wide delivery of solutions.
Why has the provision of equity capital become so increasingly important for small firms in Canada? I must say that access to equity capital is not a uniquely Canadian issue; rather, it is a problem in most developed nations in the world. However, the issue in Canada has become a bit more problematic in the last little while, partly because governments have changed investment and tax policy approaches in the past two decades but have not examined the cumulative impact of those policies in restricting the flow of equity capital to the small-business sector.
When we asked our members to identify the most appropriate sources of business equity for their enterprise, 56 per cent indicated personal savings, 45 per cent indicated reduced taxes that would result in higher retained earnings and 19 per cent said more favourable capital gains treatment. I refer you to Appendix B for that information.
What has happened to those sources of supply over the past 25 years? The change in the tax mix imposed by governments on business is one important development that has cut into the supply of equity capital. Whereas 20 years ago we had a relatively progressive tax regime that was driven by corporate income taxes, today the system relies much more heavily on profit-insensitive taxes such as payroll and capital taxes.
The growth in profit-insensitive taxes outlined in Appendix C demonstrates the point. Since the early 1980s, those taxes have increased dramatically while the profit-sensitive taxes have gradually declined. The impact on firms that depend on retained earnings to build up their equity base and finance growth is obvious: lower profits, less retained earnings, restricted ability to build the equity base of the firm, restricted ability to grow.
No doubt one of the reasons the job-creation, post-recession period fell below governments' expectations is that those firms that had been lucky enough to survive the recession had to eat deeply into their equity base. Increased reliance on taxes unrelated to profits will make it harder for those firms to replenish those stock bases.
What else has changed in the last two decades? Two important developments have occurred. First of all, since the small-business deduction threshold has not been touched since 1981, the value of the deduction has been severely eroded. Second, there has been a tightening of the capital gains taxation system, including an increase in the inclusion rate from 50 per cent to 75 per cent.
The impacts of insufficient equity capital are many and varied and depend on the size of the firm and its stage of growth. They include, but are not limited to, the following: over reliance or inappropriate reliance on debt capital; increased vulnerability of the firm; little manoeuvrability to finance risk of losses; restricted access to working capital to finance R & D, marketing, inventories or exports; suboptimal growth; suboptimal productivity, growth and jobs in the economy. We hear the word "suboptimal" a lot these days.
Too often in the past, debates around the provision of equity capital in Canada's businesses has focused on public markets and venture capital. That is understandable. Those players dominate their markets. It is also fair to say that they serve their markets very well. It is important to note, however, that those players largely do not serve our market.
Indeed, Appendix B illustrates the point. Five per cent of members look to labour-sponsored venture capital corporations, LSVCCs, or venture capitalists for funds. Public markets are simply not an option, and repeated studies have documented that there is a serious problem of access to equity capital in small-size categories, especially under $1 million.
For example, what does a firm looking for $50,000 to $1 million do in terms of a realistic alternative? We in Canada have tried many programmatic approaches without much success. We need to analyze this issue conceptually from our perspective along a "needs continuum," looking at the need according to the size of the business and the stage of development. We need to conduct a serious gap analysis, and appropriate solutions must be developed to fill those gaps.
There are those who would say that we should be concerned only with high-growth, export or high-tech firms. It is our view that that would be a serious mistake. A balanced approach is needed. There is no point in assisting the glamorous queen bee if the worker bees do not survive. Moreover, at the early-entry stage, it is impossible to predict which firms will grow quickly and which ones will follow paths of lower growth. We need both types of enterprise and the wealth and jobs that they create in order to build an effective economy and maintain the regional balance in economic growth in this country.
We need to examine new approaches to fulfilling the equity needs of small firms. CFIB, the Canadian Federation of Independent Business, would say that at the small end of the continuum, changes in the tax policy would be the most effective approach. As one moves up the needs continuum, different tools may be useful. We must find methods to grow our firms to be more established, to graduate them to the more established equity markets. To get there, we need new approaches relevant to small business, and I document some of the things that the Small Business Working Committee recommended in 1994.
I talk a bit about other related issues, such as the dearth of advisors and how liability laws and legislation affect that, and about the issue of sophisticated investors. I will not go into detail on that here.
We also talk about the causes and effects of having an underdeveloped sector for mid-size firms in this country. It really hurts us as a nation to see firms that are moving into the mid-size category being bought out by foreign companies and grown from there by foreign capital. I think Mr. Doyle discussed that a bit yesterday.
In Canada, as in most developed nations, the informal investment market dwarfs the public market in terms of size. Unfortunately, the potential has largely been untapped. Innovative fiscal approaches must be developed to move the money to productive uses. Such a strategy must be balanced in approach. The policy framework should assist in moving money to where it is needed, regardless of size, sector or geography. The strategies will differ depending on the size of the enterprise and the dollar amounts required. At the end of the day, we require an approach that will serve the continuum of equity needs from the very smallest to the largest firms in the economy.
We know that you are at the start of your proceedings and we would offer some observations and preliminary recommendations. Also, CFIB will be undertaking extensive research in the coming months to document the demand side of the equation from the perspective of SMEs. We welcome input from all parties.
Just as with bank lending statistics, it is important to release publicly all details of LSVCCs and other venture capital activity where it is available, especially where it is supported by tax assistance. CFIB supports an educational campaign on sources of capital for SMEs, but we would caution that such a campaign must not create unrealistic expectations.
CFIB encourages the Senate to undertake original and comprehensive research or gap analysis focused on addressing the needs and the supplies in various investment size categories in the SME sector.
CFIB re-emphasizes in the strongest terms the need for all levels of government to move away from profit-insensitive forms of taxation. We would recommend that you look to increasing the small-business deduction to $400,000 over a period of five years. CFIB supports incentives to encourage investment in Canada's SME sector, and present incentives are aimed largely toward the corporate sources and LSVCCs. We would say that you ought to look at lowering the inclusion rate and that you ought to look at a lower rate altogether for firms, for investments that are made for more than five years in a CCPC, a Canadian-controlled private corporation. Relax the RSP restrictions and you may also consider increasing the eligible investment level from $25,000 to $50,000. We think that you ought to examine the expansion of the ability to write off investment losses against income.
We think you should investigate the effectiveness of ACENet, the U.S. Small Business Administration's electronic matchmaking service, for possible imitation in Canada.
Finally, we would say that you should engage the advisor sector to become much more involved in helping to get their clients "investment ready" and in identifying sources of capital and facilitating deals.
In conclusion, we congratulate the standing committee for undertaking this review. This examination is long overdue and we encourage you to take the time to investigate the supply and demand sides of the unique SME market. You hold the keys to opportunity for our sector in your hands. Small-business operators from across the country are hopeful that you will find the right solutions and we are committed to helping you.
Ms Mary Macdonald, President, Macdonald & Associates Limited: I appreciate the opportunity to be here. As I mentioned briefly to Senator Kirby before we started, I have been reading your testimony and I have to confess that I am a bit jealous that you have had an opportunity to take a step back and to look at what I think is a really critical issue. Back in the late 1980s, I used to do a fair bit of research and policy analysis in this area from a conceptual perspective and I did a fair bit of writing that was published by the science council. I think the fact that our information company is so busy now is a good sign of what is going on in the venture capital industry, but I do not get many opportunities to actually go back up to 100,000 feet to take a look.
I think my time this morning is best spent running quickly through some information. I believe you have all received a copy of this booklet. I have put together data on the activities of the venture capital segment of the equity market that I think provides a useful context for you and speaks to a number of the issues that I believe have come up in your prior discussions.
Building on Mr. Gray's point about a continuum, I think that one of the real challenges in looking at the issue of equity for SMEs is being able to differentiate within the SME universe. That is always particularly difficult within a political environment.
As you can see from this first chart, from a simplistic point of view, you can divide small and mid-size companies into three categories based on growth potential. The nature of their growth potential will in large part dictate the type of capital they need to grow.
Gordon Sharwood will speak to this in more detail later, but I think the fundamental principle is that all SMEs are not the same and their financing needs are not all the same. The low-growth companies, what we would call lifestyle companies, which could be $3-million or $4-million firms, are extremely important to the economy, but they will not be candidates for outside equity.
The moderate-growth companies that could grow to $10 million or $12 million do need equity. They are a particularly interesting challenge. We have seen the evolution of some quasi-equity products, which I know has come up in your discussion, but the venture capital segment of the market, the reasonably pure equity piece, is focused primarily on the high-growth companies, companies that today are small but that have the potential to be $30-million, $40-million or $50-million companies down the road. Clearly, that is where the venture capital market focuses.
In terms of supply of capital and the needs for equity there, from a public policy point of view, I think it is really important to distinguish among those different types of companies. The bottom line there, of course, is that not every SME will be a candidate. Certainly, for venture capital, I would guess that maybe 3 per cent or 4 per cent of the small and mid-size business universe would ultimately be candidates for that. Not every SME will ultimately be a candidate for equity, either.
The second chart shows you where the capital for the venture capital industry has been coming from over the last five or six years. In Canada, individuals have been a very critical source. We have had reasonably strong inflows of new capital each year running in excess of $1 billion since 1994. In 1998, we had $1.949 billion of new capital coming in but, as I said, it was heavily dependent on individuals. Of the $1 billion that came from individuals in 1998, a significant portion came through the LSVCC vehicle. Without question, they have been critical to the stability of supply through the 1990s. We are starting to see some changes in that, with other sources coming back to the market in the last couple of years.
The corporate players in Canada are primarily the banks that have segregated, captive venture capital activities, and the subsidiaries of the Caisse de dépôt et placement du Québec that are specifically in the venture capital market. We would include that last group in corporate activity so that we do not treat them independently. As you can see, the corporate source has been important as well.
Pension funds have been a very limited source of capital in Canada, although they were key in the mid-1980s. In the late 1980s they withdrew from the market in Canada as they did in the U.S. The difference is that they came back in the U.S. in 1991 but they did not come back here. I think that there is a variety of performance-based and structural reasons for that. I suspect that you have discussed the report that the Canadian Labour Market and Productivity Centre, CLMPC, released in January of this year -- "Prudence, Patience and Jobs: Pension Investment in a Changing Economy." I worked on much of the research for that report. There are some important issues that the pension funds are at least starting to talk about now and we can discuss those in more detail if you wish.
With the exception of some of the handful of immigrant investor funds -- which is a separate conversation -- we have no foreign investors typically investing in Canadian venture capital vehicles. In fact, there are withholding-tax rules that make it difficult for a U.S. pension to invest in a Canadian venture capital vehicle. They can taint the partnership and throw everybody off side, so there is clearly a disincentive there now, as I understand it.
The next chart compares the structure that is a result of those sources of capital to the situation in the U.S. The traditional venture capital vehicle is what we call a private independent fund. It is a group of venture capitalists that go out to the private-market pension funds, insurance companies, et cetera, to raise their capital. Seventy-five per cent of the industry in the U.S. -- which is $84 billion under management now -- is made up of private independent funds. The comparable number in Canada is 19 per cent. Clearly, we have some structural issues around tapping into that institutional money.
The labour-sponsored funds comprise 50 per cent of the $10 billion under management in Canada now. As I said, they have played a critical role in recent years. Their relative importance is starting to moderate and I think we are seeing the evolution of a more balanced market.
To return to the pension fund issue for a minute, of the $22 billion of new capital that came into the industry in the U.S. last year, 60 per cent came from pension plan funds. Of the just under $2 billion of new capital that came into the industry in Canada last year, 6 per cent came from pension funds. I think that while the size of the Canadian market makes it highly unlikely that we will ever draw as large a percentage of new inflows from the pension fund community, there is an issue there that warrants further discussion.
Having said that, given the relative importance of individuals as well, I think it is fairly clear that for stability and security of supply going forward, it is very important that the government maintain some stability in its existing programs. The labour funds have established themselves as a fairly central piece and one would not want to destabilize that as one looked at attracting other sources of capital.
With respect to individuals as the source of capital, I should like to touch quickly on the fact that in the last few years we have actually seen a handful of small venture capital funds set up with a commitment of capital from wealthy individuals. You will no doubt hear much more about that today, given the people appearing in front of you. In fact, the three witnesses in the next group, Barry Laver, Brad Ashley and Vernon Lobo, have all created venture capital vehicles in the last couple of years that have been established primarily by a commitment of $5 million to $10 million by high net worth individuals prepared to put that money at risk. In some cases, they built additional capital around that. I believe that David Latner from XDL is also appearing. After Delrina Corporation, the creator of WinFax, was sold to Symantic, Dennis Bennie took a significant chunk of capital to create XDL.
It is important to listen carefully to what those people have to say, because we are finally creating a group of successful Canadian entrepreneurs who have made a good deal of money as a result of their business endeavours. We certainly want a tax environment that encourages those individuals to recycle those gains.
After he established XDL, Dennis Bennie indicated that had the capital gains tax been lower, he probably would have increased the amount of money that he put into XDL. The amount that we leave them to work with dictates the amount that ultimately they reinvest. That is an important issue.
The last few charts reveal the perception that there is a huge overhang on the market. Even testimony before this committee has included some discussion about the money sitting in big pockets and not being deployed. In this chart, we have taken the amount of capital raised each year, including the money coming into the labour-sponsored funds, and we have subtracted the 30 per cent that they are not mandated to invest in venture capital investments. Actually, that percentage varies. It is 40 per cent in Quebec and 20 per cent in B.C., so we use 30 per cent as an average. In any case, because they are mutual funds there will be a margin at the top that is not intended to go into venture capital vehicles. If you take that out, you can see that for the last three years, in fact, demand has easily absorbed if not exceeded supply. Again, in my view, that underscores the importance of a public policy framework in every context that encourages and ensures the stability of that supply going forward.
Entrepreneurs in Canada have started to believe that they can access capital if they are high-growth companies. Five years ago, if you were a software company and you needed $3 million, chances are you would have had trouble accessing it. Today, if you are a software company with the potential to grow, you can access that $3 million and, more important, you can access the additional rounds to get yourself to the $10 million or $12 million that you need before you are ready to do an IPO.
I believe that when Michel Ré was in front of you he tabled the economic impact survey that we do for them each year. That survey makes it very clear that those quantities of capital are available if a company is going to make it to the IPO market.
Since there was some discussion around seed investing, I tossed in a chart to show you that, in fact, seed capital investing is on the rise in Canada. We have seen several funds: the Eastern Technology Seed Fund, the Western Technology Seed Fund, and the Canadian Medical Discoveries Fund. The Royal Bank has established three or four new seed funds. Evidently, seed capital is starting to evolve in Canada. Those funds are focused specifically on very early-stage technology opportunities that have significant commercial potential. Again, they are not intended to focus on companies that need less than $1 million because those companies will grow only to a relatively small size. Rather, they are the early high-risk rounds in high-growth potential companies.
The final chart shows that while we have come a long way, we have still got some way to go. This is simply a per capita comparison of Canada and the U.S. on a disbursements basis. I cannot give you the actual numbers, but that gap was much wider five years ago. It is closing, and I think that there is a good deal of momentum under way.
My closing observation is this: The venture capital market is, contrary to much economic theory, the one place where to a certain extent supply really pulls demand. There are too many risks associated with building a high-growth company to bother taking them if you are not fairly confident that you can raise the capital if you have a good business opportunity.
I believe that security of supply has started to evolve in this country. I think it is extremely important that whenever we are looking at policy issues, we try to keep that in mind and ensure that whatever those policy matters might be, the stability of supply is taken into account.
I think we need to continue to encourage dialogue with the institutional community and the pension fund community to figure out if and how more of that money can more naturally gravitate into this market. I think we need to make sure that we are not discouraging foreign institutions from backing our Canadian venture capital funds as they continue to grow, and we need to encourage individuals to reinvest their gains from successful business ventures.
In closing, I should just like to point out that each quarter we provide The Globe and Mail with a deal list of all the disclosed venture capital transactions, and this morning they list the 116 deals that involved less than $1 million. Thus, the venture industry is in fact involved in that area. Mr. Sharwood very kindly just did a count for me, and half of those deals were in the province of Quebec. There is no question that the infrastructure is strong there for smaller deals, primarily the regional funds that I know you have discussed before. A good number of smaller transactions are being done in other parts of the country as well, and you may wish to peruse that at your leisure.
Thank you again for the invitation to be here.
Professor Jeffrey G. MacIntosh, Faculty of Law, University of Toronto: The last time I appeared before you I started off with a quotation from Dr. Seuss. Although I anxiously searched my Dr. Seuss and even Mother Goose, I could find nothing suitable to bring before the committee this morning. For that I apologize. I will try harder next time.
My own particular interest is technology SMEs versus non-technology SMEs. I think Mary Macdonald made a similar distinction when she talked about high-growth firms versus low-growth firms. I think that technology SMEs are particularly important to Canada's economy. One reason is, of course, that we have seen a flow of low-value-added, high-labour work to offshore locales. Moreover, the developed economies in the world, including Canada's economy, increasingly have to focus on the so-called knowledge-based industries if we want to compete successfully on a world stage. I would suggest that when we look at SMEs from a public policy point of view, the emphasis should be on technology or high-growth SMEs.
Indeed, as the Premier's Council in Ontario pointed out some years ago, many non-technology SMEs are non-exporting firms, and if a new non-technology SME comes on the scene, very often it will simply displace an old non-technology SME with relatively little net gain in the economy. By contrast, many technology SMEs are exporting firms and when they displace other firms, they displace foreign firms rather than domestic firms. It seems to me that that emphasizes the importance of looking at technology SMEs.
Many technology SMEs start out as small, private businesses. Take Microsoft, for example. It was started in 1975 by Bill Gates, went public in the early 1980s and we know where it is now in terms of size and market power. Intel and many of Canada's technology companies have followed a similar path.
What lesson do I draw from that? Well, it is important to focus on the availability of equity capital right from the outset when an idea is formed, rather than simply focusing on firms that have an established product already.
I will turn to that now and, to some extent, rehash my previous academic work and work as a member of the Ontario Securities Commission Task Force on Small Business Financing. I will focus on particular areas of capital where I think there are still problems.
One of those is in the area of so-called love capital. Love capital is capital supplied by friends, relatives, neighbours and so on and is often the first source of capital available to the entrepreneur with an interesting idea. It is absolutely vital that that kind of capital be available in the early stages of a firm's formation.
The problem, which I identified in my academic writing some years ago and which the Ontario Securities Commission task force also identified, is that the securities regulatory apparatus in a number of provinces actually makes it illegal for many people to invest love capital. I will skip over the details now but I would be happy to get into them later if you like. That problem in the securities regulatory regime has been identified. I made proposals for reform. The task force made proposals for reform. Those proposals have been broadly endorsed by the business community and even the by OSC staff. Yet nothing has happened, unfortunately more by neglect than by a deliberate decision not to proceed, I think. Perhaps the commission could play a role in urging securities regulatory authorities like those in Ontario to proceed with that kind of reform.
A second kind of reform, which the Ontario Securities Commission Task Force on Small Business Financing and I proposed, is in relation to angel investors. Angel investors are high net worth individuals who come in, typically before venture capital investors are willing to enter the fray. They, too, are vitally important to the supply of capital to young, growing technology enterprises.
The problem again is that many angel investments -- indeed, I would say most angel investments -- are currently illegal under securities regulation in Ontario and some other provinces, although not necessarily in all provinces. Here again, simple proposals for reform have been put forward, have been endorsed by the Ontario Securities Commission staff, but have not yet been put in place.
On the venture capital front, venture capitalists typically can get through the securities regulatory apparatus, but there remain indirect barriers to venture capital investing, and those are detailed in my own writing in the task force's report.
I will mention only one: escrow requirements. After a firm goes public, venture capitalists and other persons with controlling interests may have to hold on to their investments for a period of years after the firm goes public, and those escrow requirements I think are widely viewed as being unnecessarily onerous. The task force made some proposals for simplification of those escrow requirements. I think that would be a good idea but, again, nothing has been done on that front.
Let me deal briefly with secondary market and trading mechanisms, another area vital to small-firm financing. Many venture capitalists will eventually exit their investments after the firm has gone public in an initial public offering and it is vitally important to those venture capitalists that they be able to sell their holdings into a liquid secondary market. The anticipation of being able to sell into a liquid secondary market encourages those types of investments in the first place, so I am suggesting that we really need to get our secondary market trading mechanisms right in order to get our primary market trading mechanisms right and to encourage venture capital investment.
Of course, we have had a bit of a bombshell dropped on us lately with the coming reorganization of the various stock exchanges. I will comment just briefly on that. I am not entirely sure what the net effect of that will be on the efficiency of secondary markets. I believe the primary reason driving the consolidation of the junior trading market, Vancouver and Alberta, is to create greater liquidity -- concentrate trading in one place and create a more liquid market -- which is a very good thing. Markets need to be liquid. Investors absolutely demand liquidity in a secondary trading market.
On the other hand, it will eliminate competition between the different junior exchanges, in this case Vancouver and Alberta, and to some extent I regret that fact. Competition between the exchanges has ensured that listing standards and other forms of regulation by stock exchanges have been reasonably efficient.
At the end of the day, it seems to me that the jury is still out on whether or not those reforms will have the anticipated benefits. I hope that they will, but it is another area that the committee might think of investigating a bit further.
Finally, I will turn to labour-sponsored venture capital corporations. They really are quite a remarkable vehicle that is I think unique in the world. As Ms Macdonald just indicated, about 50 per cent of the capital in the industry is in the hands of labour-sponsored venture capital corporations.
Now, I do not want to be the fellow who throws the blanket over a happy party, but I want to raise some concerns I have about labour-sponsored venture capital corporations.
It seems to me that the goals of the labour-sponsored venture capital corporations have never been entirely clear and I think that they need to be clarified. They were originally started as a vehicle to encourage blue-collar investment in Canadian industry but they have never served that function. Academic evidence discloses that it is not blue-collar people who are using those vehicles, but white-collar, middle class individuals. That may or may not be a problem, but it is at least a bit unusual that those organizations do not seem to be serving the purpose for which they were started.
The purpose needs to be clarified. Are they, in fact, simply vehicles to encourage investment in SMEs, particularly technology SMEs? If so, then perhaps we need to re-jig the governance structures of labour-sponsored venture capital corporations. Why do we need labour-union sponsorship? The labour unions do not seem to supply any useful oversight. One sometimes hears the phrase "rent-a-union." The funds are simply renting the union's name. Perhaps we need to revisit the question of the purpose of the labour-sponsored venture capital corporations.
Many people have pointed to the fact that labour-sponsored funds have created an awful lot of jobs and invested in an awful lot of businesses. I should like to suggest some reservations about that. Invariably, those claims do not consider the opportunity cost of the funds. In other words, if the funds were not put into labour-sponsored venture capital corporations and then invested in industry, they would not be hidden under a mattress. Presumably, they would be put into something else that might well create jobs. Clearly, when we are looking at job creation, we need to look at net job creation, not just gross job creation.
Another concern is that there may have been some crowding out of private capital. An enormous number of individuals have been prompted to put money into labour-sponsored venture capital corporations by the generous tax expenditures associated therewith, and I worry that there is some crowding out of private capital. I believe we have in fact seen some private funds reincorporate themselves as labour-sponsored funds because at the end of the day, when the tax benefits are considered, their investors do not get the same investment return as individuals investing in labour-sponsored funds.
I also think we need to be concerned about the governance of labour-sponsored funds. When institutional investors invest in funds, they provide some useful oversight; they are sophisticated players and they know how to discipline managers when necessary. On the other hand, retail investors who invest in labour-sponsored funds do not do that. We are missing one primary mechanism of accountability and oversight. That worries me a little bit.
Ms Macdonald suggested that there is no overhang of capital. I would take a slightly different view. I think you need to consider the 30 per cent or 40 per cent that does not need to be invested. From a public policy point of view, is it not a little strange to be giving these generous tax incentives to invest that money in T-bills? It does not seem to make an awful lot of sense. I think the reason they are not required to invest that 30 per cent or 40 per cent is the realization that it is difficult or impossible for them to do so.
In the past number of years, there has been an overhang of capital, which has driven up the cost of deals for all of the funds. That, of course, ends up driving the profits down, not only the profits of labour-sponsored funds but also the profits of private funds. Indeed, early figures show that the profitability of labour-sponsored funds has been very poor.
Regarding manager quality, the pool of capital has expanded so quickly that many new managers have had to be hired to administer labour-sponsored funds. Where do those managers come from? Well, we find that many of them come straight out of university M.B.A. programs. Now, I do not want to slang university M.B.A. programs, but it is important that venture capitalists have experience and I do worry about the quality of investments made by those new managers. Indeed, if one looks at comparable experience in the United States, when there was a huge expansion of capital in the 1980s, returns really went south and many people suggest that that was a result of hiring new and inexperienced managers.
I would also suggest that in labour-sponsored funds there has been a mismatch between investor type and the riskiness of investments. We have several individuals investing their retirement savings, or at least a portion thereof, in very risky investments. Let us not kid ourselves: Venture capital, whether administered by labour-sponsored funds or private funds, is very risky. Many of those individuals have very slim portfolios; indeed, many have no other portfolio investments. Is this an appropriate investment for individuals to be putting their retirement funds into? I would suggest that in many cases it is not. I believe that this is a concern from a public policy point of view and that it will become more of a public concern when some of those funds come in with terrible results.
Finally, we are all familiar with investment deadlines whereby money has to be invested by a certain period of time. I guess that is so that we know that those funds are actually being turned into SMEs. We have heard a lot about the fact that that encourages the managers of labour-sponsored funds to put money into businesses that they would not otherwise put money into, simply because they have to invest the funds.
I will stop my critique there. I propose to you that there are issues here worth looking at. It may be that the labour-sponsored vehicle is a good one in net, in that it has poured a lot of new funds into SMEs and into technology SMEs in particular. Technology SMEs are vitally important to the economy. In net, the benefit may be strongly positive. I am simply suggesting that there is some reason for concern here.
The Chairman: Before turning to Senator Angus, I would ask Mr. Gray to respond to Professor MacIntosh's comments on high-tech. He focused entirely on high-tech, whereas you talked about a much broader range of businesses. From the point of view of the CFIB, to what extent do you believe that government has become infatuated with knowledge-based, high-tech industries; and to what extent does that have the potential to skew public policy?
Mr. Gray: Please do not misconstrue what I am saying. The high-tech sector is vital to the country and its well-being. However, the concern of the small business community is that an approach to the provision of equity capital in the Canadian market ought not to be focused exclusively on that end of the market. An exclusionary policy, frankly, leaves out the vast majority of firms in this country. There are many vehicles in place right now.
It is a very high-profile kind of industry. Ministers are invited to cut ribbons and become the focus of all kinds of attention. Small firms in this country with 10 or 20 employees cannot offer the minister a photo opportunity. Although I hate to be cynical, I must say that these things tend to drive some of these approaches.
I believe that the high-tech sector is well served. They should not be denied attention, but the approach should be inclusive. There are many mid- or low-growth firms that create all kinds of jobs and potential jobs in every part of this country.
Notably, two such firms come to mind. One is in the business of developing parking meters and, although it is relatively low-tech, it had huge export capability and potential. It represented Canada at a trade fair in Mexico. Why would we focus our funds exclusively on high-tech and ignore a sector like that? Another one that comes to mind in this part of the country would be Miss Vickie's potato chips, which, when its market share grew to a certain size, was bought out by an American company. That is not the best thing for Canada.
We discussed a needs continuum that includes the quite small firms, and which also reflects the difference between high growth, mid-growth and low growth. I would argue that, at the low end, the tax system will be the most important factor in terms of moving money into the small-business sector. We must consider the high-tech sector, but not to the exclusion of the other important parts of the economy.
Senator Angus: I would like to focus directly on what some witnesses have referred to as the perverse or even obscene tax environment, particularly in capital gains, and in other punitive fiscal provisions. "Perverse" has been defined as the limit, or beyond the limit, of what is reasonable. We have been given a myriad of examples. The fact that capital gains tax is higher than the tax on dividends is an indicia of the kind of environment which exists.
We have had universal advice about the inhibitions to individuals or, as they are called, "angels." I am not referring only to inhibitions in the securities area and all the regulatory red tape, I am including the non-level playing field in the tax structure. People have told us about the U.S. rollover provisions which facilitate the recycling of these people's successes, if you will, having made good investments.
I know you all speak to government representatives and you know that this is not a new problem. Personally, I believe it is about the biggest problem we have in the country. What are the governments telling you? We hear two things: One, that they cannot afford the capital gains tax; and, two, there is not the right political environment.
Yesterday somebody put their finger on it, for me at least, by saying that, sure it would fly if people understood the facts and that there is this horrible lack of understanding and education in the country. Young people can go through secondary school and university and never have taken a business course. People do not even know how to spell "capital gains" far less know what it means.
It seems to me that organizations such as the ones you represent are trying to evolve a framework which will unleash this capital, increase our productivity, and push Canada forward into the new economy. You want government bodies to listen to what you have to say and to you may be able to help them make it more politically acceptable to take the necessary steps. Could you perhaps comment on that?
Mr. MacIntosh: I believe you are accurately stating that there is a political problem. Mr. Gary Levy prepared a background paper for this committee in which he discussed some of the issues relevant to taxation. He made an interesting point that the capital gains tax accounts for a very small percentage of total government revenue. It seems to me the tax expenditures necessary to give a break in the capital gains arena would be very modest, especially if they were targeted efficiently so that you were not, as Gary suggests in his background paper, allowing simply wealthy secondary market traders to benefit from a capital gains exemption.
If the exemption were targeted efficiently towards new investment, towards entrepreneurs, I believe that the tax expenditures would be quite modest and the benefit would be substantial.
Senator Angus: As you describe it, it appears to be a sort of a "slam dunk" kind of a thing, and yet we all seem to be beating our heads against the wall when we advocate it. That, to me, is the very key to the dilemma. If we can resolve that dilemma in these hearings, we will have done something meaningful.
Mr. MacIntosh: It reminds me of what Winston Churchill said about democracy -- that it is the worst form of government except for all the rest. One of the flaws of democracy is that, oftentimes when something complex needs to be done, the real hurdle is getting people to understand that it needs to be done and that it is truly not an invidious thing. I think you are quite right in saying that it is a political or perceptual problem.
The Chairman: I believe Mr. Gray wants to comment on that.
Mr. Gray: In Canada we have a cultural problem. Historically, the United States has celebrated free enterprise and their entrepreneurs. I noticed a remarkable change in the Province of Quebec when magazine covers no longer showed politicians or the archbishop and they started to celebrate the entrepreneurs.
The rest of the country has not picked that up. We tend to denigrate, not celebrate our entrepreneurial class in this country. I am not referring only to the role we play and that of the media, but I am also referring to the role of political leaders. They must begin to recognize and understand the importance of the entrepreneurial equation, that is, its contribution to the economy and its ability to assist in delivering all kinds of other benefits or goods in society. We often say that the best social program is a job and that, if you inhibit the creation of wealth and jobs and, then you cannot be any further ahead.
The two must go together. If we acknowledge the need for wealth creation and that profit is not a dirty word we will start to see some activity because the appropriate policies will start to emanate and the population will be on side.
Ms Macdonald: I am sometimes accused of being a Pollyanna, but I think that the environment is changing, albeit slowly. I see the creation of a whole new type of successful entrepreneurs, first-generation-successful entrepreneurs, which is relatively new in Canada. Those individuals somehow need to get to the front of the line to lead the charge. I am referring to people like Mike Potter in Ottawa, a founder of Cognos who is now in the investment business, specifically in venture capital, as well as companies such as McLean Watson Capital which invests in software companies, linking capital and expertise. I would also again mention Dennis Bennie in this regard.
It has not typically been the Canadian way for a person to stick his head up and say that we need to do something differently, but I think we need to be more inclusive of those types of individuals in our policy debates. They have been busy in their own businesses, building companies, and I think it is now time to try to draw them into the discussion and, ultimately, into finding what works to encourage them to recycle more of their productive capital.
Senator Kolber: When you responded to Senator Angus' question you referred to a study by Mr. Levy.
The Chairman: I believe he was referring to a paper by Gerry Goldstein.
Mr. MacIntosh: You are quite right.
Senator Kolber: You quoted him as saying that it would be a small cost to Canada to change the capital gains tax regime. My understanding is that, if that were to happen, there would be a huge gain.
I believe some studies have indicated that, for example, there are probably a thousand buildings in Canada which are owned by people who are very anxious to sell them but who cannot afford to do that because of the tax implications. That revenue would go to the government. There are people who will not sell securities because they feel they would be ripped off. All the studies I have seen indicate, as David points out, that it is not only a "no-brainer," it would be a big win for Canada. Why are you not making a point of that?
Mr. MacIntosh: That was my point, senator.
Senator Kolber: You said the cost would be small.
Mr. MacIntosh: There would be a small cost but a great benefit. Yes, I was suggesting that the revenue shortfall would be relatively small.
Senator Kolber: There would be no revenue shortfall. There would be a revenue gain.
Mr. MacIntosh: That just reinforces my point, does it not?
Senator Angus: Yes, I thought it did.
Mr. MacIntosh: We are certainly in agreement.
Senator Angus: Being from "la belle province," I was interested when one of you mentioned that the infrastructure in Quebec is becoming more conducive to furnishing a supply of this kind of money. There is a more small "C" conservative population in Quebec, and there are at least some small signs that we are celebrating our business successes. The Quebec hockey team is now somewhere in California or Colorado and the other one is for sale and so forth, but there seem to be some good signs there on the business front. What structural changes, if any, have you noted that are more favourable in Quebec?
Ms Macdonald: Allow me to address the infrastructure, because the water gets muddied fairly quickly. Following on some of Mr. MacIntosh's points, one of the reasons that a lot of smaller deals are being done in Quebec is that a whole network of regional funds has been set up by the National Solidarity Fund which is, by far, the dominant labour-sponsored fund.
Senator Angus: Is it more dominant than Working Ventures?
Ms Macdonald: Yes. The Solidarity Fund is at about $3 billion now, and I think Working Ventures' assets are about $650 million. The Solidarity Fund is five times as large, and it is the largest.
The Solidarity Fund is very clear that its mandate is to create and maintain jobs and provide a reasonable rate of return to investors, which is not necessarily the same mandate that other labour funds or venture capital funds would have. Their mandate is to maximize their IRR, so that they can provide a reasonable rate of return and invest in an infrastructure that is not driven exclusively by rate of return considerations.
These regional funds are making small investments, and they are making relatively small ones in local companies. Local business people are involved in the decision-making process, and the rest of the financial infrastructure has become involved in that. In the example of the Caisse de dépôt, the CDPQ subsidiary does all small deals, but it is a mix of objectives.
In my opinion, this is one of the issues that we ultimately have to sort out. The questions are: Who is in the business of financing companies that have the greatest commercial potential and therefore, investment return? Second, who is in the business of making investments that have more mixed objectives? This is not constant in any group of investors across the country. Those objectives are not constant.
I would argue that, in Quebec, the reason is primarily because that motivation exists. If you tried to sell an LSVCC in Ontario to people saying, "Part of the benefit of this is we are going to create a bunch of small funds in northern Ontario or eastern Ontario that will not be driven exclusively by investment returns," I would be surprised if any Ontario residents would invest in it. It is a different mindset. That has been a very large part of it, and it has clearly been reinforced by the institutional structure -- the Caisse de dépôt, Investissement Desjardins, a whole group of them that are behind that mentality.
Senator Angus: The Quebec Stock Savings Plan was one example. If I am not mistaken, the only other province that has had a similar thing is Alberta, but it did not work out too well. You were not, however, referring to the QSSP as one of the structural things.
Mr. MacIntosh: It is interesting that you raise the QSSP, because I think that it comes out of the same mindset. Interestingly enough, and going back to my earlier reservations about the LSVCCs, the academic studies which have been done on the QSSP now suggest that it, in fact, was a major policy failure. I think there is quite a bit of agreement on that now which suggests to me that good intentions are not enough. At the time, the QSSP was hailed as quite revolutionary and as demonstrating a great deal of forethought and so forth, but it turned out that it just was not worth the cost of the program.
I raise that point just to emphasize that we must be cautious about how we deliver government subsidies.
Senator Angus: We were told yesterday -- or at least this is my understanding of it -- that it did not fail because the concept was bad. The argument was that, when a government takes a risk like that, as opposed to having the individual investor share more of the risk, there is a greater need for scrutiny and for management. It failed because it was not fully thought out and because it was very poorly administered.
Given that tax is the big bugaboo and given governments' reluctance to sell it and get ahead, it seems to me that there are all these funny little ways to do things fiscally. As an investor, I have seen people quite attracted to the idea, but it seems to me that the quality of the companies has gone down very sharply. In fact, I have not seen a good QSSP investment around for about two years. Often, once the money is raised and there is an IPO then -- boom -- one fellow buys a new car, a new garage, and the principals buy a new fishing lodge. It seems to me that that could be better managed.
The Chairman: Do you want to comment on whether the infrastructure is, in fact, different in Quebec? In other words, is it an infrastructure issue or is it a psychological and cultural issue? We can do something about the former, but not about the latter.
Mr. Gray: I actually believe it is both, and I think you can do something about the culture issue. The question that led into this was: What happens when you talk to people in government about the concept of freeing up this money for investors, be they venture capital corporations or individuals? Frankly, you get blocked every time by "This will not be acceptable to the Canadian public."
In my estimation, it is a political calculation that Canadians will not accept some people making a reasonable profit, or sometimes getting a 30 per cent or a 50 per cent rate of return on their investment. That is somehow politically unacceptable.
In Quebec -- and no doubt nationalism is involved in this -- they have set up mechanisms, but they have also played on national pride within the province to drive activity within the business sector. There is no question about it.
Senator Angus: They call themselves Quebec Inc.
Mr. Gray: That is right, and the politicians who represent Canada have to do the same thing on a national level, but it has to be embraced by your colleagues in caucus. If it is not embraced there and really accepted there, it is kind of like changes in the banks to embrace small business. Unless the chairman decides that the bank will change its attitude toward a business sector or a segment of it, nothing will happen.
Similarly, I think it is a question of political, business, and general public leadership. We have got to move Canada and Canadians to feel that these are important objectives. I think it is very much a question of the structural side, as well as of leadership in this direction on the part of our business and political leaders.
Senator Hervieux-Payette: I was the Assistant Deputy Minister of Labour with the Bourassa government, and we started the first study to prepare the QSSP. At that time, we had the highest level of strikes in Canada and people did not understand the notion of profit.
This was a mechanism that would help to build a partnership between entrepreneurs and the workers. It would help them to understand that profit was a good thing; that this was how companies grew. We were inspired by the ESOP plan in the United States. We believed that it should be invested in small and medium businesses, not used to give a tax incentive to buy shares from Banque Nationale, but Mr. Bourassa was defeated in 1976.
The studies came out of the Deputy Minister of Finance's drawer, he gave them to Mr. Parizeau, and Mr. Parizeau took used them to reduce the tax burden on the high income people of Quebec, because Quebec had the highest personal taxes.
That is the history. Our original intent was to serve SMEs, but the securities did not play their role correctly. I mean, the owners were giving just 10 per cent of their company, and receiving a lot of money, and investors were not educated. I agree with you. It was the first time that social workers in Quebec were buying shares. They had never seen that in their whole life, but everybody, as you say, was proud to contribute to the Quebec economy. This is the story of the cultural differences.
I agree that there is a culture difference. We needed to educate people about the notion of profit or gain and all these things that seem to be a little bit more immoral now in the rest of English Canada than they are in Quebec.
Nowadays we are comfortable with the notion of profit and gain. How can it be, however, that some countries have a better system so that people can grow, can invest, and can take advantage of these programs with a much better tax structure? Countries have like Germany have no capital gain, and I wonder why our southern neighbour is certainly more competitive than we are.
I go back to my pet project, which is the Employee Stock Ownership Program. Why has your group not convinced the people in Finance, for instance, that this would be a major change for the investment in the SMEs? Where is the mental block on this question? I cannot understand it. I talk to people, and I think that they understand me, but at the end of the day it goes nowhere.
Mr. Gray: In terms of employee stock option plans, as long as I have been representing small business, I can remember that various presenters have suggested ESOPs. Within our membership, they are not well understood or even highly used or valued. I think there has been really inconsistent experience with their use in our end of the market.
Profit sharing plans or incentives tend to work better in smaller firms, where you can set an objective for the year, help the employees participate in the earnings of the firm, and then distribute them that way. That seems to be a more common practice, and it is something that is used more often.
In terms of convincing Ottawa, one could argue that part of it has been that we have been fighting a deficit, that fisc is protecting itself, et cetera, but this has been a problem since the mid 1970s. This is not something that has come along only with a battening down of the hatches in Ottawa. Now that we have presumably eliminated the deficit, I do not think anybody is disputing the need to free up the investment capacity of average Canadians as well as sophisticated investors so as to allow for productive business and wealth creation. I think that is critical.
I think both this committee and the caucus have a key role in moving this agenda forward. We can do what we have done for years to try and change this, but things will not actually change until the political masters are ready for that change, and until they embrace it.
Senator Hervieux-Payette: In your paper you say that all levels of government need to move away from forms of taxation that are insensitive to profit. Do you think you could at least give us the forms of taxation you are talking about? Are we talking about amortization? What forms are you referring to?
Mr. Gray: I will give you an example that is in your own backyard; it is out of Quebec. When I first joined the CFIB some twenty years ago, they had a payroll tax to pay for the province's health care system. It was constructed a little bit like the EI system today. It was paid 0.8 per cent by the employee, and 0.8 per cent by the employer.
Mr. Parizeau came along and decided that it was no longer legitimate for the employee to have to pay into the health care system. He decided that it would become a 1.5 per cent payroll tax and that it would be paid entirely by the employer. For years thereafter, various Quebec governments decided to keep moving this rate up. It was not politically controversial, and you could get away with it in a budget. The cost to business in terms of that payroll tax -- and this is particularly damaging to smaller-end firms that are more labour intensive -- finally was over 4 per cent.
We have been able to convince the PQ government that it is in its interest to move this back down, but it is still exceedingly high. Combine that with high EI rates, especially considering the surplus in the fund and the break-even level for EI right now as opposed to what they are charging. CPP is also increasing on an ongoing basis -- if you look at the graph there, it shows you exactly what has happened. Governments have collectively decided that they love the nice steady stream that does not gyrate with the business cycle. They do not lose when times get tough, and they do not have to go and raise money other ways. It keeps coming in.
A company may be totally unprofitable, but it still has to pay those payroll taxes and property taxes. Perhaps the rates should be predicated on a more progressive system whereby a company would pay more if it made a profit, and less if it did not.
That is a structural change in Canada that has occurred over the past 15 or 20 years. It is serious in terms of not allowing money to flow down, which is the way that most small firms grow. They take the profits and put them back into their operation, but if no money gets there because it is grabbed away by governments before it gets to the bottom line, then what is the point of that?
I can tell you that that kind of policy would help the north shore of New Brunswick. It would not be another round of past failures, where we threw money at a problem and hoped it would resolve itself. You have to structurally help the small firm sector to grow, create jobs, and create wealth.
Senator Meighen: On the subject of the small business sector creating jobs and creating wealth, I could not agree with you more.
To borrow from Professor MacIntosh, I do not want to throw a blanket on anything, but I was struck by an article that Neville Nancekivell wrote a week or so ago talking about the productivity gap between Canada and the United States. He wondered what would explain that difference, and the first reason that he pointed to was our industrial structure. He said that the U.S. had a greater share of high-value, knowledge-based industries. The second one rather caused my eyebrows to go up. He said that small companies are typically only half as productive as large ones, and he noted that small firms account for a larger share of the economy in Canada than in the U.S.
Would you share that view? If you do, must we ensure that, rather than starting a big business by opening up a large business and waiting for it to shrink, as was the joke in Ontario some years ago, small businesses grow into larger businesses as quickly as possible in order to improve the productivity level?
Mr. Gray: I saw that article, and I did not see where Nacvel referenced any study. I have not seen the study upon which he has based this declaration. If indeed there is a difference in productivity, I think it may have something to do with the use and application of capital machinery within firms.
Canada does have higher labour rates in small firms than other countries, but one of the things that is interesting about the productivity debate in this country is that we are not talking about taxes and their effect on productivity. It is absolutely essential to talk about the two in combination, but reduction of taxes seems to be a sensitive topic in this country. Frankly, I think that one of the reasons the whole productivity debate is all over the map is because nobody will get to "It is the taxes, stupid."
With regard to small firms, why do we have a very well established small firm sector vis-à-vis the United States? A lot of it has to do with what I call artificial barriers to growth. Whether they are in the tax system, in the regulatory environment, in access to markets for equity or whatever, we do not know what they are and we do not have public policies to manage them. That is why I stressed the importance of examining why we do not have a bigger mid-size sector in this country.
What policies do the Americans have? Notably, they help small firms grow to mid-sized and large firms, which is something that the Small Business Working Group in 1994 really emphasized. If you examine that document, it discusses a whole lot of barriers that prevent small firms from graduating. That growth in size, however, is what we want. We want firms to increasingly graduate from smallness to the mid-market to the public markets, and in that way to keep the economy growing.
Mr. MacIntosh: If I might just add a comment, senator, I wanted to get back to the point I made earlier about the importance of secondary market trading mechanisms.
Some interesting work has been done recently in developing countries. The question is, does a healthy economy result in good secondary markets, or do good secondary markets pull the economy along? Which way does it work? The preliminary conclusion seems to be that healthy secondary markets really pull the economy along.
It seems to me that there might be some connection here to the absence of a really healthy and vital sector of mid-sized firms. The U.S. has more effective secondary markets, and I think that does feed into a healthier mid-size firm sector. The public markets there are much more effective in the range of very small firms. Firms can go public more quickly and raise public funds at a much earlier stage, and I think that that is one thing that contributes to growth.
I would emphasize the importance of developing effective secondary market trading mechanisms to encourage early investment and to supply public capital at early stages of growth.
Senator Meighen: How might we achieve that? Is that a government responsibility?
Mr. MacIntosh: Well, that is the $64,000 question. I think that part of it is pure economics. We are a relatively small country compared to the United States, and we do not have the same economies of scale in underwriting. That will slowly change as the economy grows bigger.
I will give you an example of that. In San Francisco, specialist underwriters like Hambrecht & Quist do technology offerings. We do not really have specialist underwriters in Canada. We have some like Yorkton that focus on smaller, riskier firms, but we do not have the same degree of specialization in the underwriting community.
This is an issue that just has not been studied in Canada, and it may be something that you should encourage people to take a look at. What is the structure of the underwriting industry in Canada compared to in the United States? Why is it different? Why do underwriters not specialize? Why do we have fewer underwriters servicing the small firm sector? This is an issue that really has not been explored, and I think that it should be.
Senator Meighen: Perhaps it goes back to what you were saying earlier about barriers. If they are not removed, why would you make your living as a high-tech underwriting expert if there were no opportunity to ply your craft?
Mr. MacIntosh: That is absolutely right, yes. There is a chicken and egg problem here, and a lot of American exchanges have indeed attempted to create junior exchanges to pull along the junior firm sector. By and large, those have been remarkable failures.
Now there is a pan-European exchange, EASDAQ, which is modelled on NASDAQ in the United States. I hold out great hopes for its success, because it has a very large pool of capital and much greater liquidity.
In the end, some may argue that the unification of Vancouver and Alberta is, in fact, a very good thing because it does create greater liquidity. That may actually be the key factor. The right direction might be to somehow create mechanisms that pool trading in one location to enhance liquidity. Liquidity attracts listing firms and it attracts investors.
Senator Meighen: There is one small detail that I wanted to get you to expand on. When you said pooling, is that what you were referring to in the Canadian context with respect to Calgary and Vancouver?
Mr. MacIntosh: Yes.
Senator Meighen: And yet you also said that one thing that concerns you about pooling is that it would reduce competition, and competition has ensured listing standards. My eyebrows went up as I thought of some of the fun and games that have gone on in the VSE over the years. How did the competition in Calgary and Vancouver ensure high listing standards on the VSE?
Mr. MacIntosh: Some people would argue that competition between exchanges has created a race to the bottom which has been won by the least quality player. I guess I tend to view competition between exchanges the same way that I view competition between firms. We do not know how bad it might have been without competition between exchanges.
There is an argument out there that when firms have inefficient listing standards and inefficient regulation, they will attract neither firms nor investors because returns will be very bad over the long haul. If you have competition between exchanges, however, the exchanges will compete to put efficient regulation in place.
Perhaps we have not had efficient regulation in some of our exchanges because we have not had enough competition, but there is an argument circulating out there that competition between exchanges is, in fact, a very good thing. If you look to the United States, I think you can see that more than you can in Canada. There has been a lot of competition between exchanges, and in Europe as well, which has really dramatically changed the nature of both the American and the European exchanges.
Senator Meighen: Do you hold out great hope for what NASDAQ is doing?
Mr. MacIntosh: I am not sure if we can do exactly what they have done in Canada, just because we are relatively small. With EASDAQ, they have pooled all trading in the European community basically to create a critical mass of trading, which I think will create an effective market. It may be that we are not large enough in Canada to do that, but perhaps the unification of the two junior exchanges will be a move in the right direction.
Being an academic, you understand I always have to say, "On the one hand, and then on the other hand..."
Senator Meighen: Lawyers tend to do that. Ms Macdonald, you spoke about the activities of pension funds, and I think you said that, in the 1980s, pension funds in both Canada and the United States were quite active in the market that we are discussing this morning. Then they pulled back. The American pension funds have come back in; the Canadian ones have not. Why is that?
Ms Macdonald: I think there are two reasons. There is no question that there were performance issues in both markets in the 1980s. A lot of money came into the market in a short space of time, and we had a very green venture capital industry in those days. There were a lot of managers who did not have a lot of experience. Performance looked bad by 1987 or 1988, and so the pension funds -- which previously would have committed to pools for ten years -- stopped committing to new pools in both countries.
As it turns out, the performance of venture capital is very much related to when the money actually goes out, to market conditions, to the price you pay on the deal, and to the ultimate exit opportunity. The venture funds formed in that period of time in both Canada and the U.S. therefore did perform poorly.
Funds that formed afterwards started performing better in the U.S. In Canada, however -- again because of size -- the market is much more personal. If a pension fund had gone to its investment committee and convinced them to put some assets into this asset class, they would have had some bad performers, and they would have taken some flak from their investment committee. They did not have as broad a base to diversify across, so they said, "Let us just leave it."
At the end of the day, they did not think the market was wide enough or deep enough to justify the push to get their investment committees -- and ultimately their decision-makers -- to agree to re-enter the asset class.
In my view, there are two problems today. One, if you look in the U.S., is that the average venture capital fund being formed there now is well in excess of $200 million. This is primarily because each individual pension fund that puts its capital in wants to put in at least $20 or $25 million, and they do not want to control more than 10 or 15 per cent of the fund. By definition, the venture capital fund has to be $200 or $250 million. You can have many such funds in the U.S., and they are not tripping over each other.
Let us take the same principle in Canada. It would be equally logical for an Ontario Teachers' Pension Plan or B.C. Pension Plan -- any of the big public sector pension plans -- to want to be part of a $250 million fund. The reality, however, is that our economy can only support so many of those funds.
Last year, the venture industry across all of Canada invested just under $1.7 billion. The average fund size has tended to be smaller, so the economies of scale show up in the institutional side as well. As for the smaller mid-size pension funds, they should be logical players. I had a fund manager in my office last week who would like, in fact, to commit some small portion, 2 per cent or 3 per cent of the fund's assets, to venture capital vehicles. To do that, however, they would probably need to invest in 10 or 12 venture capital funds.
In Canada, we do not have the gatekeepers or fund-to-fund managers that they have in the U.S. An institution in the United States can say, "Okay, that means $200 million for us over the next five years. We are going to put it under the management of this one gatekeeper and, over time, they will then put it in venture capital funds." We do not have that intermediary vehicle in Canada, again because of the size of the market. A lot of the funds just are not interested enough in supporting the evolution of that type of mechanism.
The net result is that the pension fund manager of these mid-sized players says, "I do not have the resources inside my shop to actually do the homework, do the due diligence, pick the 10 or 12 funds and put the money in." The smaller guys cannot do it because they do not have the time, and the bigger guys have trouble doing it because they cannot find enough big funds to accommodate the capital they want to do.
Senator Meighen: Just a comment, if I may. I think we are starting to get managers of managers here, whether it is an indigenous idea or imported from the United States. I was at a beauty contest for the investment of an institution's funds the other day and one of the candidates was a manager of managers, so it may come.
When we were in Vancouver looking at the Canada Pension Plan, we had some very intriguing testimony from somebody saying that 1 per cent, 2 per cent, or 3 per cent of their assets should be dedicated towards venture capital activity.
Ms Macdonald: Absolutely. If you look at the asset allocation models in the U.S., typically 3 per cent to 5 per cent goes into alternate assets.
Senator Meighen: But not here.
Ms Macdonald: Some of the big funds are, in fact, making a deliberate entry into the field. I think the fund-to-fund managers are still perhaps focusing on the more traditional securities, and we are not yet seeing them involved in this market segment.
Senator Kroft: The more I listen to this, the more I realize that it is possible to get confused. On the one hand, there is an opportunity for all sorts of funds to be there, yet there does not seem to be room for them because of the structural considerations.
I want to come back to the tax element. Put it very simply: You have funds that are gathered there where the tax benefit is granted on a going-in basis. Yet we have not found any tax opportunity or acceptability of giving any tax consideration on the going-out basis. You are giving an inceptive for the gathering process with the tax mechanism, but you are not doing anything for an incentive on the ultimate liquidation and reward side.
I do not know if you have any comment on that. The policy seems to be rather unequal. If I can be cynical enough to say so, it seems to have flown by on the labour-sponsored funds because the objective was the blue-collar type of investor opportunity. We have heard, however, that that is not the substantial composition of the funds. The collar is getting bleached as we go and, in fact, is not really what it was set out to be. Is that an overstatement?
Ms Macdonald: I think you would find a lot of variance across the country. I have not seen any data on that. I am not sure where Mr. MacIntosh's data comes from but, being an academic, I am sure it is well-founded.
In Quebec, there is no question that the Solidarity Fund and the Quebec Federation of Labour are closely tied. I would imagine that a very high proportion of the shareholders in that fund had some links into the community.
There are two sets of issues here. You are right to say that the incentive has been on the gathering end. I would not claim to be an expert, but there clearly were political drivers in both the creation of the Solidarity Fund in 1983 in Quebec and in the creation of the framework for national funds in the late 1980s at the federal level. Those drivers probably had very little to do with the venture capital process in many respects, but you folks would understand that stuff much better than I do.
It gets complicated, however, with the withdrawal of institutional sources in Ontario. Mr. MacIntosh is absolutely right that the link is very tenuous, but these vehicles became a critical way of getting capital into the market. Encouraging the gathering process was therefore not a bad thing between 1991 and 1995, for example, in Ontario or in B.C., where the institutional sources had gone away. The original intent was turned around, but the ultimate outcome had some value.
It did not make sense for anybody to be seriously rocking the boat until things got out of balance, which they did in 1995-96. The government responded shortly thereafter with changes to the incentives, and we have seen a great moderation.
If you look at the inflows now -- again, with the exception of Quebec, which is a unique and distinct situation because they are still attracting $350 million or $400 million a year -- they have moderated.
I do not disagree with you, then, that from a policy perspective the emphasis in this marketplace needs to be on performance and outcomes. It is also important, however, to recognize that there are a lot of successful entrepreneurial companies in several parts of the country. I totally disagree with Mr. MacIntosh that the window of time and the other sources were simply not available, and I do not believe the labour funds crowded them out. They are now easing off and other funds are coming in, and we are achieving more balance, which is far more appropriate.
Senator Kroft: What has the change in the incentive offered or allowed?
Ms Macdonald: In the first round of changes two or three years ago the tax credit itself was reduced from 20 per cent and 20 per cent. So 40 per cent in total to 15 per cent and 15 per cent -- 30 per cent.
The holding period was increased from a five year minimum holding period to an eight year period. Frankly, that is where it should have been in the first place. The maximum amount that individuals could purchase was originally reduced from $5,000 to $3,500. That was increased back to the original amount in last year's budget. We still got the 30 per cent, the eight year hold, and the $5,000 maximum.
Mr. MacIntosh: Your question reminded me of what I see as an additional problem with labour-sponsored funds. I did not put it in my submission, but it is that, particularly in the early stages, investors could redeem after five years. A normal institutional capitalized fund would last for 10 years, and because venture capital was necessarily very long-term capital, that created a lot of problems for funds.
It has been lengthened to eight years. I think it probably ought to be lengthened to 10 years to make it comparable to the average private fund so that labour-sponsored fund managers have basically the same incentives facing them as private fund managers. That is to say, so that they do not have to invest too quickly.
Senator Kroft: There is a tax cost to the gathering of funds through this mechanism, but I do not know what calculation there has been of that tax cost compared to the way that the Department of Finance will calculate the cost of the RRSP benefit. If the taxing authorities were prepared to make that type of a tax investment -- if it were put on the other end, on the realization end -- is there a supply of funds in place that would reduce the need for the tax subsidized gathering process?
As I understand it, you disagreed about how much it was needed, and about how it responded to a window in time when the supply of funds had substantially dried up. I am now looking forward, because governments have a way of carrying forward ideas that were good ideas 10 years ago, but that no longer meet current circumstances.
What would you say as to the availability of funds if we could give more emphasis to the ability to realize after five years, eight years, or whatever, on a realized investment basis?
Mr. Gray: In this country we have artificial things that sort of direct money in various directions. For example, why do I put money in an RRSP? I am given a tax incentive to do so. I get a kick out of the fact that, if I invest in Olympia and York, that is a safe investment, but if I invest in a private company in northern New Brunswick, that is somehow risky for my pension plan. I get incentives to go to the major capital market players, and to some extent there is also artificiality with regard to LSVCCs.
As a taxpayer, I get an incentive to throw my money into an LSVCC and hope that the investment will get to a firm. It probably will not get to one that I know, but it will get to a firm that may create wealth and a return to me or to the investment pool.
I suspect that, if you made the capital gain provisions a little bit more generous, you would see a much wider diversification of investment by average Canadians in every part of the country, and a smaller size of categories. That would be good for our sector, but it would also have an effect on the flow of funds into the LSVCCs. I would then make a decision that maybe I want to investigate locally instead of through the LSVCC mechanism, wherever it may exist.
Mr. MacIntosh: I think less money would have flowed into the LSVCCs if we had had the kind of mechanism that you propose. It would have been a better mechanism, because it would have induced a lot more discipline in those who had been investing in a labour-sponsored funds. They would make sure that they were investing in a good fund, one that would produce profits.
Many people have invested in the labour-sponsored funds on the basis of the current tax regime. They have done little or no investigation of the nature of the fund that they are investing in, simply because of these extraordinary tax benefits that they have been reaping. As I mentioned before, that creates this mismatch between investors and investments, and I think that is very troubling.
The kind of mechanism you propose would be a great improvement.
Ms Macdonald: In my view, stability of supply is one of the most important factors. I do not think it makes sense in a country the size of Canada to take one-shot approaches.
We have invested a lot of money in the creation of the labour-sponsored vehicles, and stability is important going forward. I think that to destabilize that with a dramatic shift in policy at this point would have a negative impact.
In terms of future flows of new moneys coming in, one of the obvious places to focus is the reinvestment of individual wealth. As you heard in Allan Riding's testimony, knowledgeable entrepreneurs tend to reinvest in businesses that they understand. Encouraging entrepreneurs to reinvest through the capital gains, reduced capital gains would therefore certainly be advantageous, as would continuing to try to figure out how to make it more attractive for institutions -- big institutions to flow more capital into.
If you can do that, you have sort of addressed the box. You have the high net worth individuals. You have smaller ticket individuals, and you have the large institutions. The large institutions will pick up the slack. They are clearly the most efficient source of capital for this marketplace.
Senator Kelleher: I would like to change the focus of the questions this morning, if I may, and look at the individual who wants the money. Our focus has been on supply, which is not the problem today that it was five years ago. It is improving. Largely, there is money out there.
There is another problem, however -- perhaps not a major one -- and that is the problem of the fellow who wants the money. Many individuals, particularly in the area of software, where many are highly educated, are relatively unsophisticated in business matters. Many of them do not know how to access this money or understand the need for a business plan. If they were to go to their local bank, they would not get much encouragement at that point because the banks are not all that interested.
To this point, I have not heard any evidence to tell us who it is that is trying to help these individuals access this money. Are there courses? Do government agencies produce booklets to guide people on what they have to do? Is there anybody out there explaining to them just how much equity they will have to give up to get this money?
I do not know how serious this problem is, but I am inclined to think that it is a problem. As such, I have not been able to find out from anybody who is helping these people who want the money. I would like to hear your comments regarding this area because if, in fact, it is a problem, then it is something we should be addressing.
Ms Macdonald: I think it is a problem, but one that we are starting to make some headway on.
I am encouraged by the fact that, for example, Mr. MacIntosh teaches a course at the University of Toronto in which a whole segment focuses on entrepreneurial financing, corporate finance. It is being introduced at the curriculum level. Therefore, the kids coming out today have a better understanding. The same is true of the MBA programs.
There is so much more media attention, and that is making a huge difference. For example, when I go back to my office today, because of this list in the ROB, my voicemail will be full of people who have looked at the paper. They often start with a call to me or to an information source. People like Gordon Sharwood have built their place in the world acting between the entrepreneurs and the sources of capital.
The infrastructure is starting to unfold. With the tools that are available, through the media and through the Internet, a small software entrepreneur who has not been able to figure out how to move from the small box into the bigger world probably would prefer to continue being a technically focused entrepreneur as opposed to a business builder. We need to do everything we can to encourage people to lay their hands on the tools. The federal government, through strategists, has introduced a whole ton of tools. A number of vehicles are available to help assess what one needs in terms of a business plan, capital needs, and sources of capital.
At some point, if entrepreneurs cannot get themselves from A to B to start to access those tools, I am not sure how far, from a policy point of view, we will need to push them. We certainly want to encourage the development of those tools, but at some point entrepreneurs have to take the initiative to avail themselves of those tools.
Mr. MacIntosh: I will just quickly add that the academic literature is identified as one of the major problems in getting many entrepreneurs off the ground. The authors may be great scientists, terrific innovators, terrible business people, but no knowledge of finance. That is one of the large gaps you have to bridge.
Ms Macdonald referred to some of the government programs that exist to try to bridge that gap. I think governments are aware of this problem; however, who knows if they could be doing more to address it. It is a big problem at the university. I think we are starting to tackle it somewhat, not only in the classroom, but in bringing universities closer to the entrepreneurial community and trying to educate them in that way. However, it is a big problem.
Mr. Gray: That is a great segue, because there definitely is a managerial expertise issue. However, I think that we had better be careful about broad-brushing here. There are many entrepreneurs out there who are good managers, who know how to run their businesses very effectively. They may not have an MBA-sponsored business plan, but they sure do have a plan and a strategic orientation.
Having said that, when we asked our members who they look to for information and advice in the operation of their businesses, the marketplace players that can help them get what I referred to in my brief as investment-ready, they look to what we call trusted sources; in other words, their accountant, their banker, their lawyer, suppliers, and even competitors, to some degree. After that, you come way down the scale to the government and academic sources. The reason for that is that the entrepreneurial sector does not believe that these sources truly can deliver the goods, in terms of their needs.
Historically, I think it is fair to say that, in this country, MBA and commerce programs were focused much more on the large-firm sector, representing millions of dollars, not thousands of dollars. I attended the business program at Western University. We were not studying about small-firm Canada; we were concentrating on the TSE 300.
Having said that, there is a role for the academic class to connect with the business community in much more effective ways, to leave their ivory towers.
Another element concerns what I call the advisor class, the chartered accountants and so on who spend a lot of their time helping the entrepreneurial class fill out Statistics Canada forms and complex tax returns. As a result, there is not a lot of time for them to give what I call strategic advice to these firms, to get them ready for the investments they require.
Therefore, in broad terms, you are onto a good subject, but many things can be done by government, as well as what I call "advisors," to deliver the goods to the entrepreneurial class.
The Chairman: I wish to thank all three of you for your participation here this morning. I know we went longer than anticipated, but it was a fascinating and important discussion.
Honourable senators, our second panel this morning consists of Mr. Barrie Laver, managing partner of CastleHill Ventures, Mr. Brad Ashley, managing director of Priveq Capital Fund, and Mr. Vernon Lobo, managing director of Mosaic Venture Partner. Gentlemen, I would ask you to please come forward.
I would ask that each of you begin with a brief opening statement. After all opening statements have been made, Senator Kolber will begin the questioning.
Mr. Barrie Laver, Managing Partner, CastleHill Ventures: Good morning, Mr. Chairman and honourable senators. It is a pleasure to have the opportunity to appear before the committee this morning in order to provide my perspective on the current issues that are facing the venture capital industry in Canada.
CastleHill Ventures is a small, private, independent venture capital fund that was formed by me in May of 1997. Prior to founding CastleHill Ventures, I spent more than nine years with Royal Bank Capital Corporation, the bank's venture capital arm. CastleHill is focused on start-up and early-stage investments in the technology sector. Typically, I take a very active role, working with management, in the companies in which I invest. My experience includes having been CEO of a small software company and, as such, my level of involvement in these companies is appropriate because, for the most part, the management team of companies I become involved with is rather thin. I have some operating background to provide to companies I invest in.
I am currently in the process of raising a second fund, targeted at $40 million, the majority of which funds, I anticipate, will come from either pension funds or insurance companies, as well as high-net-worth individuals.
From my perspective, the Canadian venture capital industry has advanced a great deal during the time I have been involved with it, which is over 12 years. When I first entered the industry, the capital came primarily from corporate sponsors and institutional investors. Venture capitalists, for the most part, had financial and banking backgrounds. With a few notable exceptions, the investment focus was primarily on what I would call low technology expansion-stage or buyout transactions.
In the early 1990s, many of the groups that provided capital to the industry withdrew their support, partly in response, I suppose, to disappointment in returns and partly due to the economic downturn, which caused sponsors to have other priorities for their capital.
As you are well aware, it was during this period that the labour-sponsored funds gained prominence and retail investors became the primary source of capital for the industry.
Over the last few years, we have seen some of the large corporations, including the banks, BCE, Newbridge, commit or recommit themselves to the venture capital markets and we are starting to see some institutional investors becoming active again.
In my opinion, the most important change is the fact that the quality of management in the industry has improved dramatically. In part, this is because certain individuals, such as myself and others you are hearing from, have now been active for a number of years -- we have significant experience -- and, in part, because the people entering the industry for the first time bring a broader range of experience and skill sets. Both of these latter factors are important and drive other changes in the industry. First, with increased experience and broader skill sets, there is a greater willingness to entertain early-stage investments with minimal attention given to whether or not they have a strong tangible asset base. Second, there has been an increase in the last few years in a number of private, independent funds in the market. I see that as a positive development for the industry, in part, because I believe the industry and the economy benefit from a larger number of independent funds with a stable and knowledgeable source of capital.
In parallel, and obviously related to the advancements in the venture capital industry, we have also seen a significant growth in the number of quality investment opportunities. I see this primarily in the technology sector, given my focus. There are an increasing number of entrepreneurs who have acquired experience in one or more companies and who have the drive and, in some cases, the money to launch a new venture. While the two must, to a large extent, go hand in hand, in my view the number of good investment opportunities continues to support the growth in the number of funds.
While, overall, I am clearly of the view that the venture capital industry is moving in the right direction, I do see a number of challenges. Notwithstanding the increase in capital commitments to venture funds over the last few years, this is an area that requires continued attention. While there are more funds in the market now and there is more capital than ever, it remains significantly more difficult for a start-up or early-stage business in Canada to attract the amount of equity capital that a competitor in the U.S. may have available to it.
High-net-worth individuals are an important source of capital for the industry. This group is active at both the angel level in seed capital situations as well as investing in private independent funds. Canada's high rate of capital gains tax is a barrier to increased investment activity by these individuals.
The relative high level of investment risk assumed by an investor in these situations requires the potential for very high rates of return, and this potential is significantly reduced through capital gains taxation. Reducing capital gains taxes for persons investing in start-up and early-stage private ventures would be an important step in recognizing the risks associated with these investments.
For the industry to continue to grow and thrive, we need to see a greater capital commitment from patient, knowledgeable, long-term investors, such as the pension funds.
It is important that this group appreciate the evolution of the venture capital industry over the last number of years, both from the perspective of the quality of professional management running the funds as well as the underlying number and calibre investment opportunities.
Furthermore, as was pointed out in Ron Begg's submission on behalf of the CVCA, there exist certain structural barriers to increase investment by pension funds, and I am supportive of the CVCA's recommendations to deal with these issues.
Overall, Canada needs a greater number of private independent funds, which will in turn allow more capital to be made available to start-up and early-stage businesses. We need to see an increased level of syndication of investments amongst equity funds.
The U.S. practice of syndicating early-stage investments amongst two to five investors is one that makes sense for a number of reasons, including risk-sharing, access to networks, and the ability to stage investments in a logical manner, and is something that I would like to see more of in Canada. To be sure, with the growth in the number of funds over the last few years, there has been an improvement in this regard, but there remains work to be done.
The proposed new escrow rules for initial public offerings will have a severe, detrimental impact on the industry. A clear achievable exit strategy is the necessity for venture capital investors. The proposed escrow rules will influence access to capital for a number of reasons. For example, the ability of new funds to raise capital will be reduced as the proposed escrow rules will undoubtedly impact the return on capital and impede the return of capital to investors.
Entrepreneurs are more likely to start a business in the U.S. instead of Canada knowing that the escrow rules will make it more difficult to attract capital in Canada and are more onerous upon the founders and other management. Companies based in Canada will be more likely to have access to public markets in the U.S. than in Canada or look to be sold as an alternative to going public, often to a company not based in Canada.
The proposed escrow rules must be altered so that they are not materially worse than those in the U.S. while still respecting the primary need to align investor interests with those of management.
In summary, as the committee has heard, the venture capital industry plays an important role in financing and providing expertise to entrepreneurial start-up and early-stage businesses. In a number of respects, the Canadian industry still lags its U.S. counterpart, but many of the gaps have been narrowed significantly in the last few years. We need to continue this trend and foster increased business formation leading to a greater number of companies that are successful on a global scale. This means we must work to make more equity capital available to these companies so that they can effectively compete in international markets.
Addressing the issues noted above, as well as those raised by others presenting here, will move us in the right direction.
The Chairman: Can you take two seconds to explain what you mean by the proposed new escrow rules because I, for one, am not familiar with them. Are these OSC rules?
Mr. Laver: They are intended to go national, but originally they came out of the OSC, I believe.
I am going on an IPO where currently a normal escrow policy would have, say, founders and major investors escrowing their shares for up to three years. The new rules propose a six-year escrow, I believe, on founders and major shareholder positions such as venture capital investors.
Senator Meighen: Is there anything in return for the increased period?
Mr. Laver: Not that I am aware of.
The Chairman: In other words, it says essentially that, where you once could sell out over a period of three years, you had to hold for three years, and in some cases five, in certain sectors, it is now six.
Mr. Laver: It is proposed to be six.
Senator Kenny: What ail is being cured with this proposed change?
Mr. Laver: I am not the proponent of it, but the perception is that investors in an IPO are taking a significant risk if management founders do not have their interests clearly aligned with those of the investors and, therefore, the investors are, in a sense, locked into the company for a longer period of time.
The Chairman: It is to get around the notion that the initial founders can bail out and leave the subsequent investors stuck. It is a rule that has been proposed by the OSC and it has been -- I am seeking clarification here -- sent out for public comment; is that correct?
Mr. Laver: That is my understanding.
The Chairman: We will deal with that when we talk to the OSC.
Mr. Ashley, please proceed.
Mr. Brad Ashley, Managing Director, Priveq Capital Fund: Mr. Chairman, Honourable Senators, thank you for the opportunity to appear before this committee to share with you my thoughts about the venture capital, private equity markets in Canada.
I established Priveq as a $10 million pool of capital in 1994 to assist small, profitable companies that required $250,000 to $1 million of equity or quasi-equity capital to grow their businesses. At that time, there was a dearth of capital for this deal size.
With the success of my first fund, I recently closed a second fund totalling just over $27 million, focusing on the same industry sector although targeting slightly larger deals, that is, $1-million to $4-million transactions.
As additional players helped to fill the under-$1-million-deal void, for example, BDC, Bank of Montreal Capital Corporation, Royal Bank Capital Corporation and some labour-sponsored funds, I moved Priveq towards slightly larger deals.
Please note that my fund is a bit of an anomaly today as we do not invest in high technology companies but, rather, focus on niche manufacturing and niche services businesses.
I understand that you have already heard from a variety of industry experts regarding the access and availability of equity capital for SMEs in Canada. I will not put forward my own statistics but, rather, will briefly provide my views on the following issues: first, the rationale for the difference between the Canadian and U.S. private equity markets; second, the role of government-assisted funds; and third, some deterrents to the growth of SMEs in Canada.
The first issue, as I mentioned before, is the difference between the Canadian and U.S. private equity markets. The major difference, as I see it, between the Canadian and U.S. private equity markets is the base of support for funds or, more notably, the investors. In the U.S., there is a tremendous available supply of private equity funds. I have just returned from a private equity conference in California, where estimates of between $80 billion and $90 billion of available liquidity throughout the private equity sector were being bandied about. That does not just include the venture capital pools, but also the buyout pools and mezzanine pools. This massive liquidity has resulted from the huge appetite of U.S. institutions to invest in this asset class in the U.S.
The institutional funding of private equity in Canada had, until recently, almost dried up. Notwithstanding this comment, I am very pleased to note that my recently closed second fund had the strong support of the Ontario Teachers' Pension Plan Board, a Canadian life insurance company, and FINOVA Capital Corporation. All of these institutional investors see this segment as vibrant, and are all keen to co-invest further in this sector.
In addition, FINOVA's recent entry into asset-based lending to SMEs in Canada complements Priveq's equity initiative to the benefit of cash-hungry growing companies.
Although there has been recent partial renewal of interest in this segment by Canadian institutions, they have generally stayed away from this sector, primarily for three reasons. First, their initial foray into private equity funds in the mid-1980s yielded low returns. This was also coupled by the institutions' perceived mismanagement of these private equity funds, which were typically staffed by the inexperienced venture capital managers. Second, the recessionary environment of the early 1990s kept most institutions on the sidelines. Third, as the economy began to recover, a new kind of venture fund was created in Canada, the labour-sponsored fund, which was primarily created through government tax incentives to help fill the void created with the institutions on the sidelines.
With the cheap dollars that funded these new labour-sponsored funds, an unlevel playing field was created that kept the institutions on the sidelines. When the economy began to recover, the institutions were reluctant to return as investors. They questioned why only investors in labour-sponsored funds were given this tax break. They suggested opening it for all venture capital investors or closing it for all. This tax incentive may have crowded out capital that may otherwise have poured into this sector but for the tax advantage available only to investors and labour-sponsored funds.
The role of government-assisted funds also warrants attention. Other than tax incentives that investors and labour-sponsored funds receive, the largest government initiative is their support of the Business Development Bank. The BDC grew up with a tradition as the lender of last resort. If a company could not receive banking elsewhere, they could turn to the BDC. This mandate has, over the last few years, changed dramatically.
The current BDC program is multifaceted. Some of their programs are very helpful to small business and are not available elsewhere -- for example, the patient capital programs and the sponsoring of technology seed capital funds. However, their mandate seems to have expanded beyond the areas where they are really needed and they now actively participate where there are significant alternative capital sources. BDC not only competes in these areas but they are, through huge promotional budgets, swamping the SME market with their offerings and are perceived to be very aggressive in their pricing.
While I believe their early-stage seed capital and patient capital programs are advantageous to Canadian business, their later-stage products are, in effect, a classic government crowding-out of a private sector that is otherwise well serviced by existing capital sources and potentially additional institutional resources. Their increased activity in the later-stage sector will deter further institutional funding of this sector. It may even cause existing participants to eventually vacate the sector.
The third set of issues that I would like to raise are deterrents to the growth of SMEs in Canada. I briefly wanted to note other areas of concern for equity investors that hurt the prospects for SME growth in Canada, many of which you have likely heard before. The tax regime definitely needs some further reform. The elimination or reduction of the capital gains tax would further spur investment, as after-tax return expectations would increase.
Private equity investors need to feel certain that they will be exempt from the associated company taxation rules that were not supposed to apply to us. I have been asked to elaborate on that on a little bit. That is the issue that, if I personally owned a series of companies, private companies, I would have to share the small business deduction across those companies. As a venture capital firm taking an interest in a portfolio of companies, to the extent that these portfolio companies are deemed to be associated, one could argue that small business deduction could be shared amongst that. I do not think that that is where the tax legislation was meant to go. I would suggest that that be clarified, to ensure private equity investors and the entrepreneurs behind these companies that they would not be subject to these potentially significant taxation.
The proposal for a national escrow regime, as Mr. Laver referred to, should exempt private investors; otherwise, I agree that the IPO market in Canada will likely die.
Directors' liabilities need to be reduced to ensure that strong boards can be created to help companies grow. Furthermore, when a company gets into trouble, the potential regulatory exposure deters good directors from staying with the company, which is counterintuitive, as that is when the company needs good outside directors most.
Please note that I strongly endorse all of the recommendations made by the Canadian Venture Capital Association to this committee.
In closing, a vibrant, private equity and venture capital market will help Canadian businesses grow, with the resultant benefits to the Canadian economy and society. The government should ensure a level playing field, to encourage an investment environment that can function without government crowding-out. The U.S. private equity market thrives without intervention. Their model works.
Mr. Vernon Lobo, Managing Director, Mosaic Venture Partners: Thank you for the opportunity to speak to you about equity financing for SMEs in Canada.
Mosaic Venture Partners is a venture capital fund that I co-founded in October of 1997. We formed the firm to fill a perceived void in the Canadian high technology venture capital market. Our view is that to nurture and grow successful high-tech companies, investors must add significant value beyond just capital, and must possess key skills: entrepreneurial and operating experience, and an understanding of technology, business strategy, and corporate finance. We believe that more of these skills are required within the Canadian high-tech investment community.
As to my background, I have an undergraduate degree in engineering from the University of Waterloo. I worked at Northern Telecom developing software and the engineering of digital telephone switches. I have an MBA from Harvard. I spent several years at McKinsey & Company, advising a variety of Canadian and U.S. high-tech companies on strategic and operational issues. I was a partner at another Canadian high-tech venture capital firm prior to starting Mosaic.
I have also started and run several business of my own. While completing my engineering degree, I built a real estate portfolio of 10 houses and two apartment buildings by the time I graduated. I had a boat chartering business, which I ran while I was at Northern Telecom. In 1994, while at McKinsey, I co-founded an Internet company called Cyberplex, which is now TSE listed and has a market value of over $150 million.
My partner David Lawee has a similar set of skills. He worked in merchant banking, has a law degree from McGill, and holds an MBA from Chicago. He started and built a $3 million multimedia business while in law school. He also spent time at McKinsey working on IT turnaround projects and large-scale mergers and acquisitions.
When it comes to equity financing for small business, we believe that our attention should be focused on wealth creation in strategic sectors of the economy. There has been dramatic growth in the amount of capital for these enterprises, but capital availability is only an input to success, not the objective.
I would like to organize my comments around three main elements that influence the flow of venture capital: entrepreneurial talent, capital quality and availability, and exit opportunities. Each of these is an important factor in the creation and growth of successful companies, and each can be influenced to some extent by government policy.
Encouraging and retaining experienced entrepreneurs is the first step to developing a healthy small business economy. These entrepreneurs need to be supported with experience, contacts, and capital from angels and professional investors who invest to help them build their companies. In addition, an attractive and robust IPO market drives the success of both of these groups.
We believe that the Canadian government has made great and positive strides in increasing the capital available for SMEs. We also believe that the magnitude and timing of tax incentives may be structured differently to more closely align long-term government interests with the interests of those who are creating wealth.
I would like to echo our support for prior recommendations made by the CVCA, and provide some additions and modifications within this framework. Some of the recommendations -- such as those around the previously mentioned National Escrow Regime -- relate specifically to the attractiveness of exit opportunities. Others, such as capital gains taxes, affect all three elements.
Although Canada has had significant growth in the availability of venture capital over the last few years, the structure here is quite different than in the U.S. As of 1988, Can. $10 billion of capital was under management in Canada, compared to U.S. $84 billion in the States. This ratio is close enough to the 1-to-10 rule of thumb that applies to most other Canada and U.S. metrics, so it seems like an appropriate amount of capital.
One difference is that more than half of the capital managed in Canada was generated through upfront government tax incentives designed to encourage capital formation. The government was obviously successful in rapidly creating large pools of capital to be deployed for SMEs through this initiative. Although this has helped get us going, however, it will not create a sustainable angel network, venture capital market, and technology sector. Virtually none of the funds raised in the U.S. were a result of tax incentives. They were raised based on the skills, experience and track record of the fund managers.
The viability and success of our emerging economy is also dependent on the availability and talent of the entrepreneurial pool and the robustness of the IPO market, neither of which is impacted by these upfront investment tax incentives. In addition, those initial benefits allow an investor to achieve the same financial return from an investment that performs poorly, thus creating less emphasis on wealth creation. This outcome does not seem to be in line with the government's objectives.
The real measure of investment success lies in the economic wealth that has been created. In fact, the roughly Can. $150 billion of market value that has been created in technology public markets in Canada -- half of which is from Nortel -- pales in comparison with the roughly U.S. $4 trillion created in the U.S., about 10 per cent of which is Microsoft.
In the U.S., the emerging economy has created more than 25 times the economic wealth that it has in Canada. If we exclude the largest companies in each company, the ratio grows to 48 times. That is in nominal dollars; if we were to put it in equivalent dollars, it is something like 75 times. Why is this? We do not know the answer, but we do not believe that it is because Canada lacks the entrepreneurial talent or the potential. We also do not believe that Canada is behind in terms of its technological capabilities. There are obviously many reasons, but we believe that our capital gains tax rate contributes in part to this contrast.
In particular, a reduced capital gains tax rate for specific qualified investments can play a key role in addressing all three elements of venture capital flows. It can improve the risk reward ratio associated with leaving a secure job and starting a company, thereby creating an incentive for experienced managers to take entrepreneurial risks.
A reduced capital gains tax rate would attract angels, and it would allow capital to flow to those venture capital investors who have the necessary skills, and who have previously succeeded in creating value in early-stage companies. It would also encourage public market investors to participate more aggressively in IPO issues, and to recycle capital for further investment more regularly. Furthermore, government tax revenues would not be reduced in the short term to encourage capital formation, but rather would be impacted only after market wealth had been created and monetized.
In short, upfront tax incentives are tantamount to giving awards at the beginning of a race rather than to the winners. We believe that a reduced capital gains tax for targeted investments would allow those entrepreneurs and investors who create value to keep a disproportionate share of that value as an incentive and reward. It would also allow the government to ensure that economic wealth is being created and recycled for further investment, rather than simply ensuring that capital is available for funding.
The relative attractiveness of the U.S. tax and market environment is also an issue. In the U.S., capital gains tax rates are 20 per cent for investments that are held for more than a year, compared to 37.5 per cent in Canada. Therefore, there is a significant financial incentive for talented entrepreneurs and venture capital investors to pursue opportunities in the U.S. Entrepreneurs and investors end up paying roughly half the tax in the U.S., not to mention the additional capital available and the significantly higher valuations afforded them in U.S. public markets.
The other result of this situation is that U.S. investors are frequently coming to Canada to invest in high-tech companies, and they are offering more attractive terms than Canadian investors can offer.
I have seen many of my most talented Canadian friends compare opportunities in Canada and in the U.S., and they have concluded that the social and personal benefits of living in this country no longer outweigh the economic disadvantages.
Let me provide you with one specific example. We recently invested in a company run by a Canadian friend of mine, whom I worked with at McKinsey in Toronto. He grew up in Canada and completed high school here, but he received his undergraduate degree and MBA from Harvard. He graduated last year, and he decided to start an Internet company in Boston. I tried to convince him to return to Canada, but it made no sense to him. He was convinced, and rightly so, that the personal and company economic potential were far greater in the U.S.
Because of our relationship, he did allow us to invest with him, and it has been a great success. He is receiving U.S. $100 million in financing from a large U.S. investor and, as part of the arrangement, we will both receive a sum of cash. Had he stayed in Canada, he would not have received anywhere near the valuation that he did receive, and he would have paid an additional Can. $600,000 of tax. As it turns out, we will be paying a large amount of tax through our fund.
Another point that highlights our loss of talent is the fact that several senior executives of some of the largest U.S. Internet success stories are Canadian. Jeff Mallett is the president and COO of Yahoo. Paul Gauthier, a Halifax native, is co-founder of Inktomi, which is a $7 billion search engine company. Jeff Skoll, a Montreal native, was one of the founders of eBay. Rob Burgess is the chairman and CEO of Macromedia, a multimedia software developer. All of them are originally Canadian. There are many stories like this, and this loss of our top talent needs to be addressed.
In summary, we believe that it is important for the government to take wealth creation -- and not just capital availability -- as its metric for success in the emerging economy. We cannot build a great industry without great entrepreneurs, and we must do everything that we can to retain them.
We also need to build an angel and VC community that will sustain itself by delivering extraordinary returns. The upfront government help has been good, but it should not be viewed as a permanent solution. We must create an attractive tax and market environment, and let market forces drive capital to entrepreneurs and investors who are successful at creating wealth.
The capital gains tax is not a panacea. It is, however, a critical tool that can be used to encourage and reward the creation of wealth and of strategic sectors of the economy. It will address all elements of venture capital flows, including entrepreneurs, angel and venture capital investors, and IPO investors. Finally, it can be tailored to focus precisely on the desired outcomes, and will only impact government tax revenues after wealth has been created, not before.
Senator Kolber: Good morning and welcome. I think, Mr. Lobo, that some of my colleagues and I are investors in Mosaic.
Mr. Lobo: I know you are.
Senator Kolber: By the way, on the issue of capital gains rates, I believe there is a bill before Congress that will change the 20 per cent to 15 per cent that will likely be passed. Therefore ours will be almost triple that of the United States when that happens.
These are terrific briefs and we appreciate hearing them and they all basically say a lot of the same things. There is really no point beating a dead horse, as they say.
What, Mr. Laver, is generally believed to be the ratio of success when you do start-up deals? They used to say one in ten succeeded; is that still true?
Mr. Laver: It is still the number that is bandied about. I do not think people go into a venture capital fund, as managers or investors, hoping that they can get one in ten. You can define "success" widely. Some would define it as making 20 per cent or 30 per cent on their investment, which I would not define as success for an early-stage or start-up investment.
I do not have the numbers at my fingertips to say factually what the success ratios are, but my sense is the target is probably, at least in terms of significant winners in your portfolio, closer to three to five out of ten, recognizing always there will be some write-offs.
Senator Kolber: If it were three, and you invested $100 in ten companies, and you lost $700 and you still had $300, what sort of multiple would you need to break even before tax? I mean, do not tell me the answer, but it seems to be quite high.
Mr. Laver: Yes.
Senator Kolber: If, after that, you have to pay out 40 per cent of your winnings, it almost seems like a dumb business for Canadians to be in. You guys have succeeded, so that is wonderful.
However, I think to achieve an order of magnitude of what we are talking about here is a really major challenge that we in Canada -- I do not know if you agree -- seem to be making more difficult.
Mr. Laver: I agree.
Senator Kolber: How would you define "venture capital"? I think that I, and the public, often confuse it with high-tech start-up situations where some guy has a bright idea, needs all kinds of help, needs equity money, but does not need the banks. Other witnesses, including you, have said that you do not do any high-tech. You only do niche stuff, whether it is Miss Vicky's Potato Chips or whoever. How would you define it?
Mr. Laver: Well, the Canadian industry has seven or eight segmented layers, from seed capital to start-up to early stage. I think in the United States, the venture capital industry is defined as much more seed, start-up, early-stage investing, and then the industry segments itself in terms of buyout funds and mezzanine funds and that sort of thing, which is something you do not see in Canada to the same degree.
I define venture capital as investing in early-stage or start-up companies, not so much the buyouts or the mezzanine, although broadly speaking, the Canadian industry does include those in its definitions.
Senator Kolber: Last question. Do you have any bright ideas on how we can put together a cadre of better managers?
Mr. Laver: I do believe it is happening. I think the laws of supply and demand work. Certainly, the people that came into the industry in the 1980s, myself included, came from financial backgrounds. Increasingly, the people you see coming into the industry, such as Vernon and others, Dennis Bennie, et cetera, are coming with direct-operating skill sets, having never worked particularly in a financial institution or a bank environment.
I think that evolution is occurring and that it will increase as people see the returns in the industry as being good or very good.
Senator Kolber: Of course, we have a collateral problem -- forget about capital gains for a second -- in that our regular tax rates drive a lot of entrepreneurs down to the United States. Do you find that to be much of a problem?
Mr. Laver: You will always see, I think, some of the real high-level entrepreneurs move into the U.S., down to Silicon Valley or Boston, partly because it is just a much more energizing environment. There are so many more companies down there that they can work with, excel with, than there are in Canada right now.
I think the issue with taxation is probably a little bit more important at the mid-level management, the guys who are actually doing the coding, who are running your marketing areas or whatever, where they are starting to migrate down to the U.S. in greater numbers.
Mr. Ashley: I think the first question dealt with the definition of venture capital. I define it quite loosely, as really covering both the early-stage and later-stage investment in small business in Canada, but I do not get caught up in the definition. Some people call it "private equity." Some people call it venture capital, and in my brief you will see I put a slash between the two of them just because I use them interchangeably.
I think what is important is, it is not just passive money that will go to these companies. It is typically money going in with a value-added component. The venture capitalists are working with these companies and helping to nurture their growth.
Senator Kolber: So writing a cheque is not, by itself, the answer?
Mr. Ashley: I consider that to be venture capital.
Senator Meighen: Welcome, gentlemen. As Senator Kolber said, these are excellent, very clear briefs. I guess we tend to, certainly speaking for myself, agree with a great deal that you say in there.
Just a couple of specifics, Mr. Ashley, I guess, on directors' liabilities. You recommend they be reduced to ensure that strong boards can be created to help companies grow. As you say, when companies get into trouble, the increasing tendency is for directors to bail out because they cannot afford to stand up to the potential liabilities.
This committee is on record -- and maybe the Chair can tell us where our recommendations are with respect to the directors' liability -- as advocating that a due diligence defence be available to directors. Would that go a long way toward solving the problem you raised?
Mr. Ashley: That would definitely help. However, I guess one has to define due diligence with respect to the directors' liabilities for withholding tax. I think there is some jurisprudence that notes that just asking the question in board meetings is not sufficient. I think one court held that one had to see the cancelled cheques in order to have satisfied the due diligence defence test.
Senator Meighen: Whoever said our lives are being run by courts and judges?
Mr. Ashley: I generally agree. I think the absolute liability needs to be taken off directors, but I think due diligence has to be defined and not just left as an open reasonableness test.
The Chairman: The question was, what has happened to the committee's recommendations on governance. I understand, as I said to the committee before, that all of the recommendations in our report of about a year, a year and a half ago, will be included in the modifications to the Canada Business Corporations Act that will be tabled in the fall.
Senator Kolber: Mr. Chairman, I might add, on some corporations, such as banks, I think half the agenda is government controlled, stuff that you must put on the agenda and say, "Yeah, we went through and it looks nice and thank you very much."
Now, when I first started on the board 27 years ago, there was nothing. Now it is half, and they say within two, three years, it will be 80 per cent.
Senator Meighen: I guess it was Mr. Laver who raised the issue of needing an increased level of syndication of investments among equity funds, which made me think of the regulations governing individual investors getting together. I think there are securities regulations prohibiting people from getting together and reaching the $150,000 threshold or whatnot. Is that something you would like to see done away with, or is it not an inhibition?
Mr. Laver: It is a factor that I think limits the ability for seed financing. I find the $150,000 rule to be somewhat artificial. It is not correct to assume that because someone can write a $150,000 cheque, they are knowledgeable, sophisticated investors. I have seen a lot of people able to write a $50,000 cheque who had a lot of expertise.
Therefore I am not in favour of the rule or the law that basically restricts you from combining efforts to get to the $150,000 level.
Sorry, the first part of your question?
Senator Meighen: You answered it because you advocated the need for an increased level of syndication of investments.
Mr. Laver: What I was really referring to there was a greater number of venture capital funds working together on an early-stage or start-up investment.
Historically, in Canada -- and this has evolved a little in the last few years -- I think the attitude in the venture capital community was more, if it is a great deal, I want to own it, rather than if it is a great deal, it still makes sense to get more investors involved. That relates, one, to the number of funds in the industry, and it also to their level of management expertise. I think as we increase that level of expertise, there will be a greater willingness and ability to see the logic of combining forces on investments.
The big benefit I see there, apart from the obvious one of access to greater networks, is that start-up companies will have the ability to raise larger amounts of capital earlier in their development.
When you look at the competition they will be facing from the U.S., it is not atypical for a U.S. company at the start-up or early stage of its development to be able to access U.S. $10 million to $20 million. Whereas in Canada, for a company that is just starting on the revenue curve, to access more than Can. $1 million to $3 million is a challenge.
Senator Meighen: Do I take it, just for the record and for my own clarification, that all of you would not see any difficulty in a definition of a qualified investment such as they have come up with in the States in order to target any tax incentive that might be appropriate?
Mr. Lobo: Yes.
Senator Meighen: Finally, I think, Mr. Lobo, you brought up, and I guess Mr. Ashley commented on as well, the business of government having done, in your words, a pretty good job of increasing the capital available for small and medium-sized business.
Then you, Mr. Ashley, pointed out that some of our government institutions got the wind in their sails and decided that they should perhaps become something that they were not initially intended to be, and have been competing in the private sector.
Have we done enough? Is it time to cease increasing upfront capital or should we just maintain the status quo and concentrate on the downstream end now?
Mr. Lobo: I guess my comments about the formation of capital related specifically to the labour-sponsored venture capital funds, which really encouraged a lot of private investment because of the tax incentives. As I mentioned, we are at about $10 billion now of venture capital in Canada and half of that is labour-sponsored. I think we should shift gears now from upfront to back-end incentives. I think we have done enough to get the pump primed, as it were. Now let the market decide who is creating wealth, and it will be possible to attract more capital down the road without the need for the upfront incentives.
Senator Meighen: What about the BDC?
Mr. Lobo: I think BDC fills an important role. Actually, one of the gaps in the overall stage of the market is at the front end on the smaller types of transactions, and as Brad mentioned, he used to focus on that level. BDC fills an important role, particularly at the very beginning stages, because the professional investors who are managing larger pools of capital do not like to invest in very small chunks since it results in poor leverage on the time available. I think the BDC needs to continue to play that role.
Mr. Ashley: On the first question, about cutting back, I think we built up an artificial capital market here to some degree. I think the rationale for it -- and I do not fully comprehend the labour component -- of helping to capitalize the system, probably had merit. There was a dearth of capital and it made sense. Today, I believe that it inhibits a much more stable, institutional flow of capital such as we see south of the border. As long as we retain those incentives, we will never move to backfilling, and will be supporting it for ever.
With respect to BDC, again they play certain roles that make sense. I wish they would emulate a little bit more of what we had in Ontario, the Innovation Ontario Corporation, or IOC. We referred to them. It was involved in the very early-stage seed, start-up kind of transactions, but I see them moving further into the later-stage market and I do not understand that. I do not understand why they have a new buyout fund that has, I think, more than $100 million under management. I am not sure how that helps the Canadian marketplace.
Bank of Montreal and Royal Bank Capital both have small groups that aggressively target the same deals as BDC and they frequently lose on pricing by 5 per cent on transactions. I do not understand that.
But what surprises me most is when I get a cold call from an entrepreneur seeking $1 million or $500,000 of capital and they say, "Mr. Ashley, we understand that you run a venture capital firm." Unfortunately, the limited partnership document precludes me from investing in early-stage and technology opportunities, and I suggest they go to BDC. They say, "We have been there and they say they do not do those deals." I do not understand that. That is the void. That is where they should be. That is where they could help Canadian business, not in the crowded-out side, where there are other, good capital sources already available.
Senator Kroft: A couple of questions. We have discussed the one in ten ratio before, and I hope you were in the one, and Mr. Laver and I could talk at length about the other nine, but those are both in other lives.
Mr. Lobo, on your capital gains proposal and the focus on the specific type of investment, are you suggesting the targeting because you think that would be as much as would be saleable in terms of capital gains reform, or because by creating a limited-opportunity, preferred capital gain situation, you would have the effect of forcing that kind of investment?
Mr. Lobo: I chose to make it targeted because of my perception of the political difficulty in selling capital gains tax reductions. I understand that that has not been viewed very positively. Paul Martin has said many times that he is not in favour of that. So I was trying to say, well, if we will not do it broadly, let us at least pick the things that are important to this country and provide the incentive for people to create wealth in those areas. Therefore we are not making it a kind of blanket type of deal.
Senator Kroft: Politics aside, it would be good if it were across the board, so it is a political call.
Mr. Lobo: Yes.
The Chairman: Can I ask a supplementary on that? I want to ask whether targeted makes sense.
The objective, as I heard the three of you say, was to increase the reward for people who were prepared to take risks in smaller businesses. Is it correct that if you made the same capital gains break available for all investments, that would lead to individuals wanting to invest in less risky ventures? Therefore you would not achieve your objective because people would go for blue chips -- bank stocks and other things -- rather than the kind of investments you are talking about.
I understand why Mr. Lobo may have made his recommendation based on a political assessment, but that aside, and given the objective you want to achieve, should it not be targeted anyway?
Mr. Lobo: That is a good point. I do not know what would be the effect of broad-based capital gains reductions. One of the important elements of this is the robustness of public markets, and I think having generally very healthy and liquid public markets could be an outcome of a broad-based capital gains reduction, although I do not know for certain. That in effect would filter down through the specific areas that are targeted.
But the logic of your point is correct, that if we are trying to create the risk/reward ratio that makes sense, then let us focus on the things which are the higher risk.
Mr. Laver: I think one of the reasons I focused on the targeted incentive is the risk/reward issue, where the risks associated with making investments in early-stage, private companies are significant.
I think you have already heard from others that another benefit of the broadly based reduction would be to perhaps free up capital that is tied up in real estate or whatever, where people are reluctant to sell because of capital gains taxation issues.
That being said, I think the person who has money tied up in that sort of investment is probably less likely to want to roll that gain into an early-stage investment opportunity. He has a certain risk profile and that is unlikely to change materially.
Mr. Ashley: My comment is more directed to just levelling the playing field on the venture capital side. Let us start with that and let us make sure everybody is treated equally from a tax policy perspective. I do not think we can slice and dice within that sector as to which is the highest risk, and hence should get the higher tax break. I think we can maybe target deals under a certain size or certain asset size or private companies. I am not sure how we do it, but it should be a level playing field and we should group all of them together within that category.
Senator Kenny: I just have two questions and one is on the issue of slicing and dicing. Mr. Lobo, how do you target and what is the target?
Second, I wanted you to comment on your later recommendation to keep a disproportionate share of that value as an incentive and reward. What is a disproportionate share?
Mr. Lobo: To be honest, Senator Kenny, I have not given enough thought to exactly how you would do this, but there would be certain characteristics that I think could qualify.
One would certainly be treasury shares, but not secondary people who are trying to make money flipping things. It would be more for people who are funding things from the beginning.
Second, my personal bias is that as a country, we should choose some industries and some sectors in which we want to be the best in the world and focus our resources on developing those. I have a personal bias towards technology. I think it will be a very important part of the future economy and that we have some natural advantages that we should encourage and reward. Areas of technology would be another example for me.
Third, I would probably specify some minimum holding period so that you are encouraging longer-term investors, rather than people who are looking to make money by entering and exiting quickly. Beyond that, I cannot really say right now what should be done, but if I gave it some thought, I could certainly come up with some specifics.
With regard to the disproportionate issue, I think I made that comment vis-à-vis the U.S. Currently, as was discussed, you pay half the capital gains tax in the U.S. that you do in Canada, and that will go even lower. My point is, let the people who are creating the wealth keep a little bit more of it if they are in Canada than if they were in the U.S.
Senator Kroft: I want to go back to Mr. Ashley. I noted that you have pointed out that your fund is a bit of an anomaly, in that you do not invest in high-tech; is that correct?
Mr. Ashley: Yes.
Senator Kroft: We have proceeded through the course of the morning, and we have almost come to equate high-tech with growth and the only kind of investment to make and everything else. I always welcome a contrarian and I would be interested just to hear your particular philosophy.
Mr. Ashley: Sure. I would be happy to do so. I am an anomaly, in that this fund is not focused on technology. Technology, based on the rapid rise of the NASDAQ over the last few years, has really attracted a lot of investment funds. Maybe it is the flavour of the decade, I am not sure, but I still like manufacturing and service businesses, which are the still backbone of the economy. Technology may come and go, as biotech did. I am not sure what is behind high-tech. I guess there will always be some, but there will always be some good manufacturing and service companies that I am targeting.
Somebody asked before what the batting percentage would be out of 10 if transactions on the technology side are going to work. One needs more home runs, as we call them. I go for singles, to use the baseball analogy. Once in a while I will get a double. I will leg one out for a triple, and the only home run I will get is an inside-the-park home run.
Notwithstanding that, our investments go into good, solid growth companies. They need equity capital as well and the board plays a very active role in helping to nurture these companies to the next level. Our returns, as compared to technology funds, have been in the top percentile, notwithstanding our lower risk profile. I call myself a "conservative venture capitalist."
Senator Hervieux-Payette: Mr. Laver, you mentioned that you take an active role in the companies, working with management and spending time with people. Are you are doing that personally, or do you have other people in your company who do that? The same question applies to the other witnesses. Knowing now that you have the talent, what kind of people are you looking to hire in order to move forward to other investments? You cannot supervise 25 companies, so I suppose that you are looking for other people. How do you train them and where do they come from? What is your success story in this area?
Mr. Laver: At this time, I work by myself. Because of the size of the fund, it is not economic to build a management team per se. Generally, I work alone with companies on behalf of CastleHill Ventures.
With that being said, I only go into investments where there are other companies investing alongside me. So my expectation is, to a greater or lesser extent, that they will also be active. I am not looking solely to myself to provide that "value-add," as we call it.
In the context of my second fund, I am looking for people who preferably have at least two to three years experience in the venture capital industry, but more importantly from my perspective, have operating or technology backgrounds. Perhaps they have an engineering degree and worked for a Nortel or a Newbridge or a whoever, but someone who has an operating background at some level. Again, it fits with my investing model and I think it is where I get the most value-add, both for myself and the companies I invest in.
Mr. Ashley: There are two aspects to venture capital. The first is transactional, finding investments, negotiating them, doing due diligence, and closing the transaction.
The second aspect is active nurturing of these companies from the board level. Quite often, those require different skill sets and one has to staff an operation to ensure that those skill sets are around the table.
Like Barry, I was on my own for several years with my first $10 million fund. From an economic perspective, it did not make sense to have additional staff. I have recently, with my second fund, hired a person with some financial background that complements my own. I am a lawyer and an MBA, and I had a fair amount of investment experience before I set up Priveq. This person is a CA and has a background in insolvency. I am not saying that is where my investments are going, but it is nice to know where they could go and how to stop them from getting there.
I make sure that, once I invest in a company, we set up a very strong board of directors, and that is where good, strong operating people, with whom I stay close, can help. Members of my investment committee, or outside, veteran entrepreneurs can help grow these companies, so I do not like to staff up. I may staff up my operation with a number of financial people. When it comes to helping with the modern functional role, I make sure there are good businessmen around the table who can help the company.
Mr. Lobo: Our whole proposition as investors is to add a significant degree of value to the companies we invest in, and so we get involved in more than just board meetings once a quarter. We will help attract management teams. We will do acquisitions or merger-type activity, and we will help with financing. We will use our network of contacts to get access to clients and potential customers and we will help on legal issues.
Our whole point is that it takes more than just capital to build a good company, and so we try to get involved as much as possible.
Now, there is a limit to how much one can do. I have a partner with a very similar background to mine and we are trying to focus on the four skills I talked about. One is the corporate finance skills; second is the business strategy skills; third is having operating or entrepreneurial experience; and the fourth, in our case, is understanding technology.
We have two associates working with us who fill us out in terms of those skill sets. Both of them are very strong in technology and one also has some experience in investment banking.
Let me make one other point. For any given partner, I find you can manage six to eight investments reasonably because things tend to go up and down. In any given week, two of them will require lots of attention. Four of them you keep in touch with on a regular basis. One or two of the others you can check on less frequently because there is very competent management or it is a bigger company.
I find that as we have the opportunity to grow, rather than have more and more partners working with six or eight companies, it makes more sense for us to leverage our time on a bigger capital base. We will make bigger investments in bigger companies, rather than try to kind of multiply horizontally, as it were.
Senator Hervieux-Payette: I have a related question. One of you was active in the telecommunication field, but for a new field like biotech, how do you evaluate which companies to invest in? Where do you find the people who can tell you the potential of these companies?
Mr. Lobo: I invest only in digital technology companies. Part of my philosophy is that I do not want to invest in something unless, (a) I understand it, (b) I think I can make a difference in helping it to grow, and I also think it is a natural growth kind of opportunity.
I think there are others who have lots of biotech experience. They have either worked in biotech companies and/or invested in them. Those people are more appropriate for those kinds of situations.
For the most part, I have a fair amount of experience in the Internet and telecommunications, so I can understand those businesses.
For ones in which I do not have direct experience, I think I have a reasonable understanding of the market, and if necessary, can bring in an expert to help me make an evaluation. However, I would not even look at biotech.
Senator Hervieux-Payette: I will tell you my point -- I thought you would give me this answer -- that it seems that when you do engineering or law, you very often have complementary training in management. When you are from the other, scientific field, the management training is not there, so how do we fill that gap? People who have gone into all of the other scientific areas, dealing with chemistry and so on, do not have that combination and it is more difficult.
What is your suggestion? We talk with the teachers about what is being taught in university. How do we help people to tap into these sources of innovation and then bring them to the market, since a lot of them do not have the same training as engineers, who do a lot more financing. You have to have some knowledge of finance when you do an engineering degree. In science, it is often very remote from their training. Do you feel that there is a gap there and that it could be filled?
Mr. Lobo: My approach to dealing with that issue is from the technology side, but I think it would also apply to biotech. In fact, I have friends who have done this in Montreal. If there is a biotech scientist who has come up with a great innovation and is looking for investment, I would say as an investor, okay, you have great technology skills. Let us see if we can find somebody with operating skills, with management experience, who has worked in a biotech company and recognizes the potential of your idea. Therefore we are combining the idea, the people, and the capital, in such a way that everybody's incentives are aligned to help build the business.
Some of the people who are technologically or scientifically oriented choose to stay in that field, and that is great, if they can be complemented by people with experience. Some of those people will end up going into management positions and then ultimately leaving to start up companies with new ideas.
I do not know that there are any specific training changes that I could suggest. All I can do is comment on how we would address that issue if we saw the technology or biotech idea without the management expertise.
Mr. Laver: I will add, if I may, that I do not actually perceive there to be a huge difference between the biotechnology and the information technology sectors. I do not look at biotechnology because I do not understand it and I do not have the network of contacts. I see a benefit in focusing on something you do understand to a greater or lesser degree.
I perceive a reasonably vibrant group of venture capital funds or subsets of funds in Canada that do focus on the biotechnology sector, and five times out of ten, when I encounter an information technology company, they do not possess a lot of business skill sets. It may well be the same in the biotech sector. Part of our job as venture capitalists is to help bring those people in. Like Brad, like Vernon, whether it is high-tech or low-tech, we are very active in bringing board level expertise and new management expertise to the company.
Nine times out of ten, the initial management expertise you are bringing to the company is a business skill that does not currently exist. I am not convinced, although I have not done a study on it, that there is a major difference between biotech and IT. There is quite a vibrant biotech community in Canada.
Senator Hervieux-Payette: My last question relates to the fact that we are being told that even blue chip Canadian companies are undervalued, that the multiples are too low. Is there any relationship between where they started, where they were financed initially and where they have grown up? Are they penalized here because if they had gone to the United States for their financing at the beginning they would be worth more and more attractive?
Mr. Laver: I think there is generally an opportunity for companies to get higher valuations in the U.S. I think that is partly because the culture in the U.S. is more entrepreneurial than it is in Canada, there is more of a risk-taking attitude, and there is also a lot more available capital chasing after investments. Therefore, that will tend to push valuations higher.
In Canada, although less so in the technology world, you will, to a greater extent, find companies that are somewhat landlocked. I mean by that that their market opportunity is in Canada. Now as I say, that is less applicable in the technology sector, but that will also tend to limit your market value.
Mr. Lobo: I think the valuations in the public markets are more a function of the overall environment, as I mentioned in my opening comments, than of where the companies started. However, I also believe that there is a tremendous potential in this country for some of our leading and emerging companies to sell in the U.S. and become commercially successful there. There have been examples of Canadian TSE-listed companies that have moved to the NASDAQ after achieving some success in the U.S. and have received valuations closer to those of the U.S. Part of my hope and my goal is to help some of the companies I am investing in gain access to the U.S. market and become successful there. Then, once we have a significant percentage of our revenues coming from the U.S., list on the NASDAQ in order to receive the valuations that those companies deserve.
Senator Angus: Gentlemen, I want to echo what I think all my colleagues have said one way or another, and that is, how much we appreciate your taking time out from your very busy and successful occupations to come here. Not only that, but you articulated your thoughts very well, and I particularly liked the practical as opposed to the theoretical examples you have given.
I think the problem in this country, touched on not only by yourselves but by the earlier group of witnesses -- I think some of you were in the room when they were here -- is the challenge in convincing our political masters at the cabinet level to do some of the things that you folks are recommending. There is a need for education so that they will become more politically palatable.
I look at you guys and I listen, and I think, boy, you know, you are all Canadians, your stories are terrific and you have been successful. Some of our leaders in Ottawa have tended to say, "Well, what do you mean, we need changes? Look at these guys. They are Canadians, they are smart, they have benefited from our environment, you know, and our education and so forth." Of course we know that there is a lie in that, but the point is, have you any thoughts on how we can overcome that attitude, because it is a terrible thing. We tend not to reward our risk-takers or celebrate our great triumphs in this country, whether it is in finance or athletics or any other area. We have great stories but that does not mean we should not have more. As you said, what is wrong with having more millionaires? We do not have enough.
I was so annoyed -- and I mentioned this to a witness yesterday -- when Paul Desmarais was, I think, blindsided by Diane Francis on the phone over the Christmas holidays with a comment on the punitive tax structure. It was later stated, "Well, you know, why is he complaining? Look at him, the little guy from Sudbury. It cannot be all bad." It was the same with Pattison, but both were entrepreneurs who did their thing and helped many others too.
Do you see where I am coming from? I am just troubled by the fact that your own successes could end up inhibiting our ability to achieve the changes that we clearly need.
Mr. Laver: I will give you my view on that. Because it can be quite an emotional and intuitive issue, I tend, fortunately or unfortunately, to fall back on logic.
When you look at the capital committed to the markets in Canada by, for example, the pension funds, versus the size of the capital pools in the U.S., that is a very factual, significant difference between the two countries for me. The capital gains rates illustrate a very significant difference. Those are two highlighted ones, or the proposed escrow rules, for that matter.
I just look at it from a logical perspective. When you set up a regulatory framework that puts us at an obvious disadvantage to our neighbour, especially when that neighbour's economy is 10 times the size of ours, the outcome can only be disadvantageous in terms of building successful, home-grown, small and medium-sized enterprises that can compete on a global scale.
Mr. Ashley: The venture capital industry is also partly to blame for not doing a terribly good job of getting the story out. I am on the executive of the board of directors of the Canadian Venture Capital Association, and we are working hard to get the story out so that we can help to change the view of the politicians.
Mr. Lobo: I am not sure how to answer that question. We can look to the exceptions, the exceptions that are successful, and say, "Hey, we don't have a problem," but I think we need to measure what is important to us. In my view, it is creation of wealth, it is making our country competitive, and on many of those measures -- I mentioned just the market value -- we are certainly way behind the U.S.
I would argue that some of the successful people who stay here do not do so because the financial incentive is greater. They stay here for family or social reasons, and that is great, but I do not think it is sustainable in the long run. We should be attracting as many talented people as we can by providing a level playing field.
Senator Angus: Your friend who stayed in Boston.
Mr. Lobo: Yes, my friend who stayed in Boston is an example. When I look at where I would have been if I had stayed in the U.S., my current situation is not even close. I am here for family reasons, and I still think this is a great country with lots of potential. However, if we are going to say, "Oh, you have done fine. What is the big deal?," I do not think we will be able to attract people who can help create wealth and I think the country will become less and less competitive over time, with fewer and fewer exceptions to point to.
Senator Angus: Yes. Well, Mr. Lobo, you have said -- and I think it is inherent in what you have all said -- that fixing this capital gains problem is not a panacea or cure-all. However, in order to really get the new or emerging economy going in this country, to get our productivity up to competitive OECD levels and our standard of living back to number three, where it used to be, it would be a hell of a good start.
I know how busy you are, but please continue to put out the story on the capital gains because it sounds so logical, Mr. Laver, and I hope you will keep spreading the gospel.
The Chairman: Gentlemen, thank you very much for coming and particularly for taking the time to write briefs and give us really concrete examples. That was wonderful.
The committee adjourned.