Business, Law, Politics

Labour Sponsored Venture Capital Corporations: Analysis, Criticism and a Survey of Alternatives

March 15, 2006

On September 30, 2005, then Ontario Minister of Finance Greg Sorbara, announced the elimination of the Labour Sponsored Investment Fund tax credit (LSIF). The program will be phased out in incremental decreases of the credit amount with complete elimination occurring in the 2010 tax year . The provincial government’s decision to remove the tax credit follows years of criticism of the various tax-incentive programs designed to encourage investment in early-stage business ventures at both the provincial and federal levels. Numerous commentators have pressed the various ministries of finance to remove the credits, arguing that the programs fail to achieve their stated objective and may even reduce the aggregate flow of capital into early-stage ventures. The importance of start-up companies is a vital part of the economy for both job growth and the facilitation of innovation, and yet consensus has not been reached among market participants as to the best way to create an environment where such enterprises are able to flourish. The purpose of this paper is to investigate the venture capital industry and survey the criticisms that have been levied against the venture capital tax credit regime. This paper is part of a series of papers that will look at various aspects of government involvement in the promotion of early stage ventures . The focus of this paper is to evaluate whether the current government involvement in the venture capital industry is appropriate, with a particular emphasis on Labour Sponsored Venture Capital Corporation programs. Firstly, the paper deals with the venture capital industry generally. This section of the paper is necessary given the uniqueness of this area of the capital market. The market for start-up capital presents challenges which are not present in the greater capital market. Secondly the paper will consider the market failures which provide the initial justification for government involvement in venture capital markets. Thirdly the origin and history of the LSVCC regime will be considered in order to better understand the policy environment that gave rise to this regime. Fourthly a survey of the various criticisms of the LSVCC programs will be presented . The paper will conclude with a survey of alternative methods of government involvement in early stage finance that may correct the present criticisms. 2. Venture-Backed Small / Medium Sized Enterprises (SMEs) Venture backed companies are start-up, high-risk, high-growth companies usually in the technology sector . These enterprises usually have few tangible assets but are based on innovative technology or a novel application of innovative technology. What distinguishes venture-backed business from other SMEs is their potential to grow very large and very rapidly. Venture backed business should be distinguished from the so-called “lifestyle” businesses which may be the same size as the start-up venture. The vast majority of small businesses are not businesses that a venture capitalist would consider for investment because there is little opportunity for rapid growth and little chance for a highly profitable exit in the future. Lifestyle small businesses, while often touted as the “backbone of the economy” are not responsible for quality job growth. Lifestyle SMEs usually produce low-level employment whereas venture backed SMEs usually create jobs in the high skill, high technology space. Rapid-growth SMEs, while accounting for only 4 to 8 percent of all small businesses in the United States, have been responsible for 70 to 75 percent of net new jobs, further to that, the top one-fifth of rapid-growth venture backed SMEs accounted for almost one-half of all jobs generated by autonomous new firms . Venture capital is concentrated on a small number of high risk SMEs with aspirations for explosive-growth. These companies require a significant supply of capital to develop ideas and bring their products to market. These companies often begin the financing process with little more than the intellectual capital of their founders. 3. Life Cycle of Venture Capital Investments No two stories of venture finance are identical. That being said, the process of venture finance has evolved into relatively standard stages of financing. 3.a. Seed Financing At the initial points in the life of a new venture, financing comes from sources close to the founders. This seed stage is financed largely through the founders, their family and friends. This is sometimes referred to as Love Capital . The “Love” stage is comprised of personal savings, retirement savings, home equity, lines of credit, and credit cards. The founders also generate initial productivity through “Sweat Equity” . This is essentially the provision of shares as compensation for services and labour. 3.b. Start-up Financing The next stage is the start-up stage of venture capital. At this stage, financing is usually needed to take a product to the next stage of development . This stage generally predates the commercial sale of products. Usually market studies have been completed and key management has been assembled. The love money is still crucial in the start-up stage. External sources of capital must also being sought. Capital is beginning to come from suppliers and potential customers of the business through the development of strategic alliances. This may also be a stage at which Angel investment enters the picture. Little substantial information is known about Angel investors; however their importance is clear as a source of capital for small business . Angel investors are high net-worth individuals who elect to invest their personal wealth in a start-up business. Their individual investments are not of the magnitude of the venture capital firm investments, but they are no less important. The dollar amount is usually in the $50,000 to $500,000 dollar range . 3.c. Venture/First Stage Financing Once the business has grown beyond the means of love and Angel investors, the founders of the business may seek the investment of a formal venture capital firm. The space occupied by venture capital firms is often territory that is too risky for traditional banks and comes at a stage where the company is too immature to offer its shares to the public. The process is more formal than the pre-venture capital stages. The three distinct players at this stage are the entrepreneur, the investor, and the intermediary venture capital institution. The venture capital firms do not, for the most part, invest their own money, but rather invest the money of others . This money may come from pension funds, financial institutions, wealthy individuals, insurance companies or any other source of pooled capital. While it does bring much wider beneficial ownership into the company structure, it differs from public equity markets in that the venture capital firm takes a much more active role in the management of the company. This involvement can, and usually does, include board representation. Involvement can include a major role in selecting key personnel as human resources demands increase . Marketing, financing, and product development are also key areas where venture capital firms may expect to be involved . These firms hold a relatively small portfolio of investments and the investments tend to be quite large . This allows the firms to maintain active involvement throughout the subsequent stages of development. 3.d. Second Stage Financing At this stage of financing, sales have begun, but the revenue being generated is insufficient to finance further growth internally or through the public markets. Additional venture capital firms may also enter at this stage of financing. The founding entrepreneurs can expect the initial investors to heavily negotiate the terms of this deal as all parties will be worried about dilution and control of the enterprise as they move closer towards self-sufficiency and profitable exit. 3.e. Third Stage Financing The third stage of financing involves expansion, the pursuit of major growth opportunities, and expanded production facilities. The involvement of formal venture capital is present here as well. The venture capital firm itself may be looking to compliment its existing portfolio with a later stage company and as such may choose to invest in the third phase of financing given their desire for a reduced risk and shorter time horizon relative to other investments made by the firm in first round companies. 3.f. Later Stage Financing Later stage financing occurs when a business has achieved relatively stable growth after an expansion in previous stages. Companies at this stage are generally cash flow positive. This was until recently, not the domain of venture capital firms. The venture capital firms had longer time horizons, however a desire to diversify and stagger time horizons has caused many firms to look to this later stage of development as a target of investment . This phase often overlaps with mezzanine financing. 3.g. Mezzanine Financing Mezzanine financing is debt that ranks below senior debt but superior to straight equity financing . This type of subordinated debt often has a quasi-equity element which comes in the form of warrants that give the investor the right to acquire shares of the corporation . Mezzanine financing can be used to fund a particular stage of development or may be combined with bridge financing (see below), to allow later stage companies to prepare for an IPO. 3.h. Leveraged Buyout (“LBO”)Financing This financing strategy may also be classified as an exit strategy given that many investors will leave the investment at this point. LBO financing occurs when financing is provided to a management group to acquire a product line or particular business at any stage of development. The targets of LBO financing are closely held companies that divest themselves of a significant equity interest in favour of new entrepreneurial management . The acquisition financing is generally comprised of debt with very little equity. 3.i. Bridge Financing When a company is contemplating and initial public offering (“IPO”) of its shares there are a number of one-time expenses and administrative fees associated with organizing the company . The company may also need to position key products or establish key relationships in order to create optimal positioning prior to the initial public offering. This round of financing comes usually six months to a year before the IPO is to occur. The funds required to achieve this positioning come in the form of short term, “bridge financing” . The terms of the financing usually stipulate that the financing is to be paid out of the IPO proceeds 3.j. Initial Public Offering Financing Initial Public Offerings occur when a company has reached a stage in its development where a large amount of capital can be raised relatively quickly by widely disseminating ownership through public markets. This is accomplished through listing on an exchange and issuing shares through an underwriter. This is a stage where many of the early investors will seek to exit the investment. In certain situations securities laws require the exit to be delayed by statutory hold periods . These hold periods are designed to reduce the “moral hazard” potentially present in IPO valuation. A founder or early stage investor would benefit greatly from overvaluation of an initial offering. The hold period provides an incentive to produce accurate valuations in order to maintain a stable market price throughout the statutory hold period. 4. Venture Capital Exits Exits from venture capital investments do not follow hard and fast rules. Investors have always been and will always be looking for innovative ways to capitalize on their initial investment. That being said, there are definitely certain trends that have emerged over time. This is the final stage of the venture investment process and as such, all previous stages are influenced by a contemplation of this eventual exit. According to MacIntosh and Cumming the venture investment exit decision is influenced by the degree to which the venture capital firm can add value to the investment . The venture capital firm brings monitoring, advice and participation in strategic decisions. Once inside management has sufficiently matured to the point where the marginal value of the venture capital involvement has greatly declined, an exit may be contemplated. If the firm has become stable enough that the enterprise can manage its own relationships without needing the involvement of the venture capital firm to add legitimacy and stability, the firm realizes that it is time for them to capitalize on their investment. Cumming and MacIntosh view the exhaustion of the venture capital firm’s skill set as the common factor that determines an efficient exit point . 4.a. Exit Via Initial Public Offerings The initial public offering is the ideal exit for most investors. Once a company has reached a point in its development where there is sufficient public interest to justify the listing of its shares on an exchange, an IPO will likely occur. The public markets, under perfect conditions, are said to have the lowest cost of capital . That also means that investors are willing to pay the highest aggregate price for the company’s shares. It is not uncommon for an initial public offering to generate many hundreds of millions of dollars for both the founders and venture investors . Very few start-up companies will ever reach an IPO , however it is this extremely lucrative possibility that drives many entrepreneurs, founders and venture capitalists. 4.b. Exit via Acquisition Acquisitions occur when the investment is liquidated through the sale of the business to a third party purchaser. The third party is usually an existing competitor or player in the same or a similar industry looking to expand. Quite often larger companies look to small start-ups as a form of outsourced research and development . This means that they look for innovation in the market and purchase it for integration with their existing product and therefore reduce the risk and expense of in-house innovation . This is very prevalent in the software market as players such as Microsoft will often purchase integrative and potentially disruptive technologies rather than risk competing . 4.c. Exit via Merger A merger is motivated by similar factors to those behind the acquisition rationale. From a simplistic perspective the element that differentiates the merger from the acquisition is the relative size of the parties to the transaction. Quite often it is unclear exactly who is acquiring and who is being acquired and it is common for practitioners negotiating a transaction to refer to any corporate integration as a merger to avoid the negative stigma associated with acquisitions. True mergers may occur when managers and owners decide that there is a need for synergy and that another enterprise may possess the key elements necessary in order to move the product forward or they may need increased critical mass in order to compete in a given market. 4.d. Exit via Secondary Sale A secondary sale occurs when one investor elects to pass along the investment to a similarly situated investor. This may happen where an Angel investor who is personally heavily invested experiences a life change that requires immediate liquidity . It may also happen as venture capital firms adjust their portfolios under some form of weighting formula . Such sales are rare as an investment exit. 4.e. Exit via Buyback A buy back is a rare occurrence in venture investments, but it may occur if the long-term growth prospects of the venture fail to materialize yet the venture itself is not a failure. There are occasions when the business is profitable and viable but not to the extent that the venture investors require given their portfolio of high return investments. In these situations the inside management of the venture or the founders themselves may wish to repurchase the outstanding equity from the venture capital firms. In this case the purchasers are content to acquire a “lifestyle” business in which income is being produced but high growth is not an expected element of the business. 4.f. Exit via Write-Off The write-off is the least desirable of all potential outcomes. The investors will ultimately reach a decision in the lifecycle of the start up where they realize that the firm’s prospects do not warrant further investment in the company and in fact it is advisable that the business be wound down to prevent further operating losses. The venture capital firms account for much of the write off risk by making certain that they hold a portfolio of investments with such a high rate of return that the success of one venture can carry the losses of the others . 5. Failures in Venture Capital Markets Major market failures are prevalent in venture capital markets. First the financial markets themselves have inefficiencies when viewed in the context of new ventures; this may lead to what is called an “Equity Gap” . Secondly, small businesses generate positive externalities and spillover effects that benefit the economy as a whole but are not captured by the small businesses. The Equity Gap refers to the inability of small business to attract equity investment through traditional channels. It is limited to equity because the inability to attract competitive debt is not generally considered a market failure. As is commonly accepted, the efficient allocation of capital in the financial markets is dependant on full knowledge of the risks and returns that go along with the various investment vehicles available in the market . Full knowledge is impossible for the general market investor to acquire. This problem is greatly exacerbated in the case of rapid-growth SMEs. The long time horizon to profitability, especially for high technology companies, makes it difficult to gain an accurate picture of the intrinsic potential of the company. There are also dramatic information asymmetries between the founders/entrepreneurs seeking investment and the external investors. These asymmetries exist because of the lack of disclosure present in most SMEs. Asymmetries that exist prior to the investment restrict the amount investors are willing to commit to the ventures and increase the required rate of return on the investment . Further, inefficiency can be seen when we examine the fact that entrepreneurs identify a shortage of available funds and investors identify an abundance of funds but no suitable investments for these funds. There are post-investment asymmetries, which, lead to moral hazard. In public equity markets, in theory at least, disclosure obligations and financial intermediaries go a long way towards reducing moral hazard . Venture capital firms can act as specialized financial intermediaries and serve a similar role for SMEs. Venture capital firms closely scrutinize the firms before making the initial investment. However, once the investment has been made, the venture capital firm must take steps to continue the monitoring function going forward. This can be done through the staging of investments, the use of convertible preferred shares (so that control can be exercised if necessary) as well as numerous other means such as board representation. Neil Brooks notes a third inefficiency, which might divert capital away from small business. He states: “Since aggregate savings in the economy are limited, any measure that is successful in directing savings into a certain area will result in a lower level of financing available for other uses. Thus for example, the exemption of principled residences from the capital gains tax [in Canada] undoubtedly results in a considerable amount of capital being diverted from small business investment to residential housing. ” Similarly tax incentives provided for other investment options such as the encouragement of pension investment through an RRSP or the investment in educational savings plans necessarily reduces the available free capital. Just as tax incentives are the cause of diversion of funds away from venture investment, tax incentives can also be provided which encourage the inflow of capital back into small businesses . A second market failure that may justify government involvement in venture investment is the existence of uncaptured positive externalities. Kutner suggests a reason that government intervention may be justified: Because investments in innovation are risky and because they often benefit competitors, market forces tend to under invest in innovation. Indeed the more perfect the competition, the less money is left over to invest in innovations that have broadly diffused benefits but that may not pay off to the investor for decades, if ever. Eisinger puts forth a very strong argument for government intervention in venture capital. In 1988 he stated: The declining importance of economies of scale in the less capital-intensive industries dependent on advanced technology, the growing tendency to contract out the manufacture of component parts to independent suppliers and the need for more flexible production and management systems to respond to the competitive challenges of rapid production innovation all suggested not only a role but also the necessity of a strong small business sector and a public policy matrix to support it. The Canadian policy matrix is the focus of the remainder of this paper. Specific focus will be on the taxation of investment through Labour Sponsored Venture Capital Corporations (“LSVCCs”) and their efficacy in correcting market failures and in increasing the aggregate amount of venture capital available to innovative SMEs. Recently there have been amendments to the income tax act, which target the supply of venture capital. These initiatives are premised on the belief that in the absence of an aggressively competitive tax system in Canada, venture capital and innovative start-up SME’s will relocate or launch in the United States or worse, that venture investment itself will cease. 6. Origin and History of the Venture Capital Corporation The government of Quebec enacted legislation in 1983 that established the first Labour Sponsored Fund: Fonds de solidarite des travailleurs du Quebec (“FSTQ”) . The idea was to get encourage Quebec’s largest trade union, Federation du travailleurs du Quebec (FTQ), to invest in Quebec based SMEs. The consensus was that this would create and maintain jobs, and facilitate the training of employees in matters of economics and finance . At the time the labour movement in the province was concerned with plant closures, job losses, and the relocation of production and investment . In a move to use labour sponsored investment funds as a vehicle for stimulating economic development in Quebec, the governments of Canada and Quebec provided seed money by making a loan to FSTQ. The loan was later converted to “Class G, non-voting, non-transferable, non-redeemable shares with no dividend rights” . Quebec residents who invested in FSTQ were given a tax credit of 35% on the first $3500 invested in the fund . The federal government also introduced a set of objectives aimed at stimulating venture capital investment. Particularly the aim was to increase the investment of registered pension plans and other retirement savings in venture capital. Of these investments and other government incentives it was an introduction of a federal tax credit for investment in LSVCCs that created the largest pool of venture capital Canada had ever experienced. In 1985 the only LSVCC in Canada was FSTQ. The federal government encouraged other provinces to create regimes similar to Quebec’s. There was little debate surrounding the introduction of these programs. Over the next ten years some provinces established their own LSVCC regime whereas others instituted a tax credit for investment in federally registered LSVCCs. The federal regime differed from the Quebec regime in that it required investors to hold their LSVCC investments for a minimum of five years in order to avoid repayment of the tax credits granted at the time of original investment; a contrast to the Quebec regime, which required that the shares be held until retirement age. For the first five years of the program the federal LSVCCs were required to invest at least 80% of capital in eligible investments , after which, the funds managers were required to invest at least 60% of the available funds in eligible investments in order to avoid deficiency penalties . In 1992 further encouragement was given to investors willing to invest in LSVCCs . The maximum federal tax credit was increased to $1000, which in turn meant the credit was available for up to $5000 of investment in LSVCCs . Also, the tax credit was given directly to the investor even if the investment was made within the protected space of an RRSP. Daniel Sandler puts forth the following example of how this regime worked: “Consider an individual in the highest marginal tax bracket (assumed to be about 50 percent, combined federal and provincial) who made a $5,000 contribution to an RRSP that was used to purchase shares of an LSVCC. The RRSP deduction has an after-tax value of $2,500, effectively reducing the cost of LSVCC shares to $2,500. The individual also received a 20 percent federal tax credit of $1,000, and an equivalent provincial tax credit. Of the $5,000 investment, the individual investor paid, on an after-tax basis only $500, or 10 percent of the cost, while federal and provincial governments-that is, the collective body of taxpayers in the province and across Canada—effectively paid the remaining 90 percent” The effect of these initiatives led to an increase in investment in LSVCCs from approximately $70 million in 1990 to over $1 billion in 1996. In 1996 the federal and provincial governments realized that they would have to cap the level of investment in LSVCCs . The concerns ran deeper than merely the large amount of capital being funneled towards this regime. While the corresponding cost to the government created by investment in these programs was a major concern, it was not the only problem. The hold period requirements, pacing requirements, and the consequences of failures to meet these requirements all became subject to review. The impact of the LSVCC regime also raised questions about the long-term feasibility of the LSVCC tax incentive program. The 1996 budget sought to reduce the total amount being invested in LSVCCs . The major ways in which the government sought to reduce the amount invested in LSVCCs included a reduction of the federal tax credit rate, a reduction of the total value of the tax credit, lengthening the holding period requirement and the introduction of a cooling off period for tax payers who redeem shares of LSVCCs . The federal government expected to reduce tax expenditure by $145 million over the subsequent three years. The reduction in venture capital invested was much more than originally anticipated. In Ontario alone in the following year the amount invested dropped to 30% of the previous year’s total . In one year the tax expenditure dropped by $137 million compared to the previous year . Effectively, the federal government met approximately 94% of its three-year goal in just one year. The federal and provincial governments sought to counter act this trend by inserting measures into the budget in 1997 to enhance venture investment in smaller SMEs, specifically through LSVCCs . By 1998 LSVCC investment was still far below the 1995 levels and well below the projections made when the government undertook the changes in 1996 . As a correction, the federal government implemented some significant changes to the LSVCC regime. The maximum federal tax credit was raised to $750 based on a $5,000 dollar investment and the cooling off period for reinvestment in LSVCCs was eliminated. The federal government issued the following press release to explain the reason for the changes: “The federal government introduced a number of changes in its budget of March 6, 1996 to limit tax assistance for individuals investing in LSVCCs. Most provinces adopted similar measures. At the time, LSVCCs had large amounts of capital still to be invested in small and medium-sized enterprises (SMEs) and LSVCCs were also experiencing high growth in the sale of new share capital. Since then, LSVCCs have injected capital into SMEs at an unprecedented pace. According to data provided by MacDonald & Associates Limited, LSVCCs were the most active investors in the Canadian venture capital market during 1996 and 1997, with disbursements totaling almost $1.1 billion. During the same period, amounts raised by many LSVCCs declined substantially, leading to a situation where some LSVCCs have little capital to invest in the coming years. [The budget] Proposals [are designed] to assist LSVCCs in maintaining their important role of providing venture capital to SMEs, thereby allowing SMEs to continue to maintain and create jobs.” The amendments made in 1998 demonstrated a government commitment to relying on LSVCCs as the primary source for venture capital investment in Canada. 7. Tax Expenditure Analysis of LSVCCs In a study entitled “Who Creates Jobs” D.L. Birch reports that the role played by large enterprises in job creation has declined dramatically in the years between 1960 and the date the study was published (1980). Between 1977 and 1987 small business accounted for 80 percent of the new jobs created and one-half of the research and development performed by private sector firms in Canada . The government has recognized, through a number of programs, that a strong small business sector is essential to a strong economy and a desirable employment rate. However helpful this may be to generally well-established SMEs, many of the existing programs fail to adequately address the unique challenges faced by rapid-growth SME’s. There are a number of incentives in the Income Tax Act, chief among these are the small business deduction and the capital gains exemption for qualified small business corporation shares . There are also benefits relating to stock-option plans and the allowable business investment loss . Credits are provided for manufacturing and processing , certain investments as well as scientific research and experimental development . These incentives are targeted at generally well-established SMEs. They do not necessarily provide any assistance towards high-growth SMEs in the start up phase. Banks are very reluctant to invest money due to a new venture’s lack of available security and even when financing is available; it often comes with a prohibitively high rate of interest. The incentives outlined above benefit SMEs by reducing the tax on earned income. For many start-up companies this is of little solace given that their biggest challenge is assembling a critical mass of capital to produce the income-generating product in the first place. Remediation of this problem is a prime objective of the LSVCC program. In order to overcome this hurdle the LSVCC program seeks to increase the aggregate pool of available capital for rapid growth start-up SMEs. Specifically this goal appears to be to build and provided sufficient source of capital in national and regional markets, making the necessary capital available to these businesses in an efficient manner. The LSVCC programs also have ancillary goals including social and ethical objectives related to facilitating a new role for unions and workers. As stated above, government intervention in the venture capital market is justified on the basis of market failures, including an insufficient amount of available capital as well as a geographic concentration of investment in central Canada . This localization can be attributed to the proactive role most venture capital investors adopt in the management of their investments. There has also been a problem with the stability of available capital for venture investment. In times of economic expansion the available pool has exceeded the number of viable opportunities whereas in times of economic downturn there is little available capital . The LSVCC program was supposed to stabilize the available capital so that start-up companies are less affected by economic cyclicality . This pool of capital would be channeled to regions of the country to stimulate local economies. The LSVCC program is supposed to increase the pool of available capital by attracting investors who would otherwise not invest in venture capital. With these incentives, union members, first time investors and middle income earners can consider entering the more volatile venture capital investment community. The stability goals are supposed to be achieved by imposing a holding period in order to obtain the full benefits of the tax deductions. The holding periods have been varied throughout the LSVCC program with a range between five and eight years. The regional investment goals of the LSVCCs are purportedly achieved through a number of measures. Firstly, eligible investments are generally limited to the jurisdiction in which the tax incentives are offered (provincial LSVCC legislation) . An example of a regional program is the Working Ventures Canadian Program, which was registered in the Atlantic Provinces. This program was responsible for nearly 100% of institutional venture capital investment in Nova Scotia, New Brunswick and PEI in 1993 and 1994 . The involvement of labour unions is unique to the LSVCC program. The programs seek to involve unions and their workers in the highest levels of the investment. Some jurisdictions have provided incentives for employee participation through personal income deductions. The legislation in British Columbia , Quebec and New Brunswick lists the education of organized labour in economic matters as one of its goals. The other “non-profit” based objectives of the regime include, without limitation, environmental and workplace safety objectives. In order to justify this continued tax expenditure the program must be accountable to its stated objectives. Various metrics have been used to examine how responsive the LSVCC regime is to these policy objectives. Major studies have evaluated these questions and include a study by Jean Marc Suret entitled The Fonds de Solidarite des Travailleurs du Quebec: A Cost Benefit Analysis (the “Suret Study”) . Suret looked at the accountability of Canada’s largest Labour Sponsored fund from a tax expenditure perspective. A study in 1994 by Pierre Lamond, Yvon Marineau and Don Allen entitled Impact Economique et Fiscal des Investissements du Fonds de Solidarite des Travailleurs du Quebec 1984-1993 was commissioned in 1994 for the FSTQ (the “1994 FSTQ Study”) as a response to the Suret Study. FSTQ commissioned a similar study in 1996 entitled “Retombees Economique et Fiscales des Investissements du Fonds de Solidarite des Travailleurs du Quebec, 1984-1995 . A third study was commissioned in 1997 by FSTQ entitled SECOR, Les investissements du Fonds: Une Comparaison de ses Impacts Economiques et une Evaluation de ses Couts Evites . The Canadian Labour Market Productivity Centre undertook a study in 1995 called Adding Value: The Economic and Social Impacts of Labour-Sponsored Venture Capital Corporations on Their Investee Firms . Francois Vaillaincourt disputed the findings of earlier studies in a 1997 Study called: “Labour Sponsored Venture Capital Funds in Canada: Institutional Aspects, Tax Expenditures and Employment Creation . Brian Smith published a supporting comment to Vaillancourt’s work in Financing Growth in Canada . In 1998 Sandler and Osborne published “a Tax Expenditure Analysis of Labour Sponsored Venture Capital Corporations” . Suret’s study examined the fiscal and investor costs of the FSTQ and concluded that: “The costs of FSTQ seems very high and they effectively invested in Quebec enterprises that are not very important. This results in poor performance indicators.” The study derived a unit cost to the federal and provincial government of venture capital investments made by FSTQ. Suret indicated that for each dollar actually invested in Venture Capital the cost to the governments was between $2-$4, depending on the method of valuation used . The cost was determined by dividing the aggregate cost of the FSTQ tax expenditure over the period of FSTQ’s existence, by the value of FSTQ’s investments . This approach to valuation failed to take into account some of the long-term benefits of the program. These include increased tax revenue generated by the firms which received the investment, possible savings in social programs as a result of job creation, increased revenue from the firm’s suppliers as well as less quantifiable measures such as worker education and regional development. In response to this study the FSTQ published a study in 1994, which claimed that the true cost of each dollar of investment was $1.35 . The study indicated that the governments’ fiscal costs were recovered over a four-year period when indirect benefits are taken into account . The study claims that after the four-year cost-recovery period has passed, the governments derived a significant gain. This study was updated in 1996 using different research methodologies, which arrived at a fiscal cost of $0.75 down $0.60 from the previous study. This method used a model where a notional judgment was made as to weather the enterprise would have survived had the LSVCC not invested. If it was determined that the firm would not have survived had it not been for the LSVCC investment, then the study attributed 100% of the firm’s revenue to the LSVCC program . This is questionable given that the proper attribution should somehow take into account the percentage holdings of the LSVCC. A third study was completed in 1997 by FSTQ designed to compare the economic benefits of an increase in disposable income generated by a general reduction in personal income tax rates. The report concluded that the benefits generated by the LSVCC program were significantly more than those that would have been generated by a commensurate tax expenditure on reduction of income tax rates. An additional factor is that the benefits created by the LSVCCs are recurrent. When these savings were taken into account, the cost recovery period was estimated to be between 0.8 and 1.4 years . In 1995 the Canadian Labour Market Productivity Centre commissioned a study (the “CLMP Study”) looking at LSVCCs from a cost benefit perspective . This study, which was the first to include the tax revenue generated by successful investee firms, concluded that the cost of each dollar invested was $1.35 and that the payback period was under 36 months. The findings of the FSTQ studies and the CLMP study are refuted in another study by Vaillancourt . Vaillancourt focuses his attention on two major issues: how is the LSVCC tax expenditure distributed among taxpayers; and whether the tax expenditure has an effect on employment. Vaillancourt concludes that the LSVCC tax credit is regressive based largely on the fact that the investors tend to be from higher income brackets and therefore the tax benefits accrue disproportionately in their favour. This runs counter to the government’s goal of increasing the participation of average investors in the venture capital market space. The study further concluded that the LSVCC program had no significant effect on employment in the sectors studied. Smith supported and furthered Vaillancourt’s criticism by comparing the ten-year rate of return for FSTQ and the five-year rate of return for the Working Ventures Canadian Fund with the return on treasury bills over the same period . In both comparisons the funds under performed the T-bills . The conclusion reached by Smith is that the realized rate of return does not affect the risk-adjusted rate of return, therefore the supply of venture capital adequate . In 1998 Daniel Sandler and Duncan Osborne undertook what was the most ambitious tax expenditure analysis of the LSVCC programs to date. Sandler concedes that the goal of creating a substantial pool of investment capital for venture capital investment has been achieved . Sandler also does not dispute that the LSVCC program has been successful in channeling funds to regions of the country, which previously suffered an economically crippling shortage of such funds. Despite these fairly substantial concessions, Sandler claims that the intended beneficiaries of the program, namely rapid growth SMEs have generally received a disturbingly low proportion of the money invested in SMEs. Sandler points out that in many instances; capital from LSVCCs was being invested in risk-free government securities rather than SMEs . Sandler believes that newly registered funds have been focused more on raising capital and less on investigating appropriate venture capital investments. The study claims that the cause of this problem is the structure of the regime itself. Many of the funds are criticized for having been established by principals who were more concerned with obtaining the tax credits for their investor clients than with making successful venture capital investments. This problem persists, despite most of the funds being managed by seasoned venture capitalists. Sandler believes that suggestions made by others that the definition of an eligible investment is too narrow are incorrect. If the spectrum of eligible investments were expanded, this would defeat the first purpose of the LSVCC tax expenditure, which is to finance start-up research and development and expansion for companies that have little or no access to other markets. If the governments were to adopt the proposal by Working Ventures Canadian Fund that LSVCCs be able to invest in the secondary market, the problems faced by start-up companies would be compounded by virtue of the fact that the safest, later stage companies would receive funding to the exclusion of the start-ups. Sandler identifies that there are timing problems inherent in the LSVCC regime. These timing problems take two forms. First there is a trend among fund managers to wait until a critical mass of investment has been received by the fund before the investment research begins. Secondly there is a time lag between capitalization of the fund and the subsequent investment of those funds in the SMEs. The LSVCCs receive the bulk of their capital during the RRSP season whereas the investment opportunities do not follow seasonal pattern . The capital is therefore invested in low-risk, high liquidity vehicles while the fund managers seek out viable investment opportunities. Sandler challenges the traditional rationale for the time lag. Often the time lag is justified based on the fact that the fund must keep a certain amount of capital in liquid investments to promote diversification and manage redemptions. The challenge comes from the fact that legislative LSVCC restrictions permit a certain amount of capital to be invested in liquid vehicles in order to manage redemptions . Setting aside capital in addition to this is excessive and undermines the LSVCC’s purpose. Further, criticism of the redemption argument is that the mandatory holding period provides ample opportunity for the LSVCC to manage redemptions, further, the LSVCC is free to create internal caps on annual redemptions and in fact many have done so. Sandler concludes that the tax incentives for LSVCC investment were so generous that they resulted in an overwhelming influx of capital. This influx outpaced the availability of appropriate investments and as such, the excess capital has been invested in wholly inappropriate vehicles. He states: “This kind of investment structure is certainly not the intent of the LSVCC regime and cannot justify the generous tax breaks offered to LSVCC investors” . The problem is that the tax incentive is too lucrative given the number of appropriate investment opportunities. Sandler prudently points out that the majority of solutions that have been proposed deal with creating incentives for the fund to shorten the fund’s time lag between capitalization and investment. These solutions fail to address the fact that the problem arises from an excessive inflow of capital and that encouraging rapid investment of this excessive pool of capital will only mean an increase in the number of imprudent investments. 8. General Criticisms of LSVCCs The labour sponsored funds in Canada have continued to be the primary source of venture capital investment. Arguments are routinely put forth stating that the sheer volume of investment flowing through the LSVCC structure into the venture capital pool is sufficient justification for maintaining the program. However, in order to make an accurate determination of the true efficacy of the LSVCC system it is necessary to determine whether the LSVCC structure has merely crowded out other investments. Critics such as Macintosh and Cumming claim that empirical evidence shows that the LSVCCs have not met their goal of expanding the pool of venture capital, and may in fact have led to some contraction. In a working paper from February 2003, they reach the following conclusion: “…crowding out is a natural consequence of the tax advantage of the LSVCCs. This advantage lowers the LSVCCs required rate of return compared to other funds (and private funds in particular, the LSVCCs main competitor). This allows the LSVCCs to outbid other types of funds for entrepreneurial investments, increasing deal prices and lowering rates of return for these other funds and discouraging the establishment of non-LSVCC funds.” The fact that LSVCC funds are more competitive is not entirely problematic in and of itself, assuming that the LSVCC structure is a better method for generating positive returns than other structures. It may be advisable, in certain situations, for the government to favour one organizational structure over another. However, in this situation it appears that the government is favouring a structure that does not produce an increased benefit over and above competing investment structures. There is evidence that suggests that agency costs are higher for LSVCCs and this contributes to lower returns than competing private funds could generate. Brander contributes evidence that predates MacIntosh’s working paper but supports its conclusions. Brander’s study in 2002 produced evidence that profitability of LSVCCs is actually significantly lower than that of Canadian private funds . This appears to support the position that crowding out in this case favours an inferior organizational form by effectively transferring control of the supply of venture capital from private funds to government supported LSVCCs. Further; this contributes to an overall reduction in the available pool of venture capital. Further criticism of the LSVCC structure can be levied based on the multiple and sometimes conflicting objectives of the funds. Unlike purely private funds with a goal of profit maximization, LSVCCs are also said to promote small and medium sized ventures, create jobs, further worker education and favour unionized enterprise. In this situation the government may be attempting to combine far too many policy objectives within the context of a single statutory regime. MacIntosh points out that “the two [labour sponsored investment funds] incorporated in Quebec pursue the full range of their statutory agendas [whereas] (e)lsewhere, and particularly in Ontario (where the majority of funds are incorporated) [labour sponsored investment funds] pursue profit maximization to the exclusion of the other statutory goals” . The LSVCC regime also adopts a corporate form as opposed to the traditional use of a Limited Partnership . This creates a problem. The perpetual lifespan of corporate structures eliminates the discipline that comes with a term-limited investment fund. In a limited partnership structure with a finite lifespan, fund managers are aware that the fund must be dispersed on a given date and as such will strictly adhere to investment objectives and time horizons. The limited partnerships are also faced with the market monitoring effects of having to return to the market in order to raise subsequent funds. This serves to reduce the moral hazard and agency costs associated with the separation of ownership and control found in any pooled investment. Market monitoring also ensures that only those fund managers who have been relatively consistent in delivering returns will be able to raise funds in the future. This serves as a natural barrier to entry for weak management. In the case of a perpetual corporation, these benefits are forfeited. Perpetuity can lead to LSVCCs investing in firms that do not fit the “high-growth” characteristics of innovative venture backed SMEs. Under the limited partnership regime the investments must achieve high return over the life of the fund. This requires expected returns drastically higher than the market rate of return. This prohibits investment in start-up ventures that seek merely to create “lifestyle” businesses. Such businesses will not generate the return required over the life of the investment. Further to that, lifestyle businesses do not carry the risk profile of the innovative high return ventures. Lifestyle businesses are likely able to seek more traditional sources of start-up capital such as general business loans from institutional lenders. These are not the types of businesses that lead to the rapid job creation and wealth generation expected of venture-backed innovative SMEs. As such, government should ensure that lifestyle businesses are not the type of businesses that are attracting investment from taxpayer-supported LSVCCs. Without the strict time horizons of limited partnerships the LSVCC itself is free to invest in any project with a positive net present value over any given time period (subject to certain legislative restrictions). Thus, a situation is created which provides incentives to the LSVCC to seek the qualifying investment with the highest rate of return over any arbitrary period. Effectively, the risk in the LSVCC portfolio is reduced as the funds target less risky qualifying investments that have longer and more stable forecasts. This is not the market ailment that the LSVCC regime was designed to remedy. In fact, it would cause firms that do fit the higher risk higher return mold to compete with less risky firms for available LSVCC funds. This is not the optimal result. Traditional corporate governance theory would postulate that the selection of a corporate structure gives the shareholders of LSVCC fund more control over their investment, given that shareholders elect the board of directors and they in turn appoint management. This advantage has been reduced because of the way in which legislation has structured these particular corporations. All LSVCCs require that a union sponsor the formation of the LSVCC . The legislation also requires that the union appoint the majority of the directors of the fund . This deprives shareholders of the control power despite the fact that they are the ones who are deeply invested in the fund. Legislation also curiously prevents the union from holding shares in the corporation . This means that the union’s sole interest in the corporation is tied to the fees paid by the fund to the union in order to “rent” the use of its name. The union is forbidden from holding the beneficial interest in any dividends or assets of the company upon winding up . This is an arrangement that would be alarming to anyone familiar with basics of the corporate finance theory of “agency costs”, which states that disparities between ownership and control creates adverse incentives which promote inefficient decisions and other value-destroying behaviours . Agency costs skew proper incentives and give rise to moral hazard. Another criticism indirectly related to the “designer corporate structure” created by the LSVCC regime, is that there is a requirement that the funds be invested within 3 years of receipt. It seems reasonable to place incentives on the LSVCC to actually invest the funds in a timely manner, however through the use of this limitation, a situation is created where managers of a fund approaching its time limit for investment may be forced to make poor investment choices especially given that Canada’s market for high growth innovation is not nearly large enough to achieve the perfect liquidity that would be required in order make the investment deadline irrelevant. Even if one were to disregard all the structural criticism levied against the LSVCC structure above, it appears as if the performance of the regime has also been quite poor. Over the last decade LSVCC performance has greatly lagged comparable indices . There is further evidence, which demonstrates that LSVCC performance has significantly under-performed US venture investments. Private Canadian venture investments also performed better than LSVCCs over the period . The first fund ever created under a labour sponsored regime was the FSTQ in Quebec. That particular fund has under performed treasury bills. . The performance of LSVCCs as a whole also under performed guaranteed investment certificates (GICs) . It is clear that the expected performance has not materialized. Many experts have proposed alternatives to the LSVCC regime and it is likely that in the wake of the Ontario government’s decision to phase out the LSIF program, the timeliness of the issue will generate many suggestions from both the academic and professional realms. The alternatives described below are in no way an exhaustive list however it may help to frame the current spectrum of ideas being circulated as a possible replacement to the failed LSVCC regime. 9. Alternatives 9.a. RRSP Eligibility for Shares of A Start-Up Business A possible alternative to the LSVCC program is an expanded definition of eligible investments for RRSP purposes. Currently, love money from friends and family form an integral part of the capital necessary to get any potential venture initiative in motion. The investors in these early stages do not receive any recognition from a policy perspective. Tax incentives accrue to the investors much later in the venture capital investment cycle. By allowing taxpayers to hold shares of start-up SMEs within the tax-advantaged structure of an RRSP there would be an increased incentive for average income earners (the target investors under the LSVCC program) to invest in start-up businesses. 9.b. Reduction of Capital Tax on Disposition of shares of Small Business Investments. Currently the Income Tax Act provides for a $500,000 lifetime capital gains exemption . It may be desirable to further reduce the tax on capital gains as a means of encouraging further investment in start-up businesses. A low tax rate is a major consideration when a regime seeks to unlock non-institutional capital. A lower tax rate will also be partial compensation for the increased risk level of investments in start-up businesses. A report by Industry Canada suggested that a the tax costs of reducing the capital gains tax on start-up business will be appropriately recovered by a corresponding decrease in the level of tax preference given to LSVCC investments. 9.c. Registered Pension Plans Registered Pension Plans form one of the largest pools of investment capital in Canada . Despite the abundance of investment capital available within Canada’s pension funds, they have been relatively under-involved in the venture capital marketplace. This phenomenon was investigated in a survey of the Pension Investment Association of Canada, . The survey found the following reasons for under-involvement in these markets: 1. Investment is management intensive and costly 2. not enough qualified investment specialists; 3. lack of critical market information; 4. returns are inadequate and unreliable; 5. it is difficult to measure long-term performance; and 6. the potential for high profile failures. There has also been criticism that pension funds with assets of less than $ 1 billion lack the ability to diversify into such investments without altering the conservative risk profile of pension investments. The Ontario Teacher’s Pension Fund has been an exception to this trend having developed a successful venture capital investment business. This is likely due to the sheer size of the fund which gives it the ability to invest in high risk projects without damaging the fund’s diversity or liquidity profiles. 9.d. National Investment Fund An alternative to tax advantaged regimes is to establish nationalized venture capital fund. This direct expenditure model would allow the government to ensure that the specific enterprises targeted by the program, receive the investment. Many of the problems seen in the LSVCC regime could be resolved using a Nationalized direct expenditure model. The discretion given to LSVCCs permits the time lag problems to persist as well as the problem of under allocation of investment funds to early-stage ventures. Under a nationalized regime the fund would ensure that the funds flowed to the appropriate ventures and in an efficient manner. There would be a reduced need for the fund to divert capital to lower risk, higher liquidity investments for the purposes of diversification or for the coverage of redemptions. The goal of benefiting average income earners could be met by issuing an equity-like security to individual investors who wished to participate in the program. 9.e. Development Bank of Canada Start-up, high growth businesses are usually focused on seeking equity financing. This is largely due to a lack of collateral or an inability to service the recurrent demands of outstanding debt. However, the Business Development Bank of Canada has tended to provide loans to SMEs. The stated goals of the BDC are to establish and develop business enterprises in Canada with particular focus on the needs of small business especially those in emerging and exporting markets . The BDC often provides term loans to borrowers that have been turned down by institutional lenders. The BDC offers venture loans that are unique in that they combine characteristics of term loans and venture capital. The average amount of BDC financing is $216,000 . This amount is far less than the average investment by the LSVCC . The BDC is able to reach start-up companies when they are most affected by the “Equity Gap” discussed above. 9.f. Capital Pool Companies The Capital Pool Company (CPC) program provides an alternative for a company either unable or not ready to go public via a conventional IPO of its shares. The CPC program permits a newly created company, with a relatively small cash infusion (from the founders/promoters/love money), with little or no assets or operating business, to raise cash from a minimum of 200 investors, via an initial public offering of the CPC’s shares, and list the CPC’s shares for trading on the TSX Venture Exchange . The capital pool companies allow start-up companies to access public equity markets. It is widely believed that public equity markets have the lowest cost of capital. It could be argued that efficiency gains will exist where we increase access to public markets. In 2004 CPCs raised $76.5 million on the public equity markets . In its first year of existence 87 CPCs were listed on TSX Venture Exchange . Another encouraging fact is that 33% of TSX Venture Exchange graduates to the Toronto Stock Exchange were former CPC issuers . 9.g. Financial Institutions There has been an argument put forth to justify the under involvement of Canada’s big banks in the start-up market place that the type of investment does not fit within the risk structure of these institutions. The due diligence required is too great, the risk too high and the potential payoff too low to justify traditional bank investment in most ventures. There has been a gradual change in this trend in recent years as banks have become more aware of this market, however it appears as if the recent and increased entry of international banks into the Canadian market has done the most to counter this under-involvement in private equity, SME investment. U.S. banks entering Canada originated from a much more competitive financial market. As such, many banks has have managed to develop expertise in SME markets. Upon entry to the Canadian market many of these institutions bring with them a range of financing products previously unavailable to Canadian SMEs. 10. Conclusion The LSVCC program appears to have been conceived without a clear focus. The involvement of organized labour is curious at best. While the program may have had a noble goal of involving the labour union membership in the venture investment community, the methods chose to achieve that goal were clearly misguided. The program involves labour in a manner where the union member has no greater incentive to invest than any other taxpayer. The union sponsorship is in name only. The legislative restrictions prevent the union or its members from having a vested interest in the success or failure of the fund. There is also no clear nexus between labour involvement and the goal of correcting market failures. The LSVCC program has only managed to direct a flow of capital to these corporations. The program has not managed to correct the systemic reasons behind the market failures. The capital which has accumulated in the LSVCCs in many cases has not been invested in appropriate ventures. The credit is too generous and the restrictions do not ensure that the money invested by taxpayers is used to fund only those investments which fit the high risk, high potential, start-up ventures contemplated when the program was conceived. The current LSVCC tax expenditure is not justified. Any solution to the venture capital market failure problems must be a tightly focused solution. Any program or proposed program should not be diluted with ancillary objectives such as labour involvement. If the government wishes to accomplish such unrelated goals, a separate program or incentive should be provided to achieve them. The move by the Government of Ontario to phase-out the LSIF program is a bold one. With Canada’s largest province leading the way in reforming this ineffective program, other provinces will likely follow suit. Desirably, this will generate debate on the current state of Canadian venture capital investment. This proliferation of opinion will help to shape any replacement program that might be introduced. Ideally this will result in a direct expenditure or tax expenditure program that addresses the systemic causes of the market failures directly without concern for other objectives. -End-