Article Tools
Albert Lai is the kind of entrepreneur Canada should be fortunate to have. The 29-year-old has been involved in dozens of startups since leaving university during his first year to work for himself. He founded MyDesktop at 18 and sold the network of technology websites a few years later to Jupitermedia; he started BuyBuddy.com, a comparison-shopping site in 2000; and sold his photo-networking company, BubbleShare, to Kaboose Inc. for US$3 million last year. Canadian Business last June put Lai on its cover, trumpeting him as a “whiz kid” on the cutting edge of the Internet.
But Lai’s next project — and his most ambitious — will not be based in Canada. “As a purely business decision, you’d be an idiot to start a company in Canada,” he says, unless you can get some capital from the U.S. Lai is setting up shop in California, and though he’s reluctant to get into specifics, he says his new company will have a social networking focus and is poised to take advantage of the convergence of mobile devices and the web — something pundits like to call Web 3.0. Such a venture sounds worthy of national interest, but for Lai and his peers, securing funding in Canada is a deflating experience. “It’s been very challenging to get the level of support necessary from the venture community,” Lai says. The lack of interested and well-heeled financiers is particularly acute for companies in the business-to-consumer space. “There is a complete lack of experienced or interested investors,” he says.
Many Canadian venture capitalists agree; some say the industry is in crisis. But a robust venture capital market is crucial if Canada is to build and keep the kinds of innovative companies that ensure this country remains competitive. “I wouldn’t put it on life support yet, but there’s fluid in the lungs,” says Rick Segal, a partner with JLA Ventures in Toronto. The amount of venture capital invested last year was $2.1 billion, up from $1.7 billion in 2006, according to Canada’s Venture Capital & Private Equity Association (CVCA). But the money raised by Canadian VC firms, declined to $1.2 billion from $1.64 billion, a downward trend that began in ’01. That’s causing concern about where next-gen companies are going to find funding.
Even more worrisome is that American funds accounted for 41% of the invested capital last year, the highest level to date. While certainly welcomed by entrepreneurs, the increased presence of American money stokes fears that our brightest companies will hightail it to the U.S. to be closer to their investors. But Segal sees at least one reason why Canada remains a good place to start a company: when there is a problem, such as the lack of financing, it gets dealt with more quickly than in other places. “Canadians might not think so, but from an outsider’s perspective, the government is more accessible,” says Segal, who left the U.S. more than 10 years ago. “That alone gives me cause to believe that people will, at some point, dive in there and fix it.”
Now would be that time. Canada’s federal tax rules, the government’s role in funding, and, in some ways, the entire approach to venture capital investing have to change in order to create a healthier funding ecosystem. As Lai says, “The options right now basically lead most entrepreneurs like myself to look south of the border.”
The easiest thing to start fixing is Canada’s tax policy surrounding foreign investment. The weak domestic market means early-stage companies have to rely on American money in order to grow. Just how much American money is desirable is debatable, but Canadian entrepreneurs have little choice in taking what they can get. Unfortunately, “The Americans are pissed off because of our tax laws,” says John Ruffolo, national leader of Deloitte’s technology, media and telecommunications group. Deloitte found that 40% of U.S. firms and 28% of global firms cited Canada’s cumbersome tax system as a key reason for not investing here — a number five times greater than any other country in the global survey of 528 venture capital firms in December.
The main problem? A system that requires reams of costly and unnecessary paperwork. The typical scenario works like this. An American firm invests in a Canadian company, which is sold a few years later. The VC is subject to a withholding tax of 25% on the gross proceeds. However, it can file a “request for certificate” with the Canada Revenue Agency, a form that essentially says the VC is not obligated to pay any tax on the sale under the Canada-U.S. tax treaty. But once the CRA has verified the VC is legit and not taxable in this instance, the process isn’t over. The “ultimate kick in the ass,” says Ruffolo, comes when the CRA still requires every single partner to file a Canadian tax return reporting the sale, even though no tax is paid. Some funds are made up of hundreds of investors spread across the world, meaning the paperwork is time-consuming, costly and pointless. “Canada is the only country in the world that does this,” Ruffolo says.
But even if this barrier was removed to stimulate foreign investment, a strong domestic market is still crucial. “If you think a U.S. venture capitalist is going to pick up the slack, you’re dreaming,” Ruffolo says. American VCs usually come in late during the investment process, leaving Canadians to fund the startup phases. Americans also rarely invest alone and generally prefer a domestic firm to lead a financing round. At a more fundamental level, it just makes sense for Canadians to be able to fund their own startups. “If there are good companies to invest in here in Canada, why can’t we invest in them ourselves?” asks Mark McQueen, CEO of Toronto’s Wellington Financial LP, which provides venture debt financing.
It’s a good question and one that, sadly, has plenty of answers. Canada is a small country with a relatively young venture capital industry, and a conservative society by nature — which runs counter to the entire venture philosophy. In Ontario, the popularity of labour-sponsored investment funds (LSIFs), which do the bulk of venture capital financing, make it difficult for private VCs to raise money. That’s because Ontario gives a 15% tax credit to retail investors who put money into these funds. The province in 2005 decided to phase out the credit, but not until 2012.
Ted Anderson, managing general partner with Ventures West Capital Ltd. in Toronto, has been active in the Canadian industry for more than 20 years, and he says institutional investors are reluctant to contribute to private VCs when the tax incentives afforded to LSIFs allow them to raise capital at a lower cost, and, therefore, participate in more deals. “The labour funds have this massive lake of money that has to be invested,” Anderson says. “So the institutional guys ask us, ‘How are you guys supposed to compete again?’”
These funds have been roundly criticized for many other reasons, with dismal returns being a primary complaint. LSIFs don’t even perform better than risk-free, 30-day treasury bills, the most conservative investment one can make. The program is also structured so fund managers typically have one to three years to reinvest fixed percentages of capital, regardless of the opportunities at the time. “They make bad decisions for how that money gets invested just by virtue of the lack of time to do due diligence,” says Douglas Cumming, an associate professor of finance and entrepreneurship at York University’s Schulich School of Business in Toronto. As a result, labour funds have a greater number of portfolio companies per manager than private venture capital firms, and managers are not as actively involved in their companies. “It’s not really like venture capital investing,” Cumming says. “It’s more like mutual fund investing.”
There is a belief in the industry that if the tax credit for LSIFs were eliminated, institutional investors would start directing more money to private VCs. But institutional investors have yet to show up in Ontario. “It’s been almost three years, and the market is shrinking,” McQueen says. “Whatever the intended benefits of the cancellation of that program were intended to be, no one can find that in the data.” Private VCs only managed to raise $447 million last year, compared to $666 million in 2005. Retail funds, meanwhile, raised $1.2 billion in 2005, but had just $741 million in capital committed in 2007. The effect on Ontario has been severe, where a paltry $267 million was raised last year, compared to $772 million in 2005.
Quebec is better off, in large part because the province still offers a tax credit to individuals who invest in LSIFs. Institutional investors there are also more active in supporting early-stage companies through VC. Desjardins Venture Capital in Montreal, for example, operates nine funds — eight that invest exclusively in Quebec, and another that invests mainly in the province. As a result, fundraising in Quebec is still relatively healthy. More than $816 million was raised last year, although even that amount is down from the $1.1 billion raised in 2005.
Rate this article
