July 2000 Fraser Forum: Venture Capital: High-risk, High-return Financing

Geographically, Ontario- and Quebec-based firms commanded a majority of the venture capital invested in 1999, accounting for 72.9 percent of the total. Ontario alone recorded a remarkable 46.2 percent of the total amount of venture capital invested in 1999.

Over the 4-year period, Ontario recorded the largest increase in growth of venture capital (180.7 percent) followed by British Columbia (152.1 percent) with the Prairies recording the smallest percentage increase of 66.4 percent.

Gross or unadjusted figures often fail to recognize pockets of venture capital activity as they do not account for differences in population. In other words, largely populated provinces may have large pools of venture capital simply due to their size as opposed to possessing concentrated areas of venture capital activity.

Labour-Sponsored Venture Capital Funds

LSVCFs account for between 34 and 61 percent of the total amount of venture capital invested in the various Canadian regions in 1997. In fact, in that year, for Canada as a whole, LSVCFs accounted for nearly half of the total amount of venture capital invested (Macdonald & Associates, 1998). LSVCFs have become the dominant source of venture capital in Canada, outstripping other sources of venture capital financing such as private and corporate investment funds.

Criticisms of the LSVCFs

This article is not intended to provide a detailed analysis of LSVCFs. However, it is important to recognize that serious difficulties plague them (Osborne and Sandler; Mintz and Wilson). For instance, LSVCFs have had difficulty finding SMEs that qualify for investment under the applicable regulations while at the same time experiencing large cash inflows. This has resulted in large cash balances, as opposed to direct investments in SMEs.

Also, LSVCFs have had difficulty generating competitive rates of return on investments. For instance, Osborne and Sandler (1998) found that the average annual pre-tax rate of return for LSVCFs was 3.7 percent over a 3-year period, substantially below the 21.0 percent recorded by small and mid-sized cap equity funds over the same period.

Important, also, are the cost of the tax incentives associated with LSVCFs. In 1996, for example, LSVCF federal tax incentives alone amounted to roughly $470 million in tax expenditures, excluding the associated cost of RRSP deductions (Osborne and Sandler). Thus, this is a relatively expensive program given that the entire capital gains tax revenue collected in 1992 was $715.6 million.

So while LSVCFs have become an important source of venture capital in Canada, there are serious deficiencies in the structure and cost of the LSVCF industry that must be acknowledged at least, if not remedied.

US venture capital

The US has been enjoying an explosion in venture capital financing since the mid-1980s. Just since 1996, venture capital has increased 387.5 percent, from $9.9 billion in 1996 to over $48 billion in 1999. Internet-related companies have led the way, attracting $31.9 billion, or 66.5 percent of the total venture capital in 1999.

Table 5's per capita data illustrates the geographic concentration of venture capital, particularly in New England and the western US, specifically California, Washington, and Colorado. Interestingly, Massachusetts is an important venture capital destination despite its relatively small population.

Comparing Canada and the US

Clearly, Canada's venture capital lacks the size, scope, and depth of that in the US. For instance, in 1999, Canada's venture capital industry was a puny 4.9 percent of the total US venture capital industry.

The under-performance of Canada's regions is highlighted in an examination of per capita venture capital investment. In 1998, the most recent year for which regional data is available, Quebec reaches 10th position in a ranking of the per capita investment of venture capital for each state, province, or region. However, the value of per capita venture capital in Quebec is only 11.3 percent that of the highest ranking US state, Massachusetts. Ontario is only able to attain 21st position while BC, the Prairies, and Atlantic Canada lingered in 27th, 28th, and 41st positions, respectively.⁴ Excluding the LSVCFs from the Canadian data would have significantly reduced the rankings for all of the Canadian regions, particularly Quebec.

Explaining the differences

What are the possible explanations for the stark differences between the two countries?

One plausible reason for the difference is the disparity in the treatment of capital gains. An overwhelming majority of venture capital investments take the form of equity investments. The tax treatment associated with gains and losses on equity will, therefore, directly influence the level of venture capital activity. Even with the recently-announced reduction in the inclusion rate (reduced from 75 to 67 percent) for capital gains, Canada still maintains a higher capital gains rate than the US.⁵ Therefore, given the tax-based reduction in returns to capital appreciation, we would expect less investment associated with capital gains in Canada.

Another possible explanation also relates to taxes, but to general, rather than specific forms of taxation. Both individuals and businesses face a much higher tax burden in Canada than they do in the US. The heavier tax burden has wide, sweeping effects that include the loss of some of the country's brightest talents, and a less positive business environment. The high degree of progressivity in Canada's tax system (in 1997, the top 12 percent of tax-filers - those earning in excess of $50,000 - paid 57 percent of all taxes) together with a heavy regulatory burden, also means that Canada impedes many high-income earners from participating in the venture capital industry. It is, therefore, reasonable to speculate that the Canadian venture capital market is as shallow as it is because of high general taxation.

An additional explanation again relates indirectly to the issue of taxes: the lack of opportunities in Canada. Some have argued that the US simply offers greater opportunities than Canada for companies and skilled individuals to develop and prosper. This is no doubt true, but the lack of opportunities may partly be a result of Canada's relatively punishing tax regime.

A number of other possible explanations may partially explain why Canada has under-performed the US in generating venture capital, including education, technology-clustering, immigration, and wealth concentration.

Conclusion

Given the increasing importance of SMEs and the innovation they encourage, the availability of venture capital and other sources of primary financing will also become more important. It is critical that Canada implement policies that are conducive to fostering a healthy and growing venture capital industry. Fortunately, one of the policies that will do so - general tax reduction - has myriad benefits that will positively affect everyone, not just entrepreneurs and venture capitalists.

Notes

Bibliography

Clemens, Jason and F. Mihlar (1998). "Government Should get out of the Small Business Business," Fraser Forum, December.

Grubel, Herbert G. (2000). Unlocking Canadian Capital: The Case for Capital Gains Tax Reform. The Fraser Institute: Vancouver.

Macdonald & Associates Limited (1998). The Venture Capital Market in Canada and BC: An Analysis of Trends in Venture Capital Activity. Prepared for Working Opportunity Fund, June.

Canadian Venture Capital Association (1999). Venture Capital Activity in Canada: Annual Statistical Reviews. Available on the internet at www.cvca.ca.

Mintz, J. and Thomas A. Wilson (2000). Capitalizing on Cuts to Capital Gains Taxes, CD Howe Institute: Toronto, February. Available on the internet at www.cdhowe.org.

National Venture Capital Association (2000). Venture Capital Investments for 1999 Reach Record $48.3 Billion, An Increase of 150% over previous year, According to NVCA and VE. Available on the internet at www.nvca.org.

Osborne, Duncan, and Daniel Sandler (1998). "A Tax Expenditure Analysis of Labour-Sponsored Venture Capital Corporations." Canadian Tax Journal, vol. 46, no. 3.

RDC Regional Data Corporation and Perrin, Thorau & Associates Ltd (1998). Analysis of Fiscal Costs and Fiscal & Economic Benefits of the British Columbia; 1992 to 1998. Prepared for Working Opportunity Fund, November.

Venture Economics Information Services (1999). 1999 National Venture Capital Association Yearbook. Prepared for the National Venture Capital Association.