By Denzil Doyle
During the past three or four decades, Canadian policy makers at both the federal and provincial levels have tried just about every trick in the book to finance technology companies, particularly those that are at an early stage in their development.
In the early 1980s, we had the Scientific Research Tax Credits (SRTCs) that allowed technology companies that were not yet profitable to predict in advance what their R&D expenditures were going to be during a certain year and then effectively sell those expenditures to taxable corporations and individuals for use as tax write-offs. The troubles came about when the companies were asked to verify their expenditure to the tax authorities. Many CEOs and CFOs ended up in jail or spent years dealing with aggressive tax auditors.
The SRTC program was eventually replaced by the current Scientific Research and Experimental Development (SR&ED) program, in which the R&D must be done in advance and the tax credit comes directly from the government to the company. In the case of a company that is not profitable, the credit takes the form of a cash payment that is a percentage of the R&D expenditures – typically about 40 per cent in provinces where the provinces top up the federal payments.
If there is a deficiency in the SR&ED program, it is that it only applies to R&D and not to other vital activities such as marketing and selling. In the early 90s, both the federal and the provincial governments got into the business of subsidizing the venture capital industry in order to address this deficiency. They left the SR&ED program pretty much the same, but they encouraged the formation of a new breed of venture capital companies known as Labour Sponsored Venture Capital (LSVC) companies. Explaining the role of labour in the LSVCs is beyond the scope of this article (in fact it is beyond the scope of most articles on the subject), but they did offer tax credits of up to 35 per cent to any individual who wished to buy shares in them.
To say that the LSVC program was a success would be stretching the truth. It was poorly designed in the first place and the two levels of government have been redesigning it ever since. For example, the managers of one of the very first LSVCs in Ontario decided they could make more money for their shareholders by investing in T-bills and it was virtually impossible to drag any money out of them for risky ventures like software start-ups. The government addressed that problem by introducing very stringent pacing rules that prevented an LSVC from sitting on its money. However, this was during the period when the so-called “dot-com bubble” was forming and the industry was awash in flaky companies and even flakier managers.
However, faced with the prospect of losing their license to raise more money, the LSVCs invested in many of these flaky situations and when they began to blow up in their faces, the traditional VC companies were quick to tell the governments “I told you so” because they were never exactly cheerleaders of the program from day zero.
As the rules became more complex and more plentiful, the cost of running a LSVC escalated. Scarcely a week went by without some policy or analysis group in one of the two levels of government coming to the industry with a request for information on anything from job creation to the hiring policies of the investee companies. The brokers who sold the investment units insisted upon something they called trailer fees even though they barely understood the product and were unable to provide much post-sale support. The LSVCs carried the full load of communicating with the unit holders . And this brings us to another problem: The typical LSVC had too many unit holders, because each unit holder was effectively limited to a $5,000 investment as that was the level at which the tax credit went away. A single mailing to unit holders could cost in excess of $50,000.
Both levels of government seem to have given up on the LSVC program and are withdrawing their tax credits. Unfortunately, this is occurring at a time when the whole Canadian VC industry is imploding. The deal flow is only a fraction of what it was just five years ago, even though our government laboratories and universities are under great pressure to commercialize their technology and there is no shortage of entrepreneurs.
A replacement program well worth investigating is the flow-through share (FTS) program that has been used for years in the mining and resource industries. As its name implies, it allows the flow of losses from non-profitable corporations to corporations and individuals that have taxes to pay. It also allows the buyers of the FTSs to participate in any upside potential of the companies selling them.
The federal government first introduced the FTS program in the mid-1950s, though the tax laws governing it have repeatedly changed since then. What is so attractive about the program is that it seems to work, perhaps for the simple reason that it has been around for so long that any bugs in the system have long been shaken out. It has withstood the test of time. It does not send people to jail. It seems to achieve the same goals as the LSVC program has been striving for without all the confusion and bells and whistles. Maybe that is why we have a robust mining industry but a poor record in technology commercialization.
Denzil Doyle’s involvement in Ottawa’s high technology industry goes back to the early 1960s when he established a sales office for Digital Equipment Corporation, a Boston-based firm that had just developed the world’s first minicomputer. The Canadian operation quickly evolved into a multi-faceted subsidiary. When he left the company in 1981, Canadian sales exceeded $160 million and its employment exceeded 1,500. In his next career, Doyle built a consulting and investment company, Doyletech Corporation, that not only helped emerging companies, but built companies of its own. In recognition of his contributions to Canada’s high technology industry, he was awarded an honourary Doctorate of Engineering by Carleton University in 1981 and a membership in the Order of Canada in 1995.