Solving the Start-up & VC malaise
After several years of contraction, the venture capital industry is now publicly admitting that the sector is less than healthy. But what can governments do other than bring some smart techies together and invent a magic wand to make the problem go away? Here are five ideas to stimulate their thinking. I welcome others, and promise to pass them along to the CVCA.
1. Encourage risk-taking
The current tax code benefits the winners but not the losers. The lifetime capital gains exemption had its root, some would say, in the problem that family farmers once had in handing their properties over to their offspring. If a son or daughter bought the Roseville, Ontario-based dairy farm from their parents for $500,000, and their parents were going to finance part of that purchase with a vendor take-back loan, they’d have to pay tax on the transaction – even if they didn’t get any money from their child as a result of the sale.
Today, any investor that has held an investment for a prescribed period of time can enjoy no capital gains tax on the first $750,000 earned.
Oddly, losses of investment capital can only be written off against capital gains. The impact is pretty clear to the venture capital world. An Angel investor who invests $100,000 in each of three start-ups can only realize a tax loss on the ones that didn’t work out if he/she has a gain on something else down the road. If each of the first three investments goes to zero, the hit is $300,000 after tax as there is nothing to deduct those losses against.
How many would-be Angel investors – or their spouses – could keep hope alive, believing that the 4th Start-up would make it? With so much start-up money coming from “friends and family”, this tax policy is one of the reasons why Angel investing for some people is a lot like charity, but without the tax receipt.
If that same investor had put $300,000 into his/her own backyard honey bee business, they could write off that entire sum against other employment income as an “Allowable Business Loss”, provided that he/she had a day job with taxable income to offset the losses. As such, the honey bee loss is diminished at whatever tax rate that person had on their normal employment income.
If VC-backable deals require a robust Start-up environment, a creative thing to do is for CRA to create a category of a “Lifetime Capital Loss” that can be used for Canadian-controlled Private Corps. Perhaps $250,000 or $300,000 per adult, but it would be designed to be a “pool” that would always exist:
• If your first few start-ups failed, then you could access it up to the capital loss limit, and write off that loss against other income. But if you had a capital gain down the road then you would be able to switch the write-off to the capital side, and pay the tax on the “prior other income” in the normal way. You’d once again have a new pool of “Lifetime Capital Losses” to utilize should the next Angel investments fail.
From a tax policy standpoint, it is lost on me why the Lifetime Capital Gains exemption even exists, as most Canadian will never have the good fortune to take advantage of it. If the point is no more complicated than: “reward people who take investment risks”, than one has to wonder why we penalize those who take investment risks that don’t pan out. No wonder the rich always get richer!
As most Start-ups fail, the tax code is actually crafted to frustrate this much-needed part of the economy.
2. Enhance the SR&ED Program
The idea that governments support legitimate research and development is a good one, but the notion that federal auditors are asked to “approve” the merits of certain technological advancements is a curious element of the process.
Imagine this. A privately-held software developer works with a bona fide audit firm and files their “SRED Claim”. A few months later, we hear stories all the time that they often receive just 75% or 85% of what they sought. The question is simple. What part of the claim did the company or auditor falsify? And how is a bureaucrat to know which Java projects are more worthwhile than the next?
The solution is clear. For small firms (ie., not Bombardier, chartered banks or Nortel), the government should be bending over backwards to approve claims for the full amount. Those SR&ED refunds invariably go directly back into further research and development in any event, not dividends to CEOs.
If the government has a limited annual budget for SR&ED funding, I’d understand. But approving 100% of claims is a very easy method of putting more money into the knowledge economy, without any new programs or bureaucracy. If a particular audit firm is caught recklessly preparing claims for many clients, pursue and prosecute them. But, overall, the government should trust that the professional advisory firms that work with early stage technology and biotech companies are not in the business of defrauding the taxpayers.
3. Reduce the paper burden on foreign investors.
As recently outlined by Deloitte (see prior post “Deloitte’s study on Canadian VC Crisis is well-timed“, December 6-07), Canada continues to impose tax filing requirements in circumstances where no taxes are payable by foreign institutional investors. When a foreign VC sells an investment, they must file a Canadian tax return even if they do not owe any taxes in Canada. Each individual investor in some of these foreign VCs may also need to comply with these filing requirements, which can result in literally hundreds of pages of documents that are required for signature and processing for a single corporate sale.
4. Section 116.
The Canadian venture Capital Association has been working for years to press the government to relax what are called the “Section 116” filing requirements. The issue refers to a certificate that must be filed with CRA. Section 116 refers to a tax clearance process that must be followed before the funds resulting from a successful VC sale transaction can flow back to foreign investors. It can often take months before the funds are freed up and can be repatriated to the foreign VC fund. If we are talking about cash, then the issue is “merely” the six month delay, but if the consideration were shares in a public company, and the value in that stock drops, the pain is more acute than “merely the time value of money.”
Earning a return in foreign lands is hard enough given the currency swings; imagine what this hurdle means to a Silicon Valley VC who has the choice of investing in Gatineau or Israel? The flight distance isn’t that different, after all.
5. More government capital, but smart capital:
Several provincial governments have organized fund-of-funds to help create new venture capital providers. This was first pioneered in Israel. Quebec and Ontario have already launched their own funds, and British Columbia and Alberta are rumoured to be considering them as well. Ottawa currently plays this role via Export Development Canada and the BDC, who each run their own fund-of- fund programs for their own business reasons. But the feds shouldn’t see this as their own direct effort. The federal government could consider setting up their own capital pool, just as EDC and BDC have done. Taxpayers could expect to “earn market returns” on their investment, plus the spin-off effects of job creation, capital equipment acquisition, payroll taxes, etc.
And these funds shouldn’t be managed by a group that is already managing another large Canadian tech fund-of-fund program. Too much money in the hands of one or two fund-of-fund managers won’t help grow the industry.
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These ideas may not be silver bullets, and I welcome other ideas. The industry needs some creative ideas at this crucial stage, not reasons why the above ideas have no chance of doing the trick. I will give both the federal and Ontario governments full marks for being open-minded to ideas such as these.
The great news is that everyone in the right Ministries are now paying attention – it’s up to our industry (VCs, Angels and Entrepreneurs) to help them help us out of this malaise.
MRM
I think another ingredient that is missing from the recipe is proper bankruptcy laws that allow for failed start-ups (and the people behind them) to quickly get back on their feet and back into the game.
I think Ontario/Canada should aim to have quickest turnaround for bankruptcies (in any jurisdiction) and special procedures that allow for proprietary information to be retained by entrepreneurs.
Regarding how SR&ED claims are prepared by consultants and audited by CRA, you have no idea what you’re talking about.
First, the CRA staff who audit SR&ED claims are not mere bureaucrats, but are engineers, programmers and other technical professionals who have many years of research and field experience, and have a practical knowledge of how research is done in industry. Most of the cuts in claims are not due to “fraud” by the taxpayer or due to incompetence by the CRA staff. They are because there is wide disagreement within CRA, among CRA’s own auditors, as well as among SR&ED consultants, regarding what costs are claimiable.
This is because the tax law, and the various CRA information circulars and guidelines that explain how to apply the tax credit rules have areas of vagueness and inconsistency.
Remember that this is not like other kinds of tax credit programmes where the requirements are fairly simple. For a child tax credit, either you have a child or you don’t.
With the SR&ED tax credit, it’s often a complicated exercise to figure out what costs are “commensurate” with the needs of the SR&ED work. Many technical activities can be “linked” to the SR&ED work, and one must try to determine the nature of those linkages in order to decide what can be claimed. There are other issues like whether or not a particular item meets the definition of a “prototype”, and what to do when the development of a manufacturing process involves a combination of eligible and ineligible activities involving experimental production and commercial production. How much of the materials consumed was due to the commercial production and thus ineligible? When a company is improving the speed or quality of a known process, there is a mixture of commercial activity and experimental activity that often requires a judgment call for where the dividing line is, especially when the taxpayer has not kept sufficiently detailed records, out of the urgent need to solve the problems so that the business can become profitable ASAP.
In other words, because of the nature of applying abstract language to real situations that are themselves more complex than the tax credit, there will always be disagreements about how much of a project can be claimed, and after CRA has spent years publishing more and more guidelines, this hasn’t changed, and never will.