|
...There reason for concern over this development, because evidence suggests LSVCCs are inefficient investment vehicles, charging high fees and yielding disappointing results: very few funds generate positive returns. Moreover, government tax subsidies to LSVCCs may crowd out private venture investment.
Accordingly, Canadian policymakers should investigate other ways to facilitate entrepreneurial investment. Potential changes to the legal environment begin with capital gains taxation: evidence shows that reduction in the capital gains tax rate stimulates venture capital funding. More generous treatment for employee stock options is also an option for Canada.
Also on the legislative front, improving the entrepreneur-friendliness of bankruptcy laws to encourage start-ups, and less-onerous securities regulation are liberalizing approaches that may offer important benefits, although with potential costs if, for example, relaxed prospectus requirements increased the incidence of fraud.
Among the suite of broader policy choices: direct government investment programs, such as the United States' Small Business Innovation Research Program and Australia's Innovation Investment Funds. While these programs involve public subsidization of venture capital, the US and Australian examples have generated records indicating effectiveness in fostering innovation and economic development.
In short, Canada's key venture capital initiative, the LSVCC, has run its course and should not be retained. Numerous options exist, and Canadian policymakers can learn from successes and failures abroad and at home.
The Organisation for Economic Co-operation and Development (OECD 1996) argues that the financing of entrepreneurship and innovative ideas will facilitate economic growth and the competitive advantage of nations in the 21st century. Much evidence, albeit not all, indicates that small, growth-oriented, high-technology start-up companies contribute disproportionately to innovation and economic growth. (1) The primary source of capital for these companies is venture capital, and venture capital facilitates the success of firms that eventually list on stock exchanges. For example, during the 1983-92 period, while venture firms averaged less than 3 percent of corporate research and development, they were nevertheless responsible for more than 8 percent of industrial innovation in the United States (Kortum and Lerner 2000).
A widely held perception is that entrepreneurial companies are not able to raise all the capital they need and that good companies are not getting funded. (2) In theory, one might expect such a "capital gap" because investment in entrepreneurial companies not listed on stock exchanges is typically highly illiquid and riskier than most other investments due to information asymmetries and the nascent technologies such firms are developing. As well, there is a perception that innovating entrepreneurs and their investors do not fully capture returns to innovation because there are broader returns to the development of an innovative society--in other words, that the social rate of return to financing entrepreneurial high-tech start-up companies is greater than the private rate of return. As an empirical matter, however, capital gaps are difficult to measure, and there is little consensus as to the extent of the capital gap for entrepreneurial firms (Canada 2002). Regardless, given the perception of such a gap, a major strategic focus of policymakers around the world has been the high-tech sectors and the stimulation of venture capital markets through direct government investment programs and laws that are appropriately designed to facilitate entrepreneurship and entrepreneurial finance. For example, the World Bank spent more than US$10 billion in the 2001-05 period to promote small enterprises (Beck et al. 2005).
In most Canadian jurisdictions, the primary government support mechanism for venture capital since the 1980s has been the Labour-Sponsored Venture Capital Corporation (LSVCC) program. One estimate places the cost of the LSVCC program between 1992 and 2002 at $3 billion at least (Cumming and MacIntosh 2004). Yet the data reported in recent studies of the LSVCC program point to a lack of success. (3) Accordingly, in the first part of this Commentary, I review the reasons the LSVCC program has not been successful. LSVCCs differ in quality, and not all labour-sponsored funds have been failures; nevertheless, reasons exist for questioning the benefits of government expenditures on LSVCCs.
In the second part of the Commentary, I review evidence from other countries on a range of alternative mechanisms that could replace the LSVCC program. (4) These mechanisms, which focus on strategies other than intervention programs in the form of the LSVCC, include capital gains taxation, taxation of stock options, securities laws, bankruptcy laws, patent policy, labour laws, accounting rules, and regulation of venture capital funds. I also discuss programs in other countries (such as the United States and Australia) that match government money with private contributions to venture capital funds.
An Overview of LSVCCs
LSVCCs are tax-subsidized investment funds designed like mutual funds. Unlike mutual funds that invest in companies listed on stock exchanges, however, LSVCCs invest in privately held companies that are not listed--typically, high-growth companies in the technology sectors. In exchange for tax subsidies, LSVCCs face statutory covenants that restrict their investment activity. LSVCCs have a three-pronged mandate to maximize employment, shareholder value, and economic development in the jurisdiction in which they are based. Most LSVCCs, however, state publicly that their only interest is in maximizing shareholder value (see MacIntosh 1994, 1997; Halpern 1997; Cumming and MacIntosh, forthcoming). LSVCCs must be sponsored by a labour union, but critics charge that labour unions merely rent their name to LSVCCs without providing any additional governance over the funds' operations. (5)
LSVCCs were first introduced in Quebec in 1983. Thereafter, the federal government adopted LSVCC legislation in 1987, British Columbia in 1989, Manitoba in 1991, Ontario, Saskatchewan, and Prince Edward Island in 1992, New Brunswick in 1993, and Nova Scotia in 1994. Only Alberta and Newfoundland and Labrador have not yet adopted such legislation. In 2005, there were 125 Labour-Sponsored Venture Capital Funds (LSVCFs) in Canada, (6) including 16 federal funds, 67 in Ontario, 7 in British Columbia, 2 in each of Saskatchewan and Manitoba, 3 in Quebec, and 28 in the Atlantic provinces.
Only individuals (retail investors) may invest in a LSVCC; while tax credits are capped, there are no restrictions on the size of their investment. Investors receive tax subsidies so long as the LSVCC follows the statutory covenants that govern the fund. Investors are, however, subject to an eight-year lock-in period, which restricts their ability to vote with their feet by moving their capital out of poorly performing funds, thereby limiting competition among LSVCCs (see Cumming and MacIntosh (2006, forthcoming). That only individuals may invest in LSVCCs clearly means that no one has the ability or incentive to control managers; by contrast, pension funds with large holdings in a firm have incentives to have a "chat" with managers.
Most individuals invest in LSVCCs to take advantage of the tax savings that are provided through individual registered retirement savings plans (RRSPs)--indeed, LSVCCs typically advertise such savings as the most advantageous reason for investing in them (Cumming and Macintosh, forthcoming). Tax benefits vary depending on the individual investor's tax bracket, as Table I shows, and are more favourable for those in higher tax brackets. In the Ontario example shown in the table, for an investor in the highest tax bracket, the initial tax-generated return on a $5,000 investment was more than 323 percent.
LSVCCs are bound by a number of statutory constraints, which are similar in each province (for details, see Cumming and Macintosh 2004a These include limits on the geographical range of investment opportunities to within the sponsoring jurisdiction, constraints on the size and nature of investment in any given entrepreneurial company, and requirements to reinvest fixed percentages of contributed capital in private entrepreneurial companies within a stated period of time (typically one to three years, depending on the jurisdiction). These constraints are extremely inefficient, however; because they limit investment opportunities and, at times, force LSVCCs to make investments in inferior companies without adequate due diligence (Cumming and Macintosh, forthcoming). Private independent limited partnership venture capital funds also have constraints or restrictive covenants, imposed by their institutional investors, but they differ significantly from those placed on LSVCCs. For instance, covenants on the former include restrictions on the use of debt (to prevent fund managers from leveraging the fund and increasing the risk to institutional investors), and time restrictions on fundraising by fund managers for their subsequent funds (to force fund managers to spend their time pursuing and nurturing investments that further the interests of the current fund beneficiaries). (7) These covenants also vary depending on the agreed-on needs of the fund investors and fund manager, which enables the limited partners and the general partner to design covenants that are best suited to the fund's particular objectives. LSVCC constraints, in contrast, are invariant across funds and change over time only with statutory changes.
To provide some sense of the relative importance of LSVCC venture capital in Canada, Figures 1 through 4 present relevant data on such funds. For example, by 2005, LSVCCs accounted for roughly half of...
NOTE: All illustrations and photos
have been removed from this article.
Looking for additional articles?
Search our database of over 3 million articles.
Looking for more in-depth information on this industry?
Search our complete database of Industry & Market reports by text, subject, publication
name or publication date.
About Goliath
Whether you're looking for sales prospects, competitive information, company
analysis or best practices in managing your organization,
Goliath can help you meet your business needs.
Our extensive business information databases empower business
professionals with both the breadth and depth of credible,
authoritative information they need to support their business
goals. Whether it be strategic planning, sales prospecting,
company research or defining management best practices -
Goliath is your leading source for accurate information.
|
