Eye on Ottawa
By Peter Diekmeyer

August 23, 2000

How about privately sponsored venture capital funds?

Recent comments by an industry expert calling for the federal government to phase out its labour-sponsored venture capital fund program are likely to get a mixed reception from Canada's small business community.

"I think the government program has been very successful in funding early-stage companies," said Cataford, managing direct of BCE Capital Inc. at a Toronto industry gathering according to a report in the National Post. "But the industry is at a point where it is mature enough that we can now start to wean ourselves from the program."

Labour sponsored venture capital funds (LSVCFs), which were created in 1985 to stimulate investment in small to medium sized enterprises (SMEs) give individuals contributing to them substantial tax breaks. To start, the federal government gives a 15 per cent tax credit, while the provinces contribute additional amounts.

This can lead to huge refunds for investors. For example a Quebecer in the 50 per cent tax bracket putting money into a registered retirement savings plan offered by the Fonds de Solidarité des Travailleurs du Québec, can get credits and refunds totaling about 80 per cent of his investment.

With those kinds of advantages it should not be surprising that money is pouring into labour sponsored venture capital funds even though returns to shareholders have been poor. According to the Fraser Institute, a pro-business think tank, LSVCFs account for more than half of venture capital raised in Quebec, and 48 per cent of the total raised in Ontario.

Money invested in LSVCFs are in large part responsible for the increase in total real venture capital invested in Canada, which jumped more than two and a half times from $904 million in 1996 to $2.35 billion in 1999.

These impressive numbers cannot however hide the fact that Canada is chronically deficient in venture capital investment, particularly when compared to the U.S., which invested more than $48 billion in 1999. This is more than 20 times the Canadian total. Given the relative size of the economies a multiple of 10 times would be more appropriate.

Canada's gap with the U.S. in providing venture capital to SMEs is an important component of our country's lagging productivity and almost certainly contributes to the brain drain as leading thinkers move south to join better financed American companies to develop and market new ideas.

Canadian SMEs now account for much, if not all job creation in the Canadian economy. According to the Canadian Federation of Independent Business in 1995, SMEs accounted for almost 60 per cent of private sector employment, up from 55 per cent in 1979. During that same period, firms with 500 or more employees dropped from a 45 per cent share to 41 per cent.

Given small business's crucial contribution toward job creation, the pivotal role that venture capital plays in small business development and Canada's venture capital gap with the U.S., it is clear that there is a role for investment incentive tools such as LSVCFs.

But the cost of these programs has been heavy. In 1996 alone federal LSVCF incentives amounted to roughly $470 million in tax expenditures according to the Fraser Institute, and that does not include the provincial governments disbursements nor the cost of associated RRSP deductions.

This heavy program cost comes at a time when small businessmen are highly equivocal about any government expenditures, even those that benefit businesses - especially programs that might result in higher taxes down the line. In a 1998 Canadian Federation of Independent Business survey, 75 per cent of members stated that total tax burden is a major concern to them.

Contrary to Cataford's assertions that LSVCFs should be phased out, the benefits they provide in helping SMEs create jobs and increasing Canadian competitiveness seem to more appropriately indicate that perhaps little fine tuning to the existing regime is in order.

For one, why should LSVCFs be run entirely by organized labour? Wouldn't professional managers be just as competent, or even better able to determine where money can most profitably and efficiently be invested?

Another problem with the current system is that LSVCF investments are too closely tied to direct job creation. This is a fine public policy goal, but it in practice it leads money managers to focus on labour intensive, old economy businesses as opposed to emerging knowledge based companies which often create fewer but higher paying jobs.

The creation of privately sponsored venture capital funds (PSVCFs) operating along the lines of LSVCFs would result in a flood of new venture capital better disbursed among emerging knowledge based businesses as well as those from the old economy.

To help keep program costs at a reasonable level, tax credits for those investing in these funds would be reduced accordingly, to say 7 per cent at the federal level, from the existing 15 per cent. The provinces would also adjust their tax incentives.

One thing should be clear, as long as small businesses are accounting for a good part of job creation and innovation in the Canadian economy, phasing out any programs that encourage these activities would be counter productive.

Peter Diekmeyer is a Montreal based business writer. He can be reached at: peter@peterdiekmeyer.com


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