Deloitte's study on Canadian VC Crisis is well-timed

Three cheers for John Ruffolo and his team at Deloitte for their very timely study of the Canadian venture capital landscape. It couldn’t have come at a better juncture, and puts some meat on the trends we’ve been identifying here – in vain – for months (see prior posts “Ontario politicians asked to address deteriorating VC climate part 2“, October 26-07 and “”Brutal venture capital stats for H1 2007, August 1-07).

Here’s the punch line:

The outlook for the Canadian venture capital industry is bleak given its ecosystem is broken and there is no immediate solution at hand. The Canadian government and the domestic VC community must join forces to bring the industry back from the brink of collapse,” says John Ruffolo, National Leader, Technology, Media & Telecommunications Industry Group, Deloitte. “Although remedies exist at each investment stage, the country must act quickly to remove major tax barriers preventing critically needed international flows of investment capital from crossing our borders.”

According to Ruffolo, the results of the global VC survey should trigger alarm bells throughout the industry and government. “If not fixed in the near term, the Canadian VC ecosystem – made up of successive and sequential stages of capital investment from early seed financing through initial public offerings – will collapse. We need the government’s help to pull the industry out of this crisis,” he says.

Here are some of the highlights and recommendations:

– As evidence, in a five year comparison, venture capital investment in Canadian operating companies in the third quarter of 2007 ($517 million) is almost 21% lower than in the third quarter of 2002 ($653 million). In addition, almost a third (31%) fewer Canadian operating companies (147) were funded by venture capital firms in the third quarter of 2007 compared to the third quarter of 2002 (215). As of the end of September 2007, new capital commitments by venture firms into Canadian operating companies totaled $852 million, down 72% from the $3.087 billion committed during all of 2002. Further, over five years, the total amount of capital raised by Canadian venture capital firms has decreased at an alarming rate from $3.087 billion (2002) to $1.973 billion (2003) to $1.779 billion (2004) to $2.21 billion (2005) to $1.635 billion (2006) to a year to date total of only $852 million (2007).

– Withholding and Section 116 Certificate process – The overwhelming majority of foreign VCs are not subject to Canadian tax when they sell an investment, but face a delay of many months to work through the Section 116 tax clearance process until funds can freely flow to them. Many foreign VCs are structured such that each of the investors in the VC – sometimes hundreds or even thousands – is subject to this clearance process as if they held the investment directly. This delay results in lower returns and frequently causes direct financial loss to investors. Canadians who invest in the United States, the United Kingdom and other major global markets do not face such taxes or delays from red tape.

– Requirement to file Canadian tax returns by foreigners who don’t owe taxes creates hundreds of pages of unnecessary paperwork – Canada continues to impose tax filing requirements in circumstances where no taxes are payable by these investors. When a foreign VC sells an investment, they must file a Canadian tax return even if they do not owe any taxes. Each of the investors 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 sale. This tax return filing issue can also apply to certain Canadian public companies.

– Barriers to liquidity also affect Canadian investors – It is also critical to defer the taxes incurred by Canadian investors when a Canadian company they have invested in is sold to a foreign company, and when no cash proceeds are paid to the investor. Current Canadian cross-border merger tax rules limit foreign capital flows for Canadians and require the use of cumbersome exchangeable share structures. This not only discourages foreign investors from participating in these structures, but also encourages Canadian companies to relocate their businesses outside of Canada. Once again, Canada is unique in this distinction.

– The recent decision to recognize U.S. limited liability corporations (LLCs) as flow-through entities and eliminate non-resident withholding tax on interest payments under the Protocol to the Canada-U.S. tax treaty was very welcome. Given that the LLC structure is a common form of corporate organization among U.S.-based private equity firms, U.S. resident investors will no longer incur Canadian taxes from the disposition of their Canadian investments. However, it is important to note, that the treaty is not yet effective and it is unclear when it might take effect.

– The Government of Canada can remove the tax barriers preventing the flow of direct foreign VC investment into the country, and it can also play a critical role in reviving the Canadian domestic VC ecosystem. At the seed and early stage financing rounds, both federal and provincial governments could provide incentive tax credits, flow-through tax deductions, and/or reduced capital gains taxes for investors. At the first round of institutional VC funding, the federal and provincial governments could also improve retail venture capital programs, particularly for provinces where such programs have been curtailed (e.g., Ontario) or do not currently exist (e.g., Alberta). And, at the latter round of institutional VC funding, the government can play a pivotal role as a source of capital for these VCs.

– Only 44% of Canadian VCs currently invest abroad – and some of that is through investing in Canadian companies with significant foreign operations. Those Canadian VCs who do invest globally do so with varying intensity: 19% have 26-50% of their capital invested outside Canada, but 44% have less than 10% of their capital invested internationally.

– There are a number of techniques that VCs use to manage the sometimes difficult process of investing abroad. Three quarters (75%) of Canadian VCs will only invest alongside another VC who has a local presence, 58% sometimes do so through strategic alliances with foreign-based firms, and half (50%) are requiring their investment partners to travel more to manage their investments. More than three quarters (78%) of Canadian VCs plan to increase their international investment activities over the next five years.

– When Canadian VCs invest internationally, they tend to invest close to home and in markets they understand, including the United States (52%), the United Kingdom and Ireland (10%) and Latin America (10%). When compared to their U.S. counterparts, Canadian VCs want to increase their global investments at a faster rate (78%) than both global (58%) and U.S. VCs (54%), but are being cautious about the number of investments they make, with three quarters limiting their investments to under five investments: 67% at one to two companies and 9% at three to five.

– Behind China (34%) and India (24%), Canada is attracting the attention of just 11% of U.S. VCs as a primary country for expansion. In addition to the historical reasons why Canada is attractive to U.S. VCs primarily geographic proximity and political/economic stability – respondents also cited lower costs, lower regulatory compliance and lower legal costs than the United States. Further, Canada did not elicit many of the negative perceptions associated with the United States, such as the cost of complying with corporate governance and the United States’ litigation environment. Canada also fared well when compared to other countries’ weak intellectual property laws and too-lax regulation (primarily China and India.)

At the CVCA and elsewhere, many of us are pushing on these topics. But the time and attention that John and his team have brought to bear here is fabulous and gives governments and VCs a path out of these dark woods.

MRM