The challenges venture capital funds and entrepreneurs face
In 1874 two Canadian inventors and entrepreneurs, Henry Woodward and Matthew Evans filed a patent in Toronto for what the precursor to the electric bulb. Their invention used a radically new process for lighting a bulb which lasted longer than many of their competitors. Unfortunately they were unable to find the funding to commercialize their invention in Canada, and were forced to sell it to American inventor Thomas Edison. Thomas Edison went on to invent and commercialize the light bulb as well as a series of other ground breaking inventions like switches, fuses, and electric meters which made him and his companies millions.
This cautionary tale demonstrates not just what could have been had Woodward and Evans got the funding they needed, but also the importance of a well-funded, dynamic venture capital industry for innovation and commercialization. A recent report by an Expert Panel on the question of Federal Support to Research & Development, highlighted the fact that ?Canada excels in research but lags behind much of the rest of the developed world in commercialization of innovation.? [i] This reinforces the idea that Canada is full of Henry Woodwards and Matthew Evans, bright, driven people doing ground breaking research, but lacks the Thomas Edisons of the world; those who can take great inventions and make them into great products. This is where venture capitalists come in, they add the business perspective that many technical entrepreneurs lack, not to mention capital for further growth and operations.
The advantages of new ventures of all kinds are clear. The report by the Kaufman Foundation said that between 1980 and 2005, firms less than 5 years old created 40 million new jobs, which accounts for about 100% of all new jobs created in the American private sector. [ii] It is clear that small businesses create jobs, and all of these businesses need capital to function. ?According to a report by the Canadian Venture Capital Association (CVCA), Canadian venture capital funds have invested in 2175 companies between 1996 and 2007, who employ a total of 64,000 people in Canada and 17,760 people abroad. [iii]
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Source: Kaufman Foundation
Some may say that ?young companies? are also ?small companies? and that some young companies are large (like Facebook), while some old companies are very small (Such as a small business that has been in the family for generations). ?To correct for this, the Kaufman Foundation split the job creation results by firm size and found that job creation is more distributed that originally suggested, but still heavily weighted toward small and young firms. This reinforces the theory that smaller firms tend to create more jobs that larger firms up to a point. Presumably, after a company has 10,000 people it needs a lot more to manage the complexity and may be more active in recruiting talent then it was before. This underlines the need for a venture capital system that can properly fund and provide advice to these small, young businesses.
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Source: Kaufman Foundation
Canada has several well-known advantages when it comes to creating a successful startup. Canada has a well-educated workforce with several leading research universities making ground breaking discoveries in health and technology. It also has stable institutions which provide the necessary infrastructure for successful research and financing of new ventures. Canadian financial institutions have also largely withstood the Financial Crisis of 2008 adding stability to the wider economy. Canada also has a unique program called the Scientific Research and Experimental Development Tax Credit Program or SR&ED for short, which gives tax breaks and credits to individuals who conduct scientific research in Canada. Despite these advantages that are easy to take for granted, there are some challenges that face the venture capital sector and the young businesses sector by extension.
Despite the advantages of the SR&ED, some argue that it does not go far enough to stimulate innovation.[iv] For example, medical companies are not allowed to write off R&D expenses in a limited partnership, which creates an extra tax burden for them. For small medical firms these R&D costs can be a substantial portion of their balance sheets, and by not allowing these to be written off, can prevent new discoveries from being made. Conversely, high risk ventures such as oil drilling projects are allowed to write off the investments in unsuccessful projects, which can often make the difference between drilling or not. The tax code should be rewritten to allow for more R&D write offs, which are proven to have substantial positive externalities that would exceed the lost tax revenue.
Canada also falls behind many global standards of R&D expenditure in the public and private sector. The OECD uses two key figures to measure R&D expenditure, one is the GERD, which is the overall R&D expenditures (public and private) as a percentage of GDP and the other is BERD, business R&D expenditures as a percentage of GDP. The chart below compares the GERD of the BRIC nations as well as many other developed economies.
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Source: OECD (2011)
When it comes to overall investment in R&D, Canada lags behind the Total OECD figure and is behind many other highly developed countries. Investment in R&D peaked around 2001, coinciding with the Technology Boom in the early 2000s and has fallen off its peak since then, even in the bullish mid 2000s. This trend is replicated in the United States, whereas countries like Japan, Korea, Singapore, and Germany have consistently increased their investments in R&D relative to their GDP. It should be noted that with the exception of Japan these countries have experienced GDP growth and presumably R&D expenditure has grown in lockstep. The chart below shows private sector investment in R&D as a percentage of overall GDP.
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In terms of private R&D expenditure, the story remains largely the same. Canada underperforms the average, although it has shown some improvement in 27 years. Some countries like the Netherlands and Great Britain have experienced flat or declining growth, whereas countries like America, Japan, Korea, and Australia have seen large increases in the same time period. Research and development is important for innovation and commercialization since it is the first step to a final product, but commonly a money losing proposition.
Crowd funding is another idea that is picking up steam in the United States that could help entrepreneurs and venture capital funds alike. There are two basic types of crowd funding, product and equity. ?Product funding is a relatively simple concept. Imagine you have a company that sells lemonade and you need $10 worth of capital before you can produce your first glass. Since you are a small business it may prohibitively expensive to use debt financing and you do not have the funds yourself. Luckily you have 10 friends who are willing to help. Each of them will give you $1 in exchange for a guarantee that you will serve them an early or exclusive cup of lemonade before everyone else. If 1 friend decides to renege and you only have $9, then everyone will get their money back; no harm, no foul.
Equity crowd funding is a similar concept. A large group of people invest small amounts of money into a company to receive a small piece of equity in the company. This time, instead of getting a cup of lemonade, you own a small piece of equity of the business. This model has a lot of advantages for the investor, the intermediary, and the company. Investors are able to invest in a real, local business directly, without needing a minimum investment or having to pay a fee to a broker. Small venture companies get access capital without having to list on public markets, which can bring bureaucracy and layers of costly oversight. Intermediaries gain by taking a fee from each transaction like a regular broker.
The details are currently being ironed out by the SEC, and there are a lot of complex issues that need to be resolved before the final draft is completed. It is unclear what this final form of ?equity? will take, but it may not have the same advantages as common stock, such as a liquid market, regular financial reporting, or voting rights. Despite the restrictions that will inevitably be enforced by the SEC, it still has the potential to become a major source of new funds for innovative new firms.
Equity crowd funding is currently illegal in Canada, while the Obama administration has relaxed the rules around crowd funding in their new JOBS Act. This has opened the floodgates for investors and companies alike. When the details are finally ironed out, it is unclear how Canadian regulators will respond. For one, each province has its own securities regulator who may institute their own version of the law, or ban it altogether. This regulatory fragmentation will make it more difficult for entrepreneurs and financiers from around Canada to collaborate and will encourage more companies to seek capital abroad.
Although this model may seem like a threat to early stage investors, it can in fact help them separate the wheat from the chaff. Take the lemonade example again, but imagine there are two competing lemonade companies, one selling pink lemonade and the other selling regular lemonade. They both appear on a crowd funding site and the pink lemonade company attracts more investment because they have a product and a business model customers like better. For an early stage venture capital fund, this can be used as a way to compare companies and see how they perform for a fixed amount of dollars in a transparent, liquid market.
Many of these problems are difficult to overcome but not impossible. Any economic recovery needs a recovery in employment and small, young businesses have provided the majority of the jobs in the past few years. The Canadian government should expand the tax credit program to allow write offs of medical R&D expenses to encourage more medical innovation. Public and private players should also look to increase R&D expenditure in Canada which will stimulate innovation further. Lastly, Canadian regulators should follow the lead of the SEC with regard to equity crowd funding, since it has a lot of potential for early stage ventures which are typically difficult to fund.
[ii] http://www.economist.com/node/21531482
Source: http://www.dayonbay.org/the-state-of-the-canadian-venture-capital-industry/
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