Public Policy and Venture Capital: The Canadian Labor-Sponsored Venture Capital Funds

By Ayayi, Ayi | Journal of Small Business Management, July 2004 | Go to article overview

Public Policy and Venture Capital: The Canadian Labor-Sponsored Venture Capital Funds


Ayayi, Ayi, Journal of Small Business Management


Introduction

One of the most significant events of the last two decades in the Canadian venture capital industry was the emergence in the early 1980s under the federal and provincial governments' legislation of labor-sponsored venture capital funds (LSVCFs). This apparently was enacted to address the lack of available venture capital and to promote investment in Canadian small and medium-sized enterprises (SMEs), whose shares are not traded publicly. Today, there are 44 LSVCFs in Canada, which collectively account for approximately half of the $20.134 billion of assets under management by all Canadian venture capital companies. The funds raised by LSVCFs have to be invested in SMEs with total assets of under $50 million. In addition, while at least 60 percent of funding provided to SMEs has to be in the form of common equity, the rest can be in preferred shares or in unsecured subordinated debt.

LSVCFs operate in a manner similar to open-ended mutual funds and are capitalized by a large number of individual shareholders. Their propensity for investing in LSVCFs is encouraged by the generous provisions of the Canadian federal and provincial tax credits offered in exchange for committing this capital for eight years to inherently risky SMEs. In this respect, the LSVCFs have received heavy subsidization for their startup costs. In addition, LSVCFs' units are registered retirement savings plan (RRSP) eligible, and generous tax credits accrue to the purchaser of the units, without reducing their adjusted cost base. Even if the front-end subsidization and the RRSP eligibility are ignored, the tax credit alone means that these funds are working in the range of 60- and 70-cent dollars, depending on the province in which the fund operates.

The objective of this article is to provide a sound analysis of the distinctive features of LSVCFs in order to examine the effectiveness of their heavy tax subsidization on the Canadian venture capital market and on the Canadian economy in attaining public policy goals. If LSVCFs' managers view the tax credits realistically--a subsidized cost of funds--and lever aggressively off that low-cost funding base by offering attractive financing terms to entrepreneurs, they will be in a position to attract the very top tier of opportunities and thus to supply a substantial financial return. However, if the managers see the tax credits only in the narrow sense of motivating individuals to part with their money, the funds will deliver poor financial returns.

The main findings of the article are as follows. First, it is illustrated that the tax incentives make LSVCFs irresistible to investors and flood the LSVCFs with more money than they may be able to invest wisely because of their general managements and their restrictive regulations. Second, it is demonstrated that despite their up-front tax subsidies, LSVCFs do not use their subsidized funds to price aggressively and to go after quality projects. Third, on the macroeconomic level, it is demonstrated that LSVCFs' legislation corroborates the Keynes (1936) theory on consumption, saving, and investment. (1) Finally, the paper illustrates how Canadian policymakers use tax incentives to raise and to retain venture capital in communities and utilize that capital for nurturing SMEs, which are key determinants for long-term sustained economic growth and employment.

The outline of the article is as follows. The first section presents an overview of the Canadian venture capital market. The second section presents a synopsis of the regulations that governs LSVCFs. The third section examines the costs and benefits of LSVCFs. The fourth section analyzes the performance of LSVCFs. The fifth section offers the conclusions of the paper and calls for policy recommendations.

An Overview of the Canadian Venture Capital Market

Over the past decade, Canadian venture capital industry resources and liquidity have grown at an increasing rate. …

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