In June of 2010 Thomas Hellman (Sauder School of Business – UBC) and Paul Schure (Department of Economics – Uvic) prepared a report evaluating BC’s Venture Capital Program for the BC Ministry of Small Business, Technology and Economic Development.
The objective of this study is to evaluate the economic impact of the venture capital program (VCP) in the province of British Columbia. The study focuses on the economic and financial performance of the companies in the program, including a comparison of the tax credits received versus the taxes paid by these companies.
The VCP provides a 30% tax credit to investors making eligible investments. Formally it includes three distinct programs, one for Labour-sponsored Venture Capital Corporations, also called Employee Venture Capital Corporations (EVCCs), one for Venture Capital Corporations (VCCs) and one for Eligible Business Corporations (EBCs).
Over the period 2001-2008, investments made in 517 companies received a total of $191M provincial and $65M federal tax credits. These companies generated an estimated $379M in provincial and $368M in federal taxes. The estimates suggest that for every $1 of provincial tax credits issued, recipient companies generated $1.98 in provincial taxes; and for every $1 of Canadian (i.e., combined provincial and federal) tax credits issued, they generated $2.92 in Canadian taxes. In short, the BC tax multiplier was 1.98 and the Canadian tax multiplier was 2.92.
The analysis distinguishes between retail funds (professional venture capitalist who invest and manage capital on behalf of qualified investors through prospectus offerings) and nonretail investors who essentially invest their own capital directly (nonretail investors are sometimes referred to as “angel investors”). Retail investors invest through either the EVCC or VCC programs, and nonretail investors through either the VCC or EBC programs. The study finds that retail investors claimed approximately 55% of the BC and 66% of the Canadian tax credits. The Canadian tax multiplier was very similar for the retail and nonretail portions of the program. However, the BC tax multiplier was lower for the nonretail portion: every $1 of BC tax credits generated $2.45 of BC taxes in the retail segment, and $1.41 in the nonretail segment. The difference arises from the fact that the federal government carries some of the costs for the retail segment (namely half of the EVCC tax credits), but does not carry any of the tax credit costs for the nonretail segment.
The tax estimates focus on sales taxes (PST & GST), income taxes and corporate taxes, both at the provincial and federal level. The two largest items were PST, which accounted for 35% of all tax revenues, and federal income taxes paid by employees, which account for 31%. Combined provincial and federal corporate taxes accounted for less than 3%.
Companies in the program generated an average of 2.43 new jobs every year. This compares favorably with a broad control sample of BC companies that generated almost no new jobs at all during the sample period. Net job creation remained positive even in the recession years of 2002 and 2008. The vast majority of new jobs were full-time positions.
For the average company, revenues grew by $572K, based on average revenues of $2.27M. Revenue growth remained positive every year after 2002. Companies financed by retail funds had significantly larger revenues ($5.18M, increasing by $1.18M per year) than nonretail investors ($703K, increasing by $235K), reflecting the fact that retail funds focus more on later stage growth companies that are more mature, while nonretail investors focus more on early stage start-ups, some of which become large established corporations.
In aggregate, we estimate that tax credits of $256M were leveraged into at least $2.3B of equity investments. On average, companies raised a total of $2.14M of equity within the program. Retail-backed companies raised considerably larger amounts ($4.61M) than nonretail backed companies ($810K). We find that for every $1 of equity raised within the program, companies raised on average an additional $3.76 of equity and $1.15 of debt outside the program, demonstrating the program’s capital leverage.
Access to capital appears to be significantly better in the two main urban areas of Vancouver (Greater Vancouver Regional District) and Victoria (Capital Regional District) than in the rest of BC, where the average company only raised $952K of program equity, and where every $1 in the program generated only $0.84 of additional equity and $1.19 of debt. These differences seem to be driven in part by companies pursuing more conservative business models, although there also appears to be lower investor appetite in the rest of BC.
2% of companies in the program went public; 7% were acquired. These exit rates appear relatively low compared to other venture capital markets both in Canada and worldwide. Part of this can be explained by the fact that many companies in the program received seed investments that precede venture capital investing. Only 16% of companies ceased operations, suggesting that the majority of companies remained in operation at the end of the observation period, providing benefit to the BC economy for an extended period.
Total amount of funds’ raised by retail funds declined from a high of $83M in 2004 to a low of $30M in 2009. Total investments increased from $50M in 2004 to $68M in 2008, but fell to $47M in 2009. Total investments trends follow fundraising trends with a lag of approximately two years. This, combined with the fact that returns have been relatively low and that financial markets are currently experiencing considerable turmoil, suggests that investments by retail funds are likely to stay low and possibly decline even further over the near horizon.
The retail fund’s returns have been negative over medium and long-term horizons if we do not take into account the tax credit. From an individual investor’s perspective, taking into account tax credits and broker fees, investment returns under- or outperform stock market returns depending on the choice of index and holding period. However, program-supported investments in the retail funds made at the inception date of these funds paid off less than unsupported investments in public equities as represented by either the S&P-TSX Composite Index or the S&P-TSX Venture Composite Index.
While this program evaluation focuses on the companies in the program, it should be mentioned that the benefits of the program are likely to extend to the BC economy more broadly. One important benefit is the legacy created by successful companies in the program. Companies that are acquired typically retain some local presence, their managers frequently move on to play leading roles in new start-ups, and their investors may reinvest part of their gains into the next generation of start-ups. Our report features short case studies, including one of Aspreva Pharmaceuticals Corporation, which demonstrates the legacy benefits of the successful companies in the program.
THE IMPACT ON STAKEHOLDERS
Evaluating the effectiveness of the program means looking at it from the perspective of each of the major stakeholders:
– The government on behalf of taxpayers must ensure that the cost of the program is justified in terms of tax recoveries and broad-based economic benefits
– Investors should ensure that returns warrant the level of risk
– Companies must look at the cost of capital in comparison to alternatives
Clearly the program appears effective from a public policy perspective in terms of increased economic activity – as evidenced by job creation – and increased tax revenue in relation to tax expenditures. This is particularly true for the federal government who benefit from much higher provincial tax expenditures, yet still share in the economic benefits.
Investments in retail VCCs under-perform the public markets generally. The study alludes to the fact that brokers and fund managers may be compensated excessively for their services – and then diplomatically fails to reach a conclusion.
This under performance has led to declining interest in retail VCCs.
The study discusses exits as indicators of success when evaluating investment success. During the period of the study, only about 1 in 30 companies actually achieved an exit for investors. This compares to a rate of 1 in 7 worldwide and 1 in 5 for Canada as a whole. Of these exits about 85% are by acquisition, suggesting that IPOs are not a realistic goal for most startups.
If we consider that more than 50% of startups don’t survive more than 3 years, the survival rate of about 83% may seem like a success story. From a public policy perspective, and from the point of view of companies this is a good result. However investors need to do much better.
It is also likely this result is not be quite as impressive as it may seems at first glance. In fact the study mentions ‘informal discussions’ suggesting that some companies are effectively out of business but retain their corporate shell for other reasons. Certainly a large number of surviving companies are not candidates for acquisition. This poses a couple of problems for investors:
- How to recognize a loss and claim resulting tax benefits
- How to exercise some management control where founders lack the skills and cannot be held to account because of the corporate structure imposed by the VCP regulations
It may be that founders may in fact be comfortable building ‘lifestyle’ companies that produce a good living for founders with little or no return to investors. In my view the lack of exit opportunities for investors is the biggest weakness of the VCP.
OTHER MOTIVATIONS FOR INVESTORS
In spite of this there are other motivations for investors that may help explain why investors continue to invest in non-retail VCCs:
- Friends and family may be investing in early stage companies for considerations that aren’t entirely economic
- Arm’s-length investors may be benefitting from consulting and advisory opportunities that arise because of their investments
As with the public at large, the benefits to companies are demonstrable:
- Much higher survival rates
- Significantly better exit opportunities
- Faster growth