Practices and Patterns of Informal Investors

The Investment Climate in Canada and Regional Differences

Investor respondents were asked to rate the importance of a variety of factors intrinsic to the local and national investment climates. Chart 7 graphs the average ratings accorded various potential inhibiting factors. The most important inhibitors to investment are entrepreneurs' expectations and valuations, and the tax environment. This is in keeping with investors' sense, noted earlier in this report, that business owners are not generally well-prepared for informal investment. In addition, it appears that investors perceive entrepreneurs' understanding of the investment process as a problem area. Of lesser concern are time demands and other regulatory issues.

Chart 7: Relative Importance of Potential Inhibitors to Investment

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The importance of taxation issues was echoed in the roundtable discussions. While much of the commentary was directed at the taxation of capital gains, it was recognized that the tax and regulatory environments had additional and complex impacts. For example, given that the primary shortcoming associated with potential investments was the shortage of managerial talent, the imperative of retaining and attracting competent and experienced managers for growing enterprises was seen to have tax dimensions. As, one Waterloo-area investor noted:

"It is ... impossible to attract American talent to come to Canada ... I think the income tax rate is a big attraction of the United States, a big deterrent to Americans coming to Canada. ... [Attracting talent] is a big factor to a business that's maturing and may be [trying to] get experts who live in New York or California to want to live in Canada. They won't go and you end up setting up offices in United States. ... For the Canadians, ... seven states in the United States have no state income tax including Texas and Florida and it's a huge disadvantage to Canada vs. living in one of those states."

"I have 400 employees [and do] about 150 million dollars a year in revenue and we gave up trying to get Americans to come to Canada. We hired close to 50 Americans over twenty years. We ended up with offices in the United States and they [the American talent] would move back into the United States. Of the 50 Americans, I think one actually stayed in Canada. ... Many [of] the people we talked to just wouldn't consider moving to Canada. ... You need that expert to relocate [to here] and move from California and if his taxes are lower [in California] then you end up paying him some huge amount of money."

The problem of attracting talent is exacerbated because of the ways in which stock options and profit sharing regimes are perceived to be taxed:

"... another difference between the States and here [relates to taxation of stock options. In the U.S.,] you can ... exercise them with out actually realizing a gain. That really helps as an incentive to the employee. In that situation it is very hard to take a massive [taxable] paper gain."

"If you're a public company and a manager of a public company part of your compensation can be options [however] ... if you're a private company you can still get the options but there's a lack of good [liquid] stock [which] has been said to penalize private small companies."

Moreover, even though regulatory issues were not viewed as being as much of a barrier as other factors, they were nonetheless recognized as a problem. For example, according to one investor:

"if you're an angel ... unless you're willing to put in $150,000 at a crack you're not welcome to invest."

Roundtable participants were also asked to rate a series of factors that might potentially encourage additional private investment. The chart that follows ranks the mean responses to this set of factors. Again, the importance of taxation (especially taxation of capital gains) was identified as important.

"With a better tax overall climate it would have to increase ... investment."

"There should be better tax treatment for risk capital. I am not to interested in risking dollars now for 50 cent dollars later."

Chart 8: Factors that Encourage Private Investment

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Regional Differences

So far, these results present the national perspective. In general, the findings reported above did not vary significantly by region; however, it must be recalled that samples within each region were small, in keeping with the exploratory nature of this study. Questionnaire responses were used to assess differences, by major geographic region (Atlantic, Quebec, Ontario, West), as to investors' experience, education, capital availability, investment activity (investment frequency, stage, sector (including knowledge-based sectors), expectations, proposals reviewed, etc.), perceptions as to deal flow, use of syndicates, etc. Based on one-way ANOVA, no statistically significant region differences could be identified in any of these parameters. As an illustration, the following table breakdowns the number of deals per investor by major geographic region.

Region	Atlantic Provinces	Quebec	Ontario	Western Canada	Total
Manufacturing	0.23	0.33	0.53	0.44	0.40
Services	0.38	0.50	0.12	0.11	0.24
Primary Sectors	0.08	0.00	0.12	0.00	0.07
Construction, Finance & Real Estate	0.54	0.33	0.71	0.78	0.62
Technology	1.31	0.33	1.47	1.67	1.31
Other	0.38	1.17	0.35	0.33	0.47
Total	2.92	2.67	3.29	3.33	3.11

Because of the small sample sizes, any differences implied in this table are merely suggestive and not statistically significant. The results suggest, for example, that technology deals are general more common than deals in other sectors, a result consistent with other research on private investors. The findings are also suggestive that deals in the technology sector may be less frequent in Quebec; however, the data set is not sufficiently large to support definitively any such conclusions.

Regional differences were noted in the sense that most investors (75%) responded in the affirmative when asked if their province differs from other provinces. In particular, investors in Western Canada and the Atlantic Provinces were more likely to hold the view that their regions differed and investors in Quebec believed that Quebec investors were more conservative. No statistically significant regional differences were found with respect in investors' rating of the inhibiting factors summarized in Chart 7.

Thus, while most investors are convinced that their home region is different, no systematic differences in investor behaviour were noted. Within regions, however, investors did articulate ways in which they thought their particular region was unique. Within Ontario, for example, investors in the Waterloo area believed that their area was unique with respect to the availability of investmentopportunities.

Response to Tax Changes

The budgets announced during 2000 included two provisions directed towards private investors: a reduction in the inclusion rate on capital gains in Canadian controlled private corporations and a provision whereby such capital gains could be 'rolled over' into subsequent investments with the result that capital gains would be deferred. To further explore these issues, roundtable participants were asked to comment on these recent federal taxation initiatives.

Both were viewed as positive steps, usually with the qualification that additional steps in this direction are necessary. The reduction in the capital gains inclusion rate was widely recognized and universally seen as a positive step. The most frequent comment was that this was a good first step. The rollover provision, however, was not as well known. Moreover, those who were aware of it viewed it as cumbersome and perceived it as being overly complex. Moreover, several investors pointed out that the time limit between cashing out and reinvestment to qualify for the rollover was unrealistic: that they had little control over the timing of when a new potentially profitable investment would become available.

Examples of the comments follow:

"If the government keeps bringing down the inclusion rate on capital gains, that's better for everybody and then people will take more risks because there's more opportunity to keep more."

"Il faut une stratégie globale de pénétration de marchés. Il faut diverses formes d'incitations (formation, conscientisation, mesures fiscales, etc.) pour mieux répondre aux besoins de l'investisseur et du développement régional."

"I came back to Canada from the States a few years ago and people asked 'why are you doing that, going from a low tax to a high tax situation?' I said 'that is not why I'm doing it. I had a choice to set up [a new] company in Seattle or Victoria, one of the issues was capital gains tax because I was bringing in U.S. investors and there is serious danger then, having to pay capital gains taxes. We actually decided to set it up here because the capital gains tax had come down somewhat."

"Let us be competitive on the world stage and if we want to create an environment where entrepreneurs feel taking the full risk they have to take to start a company and move it forward. Having low capital gains taxes ... works for everybody."

"But it doesn't really put Canada at a competitive advantage just by being close ..."

"L'État doit aider les investisseurs à prendre plus de risques en offrant de meilleurs incitatifs tel que crédits d'impôt. Un tel crédit d'impôt pourrait aider l'investisseur à aller chercher un retour sur investissement plus élevé. Ceci ne coûte pas cher à l'État puisque c'est un impôt reporté et pourrait se rembourser assez vite en accélérant le développement de l'entreprise."

"L'échéancier de 90 ou 120 jours pour le réinvestissement du gain en capital (rollover). J'ai perdu 90 jours de ma vie puisque ce n'est pas réaliste de penser que nous pouvons réinvestir dans une telle période. Une période d'un an serait plus valable puisqu'il faut trouver un bon investissement, rencontrer les partenaires, monter le plan d'affaires, monter un projet de partenariat."

"They give me a reason to hate the government less which is obviously not a possible endorsement. I don't think an entrepreneur or an investor sits there and says 'gee, if I make a hundred alright I m going to include fifty and provided its the basis on which this country can count I m going to included fifty as capital gain and I m going to pay tax ... I think at the early stages I can make a ton and in which case I don't mind the government being my partner because I'm making a ton anyway.' So the rearranging the deck chairs on the Titanic doesn't have an effect. Oh sure its nice instead of being seventy five its now fifty and yeah I can roll it over into other stuff."

Investors' Suggestions

In each roundtable discussion, participants were invited to provide suggestions about ways by which government might encourage additional private investment. Most comments focussed on taxation aspects. Overall, respondents expressed the view that what is really needed is a generalized reduction of tax rates across the board. In their view, this would have the effect of both helping to attract managerial and technical talent (human capital) to Canadian businesses and increase the availability of financial capital.

Some investors expressed concerns that tax incentives to providers of risk capital were unevenly distributed. Of particular concern were incentives to encourage individuals to invest in labour-sponsored venture capital funds when no such incentive attended higher-risk private investment in new businesses. For example:

"When you look at some of these tax credits for labour funds ... you're creating problems You're creating the wrong kind of investment objectives"

"Labour-sponsored funds ... have diverted what would otherwise be money available. ... These kinds of funds have amassed large amounts of money sitting in T-bills. And it seems that the investments they do make are in large established companies because they have such a large amount of capital under their control so [these funds] probably actually deflect direct investment."

"Il y a de l'argent mais peu de bons projets prêts à l'investissement. Il faudrait faire de la formation et de l'accompagnement auprès des promoteurs pour bonifier leur projet et le rendre 'investor-friendly'."

"We have all worked long and hard and paid the tax to get the money we have in our pocket and are a little reluctant to hand it over to risky investments. If there is a tax credit available upon the investment then at least you're getting some return immediately from something that might be gone. REPLY: The problem with tax credits is sometimes the investment becomes more of a. tax reason as opposed to an investment reason. ... just simpler tax laws, lower tax laws, rather than targeting. ... The danger with [targeting is] that [when] you start pushing in one place ... you're [hurting] some other entrepreneur somewhere else. I'm in the grape industry, and I saw where the business was going. So we pulled out all the crap grapes, put in good grapes. Right after we do that, [government initiated a] new incentive programs for all the slugs in the industry who wouldn't do anything [and then they] got grants to pull out the grapes and replace them. Why would I be on the leading edge when the slugs get the money from the government?"

"As many angels have sold out of [investments held for many years], they paid capital gains. Then if they were to lose money going forward on a new investment, they could only carry the loss back three years. ... So, it [seems to make sense that], for angel investments, government should find some way that the tax loss carry-back on those kinds of investments could be extended [back farther]. Then you at least you're taxed evenly [on gains and losses] as opposed to buying stock in the stock market that is so liquid that you can get out if you're negative right before the end of the three year."

"Il faudrait mettre en place des guichets uniques d'information et d'accompagnement pour aider le maillage des entreprises et éviter aux investisseurs de cogner à trop de portes pour connaître les possibilités d'investissement."

"Il faudrait que les organismes régionaux de développement économique tel que les CLD accroissent les maillages entre investisseurs et promoteurs et fassent de l'accompagnement plus soutenu dans les relations investisseurs-promoteurs qui se développent."

Other suggestions related to the $500,000 lifetime capital gain exemption for individual investors and tax incentives. It was observed that the $500,000 lifetime exemption from capital gains in CCPCs was designed during the 1980's and that and upward revision in the ceiling was arguably overdue.