Canadian Venture Capital Activity: An Analysis of Trends and Gaps (1996–2002)

Part III: State of Current Government Actions Related to Venture Capital

The unique link between venture capital (VC) and innovation (see Part I), and the financing challenges faced by seed, start-up and early-stage firms, mean that increasing these firms' access to private sector capital markets has become a vital government priority in several countries. In Canada, government has designed programs to make VC more available to Canadian small businesses (these programs are presented in the following tables). Most of these programs operate through indirect and direct participation in the quasi-equity and equity markets.

To complement the review and analysis of the Canadian VC market presented in Part II, this third part examines the following question regarding Canadian VC:

• What is the state of government action — federal and provincial — with respect to VC?

To achieve this, the government action has been divided into three broad categories, as follows:

1. Indirect measures for VC suppliers that shape the marketplace framework in which the private sector VC industry develops. These include income tax measures that define investment regulations for pension funds and other VC funds, as well as securities regulations that cover private equity investments. While not covered in detail in this report, these regulatory measures are probably the most important factors in the development of the Canadian VC industry. Over the long term, Canadian economic policy must develop policy and regulatory frameworks to ensure a vibrant private sector VC industry. For example, federal and provincial tax measures support labour-sponsored venture capital corporations (LSVCCs), which are investment funds with the characteristics of both direct and indirect interventions. Since LSVCCs are supported mainly by provincial and federal tax credits, they have been included as indirect measures for VC suppliers (see Section 3.1 and Appendix D for more details).
2. Direct government investment programs that support quasi-equity or equity investment in firms, either directly by government agencies [such as the Business Development Bank of Canada (BDC)] or indirectly through other channels. In most cases, these investments are explicitly designed to fill gaps in the marketplace left by the private sector. From a government policy perspective, there are important questions and concerns about direct government programs. Do they respond to real gaps in the market? Do they help close these gaps over time, or do they crowd out private sector investment and, therefore, perpetuate market gaps? (See Part IV for a detailed discussion of market imperfections and gaps).
3. Programs and initiatives that build a critical mass of VC-ready Canadian businesses (see Part I for the characteristics of firms that are generally financed by VC investors). For example, some programs provide basic information about financing options, as well as direct and indirect assistance to firms seeking risk-capital financing, particularly angel and VC investment. Unfortunately, as explained in Part II, the importance of building effective demand for VC is often neglected or underestimated. These programs are described here in detail in Section 2.3.

Some observers may be surprised by the scale and scope of government involvement in the Canadian VC market, since VC investment is often held out as the epitome of a private sector capitalist market. Nevertheless, for better or for worse, governments have played a major role in shaping this market in Canada and in other countries.

In the U.S., for example, federal and state government actions have moulded the industry's development. A recent report by the Organisation for Economic Co-operation and Development (OECD) outlines some of the policy and program initiatives in the U.S., including, among others, the changes to the Employee Retirement Income Security Act (ERISA) "prudent man" rule, which opened the VC market to pension funds; the Small Business Investment Company (SBIC) program, the specialized small business investment companies program, the Small Business Innovative Research program, and the Small Business Technology Transfer program; and several other VC funds created by federal programs in many states.^{Footnote 89}

Of particular interest is the SBIC program, which played a major role in developing the U.S. VC market in the early and mid-1960s. In fact, about 700 SBICs controlled the majority of the risk capital invested in the U.S. While their role in the VC market has declined since the late 1970s, SBIC direct equity investments in small businesses accounted for 12 percent to 15 percent of total U.S. VC investment in non-boom years (with an average of about 8 percent from 1994 to 2002).^{Footnote 90} When compared to direct VC investments by Canadian government funds, which accounted for an average of 7 percent of total VC investment between 1996 and 2002 (13 percent in 2002), the relative contributions of direct government actions in the Canadian and U.S. VC markets is not significantly different. However, if Canadian VC investments made by LSVCCs are added as direct government actions, the Canadian government's contribution has been more pronounced.^{Footnote 91} LSVCCs' investments accounted for 25 percent of the VC market in 2002, and an average of 27 percent between 1996 and 2002.

The federal government's basic role in the VC market is to establish a fiscal, regulatory and policy framework that fosters an effective marketplace that supports business start-ups and growth and encourages a sustainable private sector VC industry. The government has several instruments available to reach these ends, such as balanced budgets; low inflation and interest rates; low and competitive tax rates; efficient regulations that balance the need for investor safety and investors' risk appetites; and well-funded research and development (R&D). Through these means, the government can fine-tune the market and ensure that private sector supply meets the needs of the risk capital community.

While there may also be a place for direct government intervention in the market, these measures must be subjected to a closer level of scrutiny. Policy-makers may be tempted to perceive and address market gaps with direct involvement. This type of program response, however, can have significant unintended consequences. Indeed, government-sponsored direct investment programs have been criticized on several levels, particularly since they may crowd out, rather than complement, private sector investment. Since the net effect of a government program may be negative, any interventions must be examined closely:

• If public sector funds have lower investment standards, they may decrease the price of VC in the market and, thereby, reduce the supply of capital that the private sector is willing to commit.
• If public sector funds have objectives other than maximizing returns to investors, the overall returns to VC may be lower, which will discourage individuals and institutions from committing funds to VC investment.
• Public sector programs may disburse funds that a venture capitalist could provide, but may not be able to offer the same managerial support, resulting in fewer successes and lower returns.

Assessing the impact of these factors is problematic at best. Nevertheless, these impacts should not be ignored. Poorly designed, narrowly conceived or conflicting government programs that lead to a government-dependent VC market will not serve the long-term interests of high-growth-potential firms. It is beyond the scope of this review to conclude whether the current array of government programs and policy measures is effective from this perspective, but this question should be considered explicitly when reviewing existing programs and when developing new policy options.

Nonetheless, there is an opportunity for direct government interventions that develop the VC market. These actions generally address gaps or imperfections that limit Canadian small and medium-sized enterprises' (SMEs) access to capital. For example, private sector investors may tend to avoid investing in early-stage companies due to higher risks and longer gestation periods, especially if there is strong demand for investment in later-stage companies.

To address this perceived gap in the marketplace, the government has recently established several initiatives to support early-stage companies. For some of these companies, investment needs may be lower (because they are younger and smaller). Consequently, government can spread its investment capital among many investments rather than concentrate on a few large ones. Some of these small, early-stage government investments will generate later-stage firms, which will eventually provide private sector investors with lower-risk, higher-returns-potential investment opportunities. In other words, government intervention in early-stage financing may act as a bridge between the owners' investment and private sector VC financing, and may help build a critical mass of VC-ready firms.

Given the potential positive and negative impacts of government interventions in the VC market, and the fact that they use scarce public funds, government programs must balance different interests through clear public policy objectives and transparent program evaluations. These objectives and evaluations should be strict on issues such as performance and timing (e.g. providing funding to those SMEs that could not obtain risk capital without government programs, but for which VC is appropriate). These programs should not seek to replace private sector activity, but, rather, should complement its weaknesses or reinforce its strengths. Indeed, according to Josh Lerner from the Harvard Business School, the most effective policies focus on improving the long-term efficiency of private markets rather than providing a short-term funding boost during periods of transition.^{Footnote 92} More generally, the greatest assistance to the VC industry may come out of less direct measures that enhance the demand for VC funds rather than augment the supply of capital.

In that context, the following section sheds light on the current state of federal and provincial government policies and programs related to VC. It begins by briefly describing the key government players in the VC market and the types of programs offered, including indirect programs oriented towards the suppliers of VC, direct quasi-equity and equity programs, and programs targeted at the demand for VC.^{Footnote 93} This paper represents an initial attempt to collect information on Canadian federal and provincial government programs that address the VC market (as opposed to an evaluation of their performance). This information will help to determine whether these approaches are consistent across departments and federal and provincial governments, and to review potential market imperfections, gaps (see Part IV) and key policy questions.

This section is limited to a preliminary overview, as it was difficult to collect the data that would permit a detailed analysis and assessment of the programs listed. Nonetheless, this section examines government's overall impact on the Canadian VC market, breaking down direct investments made by government funds and the activities of the LSVCCs. There are vast differences in the scale of interventions catalogued. Some, such as the investments made by LSVCCs (which are supported by provincial and federal tax credits), are in the annual range of $500 million to $800 million, while the BDC's VC division invests around $80 million to $100 million a year; other interventions are more limited in scope. For further details on the size of financing offered, and a recent evaluation of government programs, please refer directly to individual program information through the contacts provided in Appendix D.

Part III

• 1. Key Government Players in Venture Capital
• 2. Overview of Current Government Actions Related to Venture Capital
  • 2.1 Indirect Measures Oriented Towards the Suppliers of Venture Capital
  • 2.2 Direct Investment Programs
  • 2.3 Programs Targeted at the Demand for Venture Capital
• 3. Conclusions and Areas for Further Investigation

^{Footnote 89} Gunseli Baygan, Venture Capital Country Note: United States (OECD, 2003).

^{Footnote 90} Ibid.

^{Footnote 91} LSVCCs do not fit comfortably in either of the broad categories discussed above. Government provides considerable tax-based support for LSVCCs, which have the characteristics of both direct and indirect programming. However, given that these investor types are supported mainly by provincial and federal tax credits, as opposed to being government funds, they are considered indirect measures for VC suppliers.

^{Footnote 92} Josh Lerner, "Boom and Bust in the Venture Capital Industry and the Impact on Innovation," Economic Review (Fourth Quarter 2002), Federal Reserve Bank of Atlanta.

^{Footnote 93} For the purpose of this report, quasi-equity programs may include some patient repayable financing and loan loss reserve programs, as these can be considered forms of patient capital and may often include a subordinated debt component.