Trouble ahead for Canada’s VC action plan?

Canada’s venture capital (VC) industry has been on the skids for over a decade. Severe VC shortages have left Canada’s technology companies without the capital needed to grow into industry leaders. Could this all be in the past now that the Canadian government is implementing its Venture Capital Action Plan (VCAP) setting forth what may just be the most innovative initiative ever devised by a government for regenerating a nation’s VC industry?

Sadly, the answer may be no.

While the government’s VCAP is intended over time to result in leveraging $400 million in newly allotted government funds into $1.2 billion in VC financing for Canadian companies, the Canadian government in 2013 also made a decision to phase out federal tax credits for labour-sponsored venture capital corporations (LSVCCs) by 2017. This could result in withdrawal over time of VC financing in amounts exceeding the total new funds anticipated under the VCAP, thus deepening rather than solving Canada’s VC shortage.

The Canadian government has taken one step forward and two steps back. Officials have developed the right plan to address Canada’s serious VC shortage by building a self-sustaining, independent, market-driven and globally focused VC industry led and funded by experienced private-sector investment managers and investors. But phasing out federal tax credits that currently incentivize individual investors to invest in LSVCCs not only imperils prospects for the VCAP, but for the Canadian VC industry as a whole.

It is unclear exactly to what extent various provinces will follow the federal government’s lead and abandon their own LSVCC tax credits or if individual investors, in the absence of tax incentives, will cease investing in LSVCCs. But the government’s phase-out decision clearly calls into question the future ability of LSVCCs to raise capital from retail investors in a manner that would enable them to continue playing their key role in the VC ecosystem.

According to leading independent VC consultant Gilles Duruflé in Review of Main Criticisms Concerning VC Investment by Canadian Retail Funds (July 2013), Québec LSVCCs, which currently represent over 75 percent of all VC investing by Canadian LSVCCs, directly or indirectly made VC investments on average of $69 million in technology companies, $58 million in traditional sectors, and $74 million in private-independent VC funds per year from 2006 to 2012, for a total of $201 million annually.

Provided the expected $1.2 billion under the VC action plan is deployed over 10 years, it will translate into VC investments per year well below this total $201 million annual amount, and also below what LSVCCs are currently investing in VC.

Canadian fund-of-funds and VC firms need co-investors in order to diversify their investment risk and leverage their investments. They can rarely invest alone. So removal of potentially vast amounts of LSVCC co-investment money from an already capital-starved marketplace does not bode well for the Canadian VC industry’s future.

Author Duruflé further underscores the crucial role LSVCCs play in Canada:

• Canadian private-independent funds raised $5.7 billion from 2004 to 2012, of which $2.5 billion (45 percent) included a contribution from Québec LSVCCs.

• Québec LSVCCs have committed $830 million to 59 private-independent funds within Québec and across and outside of Canada.

Without the direct and indirect investment of LSVCCs, it would have been very difficult for many of Canada’s private-independent VC funds over the past decade to have achieved even a first closing.

While LSVCCs, particularly in their early years, have been justifiably criticized for various deficiencies (as to which there has since been considerable amelioration), their diminished presence in the marketplace by 2017 could very well imperil the success of the VCAP.

But it’s not too late for the government to rescind the phase out of federal tax credits for LSVCCs. The Canadian VC industry needs both the VCAP and LSVCC investment to succeed. Canada’s future as an innovation nation may just hang in the balance.

Stephen Hurwitz is senior counsel at the Boston-based law firm Choate, Hall & Stewart LLP. He specializes in Canada-U.S. cross-border transactions involving venture capital and private equity, as well as technology and life sciences companies.

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