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Phasing Out an Inefficient Venture Capital Tax Credit

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Abstract

In 2005, the Government of Ontario, Canada, announced the phase out of the Labour Sponsored Venture Capital Corporation (LSVCC) tax credit, which will become effective in 2011. Some media attention has suggested this might lead to difficulty for Ontario entrepreneurs and emerging firms in raising capital. This study presents evidence from Ontario innovative healthcare firms that capital raising concerns are not related to the phasing out of the LSVCC tax credit, and this evidence is consistent with evidence of extreme underperformance of LSVCCs. However, amongst firms currently funded by LSVCCs, there is significant concern about the phase out of the tax credit, which is at least in part attributable to the terms within LSVCC shareholder agreements. Policymakers should account for firms currently funded by LSVCCs to efficiently facilitate the phase out of the tax credit.

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Notes

  1. Cosh et al. (2009) show entrepreneurs typically are able to raise the capital they want, but not necessarily in the form that they desire.

  2. http://www.crvca.com/press/index.html

  3. Ibid.

  4. Susan Hickman, “Show me the money: The hunt for fresh funding” Ottawa Citizen March 27 2008 http://www.canadait.com/cfm/index.cfm?It=106&Id=26196&Se=0.

  5. Ibid.

  6. For theoretical work on topic, see Keuschnigg and Nielsen (2001, 2003a, b, 2004a, b, c) and Cressy (2002). For policy discussions, see Osborne and Sandler (1998), Sandler (2001), Cohen (2007) and Soete (2007).

  7. Armour and Cumming (2006, 2008), Carpentier and Suret (2005, 2006), Cumming (2007a, b), Cumming and MacIntosh (2006, 2007), Cumming and Johan (2009).

  8. More generally, see also World Bank (1994, 2002, 2004).

  9. Sections 2 and 3 of this paper are based on Cumming and Johan (2010), while section 4 is based on Cumming (2007a).

  10. http://www.fin.gov.on.ca/english/media/2005/nr08-lsif.html

  11. YORKbiotech http://yorkbiotech.ca/ is a non-profit organization based in the Greater Toronto Area with a mission to: serve as a gateway to relevant companies and resources; advance entrepreneurship, enhance commercialization, and increase investment; and become the preferred business development partner for regional entrepreneurs and organizations.

  12. It is noteworthy that our response rate of 18.6% compares favourably with previous financial surveys. For example, Brau and Fawcett (2006) obtained a response rate of 19%, and Graham and Harvey (2001) obtained a response rate of 9%. Likewise, these authors emphasize that their response rate is in line with previous financial surveys.

  13. Prior to May 19, 2005, registered Canadian pension plans were limited to investing no more than 30% of their assets in foreign property. See, e.g., http://www.cansofunds.com/current2_may05.htm; http://library.findlaw.com/2005/Jun/15/246359.html. The removal of these limits has the potential effect of, among other things, lowering institutional investment in Canadian private equity funds. As this change might pose a concern to Canadian firms raising capital, and because this change occurred in the same year as the removal of the LSVCC tax credit, this survey question asked for replies to both legislative changes to assess comparative importance to firms raising capital.

  14. R&D/revenues is scaled by 1 in the denominator since some firms did not have revenues.

  15. A co-sale/tag-along right means that if the company wants to sell its shares, the VC can also sell at the same terms. A drag-along right means that if the VC wants to sell then the VC can force other shareholders to sell as well at the same terms.

  16. One concern with the ranking variables is that they may be endogenous. There does not appear to exist suitable instruments; therefore, we present the specifications with and without the ranking variables.

  17. The calculation is \( { \exp }\left( {0.{1} * 0.{139}} \right) - {1} \).

  18. For example, while venture capital-backed firms averaged less than 3% of corporate R&D in the period 1983–1992, it was nevertheless responsible for more than 8% of United States’ industrial innovations in that decade (Kortum and Lerner 2000). See also Hölzl (2009) for related evidence that confirms the importance of R&D for high-growth firms close to the efficient frontier across a sample of 16 European countries.

  19. These terms and conditions are summarized at http://www.sba.gov/INV/overview.html.

  20. Private Equity Comment from SJ Berwin, http://www.sjberwin.com, 8 September 2006.

  21. See, e.g., http://cliffreeves.typepad.com/dyermaker/2005/12/rim_blackberry_.html.

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Authors and Affiliations

  1. Schulich School of Business, York University, 4700 Keele Street, Toronto, ON, M3J 1P3, Canada

    Douglas Cumming & Sofia Johan

  2. Tilburg Law and Economics Centre (TILEC), University of Tilburg, Postbus 90153, 5000, LE Tilburg, The Netherlands

    Sofia Johan

Authors
  1. Douglas Cumming
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  2. Sofia Johan
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Correspondence to Douglas Cumming.

Additional information

For helpful comments and suggestions, we owe thanks to Werner Hölzl and an anonymous referee, and to the seminar participants at the CD Howe Institute, Toronto (November 2008), and the Express Seminar, Stockholm (November 2009). We have benefited from helpful comments and assistance from YORKbiotech, particularly Robert Foldes, Adrienne Ng and Lyudmila Kurochkina. YORKbiotech collaborated in the design of the survey and collected the data reported herein.

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Cumming, D., Johan, S. Phasing Out an Inefficient Venture Capital Tax Credit. J Ind Compet Trade 10, 227–252 (2010). https://doi.org/10.1007/s10842-010-0080-3

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