A crucial component of a functioning tax system is that it should establish a level playing field, and should not arbitrarily pick “winners and losers”. I happen to believe that the tax system should rarely be used to drive policy, but that is obviously a minority view. But a tax system that perversely favours some over others for no policy reason at all is clearly flawed.

Our HST system is trapped in 19th century mercantile thinking and is such a flawed system. We levy HST on services provided by Canadians for Canadians, but we do not levy HST on the same services if they are provided by “non-Canadians” for Canadians. It defies belief that Google can direct Canadian search queries to google.ca instead of google.com, while at the same time evading any responsibility to levy HST on its advertising (the real service it sells and thus its core business, not the free service it provides to support its advertising business), while domestic advertisers must charge and remit HST is ridiculous. It is also an instance of massive tax leakage.

Google, Netflix, Amazon … the list goes on. They must be forced to levy HST on the services that they provide to Canadians – otherwise, they gain an enormous (i.e. roughly 13%) advantage over Canadian competitors for no reason, all to the detriment of Canadian companies and Canadian taxpayers.

Neil

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If you want to move the needle with economic development, it is services that matter the most. Manufacturing and resource extraction may be easy, but they are not the core of a first world economy. The challenge – and it is a very serious one – is that to improve standards of living, we must figure out how to improve productivity in services. Services make up >75% of the economy, and yet, most are still conducted much as they were a century ago. Think of education or health care or accounting – are they really ‘more efficient’ or delivered differently than 100 years ago? In the main, they are still the same services delivered the same way. This must change if we are to create wealth and grow GDP per capita in the years ahead.

Neil

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Zero to One by Peter Thiel.

Peter Thiel was one of the co-founders of PayPal (along with a ridiculous number of other very successful folks including Elon Musk of Telsa and SpaceX fame, and Reid Hoffman of LinkedIn). Much of his early ranting was of the ‘libertarian loonie’ variety (everything would be better if there were no government), which is a sentiment I think only someone who is rich, young and utterly devoid of empathy and introspection can truly ascribe to. However, perhaps with age comes wisdom, because this is an excellent little book. It is short, pithy, and insightful. I strongly recommend it.

Most books on entrepreneurship and technology start ups are not worth the paper they are written on. This one is worth paying for the hardcover version.

Two thoughts in the book stand out. The first is that when there is perfect competition, marginal profit is zero. As an entrepreneur you must look for a niche where there is less than perfect competition, and thus try to capture some form of ‘monopoly’ profit. I have made this mistake myself several times – looking a large markets with large numbers of incumbents and assuming that I because we had a better offering, we would grow quickly. Instead, I should have understood from the level of competition that marginal profits for the incumbents were low – and that this should be a clear warning to me to ensure that I had something radically different and better to have strong margins. Something that is just a bit better will not have the margins to support the sustained and expensive effort of building market share.

The second, and related, point, is that you should start by trying to dominate a modest niche – and after you have done that successfully, you should find an adjacent niche and dominate it. This is a very apt point, and in direct conflict with the usual “advice” that you should target a massive total addressable market from the get go. It is, in fact, in direct conflict with the usual VC metric of looking for a company that from the get go can scale to be “a $100M business in a $1B space”. Of course, it helps if there are obvious adjacent niches that you can transition into readily after your first success – but that is a far cry from the target being one large market.

When you put the two together, a good start up will be very focused on a small identifiable niche and will have very strong margins early on, and thus will rapidly start generating cashflow from which to fund its growth.

Happy reading.

Neil

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Investing is a low-barrier to entry, poorly-regulated business so it should come as no surprise that many fund managers say crazy things when talking about their historic returns. Similarly, retain and angel investors prefer to glorify their returns even if it does not benefit them financially.

Recently, I have heard a number of investors refer to their ‘cash-on-cash’ rate of return. When this is specified without any reference to “the time period” it is utterly meaningless, and likely deliberately misleading. Investing is about ‘rate of return over time’. If you fail to mention the time period, you are talking gibberish, and trying to mislead. A very common retail example of the same behaviour is people talking about how much they have made owning their own home, but without any reference to the duration of the investment or its annualized real rate of return (after inflation).

One of the most significant trends of the past generation has been the ‘democratization of capitalism’. What I mean by that is that we are all, by necessity, required to try to ‘make money from money’ (which is the essence of capitalism). We are all investors now. Ands everyone has much more stake than ever before in a) saving, and b) investing these savings successfully, for retirement – and all taxpayers, as guarantor of various public sector pension plans, also have a much higher stake in understanding the liabilities that flow from weak investing returns. Sadly, the financial literacy of most people – including of most people who are nominally “investors” – has not kept pace with this transformation. We need the financial equivalent of mandatory high school – a mass education program that improves financial literacy among all adults.

Neil

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Here are some fundamental truths:

• Patents are not self-enforcing, nor does the state enforce your patent rights;
• A patent is nothing more than a call option to sue, and unless the patent owner enforces its rights, a patent is worthless;
• Enforcing patents is hard and requires expertise, resources, tenacity, and capital;
• No business can be good at everything; every business needs to focus on a few core competencies; and,
• Very few businesses have expertise in patent enforcement.

Accordingly, as long as we have patents, it is inevitable that we are going to have businesses whose core competency is in patent enforcement.

Moreover, for additional reasons – such as ‘reputation management’ – entities that produce a lot of patents (like universities and research labs), have a lot to gain by outsourcing the dirty work of enforcing their patents to third parties.

So it is well past time that we got past calling patent licensing and patent assertion entities nasty names, and learned to love our favorite trolls.

Neil

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Moneyball by Michael Lewis is an excellent piece of financial journalism, vastly better and more insightful than you would glean from the movie starring Brad Pitt.

The premise of Moneyball is that the Oakland As revolutionized baseball by abandoning heuristics and instead analyzing the data very carefully: and what the data told them was the teams that won baseball games could be assembled more effectively and with much lower payrolls than teams built by buying expensive free-agents.

The Moneyball thesis is the dominant trend of professional sports team management of the past decade, and has had a dramatic impact on MLB (baseball) the NBA (basketball), and now the NHL (hockey is always a bit behind the curve).

However, the thesis – that you should look very carefully at the data is more relevant than ever in virtually every business. We have more data at our disposal than ever before, and much of it will provide insights that overturn old heuristics and make it possible to win more games with smaller budgets. Or at least, that’s what I keep telling myself when I look at my meager budget.

Neil

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We face a crisis of ignorance about intellectual property – seriously, more people know less about IP than any other core business discipline. IP is not the be-all or end-all of business. Lots of other disciplines like marketing, sales, finance and HR are more important for more businesses than IP. But the knowledge gap in C-suites between what folks do know and what they should know is greater, in my view, for IP than any other core discipline of business and that is why I have devoted so much energy to trying to explain the basics of IP to people.

That is why it drives me bonkers when people who should know much better say stupid, deliberately misleading things about patents in order to lobby for their pet position. In this rant, I talk about some recent foolishness from the new CEO of AbbVie Canada, who happens to be a Frenchman. I am sure that his PR firm was delighted to get his speech featured in the Globe & Mail, but shame on him and shame on the Globe for mindlessly repeating drivel. Put charitably, if this came out of a four-legged animal, it would be fertilizer. Here is the article in the Globe..

Here is the key point: patent law makes it possible to ‘invent anywhere, and patent everywhere’. Whatever pharma companies may think about the scope of Canadian patent protection, it has no logical nexus to whether or not they conduct pharma R&D in Canada: none.

Sadly, there are many more examples of this self-interested misinformation about IP. In Rants to follow, I will try to highlight some choice idiocy from Google and others.

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There is lots of talk about Canada needing a national securities regulator and very little action. I think that one of the main reasons for this is that in fact, there is no compelling need in Ontario for a national regulator. The cost of not having a national regulator is being borne by issuers (and their shareholders and investors) in places that need to access capital from outside their home turf – Alberta especially, and to a lesser degree, Quebec and the Maritime provinces. Ironically, these are the very jurisdictions that are hostile to a national regulator. In the case of Alberta, I suspect that is of classic ‘interest group politics’ – the small group of folks who might be be negatively affected by the change (bureaucrats, securities lawyers and the like) scream much louder than the large but diffuse group of people who are likely to benefit (all of the issuers in Alberta, and the various shareholders in them). In particular, times have been so good in Alberta lately that no one is too worried about a slightly elevated cost of capital.

Ontario has some of the deepest, broadest, and best regulated securities markets in the world. Issuers in Ontario, other than mutual funds, ETFs and similar vehicles, rarely really need to issue securities outside Ontario. As a result, most Ontario issues rarely incur much true cost as a result of our fragmented regulatory regime. In particular, the biggest issuers of securities in Canada – various governments issuing bonds – really only care about Ontario and foreign markets. Ontario entrepreneurs really do not suffer as a result of the balkanized regime and can comfortably ignore the whole issue.

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Caveat Investor

With OSC hearings underway for the Sino-Forest fiasco, I thought it time to think about the lessons it and similar investor frauds teach us.

Curious what one of these frauds looks like? Read this press release and ask yourself, how did this company ever get listed?  What on earth were the auditors, underwriters, Exchange, regulators, directors and all their respective legal counsel doing?

To re-cap, Sino-Forest was a TSX-listed, Chinese forestry company. It rose rapidly in stock price and value to a market cap exceeding $6B CDN, through with many secondary offerings of debt and equity after the initial public offering. Ultimately, it was shown to be an utter fraud and it collapsed in bankruptcy. Interestingly, it was by no means an anomaly – it was one of many similar North American – listed publicly traded Chinese frauds.  In my case, I avoided Sino-Forest which I thought was a an obvious fraud, and in turn was sucked in by one called Zungui Haixi, which supposedly made and sold running shoes.

Sino-Forest may have been a Chinese forestry company, but its consequences for all companies needing to raise risk capital in Canada are real – and the lessons it teaches about the importance of trust, and how quickly trust can be squandered, are real for all participants in the capital markets (and thus are very important for innovators and entrepreneurs).

The most obvious lesson to be drawn from Sino-Forest et al is “never rely on auditors or audited financials”. That is a valuable lesson to be reminded of, and not just in the case of outright fraud. On Sino-Forest, as on Zungui Huixa, and on many others, the work done by the auditors (E&Y in this case) was totally, utterly substandard, but even in normal times, audited statements are at best a professional opinion bought by the issuer.  Issuers then waive this opinion in front of investors, but wise investors don’t actually give the opinion much weight and certainly do not rely on it. In one of the few recent Supreme Court of Canada cases that I think was absolutely wrongly decided, Hercules Management, the SCC agreed with the accounting lobby and insulated auditors from the vast majority of lawsuits from shareholders. In short, in Canada, investors cannot normally sue auditors even if the financial statements are wrong and misleading.  As a result, the only prudent course for an investor is to assume that audited statements are just another piece of issuer-bought marketing puff.

But the brutal truth of these cross-listed frauds is that absolutely no one in the investment eco-system is devoid of blame, and most of these failings were caused pure and simple by greed (the hunt for fees, and the hunt for returns). The auditors are the easiest target, but everyone dropped the ball in some way:

– the underwriters and their legal counsel. They were happy to take big fees for each offering, and doubtless charged hefty fees for due diligence and still failed to uncover a blatant fraud.

– the investment banks and their “analysts” who all had “Buy” recommendations on the stock.  Of course, recommendations from analysts who work for sell-side investment banks are worse than useless – Sino-Forest was just a reminder of the obvious.  Sell-side analysts fill a marketing function for investment banks, and their recommendations are no more valuable to an investor than a beer commercial is to a beer drinker.  Put another way, if sell-side analysts knew anything about investing, they would not be sell-side analysts they would be investors.

– management and directors, especially directors who did not speak Chinese who agreed to try to perform a role they were not fit to fill (supervision of a company whose operations, an ocean away, were conducted in a language they do not understand)

– the stock exchanges (in this case the TSX, but across the border the NASDAQ and NYSE), who completely failed to protect investors by enforcing real listing standards.  Exchanges hungry for listing fees lowered their standards and chased listings, and anyone who thinks that the TSX was not partly to blame for the Sino-Forest disaster is being far too kind to them.

– the regulators, in this case the OSC and in the US the SEC. Permitting a company with no nexus to Canada, with no assets in Canada, with management with no assets in Canada, to offer securities to the public in Canada is at best naive, and probably stupid. Regulations without realistic sanctions are just wishes – and the cold brutal truth is that a regulator who does not have the ability to enforce its orders with real consequences (by stripping people of assets and putting people in jail) is an impotent enabler of fraud and has abandoned its duty to regulate. The OSC’s ‘remedy’ in the Zungui case would be laughable if it were not so useless – the OSC imposed a cease trade order, which hurt domestic investors and prevented them from even crystalizing their losses for tax purposes, but had absolutely no real negative consequences for the fraudsters in China who had long ago looted the treasury.

– investors. Investors chasing returns to good to be true ultimately bear the most responsibility. Greed kills, and investors (myself included) really have no one to blame but themselves for letting greed cloud their judgment.

The first and most important rule of investing is Caveat Investor: “investor beware“. Just like in boxing – you must protect yourself at all times, and you cannot count on anyone else to do it for you.

Of course, what makes investing so fascinating and challenging is that you must “beware, but take risk; trust but verify”. You cannot invest without taking some risk. Risk-free investing does not exist, and risk-free saving without investing just does not cut it.  By the same token, however, trust is the bedrock for investing – without some trust in the behaviour of other participants in the system investors cannot invest, the cost of capital skyrockets, and innovators are starved of capital.  For the capital markets to function, for innovators and entrepreneurs to access risk capital, investors must take risk and investors must trust – while being sceptical, prudent, and careful, protecting themselves and trusting no one too much.

Squaring that circle is what makes investing (and regulating the securities business) so difficult, and so much fun.

Neil

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Good public infrastructure and good public policy are crucial for entrepreneurs.  The overly simplistic notion that all government needs to do is “just get out of the way” grossly fails to capture the myriad important things government must do in a modern economy, and the things government can do to improve the environment for wealth creation by entrepreneurs.

All businesses (and taxpayers, and citizens) need to interact from time to time with government.  I refer to the point where these interactions happen as GUIs: government-to-user interfaces. Some are great; some are not so great, and that is a real shame. Less friction in GUIs means more and better commerce. Less hassle conducting business means more time and money creating wealth.

I understand that it takes money to build good IT systems, and there are certainly plenty of examples of government IT projects that went horrible wrong (the long gun registry being just one horrific example). However, a few failures is not a reason to stop – it is a reason to do a better job. Also, there is no reason that all of the development risk needs to be borne by ‘taxpayers’ – there are lots of ‘savers’ (investors) who can and should be sharing risks with taxpayers.

Everyone wants to talk about “infrastructure” but what they really means is the subset, ‘hard infrastructure’ that involves pouring concrete (roads, trains, etc.). Soft infrastructure offers some very interesting opinions for areas where money invested could produce very significant economic dividends, and, the investment does not have to come from taxpayers.

The world is awash in capital chasing investment returns. Investors, especially pension funds, face a scarcity of suitable public infrastructure investments. In my view, upgrading, enhancing, and re-building a number of government-user interfaces is actually a form of “soft infrastructure” that lends itself perfectly to “triple P” (Public-private partnership). For instance, Teranet (Ontario’s online land titles system), which was once a publicly traded income trust and now is wholly-owned by OMERS (the pension of Ontario’s municipal employees) is an excellent example of a very well built and well run piece of GUI that generates income for the province, and has dramatically reduced the transaction costs of doing business in Ontario (by making it easier, faster and cheaper to buy, sell and encumber title to real property). Similarly, Saskatchewan’s corporate registry system is now owned by a publicly traded company, with the very sexy name of “Information Services Corp.”. You can buy shares of it on the TSX, under the symbol ISV.

We need better GUIs, and one way to get them is to do a lot more creative thinking about who can and should be investing in the development and operation of them – taxpayers, or savers.

Neil

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