This zombie policy must die

Nov 13, 2015
miltons ip

Is there anything less ‘innovative’ than reviving a policy that was tried before, failed miserably and was properly cancelled?

Other than a desire to hit new lows in policy innovation, or new highs in irony, there is no reason for the new federal government to revive the old tax credit for labour-sponsored venture capital corporations (“LSVCCs”).

And yet, this ghastly prospect is part of their platform.

Tax credits for LSVCCs were tried before.  They were a complete and unmitigated disaster.

Retail investors (you and me) received a massive tax credit for investing small amounts of money in LSVCCs.  A slew of crappy little funds popped up, sponsored by unions with no business acumen, run by managers with no investing ability and flogged by greedy stockbrokers to naïve rubes (you and me).

Two features distinguished the LSVCC program: rapacious fees paid to a myriad of “professionals”, and abysmal returns.

They were a disaster for taxpayers: massive losses in tax revenue from the credits to investors.

They were a disaster for investors: losses of principal, and massive opportunity costs in terms of investment returns forgone (if the money had been invested in something decent).

They were a disaster for innovative companies who, every time they pitched for funds, faced a barrage of useless advice from VCs.  Most of the folks running LSVCCs were not capable of running a lemonade stand, but they had no qualms about pontificating about how every the company should change its business model; then when they did invest, they invested tiny amounts and were too timid to invest enough money to actually give the company a chance to succeed.

The only people who did well from LSVCCs were the sycophants and leeches – the stock brokers who sold the units for massive commissions, the accountants and lawyers who feasted of the tiny little deals that they did, the unions that sponsored funds that they had no business being involved with, and the directors and management teams, who got to play investors.

There is no evidence that LSVCCs benefited Canadian innovators.

There is no shortage of capital.  The world is awash in capital chasing decent returns.  If investors thought that it could earn decent returns in venture capital in Canada, capital would flood into the space.  There are no obvious barriers to entry for the Canadian VC market that would prevent capital from flooding in from around the world, if it wanted to.  Accordingly, anyone who claims that there is a shortage of VC in Canada must prove what market failure has led to a less than optimal amount of venture capital in Canada.  But when you ask for proof, you get none – just crickets.

The VC industry in Canada has a track record of terrible returns.  This, not market failure, is what is scaring off investors.  Terrible returns, born from weak investors using a bad business model, not market failure, are the reason we do not have more venture capital in Canada.

The mere fact that there are companies that don’t get financed does not prove a market failure leading to inadequate venture capital.  It just proves that many companies do not raise as much equity financing as they think they want.

Nothing prevents anyone from forming a venture capital fund in Canada right now.  Nothing prevents anyone from forming and financing a LSVCC right now.  However, right now, any VC fund, including a LSVCC fund, would have to raise funds without the investors receiving preferential tax credits.  Milton’s First Law of Investment Vehicles is: if no one will invest in your investment without receiving tax credits, then your investment is crap.

What is wrong with LVSCCs:

  • Wrong incentives: too many fees, encouraging too much broker push, not investor pull based on returns.
  • Wrong size: far too many small funds; large costs need to be spread over a large pool.
  • Wrong vehicle: short term private equity limited partnership are wrong for the exercise at hand, of building innovative companies.
  • Wrong investors: small retail investors; venture capital is an asset class much better suited to institutional investors with very long time horizons (eg. Pension funds who are playing a long game)

Reviving the LSVCC tax credit program would be a spectacular admission that the new Liberal government is utterly devoid of innovative thinking about innovation.  The first time that the tax credits for LSVCCs were introduced the policy was naïve, but well meaning.  Reviving them now in the face of clear evidence of failure would be stupid, and horrible public policy.