The Standing Senate Committee on Banking, Trade and Commerce has the honour to present its

NINETEENTH REPORT

Tuesday, December 8, 1998

Your Committee, to which was referred the Bill C-53, An Act to increase the availability of financing for the establishment, expansion, modernization and improvement of small businesses has examined the said Bill in obedience to its Order of Reference dated December 2, 1998 and now reports the same without amendment, but with observations which are appended to this report.

Respectfully submitted,

Chair
MICHAEL KIRBY

Introduction

In preparation for its hearings on the SBLA which will take place after the bill reaches the Senate late this fall, and at the request of the Honourable John Manley, Minister of Industry, the Standing Senate Committee on Banking, Trade and Commerce met with witnesses across Canada to review the SBLA and to respond to a number of specific questions. These questions included:

1. Should the SBLA be expanded to target knowledge-based industries?
2. Should the SBLA be extended to the volunteer sector recognizing that non-profit organizations are an integral part of the economy and the labour force?
3. Should the current maximum loan size of $250,000 per borrower be maintained or changed?
4. Should the current provision for allowing personal guarantees up to 25% of the value of the loan be eliminated?
5. Should the SBLA be expanded to include working capital financing in addition to current loan guarantees for the acquisition of land, buildings, equipment and leasehold improvements?
6. Are there provisions of the present act that could be modified to facilitate administration of the SBLA from the perspective of both the lender and the borrower?
7. Should the SBLA be extended to include the leasing of equipment?

Background to the SBLA Program

The SBLA program began in 1961. Selected changes have been made to the Act over the past three decades to reflect the needs of small business and the lessons learned by government and small business with the program. Another round of changes will be introduced in the fall 1998 session of Parliament.

The aim of the program is to increase the availability of loans for the establishment, expansion, modernization and improvement of small businesses in Canada. The maximum amount of the loan available under the SBLA to any borrower is $250,000; the average loan is $65,000. Loans are available for the purchase and improvement of premises and equipment and for the purchase of land, but not for share acquisitions, working capital, existing debt, real estate purchased for resale, goodwill or other intangibles.

Businesses with sales under $5 million are eligible for an SBLA loan. The program, however, does not apply to farms or voluntary, charitable or religious organizations.

Industry Canada has recently completed a comprehensive review of the SBLA program in preparation for legislation extending the SBLA. This legislation must receive Royal Assent by March 31, 1999 or the program will no longer exist.

What the Committee Heard

The SBLA program received strong support from witnesses who appeared before the Committee. It is a very useful government program facilitating loans to small and medium-sized businesses, especially in start-up situations. Some modifications to the program can make it even more useful.

Most witnesses argued, however, that the program should stick to its fundamentals and not be used to address applications for which it was not designed. There are other innovations in small business financing which are certainly worthy of government support, but such innovations should be developed outside the SBLA program. These innovations will be discussed further below as will suggested modifications to the program.

1. Should the SBLA be expanded to target knowledge-based industries?

While witnesses recognized the critical importance of knowledge-based industries to the economy, there was considerable skepticism that the rules of the SBLA program could be modified to deal with firms in this sector.

These firms are in need of additional equity financing, rather than funds to make purchases of equipment, land or premises which SBLA funds can be used for. The key assets of these firms are intellectual and not "real" assets which can be easily assigned a market value and which can be used as collateral.

The Committee recognizes that there are other government programs serving this sector. For example, the Business Development Bank of Canada offers Patient Capital® financing in partnership with certain chartered banks and regional agencies. This vehicle is designed for firms in knowledge-based industries and does recognize intellectual and intangible assets.

The Committee views the development of well-designed financing vehicles for knowledge-based industries as highly desirable. There are firms in the knowledge-based industries that are unable to obtain private sector support because the risks involved are outside the financing parameters of the private sector, but for which the "deep pockets" of the government make taking such risks acceptable. These firms need very patient capital because it will be a number of years before repayment occurs. Government has the resources to be patient.

The Committee recommends that the government not make knowledge-based industries an explicit target of the SBLA program, but that it set up a pilot project to develop additional means of funding those firms in the knowledge-based industries that are currently unable to obtain private sector funding, but that do present reasonable prospects of success.

The non-profit sector is composed of a wide variety of organizations, many with uncontrollable and unpredictable income streams based on grants and donations, but others with characteristics quite similar to firms in the for profit sector. Witnesses generally were not supportive of extending the SBLA program to the volunteer sector because its focus and operating characteristics (instability of revenues, costs) are fundamentally incompatible with the parameters of the program.

The Committee heard witnesses from the Digby Network, a not for profit organization that promotes social. labour market and economic development. The enterprises that the Digby Network promotes are community owned enterprises and business ventures, often called Community Development Corporations. Examples are theatres, cultural festivals and handicraft-producing enterprises. The only difference between these enterprises and similar private sector ventures is that the revenue left over after all expenses have been paid, the surplus, does not belong to a single individual or group of individuals. It is used for the expansion of the enterprise or the development of similar enterprises.

Extension of the SBLA program to those enterprises in the not for profit sector that operate in a manner similar to those in the private sector, and that can meet the requirements established by the SBLA program should be considered. The Committee asked the witnesses from the Digby Network to suggest a definition of what not for profit organizations might be considered for eligibility for the SBLA program. Their suggestion is presented in Appendix 1.

3. Should the current maximum loan size of $250,000 per borrower be maintained or changed?

With the exception of the tourism industry, there was very little support for an increase in the maximum loan size. Witnesses argued that the SBLA is a program for small business and the current maximum is already far above the average loan size of $65,000 granted under the program. In fact, until recently, the Canadian Federation of Independent Business (CFIB) argued for a lowering of the SBLA loan size threshold; at its meetings with members of the Banking Committee, representatives of the CFIB went on record against any increase in this threshold.

Witnesses from the tourism industry did call for an increase in the SBLA loan size threshold to at least $500,000. This industry has many enterprises who must invest a considerable amount in facilities in order to compete for tourism dollars. The problems with this sector from a financial institution point of view are that:

1. cash flows can be highly irregular because of the seasonal nature of many attractions;
2. infrastructure costs are high;
3. profit margins are low; and,
4. there is a significant lag from the time the initial investment is made to the time that revenue begins to flow.

The Committee heard from one witness in Halifax that the tourism industry is looking into setting up its own bank. The industry might put up $1 million and try to leverage this with help from provincial and federal governments or in partnership with credit unions. The industry itself would form part of the due diligence for loans.

4. Should the current provision for allowing personal guarantees up to 25% of the value of the loan be eliminated?

It was the view of almost all whom spoke with the Committee that the personal guarantees should be maintained. Business owners should share the risks involved in the operations for which they have secured a loan. The personal guarantees, it was argued, increase the commitment on the part of borrowers to exercise good management practices. In addition, these guarantees lower the cost of the program to the government.

The Committee did hear arguments for both raising and lowering the ceiling of 25% on the personal guarantee however. Some argued that with a guarantee of this magnitude, borrowers may become too conservative in operating their businesses and then not achieve the success that a greater assumption of risk would lead to. On the other hand, others argued that in higher risk situations a higher guarantee is needed to mitigate the potential for more failures.

The Committee recommends that the personal guarantee be maintained and that the ceiling of 25% on the personal guarantee be unchanged.

5. Should the SBLA be expanded to include working capital financing in addition to current loan guarantees for the acquisition of land, buildings, equipment and leasehold improvements?

The Committee heard from witnesses across the country that there is a demand for working capital in the small business sector. Working capital, money used to pay ongoing operating costs, to purchase inventory and to finance receivables, is critical to the success of a business. Assets like inventories and receivables are, however, not like the fixed assets for which the SBLA program was designed. Because the stock of these assets fluctuates on a daily basis and because the magnitude of working capital needed fluctuates as well, the SBLA program, which was designed to finance a specific acquisition over a specific time frame, is not the appropriate vehicle for meeting this need.

The Committee also heard from many that access to capital in general is still a problem for many small businesses. While the SBLA program is quite helpful to small business, it is limited to fixed asset financing. There are other potential applications for debt capital such as leasing (to be discussed below), but of equal importance is access to equity capital for small business. Some argued that the present range of tools to address the equity capital needs of small business is seriously insufficient.

Many argued that the current tax system acts as an impediment to the supply of venture capital. For example, recent changes to the tax laws dealing with Labour Sponsored Venture Capital Funds, the dominant source of venture capital in Canada, appear to have significantly reduced their attractiveness to investors. Further, the tax treatment of capital gains is seen as another major impediment to the supply of venture capital.

The Committee recommends that the government work with private sector venture capitalists to develop pilot projects that can serve as the basis for instruments that will expand the flow of equity capital to small businesses in Canada. Further, it is important that the government examine the impact of the tax system on the supply of equity capital and rectify any unintended impacts of tax policy on capital markets.

6. Are there provisions of the present act that could be modified to facilitate administration of the SBLA from the perspective of both the lender and the borrower?

While administration of the program was not addressed as a major issue by witnesses in their oral presentations, most indicated that the paperwork is reasonably straightforward. Some witnesses did make specific suggestions, a number of which are presented in Appendix B.

While the Committee makes no specific recommendations with respect to the administration of the program, it supports efforts to minimize the administrative burden.

While the SBLA program addresses the traditional approach to the acquisition of plant and equipment by an enterprise, that is borrowing to purchase the asset, leasing has become a significant alternative to immediate ownership. According to the Canadian Finance and Leasing Association,

a "capital" or "finance" lease is usually used to finance an asset for the major part of its useful life and there is a reasonable assurance that the lessee will obtain ownership of the asset by the end of the lease term. An "operating" lease usually finances the asset for less than its useful life and at the end of the lease term, the lessee can return the asset to the lessor without further obligation.

In both cases, the leasing company typically purchases the asset from the manufacturer or distributor and then provides use of the asset to the lessee under the terms and conditions of the lease.

Cash flow management is one of the key factors in the business decision to purchase or lease plant and equipment.

Most witnesses who appeared before the Committee acknowledged the importance of leasing as an alternative to purchasing for businesses in almost every sector of the economy. While many felt that public support should be made available to enterprises that would be eligible for an SBLA loan if they decided to purchase an asset but who chose to lease, they did not view the SBLA program as the appropriate vehicle for providing this financing. A program designed specifically for the needs of those who choose to lease should be developed.

The critical issue from a public policy point of view is what losses would be incurred with a vehicle designed to provide financial support for leasing.

Recommendation 8

WITNESSES