Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 19 - Evidence
OTTAWA, Wednesday, October 17, 2001
The Standing Senate Committee on Banking, Trade and Commerce met this day at 4:10 p.m. to examine the present state of the domestic and international financial system.
Senator E. Leo Kolber (Chairman) in the Chair.
The Chairman: Honourable senators we are meeting to examine and report upon the present state of the domestic and international financial system. The witness today, Mr. Denzil Doyle from the Capital Alliance Ventures Incorporated, has appeared before us on another occasion of this committee.
Mr. Denzil Doyle, Chairman of the Board, Capital Alliance Ventures Inc.: I reviewed the material that I presented to you in 1999, and some things have changed for the better and some things have not changed at all. The capital gains tax rate has changed for the better - it has been reduced twice.
The Chairman: Are you willing to give this committee credit for that?
Mr. Doyle: Certainly, someone deserves that credit. The main point I emphasized two years ago is that the front end of the investment spectrum is broken. It is very difficult in Canada to start a new high-tech company. We must rely on private individuals to do that, because the venture capital companies do not do that, notwithstanding what many of us say in the venture capital industry. The fact is that it does not pay to do raw start-ups in the high technology industry, so we rely on individuals to do that. Of course, the reduction in the capital gains tax was a big help in that direction.
Another positive move in the last year is the rollover provision, whereby you can rollover capital gains from one Canadian- controlled private corporation and invest them in another one within a certain period of time, and thereby delay the capital gains tax.
That has been changed twice. I believe the first time was a rollover provision of about $250,000 and then it was changed to several million dollars, which, of course, is in line with what has been in place in the U.S. and in Great Britain for a long time.
Another change in the last couple of years is in the tax on stock options so that people do not find themselves with a liability on their hands the minute they exercise a stock option, even though they have not yet made any money on it. That has been change for the better.
The Scientific Research and Experimental Development, SR&ED program, of which I previously painted a bleak but accurate picture because it was a total mess, have had new management in place and there is now a whole new approach to the concept of experimental research and development. The program is working quite well and to the benefit of Canadian taxpayers. It is not as if the high technology companies are ripping off the Canadian taxpayers, because the program has well- understood rules now and good administration.
I was also rather harsh on a program that had been put in place called the Canadian Community Investment program. That was a pilot program whereby approximately 20 communities across Canada were given money by the federal government to help improve the communications between local "angel investors" - people who do early-stage financing. The problem was that people who start companies tend to be very young and they do not generally talk to older people like myself, who tend to be the angels. Thus, there was a communication gap.
The purpose of that program was to assist with the communications between the angels and the entrepreneurs. I was critical of it primarily because I felt that we had to fix the basic problem first - we had to make it worthwhile for angels to become involved in this business. It is a bit like having one foot on the gas and the other foot on the brake - trying to create incentives for communities to initiate communication between the two parties when, in fact, there are huge disincentives for the angel investors to even become involved.
Those are some of the things that have gone right and they are not to be diminished at all. There are some areas that still warrant our attention. There is a serious need to provide what I would call "Canadian-owned receptors." At the moment, a company will be formed, and typically, it will be initially launched by a group of angel investors. They will grow it for one or two years to get sales going and then the venture capital companies come into play and build up the balance sheets so they can start using bank credit. Then the banks enter the picture.
A couple of years ago I showed you a spectrum of the various players and how they come on stream at various places in the investment spectrum. Eventually, you hope to do an initial public offering, IPO, whereby you sell your shares to the public on a public exchange. Well, for a whole variety of reasons, our stock markets are not working when it comes to high technology. Stock markets in Canada do not really provide an outlet for liquidity for venture capitalists or angel investors.
I would like to tell you a personal story, if you do not mind, which illustrates many of the points I have made so for and that I would like to make further on. It particularly presents this issue of receptors.
At the present time, if you build a company up to $20 million in sales, normally you should be able to take that company public on a stock exchange, whether it is the TSE or the CDNX. However, the trading volume in high technology shares is very light. In other words, the investment community still does not feel comfortable with buying and selling high technology shares. The poor old venture capitalist can end up owning 20 or 30 per cent of the company by the time it goes public and then finds that if he or she tries to dump their shares on to the market, the stock price will collapse.
Thus, more and more venture capitalists are shying away from taking companies public. Today, the stock market is in such a mess that you would not take a company public anyway, but even one or two years ago, venture capitalists were looking for other exit strategies rather than go public on a stock exchange.
That is a serious problem. We need to find ways to get Canadian receptors. I have always said that if we had more large companies such as Nortel, for example, who could buy up those companies, then that would provide an exit strategy for the investors.
In 1983, I co-founded a company with another person. We put about $400,000 of our own money into it and built the company over an 18-month period. We built it to the point where product was flowing, and then we needed more money. I approached a group of my friends - about 15 or 20 so-called angels - who put another $400,000 into the company. Believe it or not, that is the only money that company ever needed. Today the company is employing a little over 100 people. Over that 18-year period, it has generated about $25 million in corporate and employee taxes to the two levels of government, excluding the GST. The company has been very profitable but all of the profits have been reinvested into the company. That is typically what happens in a high technology company; namely, you do not typically declare dividends. Neither my partner nor I wanted to run it so we had to find professional management for it. We paid the management high salaries and we also gave them some of our stock in the company.
We now have the company to a point where, normally, you should be able to take this company public on a Canadian exchange and Canadians would benefit from buying and selling the stock. If you look around, the only exit strategy for this company is to turn around and advertise it and sell it to an American company. That is exactly what is happening, I hate to say.
Senator Oliver: What are the gross annual sales?
Mr. Doyle: About $20 million. This is a distinct change from 20 years ago, when, if you were in the business of building companies you took them public on the exchanges and that was your exit strategy. That is no longer the case. Heaven only knows what the Americans will do to it. They will probably tear it part and leave some R&D in Canada because of our tax incentive for doing R&D. However, they will take the selling and marketing and do it all south of the border and all the good management jobs will go down there.
It is kind of tragic. If I wanted to emphasize one point in my presentation to you this afternoon, it would be to fix the receptor problems. At the moment, we are rapidly becoming a "farm team" for the U.S. high technology industry. If that is what we want, let us say so. However, we can do much better than that in Canada.
In fact, one of the things that is happening today is that we are frantically trying to bring U.S. and foreign venture capital - not only venture capital but also working capital - into Canada. Industry Canada, for example, has a group of people who travel around the world looking for foreign investment to come into the high-tech industry. My question is: Why do you not go to Toronto and teach the people in Toronto how to invest in high technology? Our Toronto investment community can tell you how to finance a tin mine in Bolivia, but do you think they can buy my high-tech company? They should be able to do so because the people who are buying my high-tech company in the U.S. are not technical people, they are financial people. They are people who put together a pool of capital and a holding company. This holding company is buying a number of so-called wireless companies, all of which complement one another. They will have a conglomerate of companies.
Why can we not make that happen with our Canadian money rather than have our Canadian money chasing tin mines in Bolivia? I do not know if they are chasing tin mines there or not, but I get the feeling that is what they are doing with their money. It certainly is not going into the high-tech industry. To emphasize this point, in the United States, the venture capital industry receives 60 per cent of their money from the pension funds. In Canada, we get 5 per cent of our money from pension funds. We have those huge pools of capital that are obviously chasing forms of investment other than the new economy investment.
I will leave my presentation at that. I hope that you have some questions.
Senator Oliver: Like you, I reread your remarks from the last time. I felt they were excellent remarks. There were a couple of other things you said at that time that you did not comment on today. You were concerned about the liability for angels because there were few defences for directors. Since that time this committee has passed a bill that has brought in a due diligence defence and proportion of liability as well. Are you familiar with that? Does this satisfy and overcome some of your concern about angels' exposure to liability if they went on the board of one of these start-up companies?
Mr. Doyle: Believe it or not, that is in my weekend reading file. I do not know the answer to your question, but it is encouraging to see that people are recognizing that it is another huge impediment. I do not know the answer to whether it is good enough or not.
Senator Oliver: You also commented on capital gains. As our chairman pointed out, this committee played a substantial role in persuading the Minister of Finance to reduce the inclusion rate.
For your concerns about getting more money involved in the new economy, has the reduction gone far enough? Is it effective where it is? Or is it just a first step?
Mr. Doyle: If I might boast for a second, my partner and I put $400,000 into this company. If we had not bellied up to the bar with that $400,000, there is $25 million worth of taxation that Canada has received over the last 18 years that it would not otherwise have received. This company would have been built in the United States. Yet I have had to wait 18 years for my money back. I do not feel that I still own anything like half of this company. Over the years, in building these companies, I had to give away some of the equity to my angel partners whom I brought in, I had to give management some stock options, and I have had to give stock purchases to the employees of the company. I would be embarrassed to tell you how little of this company I own today even though it has not had a lot of external financing required and I have had to wait this long period of time.
It would be in Canada's best interest if angel investors were allowed to get back at least their original seed capital with a some kind of scheme. For example, in this case $400,000 was originally put into that company. Whenever I generate, say, $1 million worth of taxes for the higher levels of government, then let me share in that tax revenue and give me back my $400,000 so that I can roll it over again and get at another opportunity like that. Although I am getting up in years, I will likely roll over much of this money that I receive into another angel investment next week. You must take advantage of us. If we are stupid enough to do this, then you should encourage us to do it.
Senator Oliver: You talked about there not being an exit strategy for venture capitalists who might end up owning as much as 20 or 30 per cent of a company when getting ready to go public and in Canada there is not much of an interest in going public for these new economy companies. What other exit strategies did you have in mind other than an IPO?
Mr. Doyle: You can sell it to an American company.
Senator Oliver: It is a Canadian solution that I was looking for.
Mr. Doyle: You could take it on the Nasdaq exchange. Certainly the Nasdaq is where you will get some action. Unfortunately, you will get a little too much action on the Nasdaq. The Nasdaq exchange is notorious for the short sellers. When a stock first goes public on the Nasdaq exchange, the short sellers will pump it way up in value. If it goes public at $10 a share, they will bid it up to $20 by saying good things, but when they get it up to $20 they will start saying bad things about the company and it will drop to $5 a share. In the process, there is also a whole legal industry in the United States where there are lawyers waiting for the management of the company to say something bad or something wrong and therefore misrepresent the real fortunes of the company. Lawyers are in the business of enacting class actions suits to represent all the shareholders who lose money on the way down.
I do not know what the statistics are today because the Nasdaq has taken steps against short selling and this type of activity. However, in 1995, I read a report that said that 90 per cent of all new issues on the Nasdaq are hit with a class action suit within the first year. It is not a pretty place to go for the average little high-tech company. I could probably take this little company of mine public on the Nasdaq but I do not want to go through that.
Senator Fitzpatrick: I have two questions about this problem of raising funds. I suspect that there are not as many angels around these days in light of what has happened with the high-tech stocks over the past year or so. You touched on the difficulty of going public. Part of that I think is because the requirements to list, and the requirements once you are listed on, for example, the Toronto Stock Exchange, are quite expensive for these smaller companies.
I would like to have your comment with respect to the regulations that you have to meet now with respect to the exchanges. I must point out that there is nothing the committee can do about the regulations. You suggested a proposal by which you can recover seed capital on easy or non-tax terms. It seems to me the real problem now is a combination of the disappearance of the angels and the complications of having to list and stay listed on the exchanges in Canada.
Mr. Doyle: You are right. There certainly are not as many angels as there once were. They are disappearing rapidly as the meltdown continues. However, if you go to places like Alberta there are still people making money in the oil patch, for example. Perhaps you could give those people some help in investing in high technology. That is one of the things this community investment program has done. There will always be angels, let us put it that way. Let us be good to them.
On your point about the regulations when going public, I do not think they are as onerous as people suggest. You hear companies complaining about them a lot. However, if a company is properly managed, much of the reporting they must do on the exchange is the kind of reporting they should be doing as private companies.
I insist that our little company report on a monthly basis to the board of directors, at least on some key parameters such as sales, bookings, inventory and so on. We certainly have quarterly reporting. For all intents and purposes this little company is behaving as if it were a public company, and it does not hurt them a bit.
I agree that some other stipulations regarding the granting of stock options and getting approval of shareholders are a little more onerous if you are a public company. However, I do not think that is a major showstopper.
Senator Fitzpatrick: I am thinking more of the information circular that you have to provide management and the prospectus and its cost. What is happening in Alberta is that many Albertans who have made money by developing and selling their oil companies are now staying private. They are not interested in pursuing public company development because of the problems with director liabilities, as well as the problems with the regulations of the exchanges and the securities commissions. I think they are saying, "We will try to do it privately and look for a buyout from someone else."
Mr. Doyle: This is where high-technology companies are different from resource companies, for example. If it were a resource company that was paying me dividends, I would probably hang on to it forever. However, it does not pay dividends and I want to get back my money and all the money of my angel investors who co-invested with me almost 20 years ago. The picture is a little different for high-technology companies. Our only way of payback is through a capital gain.
Senator Angus: Senator Fitzpatrick's point is absolutely true. The costs of an IPO today in Canada for start-up tech companies, or companies in any field, are more than $100,000. That angel money - or money from whatever source of private placement - is so prohibitive that, as Senator Fitzpatrick said, they are not doing it any more in the oil patch. I do not think they are doing it anywhere. It is absolutely strangling.
If there is anything you can suggest in that regard, it would be appreciated. It is not so much the regulations that are there, but the professional fees for the accountants, the lawyers and the cost of getting rulings and measures to protect the public investor.
Mr. Doyle: There is financing around for that. You can go out and do what we call "mezzanine financing" where, just before going public, you can go to a venture company and say, "I need all this money to write my prospectus and so on, and there is no money in the company."
It is called mezzanine financing and that end of the spectrum in Canada is overheated. There is too much activity there. It is costly, but I do not think it is prohibitive. This little company that I am talking about just fought a $600,000 lawsuit last year. We became so dominant in one of the markets that a main U.S. competitor said, "We have to put a stop to these guys." They claimed that we violated one of their patents, which was nonsense. It is like a wheelbarrow manufacturer violating an automobile patent. We knew we were in the right. We fought them and won the case, but we are also $600,000 out of pocket. This is a very profitable company. If you are a profitable company, you should be able to afford the cost of going public all right.
Senator Angus: I think you are right. Ideally, if you are getting $20 million of earnings, then you should be on your way.
Mr. Doyle: Your point is well taken. It is too costly.
Senator Angus: Today, obviously, there are many factors at play. We are into, apparently, a very serious economic downturn, to avoid the "R" word. We have September 11 and subsequent things that are happening all around us.
It seems to me that the money has dried up completely. I practice law in Montreal. All the small companies are not paying their rent. They have hit the wall. It is just devastating.
One of the things this committee is trying to achieve through this study is to highlight the fact that something is wrong in Canada in terms of attracting money for these junior companies to get up and running and therefore avoid our good friends to the south who are cherry-picking our brains, talent and ideas.
Mr. Doyle: I would certainly suggest that you give some consideration to what I call the "angel tax credit program." It has several by-products to it. Now, it could be a field day for the fraud artists. There will be people who will be forming new companies and applying for tax credits. We have to find a way of avoiding that.
However, what I would like about giving a tax credit to the angels whereby they would get their money back over a three- or four-year period by sharing in the tax revenue to the government, it would cause the angels to really get serious about building companies. As we know today, many angels just throw money at a bunch of kids to get them off their backs, and there is no incentive for them.
I think in this case the angel would say, "If I am going to get my $400,000 back in the way of a tax credit over a four-year period, perhaps it is worth me putting together a proper board of directors and putting some effort into this." It would only apply to the very first tranche of money that goes into a company. That would have the impact of it making it easier for them to raise that first tranche of money and a little more difficult after that, which is fine. It is just the opposite at the moment. It gets easier as you go up the chain.
Senator Angus: I find your material fascinating. The first time you appeared before us you were very helpful.
Could you walk me through the concept of Canadian-owned receptors, using a concrete example?
Mr. Doyle: One way of getting liquidity is for Northern Telecoms and other large high-tech companies to buy up little companies and tack them into themselves as new product lines.
Senator Angus: Is the concept a small biopharmaceutical company being bought up by a big pharmaceutical?
Mr. Doyle: That is right.
Senator Angus: They work on a product line. Those big guys are usually criticized for killing off little guys and stealing their stuff.
Mr. Doyle: You will notice that I said "Canadian-owned receptors." It is interesting to note that the people who are buying my company are not high-tech people. They are not a company like Nortel or any such thing. In fact, they are bankers. They have decided to put together pools of capital, buy these companies and inject proper management into them. They want to have a whole stable of these companies.
They are particularly interested in this company because it has some very unique wireless technology. They have already bought a company in Maryland that has complementary wireless technology. Why can we not be doing that with our Canadian pools of capital rather than buying tin mines in Bolivia? I hope we do buy tin mines in Bolivia, but I am sure you understand my point.
I listened to a presentation a couple of years ago at a financial meeting in Toronto. A fellow was talking about the wonderful investment opportunity there was for Canadians to help build the airport in Havana. Why are we building airports in Havana when we do not know how to finance a new economy in Canada? That is the fundamental problem.
Senator Kroft: Before moving to a different subject, I would like to suggest that there may be another side to the coin. There are new companies being developed and there are companies maturing that are ready for another level of investment. One of the pluses I have observed in my experience is that the entrepreneurs and the developers of these companies no longer have the extravagant expectations that the exaggerated markets of the latter 1990s provided. There is, in fact, a more realistic market at which the private investor with more traditional values might have an opportunity to see some of those companies whereas they did not before because they were racing off to take advantage of dramatically inflated markets. I offer that only as an observation.
The area I would like to spend my time on is the labour-sponsored venture capital funds. You spoke about that in your last appearance. As I understand it, you were then and are still the head of one of those companies.
Mr. Doyle: Yes, I am Chairman of Capital Alliance Ventures.
Senator Kroft: You have obviously succeeded there. It has been effective, but it was sort of a good news-bad news story. You suggested there were flaws or problems in that formula and we had the benefit of some of that in your earlier testimony.
I would like to take you over a bit of that ground. The statistics on what happened to the availability of venture funds in Canada before the arrival of labour-sponsored funds and after are quite dramatic. We would need better analysis before us to establish whether all or what portion of that growth in available venture capital funds was due to the labour-sponsored funds, but it was certainly a substantial portion of it.
The available pool of venture capital money did expand dramatically through the 1990s at the time that the labour- sponsored funds were growing. I am speaking now from a regional perspective - which is an important part of our responsibility as senators. We have had a lot of evidence before this committee on this project and others addressing the fact that the availability of venture investment is very uneven depending on geography. Various witnesses before this committee have spent much time and energy analyzing this. They have suggested that there is lots of venture capital available for good projects if you are located in Toronto, Montreal, New York, Chicago, or maybe even Vancouver. However in pretty direct proportion, with a few dramatic exceptions, when you get to smaller centres it is much more difficult.
As a Winnipegger, I am aware of that reality. I am aware of the dramatic success of the principal labour-sponsored venture capital fund in Manitoba known as the "Crocus Fund," not only in terms of the industry but also in terms of the profile it has developed on quite public investment projects. That fund is a major player in the development of a new arena complex in downtown Winnipeg and other things where there is a high level of risk but there is a community thrust.
I would like an update from you on the regional basis. What is your view of the labour-sponsored funds today? Would you particularly address whether you think they might play a particular role in the places in the country where private funds are not so readily available?
Mr. Doyle: The labour-sponsored fund has been a good program. It is a little heavy in terms of administration that is required. In our own fund, we have raised about $50 million over a five-year period. At about this time last year, that $50 million had turned into about $95 million. Today it is about $75 million. We have been the best performing labour-sponsored venture capital fund, as far as I can tell, although Crocus has done very well too.
However, it is heavy in terms of administration. I have 13,000 shareholders and it costs $20,000 every time we do a direct mail campaign to them. As well, we must do a lot of reporting to both levels of government. It is a little top heavy.
One of the challenges to government may be to build on the tremendous experience. The labour-sponsored fund has created some real expertise in managing venture capital. We should now find ways of encouraging the pension funds to assign pools of capital to those same managers. For example, in my own company, a management company called Capital Alliance Management Inc. manages the pool of money. It would be great if Capital Alliance Management Inc. could convince a pension fund to let it manage $20 million or $30 million for them.
The government's challenge should be to figure out the second level of labour-sponsored because the big pool of capital in the pension funds is not playing in the new economy. It is not playing in venture capital at all.
In terms of regionalization, the Crocus Fund, for example, has created a venture capital culture in Winnipeg. It is a step in the right direction, but I do not have a quick answer on decentralizing the venture capital industry in this country.
I would like to compare it with the venture capital industry in the United States. In the United States in the 1950s, when venture capital was first invented, it was all on Wall Street. If you were in Boston or Chicago and wanted venture capital, you had to go to Wall Street. As the activity moved up to Boston and then to Silicon Valley, the venture capital industry moved with it. If you go into the United States today, you will not find any venture capital on Wall Street because it is all distributed throughout the high-tech community.
Whereas in Canada - and I hate to say it - most of the venture capital is still sitting on Bay Street. I am not sure what the answer to that is, but I throw that out as a challenge. If you are sitting on Bay Street looking for venture capital opportunities, you are not likely to look to Manitoba, you see. I do not have a good answer for that.
Senator Kroft: I have one more question on the same subject of the labour-sponsored funds. In your portfolio of investee companies, are there many situations that you think would not have received investment from conventional venture capital investors?
Mr. Doyle: Yes.
Senator Kroft: The unique feature of the labour-sponsored style of funds is that the money reaches the company.
Mr. Doyle: Yes, I think the labour-sponsored style of management adds more value. Certainly, we take an active interest in our investee companies by serving on their boards of directors and by quietly telling the president that he should go off and take another job so that someone else can manage the company.
We have invested in a total of about 25 companies. We have lost four of them and the remaining 21 are still responsible for that big up tick in our value, if you like. Of those 21 companies, I can think of at least three or four that would not have received funding had it not been for us. One company in Ottawa that makes nuclear cameras for bio-medical diagnostics is in the process of developing a camera that we think will detect breast cancer in women between two and five years earlier than the current detection systems. A woman can have breast cancer for as long as nine years before it is known, and the existing technology is not capable of detecting it any earlier. With this particular camera, we think we will be able to do that from two to five years sooner.
That kind of company has meant high risk or high maintenance, if you like, to us. We have spent a great deal of time placing good management and processes, but we believe it will be a real winner. The labour-sponsored funds have achieved the purpose of getting the money closer to the management, if you like. In some cases, if you do not know what you are doing you can do more harm than good for a company. However, we believe we know what we are doing.
The Chairman: Thank you, Mr. Doyle.
The committee continued in camera.