Canadian Government removes tax barriers for startup VC

Onerous hurdles that have kept foreign venture capital funds from investing in Canada have been lifted, providing access to billions of dollars that were out of reach for promising startups desperate for cash to fund their development.

Thursday's federal budget struck down a rule that said foreign investors had to pay a 25-per-cent tax on any capital gains made when a Canadian investment was sold, unless they filled out paperwork to receive an exemption. Each individual investor in a fund – there could be thousands in each – had to personally fill out the forms, and then wait months for a reply. Once they received an exemption, they had to file a return with Canadian tax authorities informing them of the exception.

“All of the complications made investors perceive Canada as not being conducive to capital,” said John Ruffolo, the leader of Deloitte's technology practice in Canada.

“U.S. venture capitalists just said ‘Forget it, I'll give my money to Israel or India where it's actually wanted.'“ Deloitte did a study in 2007 and found American investors considered Canada the worst place to invest in the developed world “by an overwhelming and massive margin” because of the rules. While the changes won't automatically lead to a flood of investment, any help is welcome in an industry that has seen sharp declines.

“There aren't 20 deals just sitting there waiting to be had,” Mr. Ruffolo said. “But what happens now is the large funds in Boston and Silicon Valley will once again take a look at Canada.”

The Canadian Venture Capital Association (CVCA) said 2009 was the sector's worst year in more than a decade, as investments slipped by 27 per cent to $1-billion.

The amount invested per firm was 40-per-cent lower than obtained by U.S. counterparts, the widest gap in Canada-U.S financings since 2005.

“The barriers we had in place left Canadian companies undercapitalized,” said CVCA president Gregory Smith, who has been lobbying for the change for seven years. “This hasn't just been an issue about an economic crisis. Other countries have been more aggressive in supporting the ecosystems where venture capitalists operate.”

Carol Leaman has seen the effects firsthand. As chief executive officer of PostRank, a Waterloo, Ont.-based social media analytics company, she had a slew of U.S. suitors “kicking the tires” when she sought financing in 2008. Their message was the same – we're interested, but it's too complicated to bother.

“I can't tell you the number of times we heard that they'd like to invest but the paperwork was just too much,” she said. “There were just too many hoops, it made it virtually impossible. So you rely on local VCs, and there aren't that many.”

While many say the changes were needed, Canadian venture capitalist Mark McQueen cautioned that it's just one piece of a larger solution to the industry's problems. Pension funds have stepped away from early-stage financing, and governments haven't stepped in to fund companies at their earliest stages of development.

He said a more meaningful move would be for the government to set aside $300-million and create 10 funds, to become self-funding as investments become commercialized.

“The industry needs to be restocked with capital,” said Mr. McQueen, CEO of Wellington Financial. “Show me one U.S.-funded deal [in Canada] that did not have Canadians in earlier. Without money early, you won't bring in the bigger investors.”

Their conclusion: just move to the US, it's easier.