Canada: Ontario Venture Capital Developments

In November 2007, the Ontario government announced it had entered into a letter of intent with Canadian institutional investors to establish an Ontario-focused venture capital 'fund of funds.' This is part of the government's stated goal to "strengthen Ontario's ability to support innovative, high-growth companies in the province to expand business opportunities and create jobs."

Ontario will commit $90 million to the fund and the other investors — OMERS Administration Corporation, Business Development Bank of Canada, RBC Capital Partners and Manulife Financial — will together commit $75 million, for a total of $165 million for the first closing of the fund.

This announcement was only the first step in putting to work the $90 million in government venture capital funding initially earmarked in the March 2006 Ontario budget. It is expected that the Ontario government and the initial investors will select an institutional fund of funds manager early in 2008, and that following an initial closing, the fund will begin operations. The government also seeks additional institutional investors for subsequent closings and hopes to bring the total fund size to at least $250 million.

This new fund's impact on Ontario-based entrepreneurs will be primarily indirect. The fund will instead make commitments to venture capital funds with some focus on Ontario, which in turn will make investments in entrepreneurial businesses. The fund of funds manager will establish criteria for making such commitments. A significant portion of this capital is expected to be committed to well-established Canadian venture capital fund managers. Some funds, however, may also be committed to emerging fund managers or possibly foreign venture capital funds, provided they can demonstrate an appropriate degree of association with Ontario. Further details of the fund are to be determined.

Ontario Government Extends Phase-Out of Tax Credits for Labour-Sponsored Investment Funds

In 2005, the Ontario government announced it would end the provincial tax credit for labour-sponsored investment funds (LSIFs). Then, in consultation with the LSIF industry, the government established a phase-out of the LSIF tax credit over a number of years. The timetable of the phase-out allows investors who purchase LSIF shares to receive a provincial tax credit until the end of the 2010 tax year.

In December 2007, the government announced a proposal to extend the phase-out by one year. If implemented as proposed, the phase-out would work as follows:

  • Tax credits would continue at a 15 per cent rate until the end of the 2009 tax year.
  • Tax credits for the 2010 tax year would be at 10 per cent.
  • Tax credits for the 2011 tax year would be at five per cent.

For tax years after 2011, there would no provincial tax credits for investment in LSIF shares (federal tax credits of 15 per cent remain untouched at this time). As part of the same announcement, the government also proposed increasing the maximum investment in LSIFs that qualify for the provincial tax credit from $5,000 to $7,500.

With these changes, the Ontario government estimates an additional $38 million will be committed indirectly to the development of entrepreneurial businesses in Ontario over the three years affected by the proposal.

McCarthy Tétrault Notes:

The launch of the Ontario venture capital fund and the extension of the tax credit phase-out on LSIF funds come at a time when many industry watchers are sounding alarm bells over the lack of venture capital funding available in Canada in general and in Ontario in particular. While venture capital investment has been strong in the US and elsewhere, it appears the venture capital market in Canada has been stagnant or shrinking.

For example, a recent report by Deloitte noted that for the third quarter of 2007, approximately $517 million venture capital dollars were invested in Canadian operating companies. This is down from $653 million for the same period in 2002, roughly a 21 per cent drop over five years. Almost one-third fewer Canadian operating companies received venture capital funding over that period.

The same report notes that total funds raised by Canadian venture capital firms also declined significantly over the same period. Just shy of $3.1 billion was raised in 2002, but just over $1.6 billion was raised in 2006. To the end of the third quarter in 2007, only $852 million had been raised. Some blame much of this decline in funding on the Ontario government's original decision in 2005 to phase out its tax credits on LSIFs.

The situation might be more harrowing if not for another significant trend: the increasing role played by foreign venture capitalists in our domestic market, particularly those from Boston and Silicon Valley. Recently announced statistics of the CVCA, Canada's Private Equity and Venture Capital Association, noted that venture investment activity across Canada had grown in 2007 as compared to 2006, but much of the increase has been due to US-based venture funds seeking investment opportunities in Canada. Through the third quarter of 2007, foreign firms represented more than 55 per cent of all venture capital dollars invested in Ontario. The influence of non-Canadian firms in other provinces (32 per cent in Québec and 29 per cent in B.C.), while not quite as dramatic, is still significant.

Even those entrepreneurs able to attract attention from south of the border have challenges. Current Canadian tax laws create barriers to efficient cross-border investment by US-based venture capital funds. If a US-based fund directly invests in a Canadian operating company, on disposition it will generally be required to obtain a Section 116 certificate from the Canada Revenue Agency, file a tax return and provide certain other details regarding each of its limited partners. However, a US-based venture capital fund may be precluded from doing so under its limited partnership agreement.

To steer clear of these administrative burdens, many US venture funds have resorted to structuring their investments in Canada through an exchangeable share transaction. These funds invest directly in a newly established Delaware company into which all of the shares of the existing Canadian operating company are exchangeable upon certain events occurring.

Other US funds have been known to structure their investments in Canada through a third jurisdiction that may be more favourable from a tax-planning standpoint, such as Barbados or Luxembourg. Each of these options, however, can add substantial time and cost to the venture capital investment transaction.

In the end, these announcements by the Ontario government — to create a new government-sponsored venture capital fund and extend the tax credits on LSIF funds — are certainly good news. The new venture capital fund will be a welcome addition to the sources of capital (albeit indirect) for Ontario-based entrepreneurs. Nevertheless, these measures represent only a small start in addressing the venture capital funding gap in Ontario. Greater effort by both government and industry is required.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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