The Study in Brief

Innovation and growth depend in large part on entrepreneurship, which in turn may require financing in the form of venture capital investment.

In Canada, Labour-Sponsored Venture Capital Corporations (LSVCCs) have become the dominant source of venture capital.

There is reason for concern over this development, because evidence suggests LSVCCs are inefficient investment vehicles, charging high fees and yielding disappointing results: very few funds generate positive returns. Moreover, government tax subsidies to LSVCCs may crowd out private venture investment.

Accordingly, Canadian policymakers should investigate other ways to facilitate entrepreneurial investment. Potential changes to the legal environment begin with capital gains taxation: evidence shows that a reduction in the capital gains tax rate stimulates venture capital funding. More generous treatment for employee stock options is also an option for Canada.

Also on the legislative front, improving the entrepreneur-friendliness of bankruptcy laws to encourage start-ups, and less-onerous securities regulation are liberalizing approaches that may offer important benefits, although with potential costs if, for example, relaxed prospectus requirements increased the incidence of fraud.

Among the suite of broader policy choices: direct government investment programs, such as the United States' Small Business Innovation Research Program and Australia's Innovation Investment Funds. While these programs involve public subsidization of venture capital, the US and Australian examples have generated records indicating effectiveness in fostering innovation and economic development.

In short, Canada's key venture capital initiative, the LSVCC, has run its course and should not be retained. Numerous options exist, and Canadian policymakers can learn from successes and failures abroad and at home.

The Organisation for Economic Co-operation and Development (OECD 1996) argues that the financing of entrepreneurship and innovative ideas will facilitate economic growth and the competitive advantage of nations in the 21st century. Much evidence, albeit not all, indicates that small, growth-oriented, high-technology start-up companies contribute disproportionately to innovation and economic growth. (1) The primary source of capital for these companies is venture capital, and venture capital facilitates the success of firms that eventually list on stock exchanges. For example, during the 1983-92 period, while venture firms averaged less than 3 percent of corporate research and development, they were nevertheless responsible for more than 8 percent of industrial innovation in the United States (Kortum and Lerner 2000).

A widely held perception is that entrepreneurial companies are not able to raise all the capital they need and that good companies are not getting funded. (2) In theory, one might expect such a "capital gap" because investment in entrepreneurial companies not listed on stock exchanges is typically highly illiquid and riskier than most other investments due to information asymmetries and the nascent technologies such firms are developing. As well, there is a perception that innovating entrepreneurs and their investors do not fully capture returns to innovation because there are broader returns to the development of an innovative society--in other words, that the social rate of return to financing entrepreneurial high-tech start-up companies is greater than the private rate of return. As an empirical matter, however, capital gaps are difficult to measure, and there is little consensus as to the extent of the capital gap for entrepreneurial firms (Canada 2002). Regardless, given the perception of such a gap, a major strategic focus of policymakers around the world has been the high-tech sectors and the stimulation of venture capital markets through direct government investment programs and laws that are appropriately designed to facilitate entrepreneurship and entrepreneurial finance. For example, the World Bank spent more than US$10 billion in the 2001-05 period to promote small enterprises (Beck et al. 2005).

In most Canadian jurisdictions, the primary government support mechanism for venture capital since the 1980s has been the Labour-Sponsored Venture Capital Corporation (LSVCC) program. One estimate places the cost of the LSVCC program between 1992 and 2002 at $3 billion at least (Cumming and MacIntosh 2004). Yet the data reported in recent studies of the LSVCC program point to a lack of success. (3) Accordingly, in the first part of this Commentary, I review the reasons the LSVCC program has not been successful. LSVCCs differ in quality, and not all labour-sponsored funds have been failures; nevertheless, reasons exist for questioning the benefits of government expenditures on LSVCCs.

In the second part of the Commentary, I review evidence from other countries on a range of alternative mechanisms that could replace the LSVCC program. (4) These mechanisms, which focus on strategies other than intervention programs in the form of the LSVCC, include capital gains taxation, taxation of stock options, securities laws, bankruptcy laws, patent policy, labour laws, accounting rules, and regulation of venture capital funds. I also discuss programs in other countries (such as the United States and Australia) that match government money with private contributions to venture capital funds.

An Overview of LSVCCs

LSVCCs are tax-subsidized investment funds designed like mutual funds. Unlike mutual funds that invest in companies listed on stock exchanges, however, LSVCCs invest in privately held companies that are not listed--typically, high-growth companies in the technology sectors. In exchange for tax subsidies, LSVCCs face statutory covenants that restrict their investment activity. LSVCCs have a three-pronged mandate to maximize employment, shareholder value, and economic development in the jurisdiction in which they are based. Most LSVCCs, however, state publicly that their only interest is in maximizing shareholder value (see MacIntosh 1994, 1997; Halpern 1997; Cumming and MacIntosh, forthcoming). LSVCCs must be sponsored by a labour union, but critics charge that labour unions merely rent their name to LSVCCs without providing any additional governance over the funds' operations. (5)

LSVCCs were first introduced in Quebec in 1983. Thereafter, the federal government adopted LSVCC legislation in 1987, British Columbia in 1989, Manitoba in 1991, Ontario, Saskatchewan, and Prince Edward Island in 1992, New Brunswick in 1993, and Nova Scotia in 1994. Only Alberta and Newfoundland and Labrador have not yet adopted such legislation. In 2005, there were 125 Labour-Sponsored Venture Capital Funds (LSVCFs) in Canada, (6) including 16 federal funds, 67 in Ontario, 7 in British Columbia, 2 in each of Saskatchewan and Manitoba, 3 in Quebec, and 28 in the Atlantic provinces.

Only individuals (retail investors) may invest in a LSVCC; while tax credits are capped, there are no restrictions on the size of their investment. Investors receive tax subsidies so long as the LSVCC follows the statutory covenants that govern the fund. Investors are, however, subject to an eight-year lock-in period, which restricts their ability to vote with their feet by moving their capital out of poorly performing funds, thereby limiting competition among LSVCCs (see Cumming and MacIntosh (2006, forthcoming). That only individuals may invest in LSVCCs clearly means that no one has the ability or incentive to control managers; by contrast, pension funds with large holdings in a firm have incentives to have a "chat" with managers.

Most individuals invest in LSVCCs to take advantage of the tax savings that are provided through individual registered retirement savings plans (RRSPs)--indeed, LSVCCs typically advertise such savings as the most advantageous reason for investing in them (Cumming and Macintosh, forthcoming). Tax benefits vary depending on the individual investor's tax bracket, as Table I shows, and are more favourable for those in higher tax brackets. In the Ontario example shown in the table, for an investor in the highest tax bracket, the initial tax-generated return on a $5,000 investment was more than 323 percent.

LSVCCs are bound by a number of statutory constraints, which are similar in each province (for details, see Cumming and Macintosh 2004a These include limits on the geographical range of investment opportunities to within the sponsoring jurisdiction, constraints on the size and nature of investment in any given entrepreneurial company, and requirements to reinvest fixed percentages of contributed capital in private entrepreneurial companies within a stated period of time (typically one to three years, depending on the jurisdiction). These constraints are extremely inefficient, however; because they limit investment opportunities and, at times, force LSVCCs to make investments in inferior companies without adequate due diligence (Cumming and Macintosh, forthcoming). Private independent limited partnership venture capital funds also have constraints or restrictive covenants, imposed by their institutional investors, but they differ significantly from those placed on LSVCCs. For instance, covenants on the former include restrictions on the use of debt (to prevent fund managers from leveraging the fund and increasing the risk to institutional investors), and time restrictions on fundraising by fund managers for their subsequent funds (to force fund managers to spend their time pursuing and nurturing investments that further the interests of the current fund beneficiaries). (7) These covenants also vary depending on the agreed-on needs of the fund investors and fund manager, which enables the limited partners and the general partner to design covenants that are best suited to the fund's particular objectives. LSVCC constraints, in contrast, are invariant across funds and change over time only with statutory changes.

To provide some sense of the relative importance of LSVCC venture capital in Canada, Figures 1 through 4 present relevant data on such funds. For example, by 2005, LSVCCs accounted for roughly half of all venture capital under management, with more than $10 billion (in 2004 dollars) under management (see Figure 1), while much of the capital allocated by institutional investors but not yet invested over the 1988-2004 period has accumulated in LSVCCs (see Figure 2). (8) At the same time, however, LSVCCs do not even outperform risk-free, 30-day treasury bills (see Figure 3), and only three LSVCCs have earned a positive rate of return over the past five years (see Figure 4); indeed, even the best LSVCCs do not earn rates of return that are comparable to the worst performers among small-cap funds. (9)

[FIGURES 1-4 OMITTED]

The average LSVCC ratio of management expenses to assets (MER) is more than 4 percent, which is substantially higher than that for all other types of mutual funds in either Canada or the United States (Cumming and Macintosh, forthcoming). Given that the economic rates of return for LSVCCs shown in Figures 3 and 4 do not include management expenses, most LSVCCs clearly are negative-value-added investment vehicles, indeed, in the absence of tax subsidies, it would not be rational for an investor to contribute capital to an LSVCC. One can only conclude that, in Canada, venture capital has been inefficiently allocated due to the tax breaks afforded to LSVCCs.

Perhaps relevant to the poor performance of LSVCCs, the managers of these funds tend to have massive portfolios: on average, 6.5 investee companies per investment manager, compared with 2.5 investee companies per manager for private independent limited partnership venture capital funds (Cumming 2006a). Normally, venture capital managers undertake the supervision of a few investee companies only in order to spend time adding value to their investees by sitting on boards of directors and providing strategic, finance, marketing, and human resource advice. (10) Research has shown, however, that a learning curve is associated with venture capital investing--that is, a major hurdle in creating sustainable venture capital markets involves developing skilled venture capital managers (see, for example, Keuschnigg and Nielsen 2004b; Gompers and Lerner 1999). Yet there is no empirical evidence that older LSVCCs perform better than those more recently formed (Cumming and Macintosh, forthcoming). One possible explanation is that, with such massive portfolios, LSVCC fund managers have little or no time to get involved in the management of their investee companies. Of course, many LSVCC managers are likely highly capable individuals, but policymakers might consider alternative mechanisms to improve the training of younger fund managers other than the environment offered by the typical LSVCC.

The inefficient allocation of venture capital through LSVCCs involves significant costs. First, there are the direct costs of the tax subsidies, estimated to be in excess of $3 billion over the 1992-2002 period (Cumming and Macintosh 2004). Second, there are the indirect costs of LSVCCs' competing directly with other types of venture capital funds--in effect, crowding them out (see Cumming and Macintosh 2006). Tax subsidies enable LSVCCs to out-bid other venture capital funds for investee companies, thereby discouraging institutional investors and private fund managers from starting private venture capital funds, since LSVCCs inefficiently drive up deal prices and lower returns in the market. Risk-averse institutional investors commit capital prior to knowing the increase in LSVCC fundraising in any given year. Risk-averse institutional investors are thereby likely to overestimate the extent of LSVCC funding and so reduce their commitments to private venture capital funds, in effect, LSVCCs might even reduce the size of the venture capital market if the crowding out is pronounced.

In sum, LSVCCs have fallen short of achieving their intended objectives for bolstering the Canadian venture capital market. In response to this failure, provincial governments have recently shown signs of the need to reform the public subsidization of LSVCCs. For example, Nova Scotia has placed its funds under a year-to-year watch since 2004 to determine if the tax credit should continue, and in August 2005 Ontario announced plans to completely drop the tax credits afforded to its LSVCCs. (11) As another example, the lack of supervision of fund manager activities gave rise to a situation in which bad management persisted for years in Manitoba's Crocus Fund. Scandals were so pronounced that the Crocus Fund had to halt trading on share redemption in December 2004, and was thereafter shut down. (12) Concern over the structure and governance of LSVCCs and evidence that they crowd out private venture capital investment suggest that Ontario's taking the lead in abandoning LSVCCs may be timely.

Alternatives to LSVCCs

If LSVCCs are not working, are there better policy options? Broadly classified, public policies toward venture capital come in one of two primary forms: law--which can be categorized further into taxation, securities law, and other types of laws for facilitating entrepreneurship and entrepreneurial finance; and direct government investment schemes; for an overview, see Table 2, where I briefly review the properties, benefits, and drawbacks of these different policies.

Taxation

At least four important types of tax incentives enable entrepreneurial finance around the world: capital gains taxes, research and development (R&D) tax policies, the taxation of stock options, and double taxation treaties for offshore tax havens (see Table 2, panel A).

Perhaps the best-known and most important tax mechanism affecting venture capital markets is the capital gains tax. Indeed, theory and empirical evidence suggest a direct causality between lower capital gains taxation and more venture capital. (13) For example, the United States reduced its capital gains tax rate from 35 percent in 1977 to 20 percent in 1982, and during the same period venture capital fundraising increased from US$68.2 million to US$2.1 billion (see Figure 5 for details). As entrepreneurial companies typically do not have the positive cash flows to pay interest on debt and dividends on equity, venture capitalists invariably invest with a view toward exiting the market and taking the ensuing capital gains.

[FIGURE 5 OMITTED]

Tax incentives for R&D expenditures represent another important public policy toward venture capital markets and one that many countries have adopted (see Bloom, Griffith, and Van Reenen 2002). Australia, for example, had a flat R&D tax concession of 125 percent, prior to 2001, for all firms with eligible R&D expenses in that country. In 2001, a policy change introduced a 125 percent rebate (or offset) for firms with R&D expenses between AU$20,000 and AU$1 million and turnover of less than AU$5 million. The most interesting feature of the policy change, however, was the introduction of a premium 175 percent R&D tax concession as an incentive to accelerate R&D expenses, available only for incremental R&D above the firm's most recent three-year history of average R&D expenditures. (14) This Australian R&D tax policy design has induced significantly more R&D in a cost-effective manner, and suggests Canada's tax policy toward R&D (15) might benefit from implementing similar kinds of premium concessions.

A third important mechanism for facilitating entrepreneurship is the taxation of stock options. In the United States, for example, the Internal Revenue Service passively acquiesces in valuations of employee stock options that motivate people to start companies. As Gilson and Schizer (2003, 876-78) note:

   [Venture capital] [p]ortfolio companies issue convertible preferred
   stock to achieve more favorable tax treatment for the entrepreneur
   and other portfolio company employees. The goal is to shield
   incentive compensation from current tax at ordinary income rates,
   so managers can enjoy tax deferral (until incentive compensation
   is sold, or longer) and a preferential tax rate ... [by assigning
   an artificially low value to the entrepreneurs' common equity claim
   at the time of investment].

Evidence suggests that the application of this type of tax incentive is much less prevalent in Canada than in the United States. (16)

The fourth tax mechanism affecting venture capital markets is tax incentives for venture capital fund managers to establish offshore funds in tax havens, such as Bermuda, the Cayman Islands, and Labuan, Malaysia. As Cumming and Johan (2006b) explain, offshore funds come in two types: inbound--those established by institutional investors from other countries and where the fund invests specifically in one country; and outbound--those established by institutional investors from one country and where the fund invests in other countries. (17) Overall, significant incentives exist for establishing venture capital funds in offshore jurisdictions, as investors are able to take advantage of double taxation agreements when they repatriate their profits from the various jurisdictions in which the fund has invested. The Canadian government, however, benefits from venture capital companies established abroad only to the extent that investment dollars flow to entrepreneurial companies in Canada. Thus, governments need to be careful to monitor offshore funds that invest within their jurisdiction to ensure that the investment is not facilitating excessive tax avoidance or evasion.

Analogous to offshore tax haven funds, many European venture capital funds invest in German entities through an intermediate holding company resident in Luxembourg in order to take advantage of the Grand Duchy's more favourable tax rules. Industry commentators believe this is an important incentive for venture capital investment in Germany, and proposals to curb this tax incentive have been criticized despite the loss of tax revenues for that country. (18) The lesson from the Luxembourg-Germany example is that a balance should be found between the provision of favourable tax treatment to facilitate investment and the country's need to collect tax revenues.

Securities Laws

Securities laws constitute another form of public policy relating to venture capital markets. They facilitate entrepreneurial finance in two main ways (see Table 2, panel B). First, where securities laws make exemptions from prospectus requirements more readily available for entrepreneurs seeking to raise capital they lower the costs of raising funds. (19) Second, if securities laws make hold period and prospectus requirements overly onerous for companies that seek an initial public offering (IPO), the costs of IPOs increase, particularly for smaller companies. Less onerous prospectus requirements, however, risk encouraging fraudulent behaviour (as, for example, in the infamous 1997 Bre-X case).

Foreign-ownership restrictions implemented by protectionist governments can also adversely affect entrepreneurial finance. Such restrictions are still in place in Canada for a number of industries; lifting them would facilitate foreign investment in this country, increase the supply of capital, and give Canadian entrepreneurs better access to capital. Similarly, Canadian investors would benefit from the lifting of foreign-ownership restrictions abroad; some of those benefits might be repatriated back to Canada. Moreover, in countries with weak standards for minority shareholders, the lifting of foreign-ownership restrictions would make companies better off, since majority foreign owners would be held to the higher standard of the foreign country when it comes to the rights of minority shareholders.

Regulations on the Demand for Entrepreneurial Capital

Since part of the mandate of LSVCCs is to provide capital for entrepreneurs, it is worth addressing other legislative tools for facilitating entrepreneurship and the demand for entrepreneurial capital. Among such tools are laws on bankruptcy, labour, and business incorporation (see Table 2, panel C). Bankruptcy laws, in fact, explain many of the international differences in rates of entrepreneurship and venture capital, and there is ample evidence that entrepreneur-friendly bankruptcy laws facilitate self-employment and entrepreneurship, thereby spurring the demand for venture capital (see, for example, Armour and Cumming 2005, 2006). (20) Also spurring entrepreneurship are labour laws that make it easier to fire employees and laws on incorporation that reduce the number of procedures for starting a business (Klapper, Laeven, and Rajan 2006).

Another potentially important legislative instrument is patent law. Conventional wisdom suggests patent laws encourage entrepreneurial activity by rewarding innovators, but an academic debate has raged regarding the suitability of patents. Some researchers argue that, since private incentives to invest in R&D exist, innovators should not rely only on government. (21) Others suggest that patents create monopolies and reduce competitive pressures, but competitive pressures to innovate may be as important as patents; perhaps less controversial is the idea that patents encourage disclosure and technology transfer (see Gallini 2002).

One well-known problem with patent law and policy in both the United States and Canada concerns "patent trolls": firms and individuals that acquire patents, not to further entrepreneurial activity, but to sue others that invent similar technologies (see Jaffe and Lerner, 2004). For Canadians, the most illustrative example is that of Waterloo-based Research in Motion (RIM) and its hand-held BlackBerry computer device, where patent trolls obtained patents relevant to the device but did not make use of them, then successfully sued RIM for a majority of the profits. (22) Patent trolls clearly dissuade entrepreneurial activity, but patent laws as they currently stand offer ample support for such behaviour.

Regulations on the Supply of Entrepreneurial Capital

In addition to laws that favour entrepreneurial activities, regulations governing investments of institutional investors also encourage investment in venture capital and private equity. In the United States, the Employee Retirement Income Security Act of 1974 established standards for the appropriate investment in venture capital for part of the portfolios of pension funds (see Gompers and Lerner 1998); standards that have since evolved as benchmarks for Canada as well. Similarly, in 2006, the Netherlands introduced the Financieel Toetsingskader (FTK), which changed pension fund portfolio management standards to enable a closer matching of assets and liabilities, thereby facilitating investment in venture capital (see Cumming and Johan, forthcoming). Similar regulations that harmonize the rules European institutional investors face also enable different types of institutions (such as banks, insurance companies, and pension funds) as well as institutional investors from different countries to act as limited partners in venture capital funds (ibid.). As a related matter, there is evidence that dissimilar regulations in Quebec exacerbate the fragmentation of Canada's venture capital market (Cumming and Johan 2006c).

Unlike institutional investors, however, venture capital fund managers face few regulations, which has hindered institutional investment in venture capital. Institutional investors' commitments to venture capital are influenced by the fund performance reports they receive from venture capital funds and by their ability, in turn, to disclose such reports to their clients and beneficiaries (such as pensioners, in the case of pension plans). Prior to a lawsuit involving the California Public Employees' Retirement System (CalPERS), venture capital funds in the United States enjoyed complete secrecy in terms of disclosure of their performance to the public generally, and reports by venture capital funds to their institutional investors were not regulated. (23)

The effect of a comparative dearth of regulations on the flow of funds into the venture capital market is not certain without empirical scrutiny. On the one hand, the lack of such regulations might facilitate the flow of funds into the venture capital market by giving the funds the flexibility they need to carry out their investment activities without interference from regulatory oversight and reporting requirements, a view often put forward in the popular press by venture capital funds and commentators. (24) On the other hand, institutional investors often argue that the comparative dearth of regulation of venture capital funds and lack of reporting standards act as a disincentive to contribute to venture capital funds, a view supported by Cumming and Johan (forthcoming); (25) as a result, some pension funds have been forced to rethink their investment strategy with respect to venture capital funds. (26)

Thus, rules (or at least formal guidelines) that increase investment transparency clearly would facilitate institutional investment in venture capital. The lack of well-accepted standards for reporting returns on unexited venture capital investments has, in fact, turned institutional investors away from venture capital funds, since fund managers tend to overreport such returns (see Cumming and Waltz 2004). Attempts to curb this problem include the introduction in 2006 of new generally accepted accounting principles and clearly described industry standards for valuation by the Canadian Venture Capital & Private Equity Association and similar associations in other countries. (27)

Direct Government Investment Programs

Aside from legal incentive structures, the second main form of government support for entrepreneurial finance is via direct, government-created, or government-subsidized venture capital funds (see Table 2, panel D). (28) Such finds need to partner with, not compete with, other types of venture capital funds, however; they also need to bridge the gap when the market fails--due to, for example, structural impediments giving rise to a dearth of capital. Further, government funds should be structured to minimize agency costs associated with the financing of small and high-tech companies. As discussed earlier, the covenants implemented under the LSVCC program are precisely the opposite of what would be an efficient investment vehicle.

Countries have adopted different forms of direct government investment programs for venture capital. The United States, for example, has the Small Business Innovation Research (SBIR) Program, administered by the Small Business Administration (SBA). The SBIR program is the largest government support program for venture capital in the world, with SBIRs having invested more than US$21 billion in nearly 120,000 financings of small businesses since the 1960s. Investee companies include such successes as Intel Corporation, Apple Computer, Federal Express, and America Online.

SBIRs, which are run by private investment managers, operate like private, independent, limited partnership venture capital funds, except that they are subject to statutory terms and conditions on the types of investments they make and the manner in which investments are carried out. (29) SBIRs do not distinguish between types of businesses, although investments in buyouts, real estate, and oil exploration are prohibited. Investee companies are required to be small (as defined by the SBA)--and generally smaller than companies that would be considered for private independent limited partnership venture capital financing. The SBA provides capital to SBIRs at a lower required rate of return than typical institutional investors in private, independent, limited partnership venture capital funds. Excess returns to SBIRs flow to the other non-governmental private investors and fund managers, thereby increasing or leveraging their returns. Empirical evidence shows that early-stage companies financed by SBIRs have substantially higher growth rates than non-SBIR financed companies (Lerner 1999).

The SBIR program has been quite effective in spurring venture capital investment and creating sustainable companies, but Canada's existing institutional environment might not enable an effective SBIR-like program to operate here.

In Australia, the federal government adopted an Innovation Investment Fund (IIF) program in 1997. In each of the nine funds created so far, the ratio of government capital to privately sourced capital is as much as two to one, a substantial government share deemed necessary because of the scant early-stage venture capital investment available in Australia when the program was established. As with the United States SBIR program, a key feature of the Australian UF program is that it operates like a private independent limited partnership venture capital fund. Investments generally take the form of equity and must be in small, new-technology companies. At least 60 percent of each fund's committed capital must be invested within five years. Unless specifically approved by the Australian government's Industry Research and Development Board, an investee company cannot receive more than AU$4 million, or 10 percent of the fund's committed capital, whichever is the smaller.

Evidence suggests that IIFs are fostering the development of the Australian venture capital industry in a statistically and economically significant way (Cumming 2007). Indeed, both the United States SBIR and Australian UF programs indicate the tremendous potential governments have to foster innovation and economic development through the public subsidization of venture capital.

For its part, the United Kingdom has adopted a type of fund, similar to Canada's LSVCCs, known as the Venture Capital Trust (VCT). Like LSVCCs, the VCTs are mutual funds listed on stock exchanges, and are not operated like private independent limited partnership venture capital funds as are United States SBIRs and Australian IIFs. As in Canada, VCT investors are individuals (retail investors), who receive substantial tax incentives for contributing capital to the funds. In exchange for the tax subsidy, VCT managers agree to adhere to a set of statutory covenants that constrain their investment decisions and activities. Like their Canadian counterparts, however, the VCTs have not been as successful in achieving their objectives as the Australian and United States models, prompting some commentators to argue that the United Kingdom would benefit significantly benefit from adopting a United States-style SBIR Program (see, for example, Connell 2006).

Other Kinds of Government Support

Governments offer a number of other kinds of support to venture capital markets in addition to the examples discussed above, including loans, paying government investors last in the event of insufficient funds, and bailouts for losses (see Table 2, panel D; for an extended discussion, see Jaaiskelainen, Maula, and Murray 2006). But such provisions also create potentially distortionary agency problems associated with debt, such as underinvestment, (30) risk shifting, (31) and asset stripping. (32) Empirical evidence suggests, however, that debt is not used when the agency costs associated with it are expected to be pronounced (see Cumming 2005a, 2005b). Similarly, if managers of government-supported venture capital funds expect such problems to be pronounced, then these schemes are not likely to be as valuable as one might think.

Governments have also delved into wholly government-owned venture capital organizations, such as the Canada Community Investment Plan, (33) although research suggests that such programs are more likely to finance companies that might not otherwise receive capital, such as entrepreneurial companies in regionally isolated communities (see Bates 2002; Lerner 2002). Other government programs, such as Canada's Export Development Corporation, focus on increasing the exports of domestic firms, or on privatization, which increases the scope of viable projects that venture capitalists consider to be investment opportunities (see Megginson et al. 2004). The success of these various policy strategies depends on a wide range of structural, political, and economic factors, and on the way the policies are implemented.

Summary

Canada's LSVCCs are inefficient, may have poor governance structures, charge high fees, and earn economic returns that lag those of 30-day, risk-free treasury bills. Further, government expenditures on LSVCCs have not resulted in value-added venture capital investment, and appear to have crowded out private venture investment in Canada. Ontario abandoned tax subsidies to LSVCCs in 2005, and research suggests that the federal and other provincial governments should follow suit.

In place of LSVCCs, a variety of other ways exist to promote entrepreneurship and efficient entrepreneurial investment. Canadian policymakers should investigate these alternatives fully, including such appropriate legal changes as entrepreneur-friendlier bankruptcy laws, lower capital gains taxes, and less-onerous securities regulation, as well as direct government programs such as those in place in the United States and Australia.

I have benefited from helpful comments from Finn Poschmann, Barry Norris, Bill Robson, Ben Tomlin, Yvan Guillemette, the Business Development Bank of Canada, and an anonymous referee. Data and assistance with creating Figure 4 were provided by www.Morningstar.ca. I have also benefited from working with Jeff Macintosh on related prior papers.

References

Aghion, P., and P. Howitt. 2005. "Appropriate Growth Policy: A Unifying Framework." Working Paper. Cambridge, M.A: Harvard University.

Amit, R., J. Brander, and C. Zott. 1998. "Why Do Venture Capital Firms Exist? Theory and Canadian Evidence." Journal of Business Venturing 13 (6): 441-66.

Anderson, S., and Y. Tian. 2003. "Incentive Fees, Valuation and Performance of Labour Sponsored Investment Funds." Canadian Investment Review 16 (3): 20-27.

Armour, J., and D. Cumming. 2005. "Bankruptcy Law and Entrepreneurship." Working Paper 300. Cambridge, UK: University of Cambridge, Centre for Business Research.

--. 2006. "The Legislative Road to Silicon Valley." Oxford Economic Papers 58: 596-635.

Bates, T. 2002. "Government as Venture Capital Catalyst: Pitfalls and Promising Approaches." Economic Development Quarterly 16 (1): 49-59.

Beck, T., A. Demirguc-Kunt, L. Laeven, and R. Levine. 2005. "Finance, Firm Size and Growth" World Bank Policy Research Working Paper 3485. Washington, DC: World Bank.

Bloom, N., R. Griffith, and J. Van Reenen. 2002. "Do R&D Tax Credits Work? Evidence from a Panel of Countries 1979-1997." Journal of Public Economics 85: 1-31.

Boldrin, M., and D.K. Levine. 2002. "The Case against Intellectual Property." American Economic Review (Papers and Proceedings) 92: 209-12.

Brander, J., R. Amit, and W. Antweiler. 2002. "Venture Capital Syndication: Improved Venture Selection versus the Value-Added Hypothesis." Journal of Economics and Management Strategy 11 (Fall): 423-52.

Canada. 2002. Industry Canada. Gaps in SME Financing: An Analytical Framework. Ottawa: Industry Canada, Small Business Policy Branch.

--. 2006. Industry Canada. Financing Global Gazelles. Ottawa: Industry Canada, Small Business Policy Branch.

Cobley, M. 2005. "Capital Ideas." The Monitor Blue Skies 128 (June); available at http://www.epolitix.com/EN/Publications/Blue+Skies+Monitor.

Connell, D. 2006. "Secrets" of the World's Largest Seed Capital Fund: How the United States Government Uses Its Small Business Innovation Research (SBIR) Programme and Procurement Budgets to Support Small Technology Firms. Cambridge, UK: University of Cambridge, Centre for Business Research.

Cosh, A., D. Cumming, and A. Hughes. 2005. "Outside Entrepreneurial Capital." Working Paper 301. Cambridge, UK: University of Cambridge, Centre for Business Research.

Cressy, R. 2002. "Funding Gaps: A Symposium." Economic Journal 112 (477): F1-F16.

Cumming, D.J. 2003. "The Structure, Governance and Performance of U.K. Venture Capital Trusts." Journal of Corporate Law Studies 3 (2): 401-27.

--. 2005a. "Agency Costs, Institutions, Learning and Taxation in Venture Capital Contracting." Journal of Business Venturing 20 (5): 573-622.

--. 2005b. "Capital Structure in Venture Finance." Journal of Corporate Finance 11 (3): 550-85.

--. 2006a. "The Determinants of Venture Capital Portfolio Size: Empirical Evidence." Journal of Business 79 (3): 1083-1126.

--. 2006b. "R&D Tax Offsets, Premium Offsets and Premium Concessions: Australia 1998-01 versus 2001-04," Report Prepared for the Government of Australia.

--. 2007. "Government Policy towards Entrepreneurial Finance: Innovation Investment Funds." Journal of Business Venturing 22 (2): 193-235.

Cumming., D.J., and S.A. Johan. 2006a. "Financing Characteristics and Exit Outcomes of Venture Capital Backed Companies." Working Paper. Schulich School of Business, York University.

--. 2006b. "Is It the Law or the Lawyers? Investment Covenants around the World." European Financial Management 12 (4): 535-74.

--. 2006c. "Provincial Preferences in Private Equity." Financial Markets and Portfolio Management 20 (4): 369-98.

--. Forthcoming. "Regulatory Harmonization and the Development of Private Equity Markets." Journal of Banking and Finance.

Cumming, D.J., and J.G. Macintosh. 2003a. "A Cross-Country Comparison of Full and Partial Venture Capital Exits." Journal of Banking and Finance 27 (3): 511-48.

--. 2003b. "Venture Capital Exits in Canada and the United States." University of Toronto Law Journal 53 (2): 101-200.

--. 2004. "Canadian Labour Sponsored Venture Capital Corporations: Bane or Boon?" in New Venture Investment: Choices and Consequences, edited by A. Ginsberg and I. Hasan. Amsterdam; Boston: Elsevier Science Academic Press.

--. 2006. "Crowding Out Private Equity: Canadian Evidence." Journal of Business Venturing 21 (5): 569-609.

--. Forthcoming. "Mutual Funds that invest in Private Equity? An Analysis of Labour Sponsored investment Funds." Cambridge Journal of Economics.

Cumming, D.J., and U. Walz. 2004. "Private Equity Returns and Disclosure around the World." Working Paper 2004/05. Frankfurt-am-Main, Germany: Center for Financial Studies.

Denis, C., and H. Huizinga. 2004. "Are Foreign Ownership and Good Institutions Substitutes? The Case of Non-Traded Equity." CEPR Working Paper DP4339. London: Centre for Economic Policy Research.

Dickson, M. 2005. "UK: Time for faceless face of capitalism to grow up." Financial Times, August 24, p. 18.

Gallini, N. 2002. "The Economics of Patents: Lessons from Recent U.S. Patent Reform." Journal of Economic Perspectives 16 (2): 131-54.

Gilson, R., and D. Schizer. 2003. "Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock." Harvard Law Review 116 (3): 875-916.

Gompers, P.A., and J. Lerner. 1998. "What Drives Venture Capital Fundraising?" Brookings Proceedings on Economic Activity: Microeconomics: 149-92.

--. 1999. The Venture Capital Cycle. Cambridge, MA: MIT Press.

Green, R. 1984. "Investment Incentives, Debt, and Warrants." Journal of Financial Economics 13 (1): 115-36.

Halpern, P., ed. 1997. Financing Growth in Canada. Calgary: University of Calgary Press.

Hill A. 2005. "Blurred distinctions in the fund industry." Financial Times, September 12, p. 6.

Jaaskelainen, M., M. Maula, and G. Murray. 2006. "Performance of incentive Structures in Publicly and Privately Funded Hybrid Venture Capital Funds." Working Paper. Helsinki; Exeter: Helsinki University of Technology and University of Exeter.

Jaffe, A., and J. Lerner. 2004. Innovation and Its Discontents: How Our Broken Patent System is Endangering Innovation and Progress, and What to Do about It. Princeton, NJ: Princeton University Press.

Jeng, L., and P. Wells. 2000. "The Determinants of Venture Capital Fundraising: Evidence across Countries." Journal of Corporate Finance 6 (3): 241-89.

Jensen, M.C., and W.H. Meckling. 1976. "Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure." Journal of Financial Economics 3 (4): 305-60.

Keuschnigg, C. 2003. "Optimal Public Policy for Venture Capital Backed Innovation." CEPR Working Paper DP3850. London: Centre for Economic Policy Research.

--. 2004. "Taxation of a Venture Capitalist with a Portfolio of Firms." Oxford Economic Papers 56 (2): 285-306.

Keuschnigg, C., and S.B. Nielsen. 2001. "Public Policy for Venture Capital." International Tax and Public Finance 8 (4): 557-72.

--. 2003a. "Tax Policy, Venture Capital and Entrepreneurship." Journal of Public Economics 87 (1): 175-203.

--. 2003b. "Taxes and Venture Capital Support." European Finance Review 7 (3): 515-39.

--. 2004a. "Progressive Taxation, Moral Hazard, and Entrepreneurship." Journal of Public Economic Theory 6 (3): 471-90.

--. 2004b. "Public Policy for Start-Up Entrepreneurship with Venture Capital and Bank Finance." Working Paper. St. Gallen, Switzerland; Copenhagen: University of St. Gallen and Copenhagen Business School.

--. 2004c. "Start-Ups, Venture Capitalists and the Capital Gains Tax." Journal of Public Economics 88 (5): 1011-42.

Klapper, L., L. Laeven, and R. Rajan. 2006. "Entry Regulation as a Barrier to Entrepreneurship." Journal of Financial Economics 82 (3): 591-629.

Kortum, S., and J. Lerner. 2000. "Assessing the Contribution of Venture Capital to Innovation." Rand Journal of Economics 31 (4): 674-92.

Lerner, J. 1999. "The Government as Venture Capitalist: The Long-Run Impact of the SBIR Program." Journal of Business 72 (3): 285-318.

--. 2002. "When Bureaucrats Meet Entrepreneurs: The Design of Effective 'Public Venture Capital' Programmes." Economic Journal 112 (477): F73-F84.

Macintosh J.G. 1994. "Legal and Institutional Barriers to Financing Innovative Enterprise in Canada." Discussion Paper 94-10. Kingston, ON: Queen's University, School of Policy Studies.

--. 1997. "Venture Capital Exits in Canada and the United States." In Financing Innovative Enterprise in Canada, edited by P. Halpern. Calgary: University of Calgary Press.

Mackie, John. 2005. "Private equity: An open-and-shut case for transparency complaints about the secretiveness of the private equity industry are at odds with its regulatory procedures." Financial Times, April 18, p. 10.

Megginson, W., R. Nash, J. Netter, and A. Poulsen, 2004. "The Choice of Public versus Private Markets: Evidence from Privatizations." Journal of Finance 59 (6): 2835-70.

Organization for Economic Corporation and Development (OECD). 1996. Government Programmes for Venture Capital. Paris: OECD.

Osborne, D., and D. Sandler. 1998. "A Tax Expenditure Analysis of Labour-Sponsored Venture Capital Corporations." Canadian Tax Journal 46 (3): 499-574.

Poterba, J. 1989a. "Capital Gains Tax Policy towards Entrepreneurship." National Tax Journal 42 (3): 375-89.

--. 1989b. "Venture Capital and Capital Gains Taxation." in Tax Policy and the Economy, vol. 3, edited by L.H. Summers. Cambridge, MA: MIT Press. 47-67.

Sandler, D. 2001. "The Tax Treatment of Employee Stock Options: Generous to a Fault." Canadian Tax Journal 49 (2): 259-302.

Tricks, Henry. 2005. "Throwing open a secretive world." Financial Times, January 17, p. 20.

World Bank. 1994. Can Intervention Work? The Role of Government in SME Success. Washington, DC: World Bank.

--. 2002. World Bank Group Review of Small Business Activities. Washington, DC: World Bank.

--. 2004. World Bank Group Support for Small Business. Washington, DC: World Bank.

(1) See World Bank (1994, 2002, 2004); see also Canada (2002, 2006) for Canadian-specific analyses and policy discussions that are closely related to the discussion herein.

(2) On this apparent capital gap, see, for example, http://strategis.ic.gc.ca/epic/internet/insbrprppe.nsf/en/rd01918e.html. Some commentators on an earlier draft of this paper suggested that capital gaps exist in Canada for late-stage venture capital, so that Canadian firms must seek capital from US investors to get suitable financing. Data in one recent empirical study (Cosh, Cumming, and Hughes 2006) show, however, that entrepreneurs typically are able to raise the capital they want, although not always in the form they would like. More data collection and further empirical analyses are warranted.

(3) This part of the Commentary draws on a number of recent studies of Canada's venture capital market, including work the author has prepared with Professor Jeffrey Macintosh of the University of Toronto; see Cumming and Macintosh (2003a, 2003b, 2004, 2006, 2007). For related studies, see also Macintosh (1994, 1997); Halpern (1997); Amit, Brander, and Zott (1998); Osborne and Sandler (1998); Brander, Amit, and Antweiler (2002); Anderson and Tian (2003); and Cumming (2005a, 2005b, 2006a).

(4) This discussion is based on a survey of a number of recent academic studies of venture capital markets in other countries, including, but not limited to, Lerner (2002); Armour and Cumming (2006); Cumming and Johan (2006b, 2006d); and Cumming (2007).

(5) For example, testimony before the Manitoba legislature in 1997, six years after Manitoba's LSVCC legislation was introduced, is consistent with this view; see http://www.gov.mb.ca/legislature/hansard/3rd-36th/vol_061a/h061a_4.html.

(6) Some LSVCCs manage more than one LSVCF, such as GrowthWorks and the Canadian Medical Discoveries Fund.

(7) For US evidence, see Gompers and Lerner (1999); for international evidence, see Cumming and Johan (2006b).

(8) Some LSVCCs (such as Working Ventures in 1997 and Fonds de Solidarite in 2002/03) had an excess of capital available for investment and thereby had to limit their capital contributions from individual investors, since they could not reinvest the money on time; that is, they did not want to face the statutory penalties for not reinvesting the contributed money within the time constraint.

(9) One common explanation of the poor performance of LSVCCs is that they are not pure profit maximizers. Some commentators state there is anecdotal evidence that certain funds are doing a good job when viewed in conjunction with their multifaceted statutory objectives (profit maximization, labour growth, regional development, and so on). A commentator on an earlier draft of this paper pointed out that LSVCCs in Quebec differ from those in the rest of Canada, and that labour unions in that province play a larger role in the governance of the activities of labour hand managers than do unions in other provinces. The data are lacking to evaluate this anecdotal evidence, but it is natural to expect differences across funds, and the characteristics of the people involved with the funds clearly play a significant role in their eventual outcomes. It is also possible that the people involved might have done a better job had the statutory constraints of the LSVCC program been designed differently. Nevertheless, there is ample room for improvement in the program design.

(10) Other evidence indicates that LSVCCs are much less likely to have successful exit outcomes than private independent limited partnership venture capital funds, and much more likely to have unsuccessful buyback exits and secondary sales than initial public offerings and acquisitions. See Cumming and Johan (2006a); for earlier work, see Macintosh (1997) and Cumming and MacIntosh (2003a, 2003b).

(11) For details of these provincial initiatives, see http://www.gov.ns.ca/finance/taxpolicy /taxcredits/LSVCCreview2002.pdf; and http://www.fin.gov.on.ca/english/media/2005/nr08-lsif.html.

(12) See http://www.cbc.ca/money/story/2005/05/30/crocusaudit-050530.html.

(13) See Poterba (1989a, 1989b); Gompers and Lerner (1998); Jeng and Wells (2000); Keuschnigg (2003, 2004); Keuschnigg and Nielsen (2001, 2003a, 2003b, 2004a, 2004b, 2004c); and Armour and Cumming (2006). I do not address tax-neutrality issues here, but they are worth considering by policymakers.

(14) In Cumming (2006b), I estimate the "inducement rate"--or the amount of additional R&D expenditure made for every dollar of benefit from tax concessions given to a firm--for the tax offset to be significantly greater than 100 percent for the premium tax concession with incentive hurdles to spend more on R&D than in previous years, and much higher than that in countries without special hurdles, as estimated by Bloom, Griffith, and Van Reenen (2002) among others.

(15) For details of that tax policy, see http://www.parl.gc.ca/information/library/PRBpubs/899e.htrn.

(16) Sandler (2001) discusses the Canadian tax treatment of employee stock options.

(17) Cumming and Johan (2006b) find, in a sample of 50 funds from 17 countries, that 28 percent were outbound offshore and 12 percent were inbound offshore.

(18) See, for example, comments by S.J. Berwin at www.sjberwin.com, September 8, 2006.

(19) Macintosh (1994) argues that Canadian prospectus requirements are too onerous and prospectus exemptions too narrow, thereby making entrepreneurial capital relatively more costly than in other countries, notably the United States. Since the passage of the United States Public Company Accounting Reform and Investor Protection Act of 2002 (better known as Sarbanes-Oxley), it is less clear whether capital costs are cheaper in Canada or in the United States; further research is warranted.

(20) Entrepreneur-friendly bankruptcy laws directly benefit entrepreneurs, of course, but they can also indirectly benefit investors, to the extent that investors capture part of the returns to more risk-taking entrepreneurs.

(21) See, for example, Aghion and Howitt (2005) and, more controversially, Boldrin and Levine (2002).

(22) See, for example, http://cliffreeves.typepad.com/dyermaker/2005/12/rim_blackberry_.html.

(23) The CalPERS lawsuit forced United States venture capital funds to disclose returns to public institutional investors. As a result, some funds have restricted participation by public limited partners. For example, Sequoia Capital ejected the University of Michigan as an institutional investor in its funds; see http: //www.mercurynews.com/mld/mercurynews/business/6390139.htm.

(24) See, for example, Cobley (2005), who argues that, in the United Kingdom, regulations hamper the flow money flow into venture capital, while a dearth of such regulations in continental Europe facilitates flows there. Other examples are Dickson (2005); Mackie (2005); and Tricks (2005), who argue that new United Kingdom disclosure laws are making venture capital groups uncomfortable. See also Hill (2005), who argues that overly strict regulations hamper the expansion of investments in alternative asset classes.

(25) In the United States, for example, the Institutional Limited Partners Association has been working toward setting standards for reports from venture capital funds, while in March 2004 the National Venture Capital Association rejected a proposal on valuation guidelines by the Private Equity Industry Guidelines Group, which has created controversy among the various industry associations; see http://www.privateequityonline.com/TopStory.asp?ID=4498&strType=1.

(26) For example, CalPERS has been forced to reconsider its venture capital allocations in ways that differ from what it might otherwise have done but for the public disclosure; see http: //www.ventureeconomics.com/vcj/protected/1070549534318.html.

(27) See, for example, http://www.privateequityvaluation.com/documents/ IPEV_Press_Release_15.11.2006.pdf.

(28) This section draws on material presented in Cumming and MacIntosh (2007); an earlier version was presented in Cumming (2007), as a report to the Australian government. See also Lerner (1999, 2002); Cressy (2002); and Cumming and MacIntosh (2006, 2007).

(29) For example, the minimum period of investment is one year, and an SBIR can indirectly or directly control the investee company for a maximum period of seven years. For a summary of these terms and conditions, see http://www.sba.gov/INV/overview.html.

(30) Underinvestment refers to situations where equity investors do not want to spend more time on or add value to a venture that is facing bankruptcy, since they (unlike debt holders) would obtain no economic benefit from doing so.

(31) Risk shifting refers to the tendency of equity holders to undertake excessively risky projects to transfer expected wealth from debt holders to equity holders. If the venture does well, equity holders earn more money and debt holders gain no extra benefit. If the venture does poorly, both equity holders and debt holders lose their capital.

(32) Asset stripping refers to the incentives equity holders have to steal assets out of companies that face bankruptcy. A common example is when equity holders pay themselves a large dividend shortly before announcing bankruptcy. See, for example, Jensen and Meckling (1976); and Green (1984).

(33) See http://strategis.ic.gc.ca/epic/internet/inccip-picc.nsf/ en/h_cw01102e.html.

Douglas Cumming is a newly appointed Associate Professor of Finance at the Schulich School of Business, York University, and has been appointed as Ontario Research Chair in Economics and Public Policy. His research focuses primarily on law and finance, venture capital, private equity, and IPOs.

Table 1: Tax Savings from an Individual Investment of
$5,000 in a Labour-Sponsored Venture Capital Fund, by Taxable Income
Bracket

                             up to    30,754-   30,813-   53,812-
Type of Tax Savings         20,753    30,813    53,811    61,508

                            (dollars unless otherwise specified)

Registered Retirement         5,000     5,000     5,000     5,000
Savings Plan (RRSP)
Investment
Federal tax credit              750       750       750       750
Provincial tax credit (a)       750       750       750       750
Combined federal and          1,500     1,500     1,500     1,500
provincial tax credit
RRSP tax savings              1,110     1,410     1,560     1,655
Combined federal and         Up to      28.2%     31.2%     33.1%
provincial tax credit         22.2%
Total tax credits and tax    Up to      2,910     3,060     3,155
savings                       2,610
Net out-of-pocket cost      At least    2,090     1,940     1,845
                              2,390
Initial return (b) =           109%      139%      158%      171%
($5,000--out-of-pocket
cost)/out-of-pocket cost

                            61,509-   61,629-   63,505-    Over
Type of Tax Savings         61,628    63,505    100,000   100,000

                            (dollars unless otherwise specified)

Registered Retirement         5,000     5,000     5,000     5,000
Savings Plan (RRSP)
Investment
Federal tax credit              750       750       750       750
Provincial tax credit (a)       750       750       750       750
Combined federal and          1,500     1,500     1,500     1,500
provincial tax credit
RRSP tax savings              1,855     1,970     2,170     2,320
Combined federal and          37.1%     39.4%     43.4%     46.4%
provincial tax credit
Total tax credits and tax     3,355     3,470     3,670     3,820
savings
Net out-of-pocket cost        1,645     1,530     1,330    $1,180
Initial return (b) =           204%      227%      276%      324%
($5,000--out-of-pocket
cost)/out-of-pocket cost

(a) This table uses Ontario provincial rates as of August 2005; for
other provincial rates, see http://www.bestcapital.ca/why_invest.htm.

(b) Calculation does not include any returns (losses) that may be
generated by a LSVCF's investment activities.

Sources: http://www.bestcapital.ca/why-invest.htm; Canada, Department
of Finance; and Cumming and Macintosh, forthcoming.

Table 2: Summary of Alternative Public Policy Initiatives for
Providing Venture Capital Support

Feature                  Description            Potential Benefits

                                          A. Taxation

Capital gains       Government charges low   Incentives for private
taxes               rates on capital gains   investors to
                    taxes                    contribute capital to
                                             venture capital funds
                                             and entrepreneurial
                                             companies

R&D tax policy      Government provides      Increases R&D
                    special tax incentives   expenses, which
                    for R&D                  benefit society
                                             generally due to
                                             spillovers

Taxation of         Government does not      Incentives for
stock options       scrutinize low           entrepreneurs to start
                    valuations of stock      their own companies
                    options provided to
                    entrepreneurial
                    companies

Offshore tax        Government enters into   Incentives for private
haven double        double taxation          fund managers to
taxation treaties   treaties and allows      establish venture
                    private investors to     capital funds
                    set up funds offshore

                                          B. Securities Laws

Minimal             Cost of preparing        Incentives for
prospectus          prospectus lower;        individuals to start
requirements;       prospectus not           companies; better
maximum             required for small       access to capital
prospectus          companies; greater
exemptions for      scope of prospectus
companies           exemptions

IPO hold periods    Low cost of going        Lower costs of going
and escrow          public                   public facilitate
requirements                                 capital raising for
                                             small companies

Foreign ownership   Majority foreign         Foreign ownership a
of majority         ownership is permitted   substitute for bad
shares in                                    laws, as foreign
companies                                    owners subject to
                                             higher standards

                                          C. Miscellaneous Laws

Bankruptcy law      Government minimizes     Encourages
                    time to discharge in     entrepreneurial
                    personal bankruptcy      activity and people to
                                             start their own
                                             companies, thereby
                                             increasing self-
                                             employment and the
                                             size of venture
                                             capital markets

Labor laws          The ease with which      Regulatory barriers
                    labour laws enable       inhibit company size
                    employees to be fired    and growth, and hamper
                                             the entry of new
                                             companies

Incorporation       The number of            Regulatory barriers
                    procedures to start a    inhibit company size
                    company                  and growth, and hamper
                                             the entry of new
                                             companies

Institutional       Prudential management    Increases flow of
investor (e.g.      rules enable             funds to
pension fund)       institutional            entrepreneurial
regulation          investors to invest in   companies
                    venture capital

Venture capital     Dearth of reporting      Increased disclosure
fund reporting      standards of venture     increases flow of
requirements        capital funds            funds
                    discourages
                    participation of
                    institutional
                    investors

Regulatory          Harmonization of laws    Facilitates venture
harmonization       governing                capital investment
                    institutional            with different types
                    investors                of institutions (or
                                             institutions in
                                             different countries)
                                             acting with same
                                             regulatory guidelines
                                             within the same
                                             limited partnership

Patent policy       The extent to which      Rewards innovators
                    intellectual property
                    is protected

                         D. Direct Government Venture Capital
                           Programs and Other Incentives

Tax subsidies for   Government provides      Greater fundraising
one type of         tax breaks to            (at least for one type
venture capital     individuals who invest   of venture capital
fund                in one type of venture   fund)
                    capital fund

Government          Government provides      Encourages
research grants     100% of funding needed   entrepreneurial
                    for a particular         activity and people to
                    project                  start their own
                                             companies, thereby
                                             increasing self-
                                             employment and size of
                                             venture capital
                                             markets

Government          Government subsidizes    Lowers fixed costs and
subsidies for       venture capital          thereby increases the
operating costs     management firm to       returns to operating
                    cover part of            a fund
                    operating costs

Government loans    Government provides      Maximum incentives for
                    loans with interest      the investee
                                             entrepreneurial
                                             company to work
                                             towards success as the
                                             investee does not have
                                             to give up equity

Government          Government matches       Increased fundraising
participation in    investments by private   opportunities for
a venture capital   investors                venture capital funds;
fund as a limited                            sometimes structured
partner                                      with limited upside
                                             potential for the
                                             government

Government lower    Government investor      Increases expected
priority            last to get paid         rate of return for
                                             private investors

Government          Government incurs        Increases expected
guarantees in       losses of fund           rate of return for
downside                                     private investors

Private investor    Private investors        Government capital
option to buy out   given option to buy      more liquid and can be
government          government's shares at   reinvested; private
                    predetermined rates      investors' returns
                    and over preset period   potentially enhanced

100% government-    Government-run and       Finances companies
owned venture       -funded venture          that would otherwise
capital fund        capital fund             not receive capital,
                                             such as regionally
                                             isolated companies;
                                             provision of trade
                                             education, consulting
                                             services

Privatization of    Privatization of         Increases scale and
government          government companies     scope of viable
entities            and assets;              projects for venture
                    particularly for         capitalists to
                    developing countries     consider as investment
                    and transition           opportunities
                    economies

Export financing    Financing companies      Encourages exports and
                    with exports and         enables companies to
                    assisting actual         be more competitive
                    exports of companies;    internationally
                    pre-shipment
                    financing, equity
                    investments, note
                    payables, credit,
                    contract, and
                    political insurance

Feature              Potential Drawbacks             Examples

                                          A. Taxation

Capital gains       Lower tax revenues       United States, 1975-80
taxes

R&D tax policy      Costly forgone tax       Adopted in various forms
                    revenues                 in most developed
                                             countries around the
                                             world

Taxation of         Lower tax revenues       United States
stock options

Offshore tax        Lower tax revenues       Bermuda; Cayman Islands;
haven double                                 Labuan (Malaysia);
taxation treaties                            Luxembourg

                                          B. Securities Laws

Minimal             Fraud                    Canada versus United
prospectus                                   States comparisons
requirements;
maximum
prospectus
exemptions for
companies

IPO hold periods    Fraud                    Canada versus United
and escrow                                   States comparisons
requirements

Foreign ownership   Transfer of knowledge    South Korean limits to
of majority         and wealth abroad,       foreign ownership;
shares in           particularly for high-   US limits to foreign
companies           tech industries, which   ownership for certain
                    the countries want to    industries
                    keep internally

                                          C. Miscellaneous Laws

Bankruptcy law      Default and fraud        Netherlands and Germany
                                             introduced discharge
                                             from personal bankruptcy
                                             in 1997 and 1999,
                                             respectively.

Labor laws          Employment security      United States versus
                    and social welfare       Europe versus less
                                             developed countries

Incorporation       Fraud                    United States versus
                                             Europe versus less
                                             developed countries

Institutional       Risk pension plan and    ERISA (United States
investor (e.g.      insurance firms'         1979) FTK (Netherlands
pension fund)       (beneficiaries')         2006)
regulation          assets

Venture capital     Costs of reporting and   CalPERs lawsuit (2002)
fund reporting      disclosing sensitive     in United States
requirements        materials

Regulatory          Lack of regulatory       The Netherlands 2006
harmonization       competition              FTK; Basel II; MRS

Patent policy       Creates a monopoly;      BlackBerry lawsuit
                    and "patent trolls"
                    that  acquire patents
                    only for suing

                         D. Direct Government Venture Capital
                           Programs and Other Incentives

Tax subsidies for   Crowds out other types   Canada, LSVCCs; United
one type of         of funds; lowers         Kingdom, VCTs
venture capital     returns in the market
fund

Government          Direct costs of          United States, SBIR
research grants     providing grants;
                    scientists using funds
                    on non-
                    commercializable
                    projects, or excessive
                    risk taking

Government          Venture capital fund     European Seed Capital
subsidies for       managers do not have     Scheme
operating costs     the same incentives to
                    invest in new projects
                    in a timely manner;
                    may also give rise to
                    excess staff or
                    unnecessary operating
                    expenses

Government loans    Entrepreneur has         United States, SBIC
                    incentive to take on
                    excessively risky
                    projects

Government          Costly; uncertain        Australia, Innovation
participation in    politicized selection    Investment Fund (IIF);
a venture capital   process of fund          Australian Pre-Seed Fund
fund as a limited   managers; possible       has limited upside for
partner             lack of independence     government
                    in selection of
                    investee
                    entrepreneurial
                    companies

Government lower    Venture capital fund     United Kingdom, Regional
priority            managers have            Venture Capital Funds
                    incentive to take on
                    excessively risky
                    projects

Government          Venture capital fund     Germany, WFG; France,
guarantees in       managers have            SOFARIS; Denmark,
downside            incentive to take on     Equity Guarantee Program
                    excessively risky
                    projects

Private investor    Timing constraints may   Israel, Yozama; New
option to buy out   distort incentives to    Zealand, Venture
government          do things that are in    Investment Fund
                    the best interest of
                    the entrepreneurial
                    company

100% government-    Costly, depending on     Canada, many provincial
owned venture       how it is structured     and federal sources,
capital fund        and operated;            such as Canada Community
                    uncertain politicized    Investment Plan
                    selection process of
                    fund managers;
                    possible lack of
                    independence in
                    selection of investee
                    entrepreneurial
                    companies; inefficient
                    projects if private
                    investors would not
                    finance such projects;
                    otherwise, possible
                    competition with
                    private venture
                    capital

Privatization of    Politicized process in   Russia, eastern Europe
government          terms of who gets to
entities            buy the company;
                    conflicts of interest

Export financing    Potentially induces      Canada, Export
                    reliance on government   Development Corporation
                    for assistance;
                    potentially
                    politicized process
                    with selection of
                    companies that receive
                    assistance

Feature                Related Research

                    A. Taxation

Capital gains       Poterba 1989a, 1989b;
taxes               Gompers and Lerner
                    1998; Keuschnigg 2004;
                    Keuschnigg and Nielsen
                    2001, 2003a, 2003b;
                    Armour and Cumming
                    2006

R&D tax policy      Bloom, Griffith and
                    Van Reenen 2002;
                    Cumming 2006b

Taxation of         Sandler 2001; Gilson
stock options       and Schizer 2003

Offshore tax        Cumming and Johan
haven double        2006b
taxation treaties

                      B. Securities Laws

Minimal             MacIntosh 1994
prospectus
requirements;
maximum
prospectus
exemptions for

IPO hold periods    MacIntosh 1994           companies
and escrow
requirements

Foreign ownership   Denis and Huizinga
of majority         2004
shares in
companies
                    C. Miscellaneous Laws

Bankruptcy law      Armour and Cumming
                    20,052,006

Labor laws          Mapper, Laeven, and
                    Rajan 2006

Incorporation       Mapper, Laeven, and
                    Rajan 2006

Institutional       Gompers and Lerner
investor (e.g.      1998; Cumming and
pension fund)       Johan 2006b
regulation

Venture capital     Cumming and Johan,
fund reporting      forthcoming; Cumming
requirements        and Walz 2004

Regulatory          Cumming and Johan,
harmonization       forthcoming

Patent policy       Jaffe and Lerner 2004

                         D. Direct Government Venture Capital
                           Programs and Other Incentives

Tax subsidies for   Cumming 2003; Cumming
one type of         and MacIntosh 2001,
venture capital     2003a, 2003b, 2006,
fund                forthcoming

Government          Lerner 1999, 2002
research grants

Government          Jaaskelainen, Maula, and
subsidies for       Murray 2006
operating costs

Government loans    Lerner 1999, 2002

Government          Cumming 2007; Cumming
participation in    and Johan 2006c
a venture capital
fund as a limited
partner

Government lower    Jaaskelainen, Maula, and
priority            Murray 2006

Government          Jaaskelainen, Maula, and
guarantees in       Murray 2006
downside

Private investor    Jaaskelainen, Maula, and
option to buy out   Murray 2006
government

100% government-    Bates 2002; Lerner 2002
owned venture
capital fund

Privatization of    Megginson et al. 2004
government
entities

Export financing    Canada 2006