Silicon Valley North #14 Dec'99

The Way I See Itů by Michael Volker

Innovation requires a climate that encourages risk

In its first annual report on innovation, the Conference Board of Canada cited weak leadership and government cuts to R&D spending for falling behind on the innovation front. "The heart of the innovation challenge for Canadian companies ....lies in execution", according to the report.

It's all a matter of risk. Without the taking of risks, there would be no innovation. Taking risk means making more, and bigger, investments in early stage companies - knowing that many will fail. Just look at the huge sums that venture capitalists are pouring into nascent Silicon Valley companies. Early investments in the $10 million-plus range are becoming commonplace. A great fear that many investors have is that the time to market will take too long and opportunities will be missed because of insufficient funding. The American approach is to kick-start ventures with ample capital whereas in Canada, we tend to favour the bootstrapping approach, i.e. invest a little and build a little to achieve some modest results. We fear failure and don't embrace it as a learning experience as do Americans.

In comparison to our southern friends, we appear conservative and risk averse. Case in point: a B.C. firm which I know has developed a technology for lumber drying. Within months of putting information on this technology on its website, it received an order and a $100K cash deposit from an American firm - sight unseen. Yet, closer to home, companies are reluctant to take such up-front risks.

Innovation is the successful commercial introduction of new technology. This calls for more investment in emerging companies with unproven products.

It's not that we're inherently less prone to risk-taking than Americans. The economics of risk-taking are profoundly less attractive in Canada. Our punitive tax system discourages risk taking. Since we get to keep less than half of what we earn in the first instance, who wants to risk their after-tax capital on risky, illiquid deals with so many short term gains in senior equities and mutual funds in the second instance?

Here's a simple solution that will fix the problem without compromising on "tax flow" to Revenue Canada. In fact, tax revenues will be increased because of increased economic activity.

Allow investors to invest pre-tax dollars, i.e. give them a 100% write-off on direct corporate equity investments and assign a cost base of zero to the investment so that the entire investment is taxed only when cashing out.

Let's say that I invest $100K in a private placement in a new treasury issue. As an incentive to take this risk, I get to write-off the entire amount (but I must now value my investment at zero dollars, which means I may pay tax on capital gains later). The money goes mainly into salaries in the target company which will, of course, be taxed in the hands of the recipients as employment income (so all we've done is transfer the tax from one taxpayer to another).

If the investment does not pay off - which is highly likely - there is still a net benefit in that some new knowledge will be created or some other spin-off may result. And, it won't be all that painful for me because I would have given up half of the original investment in taxes anyway. But, I'll be encouraged to make more investments knowing that, when one does pay off, I'll get my payback - and only pay tax at the lower capital gains rate. If I just breakeven, I would have to pay tax on only 75% of the full amount, still giving me a slight incentive.

The way I see it, a prerequisite for a healthy innovation climate is more risk capital encouraged by an innovative investment tax incentive. Taking more financial risk will result in more innovation and wealth for us all.
 



Michael Volker is a high technology entrepreneur and director of Simon Fraser U's University/Industry Liaison Office. He is a former executive director of the BC Advanced Systems Institute and is chair of the Vancouver Enterprise Forum. He may be reached at mike@risktaker.com.

Copyright, 1999.