Tech entrepreneur calls for elimination of capital gains for early-stage investment

“No R&D, no future”

One of Canada’s most prominent technology entrepreneurs is reviving the call to eliminate capital gains taxes for early stage investors in technology start-ups. Terry Matthews, chairman and CEO of March Networks Corp, says angel investors need such a stimulus to ensure that emerging firms receive badly needed funding and to offset the lack of true venture capital (VC) in the market.

In remarks made at RE$EARCH MONEY’s annual conference in Ottawa on November 18, Matthews trumpeted the importance of continued R&D investment and described 2003 as an “awful year” for Canada and the high-tech business sector. But it was the call for eliminating capital gains for high-risk, early-stage investors that is likely to increase pressure on the incoming Paul Martin government

“Let’s encourage the angel investors …I’m of the opinion (we need) capital gains tax holidays for early stage investors,” said Matthews. “Put a lot of wealth creation in the hands of the angels and then they reinvest into the next lot…The more start-ups there are, the more chances we have of creating Newbridges.”

Matthews contends that, based on his own experience in early-stage financing, for every $1 in early-stage investment, governments will ultimately receive nearly $6 in corporate, transactional, salary and other taxes. Therefore any concessions that increase the volume of early-stage investment not only increase future deal flow and company formation but provide almost 600% return on investment.

Matthews says if angel investors are encouraged to invest and build value in new start-ups, it may help to counter recent negative trends in VC investment. Because of low valuations for many start-ups, VC is exacting a high price for its financial support.

“Companies today cannot afford R&D so it gets back to the angel investor, it gets back to VC funds. And VC funds more and more they are becoming vultures,” he says. “They’re almost as bad as the banks…You cannot get outside funding unless it’s of a vulture nature. That means previous investors get mulched and taken down to nothing and the new investors just take the whole company. It happens day after day.”

To illustrate his argument, Matthews points to his own experience starting and supporting technology firms. By his own estimation, he has invested in or created more than 100 firms including Mitel Corp and Newbridge Networks Corp.

Matthews calculates that for every $1,000 invested in his firms over the past 20 years, there has been $5,000 in follow-on investment. Those firms, in turn generated $5,783, a six-fold return on early-stage investment.

“That’s a pretty damn good ratio. The government does pretty well out of this I would say,” he commented. “It’s quite clear that if there are early investors taking the risk, you get a lot of return in our society to that. That’s the way to do it — get people that are more bold, people that are prepared.”

The call for the elimination of capital taxes for early stage investment is not new, although the federal government has yet to enact appropriate legislation. Denzil Doyle, Ottawa’s legendary high-tech figure and chair of the Canadian Alliance Ventures Inc, has long advocated reducing capital gains taxes. He agrees the time is ripe to consider their outright elimination.

“It may be justifiable at this point in time. The stock market is not working in Canada. Let the angels share in the tax revenue they generate,” he says. “We need a special program for angels who do the first injection of capital. It would be a system where angels are given a tax credit for each of the next five years. I’d reward them as they go in, whereas Terry is rewarding them as they go out.”

Doyle also shares Matthew’s concern over the current state of the VC industry, particularly those firms that engage in what’s been termed preferential liquidation. Under the practice, VC investment includes a clause stating that if the recipient company does not return two to three times the original investment within a set period of time, the VC takes control of the company.

“In the US, VCs introduced this sort of thing and it’s made its way into Canada,” says Doyle. “I don’t know how you put a stop to this ... VC companies that participate in this activity are more interested in loan sharking than building companies.”

POT OF GOLD

In the current market it’s not just brutal investment terms growing companies have to worry about. It’s also the reluctance of many investors to re-enter the market after the tech meltdown. Matthews estimates that a staggering $2-2.5 trillion in capital is currently “sitting on the sidelines. It’s simply not being deployed”. He says that it could quickly be directed back into the equity markets if the investment climate improves and Canada must do all it can to ensure the largest slice of the investment pie.

“This is a huge pot of gold sitting there. And of the cash that is available to move back into the market, what can we expect in Canada? Can we take 5%?” he says. “This is a big big number we’re talking about here and it’s now. I’ve seen the swing back in the economy. Look at the US economy, which drives every other economy on the planet.”

Matthews was one of several company executives at the conference who expressed considerable optimism for S&T and R&D under the incoming Martin government. He described Martin as someone who listens and has a deep understand of S&T and how it underpins a prosperous society.

“Here is somebody that listens, that listens on many counts. He understands this border of 4,000 miles with the US, (and that) it’s incredibly important,” he said. “He listens with respect to investment by the angel investors. He listens when it comes to R&D funding, because without it we have no future. We need to get on with it. We need to work with this government, to help them understand the early investors.”

Matthews points to Ottawa as a region that is primed to exploit a new wave of investment. With its well-established critical mass of telecommunications expertise, new early-stage investment will take advantage of a rich pool of labour and facilities.

“We should be investing now when the price is low. There are all kinds of available first class engineers in the Canadian environment and in the US too,” says Matthews. “Now is a great time to start encouraging angel investors ... If we can pull this one off ... we reap the rewards. The Canadian economy reaps the rewards. That’s what I want to see.”

In addition to the elimination of capital gains tax, Matthew is also advocating a tax exemption for stock options. Such a measure would go far towards helping firms retain skilled employees — a tacit acknowledgment of the global competition for highly qualified personnel. Matthews was an early and constant supporter of the $500-million eMPOWR initiative, to accelerate the growth of Canada's skilled labour force in microelectronics, photonics, optoelectronics, wireless and radio engineering.

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