The following first appeared in the Financial Post, 5 July 2012, p. FP11
For real estate, it's location, location, location. For national prosperity, it's innovation, innovation, innovation. Unfortunately, Canada still sets up shop in the low-rent district. We do lots of great R&D, which then sits on the shelf and collects dust.
The recent federal budget recognizes the problem and makes generous commitments for the support of innovation commercialization. There may be a fly in the ointment, however. The government plans to shift money out of the Scientific Research and Experimental Design tax credit (SR&ED - pronounced "shred" by aficionados) and into "direct" assistance, such as government-administered grants. This has the potential for harming rather than helping commercialization efforts.
Under the current SR&ED program, businesses that undertake qualifying research and development receive subsidies from the federal government (with most provincial and territorial governments supplying top-ups). Qualifying expenditures include both labour and capital costs. If the company is a "Canadian controlled private corporation" (CCPC), the federal government will refund 35% of the cost of the R&D expenditures - whether or not the company has taxable income, or indeed net revenue. Mr. Flaherty's budget leaves the 35% rate intact, but restricts qualifying expenditures to labour costs alone. Expenditures on capital and equipment no longer qualify.
This change is ill advised. Many of the 20,000 CCPCs taking advantage of the SR&ED are early-stage firms that reside in what is often styled the "Valley of Death" - the capital-starved region sandwiched between government-financed basic and applied research, and later-stage private funding by angel investors, venture capitalists, and strategic partners. For many of these seed-stage firms, the SR&ED is the only available source of external funding. Any reduction in the SR&ED will inevitably increase the number of carcasses littering the floor of the Valley of Death. This is a matter of consequence because the vast majority of firms introducing consequential innovations were dainty little acorns before they grew into mighty oaks. If the forest floor is scoured of acorns, where will the mighty oaks come from?
The government's plan is based on the recommendations of a blue-ribbon panel under the chairmanship of Open Text's Tom Jenkins. The committee's view is that much of the $3.5-billion poured into the federal SR&ED program is wasted since there is no vetting of the quality of firms receiving SR&ED support. By contrast, when doling out "direct" assistance (e.g. grants), the government is able to meter its largesse by selecting firms that it thinks are likely to be winners in the commercialization sweepstakes. The committee relied heavily on a study by the federal Department of Finance that concluded that, within five years of incorporation, only 2% of SR&ED recipients grow into large firms still performing research and development.
However, no comparative growth rates are presented for firms receiving direct assistance. Moreover, the pool of firms featured in the Department of Finance study were incorporated in the period from 2000 to 2004 - immediately following the bursting of the tech bubble in 2000. As tech business failures were generally higher in this period, the data relied on is unlikely to be a good proxy for normal growth rates of SR&ED firms.
Remarkably enough, growth rates of firms incorporated in 2000 in Silicon Valley - the world's premier high-tech incubator - were not materially greater those of SR&ED firms, despite receiving record amounts of venture capital. This is reflective of the fact that seed-stage technology firms, virtually by definition, operate at the cutting edge (sometimes called the "bleeding edge") of the technology envelope. They seek to implement experimental approaches with potentially high transformative impact, but equally high risk. No one should be surprised that many of them fail. But again, no acorns, no oaks.
Indeed, of every 100 investments made by the most skilled technology investors in the world - highly sector-specific U.S. venture capitalists (VCs) - perhaps one or two end up as "home runs." If these masters of the universe find it so difficult to pick the right acorns, can we expect the government to materially improve its track record by shifting money from indirect to direct assistance programs?
Add to this the peculiarity of the five-year growth benchmark adopted by the Jenkins committee. As technology advances, the tectonics of innovation have pushed the boundaries of the Valley of Death ever wider. In order to trump complex, entrenched technologies, successful innovations must delve ever more deeply into nature's grab bag of tricks. This cannot be done overnight. Most experts, for example, agree that it takes between 10 and 15 years to commercialize a new materials technology. Energy technologies may take 30.
While the budget generously sets aside some $400-million to rebuild Canada's VC industry, the manner in which this is to be deployed remains uncertain. The Jenkins committee sensibly suggests that direct assistance be effected as a tag-along to private investment, whether by angel investors or venture capitalists. Nonetheless, firms situated in the Valley of Death are not good candidates for any form of private investment other than the initial resources contributed by the founder, family and friends. Lacking SR&ED money, private investment or direct assistance, many seed-stage firms could be left, to borrow John Ehrlichman's evocative phrase, "twisting slowly, slowly in the wind."
What the Jenkins committee and the government view as a disadvantage of SR&ED funding - the absence of vetting - is actually a huge plus. Three key parameters loom large: risk, time and opportunity cost. The risk of applying for direct funding is great. So are the time and paperwork required - win or lose. These impose a huge opportunity cost on human-capital-constrained seed firms, pulling scarce personnel away from the business at a time when their attention is most critical. The SR&ED has considerably less risk and funds are received in about half the time. Moreover, much of the time and effort can be outsourced to an accounting firm or other professional SR&ED facilitator.
The Jenkins committee suggests that restricting the SR&ED to labour costs will substantially reduce the burden of applying for the SR&ED, and the degree of reliance on third-party preparers. This is unlikely. Applicants must still establish that they aim to improve a product or process via an experimental approach and that there is technological uncertainty. Particularly given the opportunity cost of applying, most startup firms will continue to find it more cost effective to turn the file over to an outside expert.
Implementing the government's plan to restrict the SR&ED to labour costs alone would significantly tilt the playing field away from manufacturing firms, which have a relatively high capital/labour ratio. This tilt is unjustified from any defensible policy perspective. This is particularly so given that research at Harvard, MIT and a variety of other august institutions suggests that, because of synergies between invention and production, a successful innovation economy is critically dependent on a robust manufacturing sector.
In response, a move is afoot in the U.S. to create incentives for the support of manufacturing industries in which there is a symbiotic relationship between the production process and innovation. Various European nations have already taken initiatives in this direction. Is Canada jumping off the bandwagon at a time when the best and the brightest are jumping on?
Finally, it bears noting that indirect assistance via the SR&ED is region-and sector-neutral. By population, however, direct assistance is disproportionately concentrated in Quebec and the Maritimes. It also flows disproportionately to a handful of industries such as forestry, aerospace and agriculture. Any move from indirect to direct assistance is likely to exacerbate these regional and sectoral preferences.
While we Canadians clearly have problems turning our smarts into dollars, it is unlikely that eviscerating the SR&ED will cure the problem. We need to look elsewhere for the solution to this problem.
Jeffrey G. MacIntosh is Toronto Stock Exchange professor of capital markets at the Faculty of Law, University of Toronto.
