The innovation challenge – and the misallocation of capital

30 janvier 2012

Personnes-ressources

Pour l'instant, cette publication n'est disponible qu'en anglais

Richard Sutin’s proposal for flow-through shares in the biotech and other innovation sectors is discussed in a front page article in the Globe and Mail’s Report on Business.

Richard is a long-time proponent of the idea. Flow-through shares have been a proven, successful program in the Canadian resource sector and have helped Canada become a global leader in resource financing.

Flow-through shares have the potential to tackle the commercialization challenge for the innovation sector and alleviate Canada’s innovation deficit. Flow-through shares are a catalyst for private sector investment—both through follow along equity as well as for earlier stage venture and angel capital which see the public markets as a natural exit. Because the investor is still at risk, partially cushioned by tax support, the private sector targets potential winners.

A recent bulletin written by Richard and Norton Rose Canada’s Senior Advisor Len Farber is below.

Flow-through shares as an answer to our innovation deficit or: How to survive the valley of death

By Rick Sutin, Senior Partner, Norton Rose, Toronto and Len Farber, Senior Advisor, Norton Rose, Ottawa (formerly General Director, Tax Policy Branch of the Department of Finance)

The recently released Innovation Canada, A Call to Action on Federal Support to Research and Development along with a study on Canada’s Innovation Underperformance by the Mowat Centre for Policy Innovation at U of T follow much discussion concerning Canada’s innovation deficit despite generous government financial assistance. While much of the earlier discussion focuses on re-tooling our education and training towards more science and technology, these reports focus on the role of government in facilitating risk capital for the innovation economy.

Absent from these reports is any consideration of a private sector mechanism to attract risk capital to the innovation sector. In particular no mention is made of “flow-through shares”, a proven, successful program in the resource sector that many in the biotech and other innovation sectors have been advocating for several years. This omission is somewhat surprising as The Coalition for Action on Innovation in Canada, co-chaired by John Manley and Paul Lucas, recommended extending flow-through shares to the innovation sector in their October, 2010 Action Plan for Prosperity.

In its November, 2006 Advantage Canada economic plan strategy report, the federal government stated that to make Canada a world leader for future generations, we have to “turn our ideas into innovations that provide solutions to environmental, health and other important social challenges, and to improve our economic competitiveness”. The follow up May, 2007 strategy report Mobilizing Science and Technology to Canada’s Advantage, announced a strategy to commercialize knowledge for wealth creation, obtain the social and economic benefits and attract the most skilled workforce of the future. The 2007 report also signalled the pre-eminent role of the private sector and recommended that government should encourage foreign direct investment, foster a leading edge financial system and stimulate the supply of venture capital.

The search for new technologies is risky with long lead times to achieve progress. Traditional risk and venture capital have been insufficient and in recent years have been retreating. Governments around the world have attempted to fill the gap with a variety of incentives and programs.

This is where the Canadian resource sector found itself almost 50 years ago when flow-through shares were introduced to facilitate a public market in venture capital for the resource sector. As the Manley/Lucas report states, flow-through shares have, by any measure, been a success in helping Canada become a global leader in resource financing. Financing leadership led to the creation of the world’s leading resource cluster. Canadian resource companies are now engaged in more global exploration and development than companies from any other country and the support infrastructure of management, finance, accounting and legal talent is world leading.

There are few private sector studies on the effectiveness of flow-through shares, which is surprising given its longevity, the significant role it has played in one of our very important economic sectors and the fact that it has survived without public criticism or scandal. There are two federal government reports, a Department of Finance report in October, 1994 and a Natural Resource Canada report in November, 2007. The reports do note that flow-through shares generated significant incremental spending on mining and petroleum exploration and benefited the economies of several provinces as well as non-tax paying junior exploration companies. Each $1 of tax expenditure resulted in $2.6 of incremental exploration spending and the costs to the government are acknowledged as modest.

Canada has abundant support for scientific and experimental research, most notably through SR&ED. But true innovation goes beyond SR&ED and there is no tax support mechanism to encourage the commercialization of SR&ED discoveries. It is the ability to translate a discovery into a product; the intersection of discovery, entrepreneurship and risk capital. This greater challenge of commercialization is often referred to as the “valley of death”.

Flow-through shares have the potential to tackle the commercialization challenge as they are a catalyst for private sector investment both through follow along equity as well as for earlier stage venture and angel capital which see the public markets as a natural exit. Because the investor is still at risk, partially cushioned by tax support, the private sector targets potential winners. By defining the qualifying expenditures, the government targets the spending it wants to incent.

Like the resource sector, the innovation sector is a discovery business with much risk capital needed from the private sector. This has been recognized in a number of industrialized jurisdictions globally. Just as flow-through shares have been a demonstrated success story for the resource sector in Canada, they have the potential to alleviate our innovation deficit by attracting needed risk capital and building global leadership in the innovation sector.