© Cumming & Johan (2013)Public Policy towards Venture Capital Public Policy for VC and PE Cumming & Johan (2013, Chapter 9) 1.

© Cumming & Johan (2013)Public Policy towards Venture Capital Why Government VC Programs? 1.Small private innovative firms contribute disproportionately to R&D 2.Social rate of return to innovation is greater than the private rate of return 3.Financing innovation is too risky for private firms (or their employees are not appropriately incentivized to take on the risk) 4.Private investors do not skill set to be good venture capitalists – need programs to create good VCs 5.Government awards to private parties certify the quality of the company and help it to become established (and secure other sources of funds, as well as suppliers and customers, etc.) 4

© Cumming & Johan (2013)Public Policy towards Venture Capital Distinctive Features of Government VC Programs Partnerships with private industry and awards of contracts to best people – Australia – USA Competition with private industry and unlimited ability to tap public monies – Canada – UK 5

© Cumming & Johan (2013)Public Policy towards Venture Capital US Small Business Innovation Research (SBIR) Program United States Australia Canada United Kingdom European / North American Comparisons Small Business Investment Company (SBIC) program started in 1958 SBIR started 1982 Awardees 51% owned by US citizens Not exceeding $750,000 Multi-government selection process Ranked according to research potential and not commercial viability 7

© Cumming & Johan (2013)Public Policy towards Venture Capital US SBIR Program is Large United States Australia Canada United Kingdom European / North American Comparisons Example: 1995 – $2.4 billion SBIR – $3.9 billion private venture capital funds 8

© Cumming & Johan (2013)Public Policy towards Venture Capital US SBIR Program is Successful United States Australia Canada United Kingdom European / North American Comparisons Firms that received an SBIR award were much more likely to subsequently receive VC funding in later years, relative to a matched set of firms that did not receive an SBIR award SBIR awardees also have higher sales and asset growth Whether or not an award is granted is more important than the size of the award, consistent with the certification rationale for government programs 9

© Cumming & Johan (2013)Public Policy towards Venture Capital US Small Business Investment Companies (SBICs) United States Australia Canada United Kingdom European / North American Comparisons SBICs are operated like private venture capital funds and are operated by private investment managers. The difference between a private venture capital fund and an SBIC is that the SBIC is subject to statutory terms and conditions in respect of the types of investments and the manner in which the investments are carried out.[1] – For example, there is a minimum period of investment for one year, and a maximum period of seven years for which the SBIC can indirectly or directly control the investee company. – Investee companies are required to be small (as defined by the SBA) which generally speaking is smaller than those firms that would be considered for private venture capital financing. – SBICs also face restrictions as to the types of investment in which they may invest. – Capital is provided by the SBA to an SBIC at a lower required rate of return than typical institutional investors in private venture capital funds. Excess returns to the SBIC flows to the private investors and fund managers, thereby increasing or leveraging their returns. [1]These terms and conditions are summarized at http://www.sba.gov/INV/overview.htmlhttp://www.sba.gov/INV/overview.html 10

© Cumming & Johan (2013)Public Policy towards Venture Capital Australia Government VC Programs http://www.avcal.com.au/ http://www.avcal.com.au/ United States Australia Canada United Kingdom European / North American Comparisons The Commercial Ready Programme – $1 billion direct gov’t VC fund – Later stage The Pre-Seed Fund – $78.7 million – Direct Gov’t fund – Max investment in any company: $1 million 12

© Cumming & Johan (2013)Public Policy towards Venture Capital Australia Government VC Programs (Continued) United States Australia Canada United Kingdom European / North American Comparisons Commercializing Emerging Technologies (COMET) Programme – Provides scientists with advice to commercialize their technologies – $100 million R&D Tax Concession – $390 million – 175% (reduce taxable income by more than the amount expended on R&D) 13

© Cumming & Johan (2013)Public Policy towards Venture Capital Australian Innovation Investment Funds (IIFs) United States Australia Canada United Kingdom European / North American Comparisons Perhaps the most important The Australian government held two competitive selection rounds in 1997 and 2000 – Five IIFs established in late 1997 (and early 1998) $Aus130 million – Four IIFs established in 2001 $Aus 91 million Matched by private sector capital on the basis of a Government to private ratio of up to 2:1. 14

© Cumming & Johan (2013)Public Policy towards Venture Capital Key elements of the IIF program: United States Australia Canada United Kingdom European / North American Comparisons the ratio of Government to privately sourced capital must not exceed 2:1; investments will generally be in the form of equity and must only be in small, new- technology companies; at least 60% of each fund’s committed capital must be invested within 5 years; unless specifically approved by the Industry Research and Development (IR&D) Board, an investee company must not receive funds in excess of $4 million or 10% of the fund’s committed capital, whichever is the smaller; distribution arrangements provide for: – both the Government and the private investors to receive an amount equivalent to their subscribed capital and interest on that capital; – any further amounts to be then shared on a 10:90 basis between the Government and private investors; – the private investors’ component to be shared with the fund manager as a performance incentive; the funds established under the IIF program will have a term of ten years, after which they will be closed in a commercially prudent manner. 15

© Cumming & Johan (2013)Public Policy towards Venture Capital To be eligible for support under the IIF program, investee companies must: United States Australia Canada United Kingdom European / North American Comparisons be commercialising the outcomes of R&D activities (as defined by the IR&D Act); be at the seed, start-up, early, or expansion stage of development. have a majority of its employees (by number) and assets (by value) inside Australia at the time a licensed fund first invests in the company; and have an annual average revenue over the previous two years of income that does not exceed $4 million per year and revenue in either of those years that does not exceed $5 million. 16

© Cumming & Johan (2013)Public Policy towards Venture Capital IIFs Relative to Private VCs in Australia United States Australia Canada United Kingdom European / North American Comparisons More likely to finance start-ups More frequently stage and syndicate their investments More likely to have smaller portfolio sizes per manager No difference in propensity to obtain IPOs and no difference in share price performance of IPOs 23

© Cumming & Johan (2013)Public Policy towards Venture Capital Labour Sponsored Venture Capital Corporations (LSVCCs) United States Australia Canada United Kingdom European / North American Comparisons Mutual funds that invest in private equity Established by and run by private VCs Affiliated with a labour union (nominally) Dual goal of employment growth and profit maximization Established in Quebec in 1983 and other Canadian provinces from 1988-1993 LSVCCs compete for new deals with private VCs Investors are individuals, and receive massive tax breaks for investment (up to $5000 contributions) LSVCCs are listed on Stock Markets, operate like a mutual fund Covenants are by statute Covenants are very poorly structured 25

© Cumming & Johan (2013)Public Policy towards Venture Capital LSVCC Tax United States Australia Canada United Kingdom European / North American Comparisons Investors into LSVCCs  Are individuals (contrast to limited partnerships and corporate VC in the US)  Receive 20% provincial + 20% federal tax credit for investments up to $5,000  Other tax savings make the after tax cost of a $5,000 investment as little as $1500  Anyone that invests in a LSVCC need only care about the tax incentive 26

© Cumming & Johan (2013)Public Policy towards Venture Capital LSVCC Covenants United States Australia Canada United Kingdom European / North American Comparisons 60% (under the federal legislation) of new funds received must be invested within a certain amount of time after receipt otherwise a penalty is imposed: – Tax on funds received but not reinvested (20%) – Revocation of the fund’s registration The remaining 40% of new funds received must be invested in liquid securities LSVCCs cannot invest more than the lesser of $10 million or 10% of the equity capital on the LSVCF in any one business 28

© Cumming & Johan (2013)Public Policy towards Venture Capital LSVCC Covenants United States Australia Canada United Kingdom European / North American Comparisons Constraints on time to reinvest are not trivial. E.g. 1996-1997: Working Ventures (Canada’s largest LSVCC) had to refuse new capital contributions for over 1 year! There are other covenants… E.g., LSVCC investees:  Cannot have more than $50 million in assets or 500 employees  50% or more employees must be full-time and 50% or more of wages must be paid to residents in the jurisdiction governing the LSVCC  Cannot carry on business or reinvest funds outside Canada 29

© Cumming & Johan (2013)Public Policy towards Venture Capital Are LSVCCs a Superior Organizational Form? United States Australia Canada United Kingdom European / North American Comparisons NO!!!!!!!!!!! LSVCC Legislation  LSVCC funds will have higher agency costs and generate lower returns than private VC funds (evidence on subsequent slides) Therefore, if LSVCCs crowd out other investors, this is a bad thing 30

© Cumming & Johan (2013)Public Policy towards Venture Capital New Funds for Investment United States Australia Canada United Kingdom European / North American Comparisons Overhang of uninvested capital Capital commitments versus drawdowns from capital commitments Why does this matter? 33

© Cumming & Johan (2013)Public Policy towards Venture Capital Why Might Crowding Out Exist? United States Australia Canada United Kingdom European / North American Comparisons LSVCCs: Required rate of return on investments is significantly lower than that of private VC funds LSVCC investors obtain a significant return from their tax savings – it doesn’t matter if the investment makes an economic return Crowding out is a natural consequence of the tax advantage of the LSVCCs. This advantage lowers the LSVCC’s required rate of return. This in turn allows the LSVCCs to outbid other types of funds for entrepreneurial investments, lowering rates of return and discouraging the establishment of non-LSVCC funds 36

© Cumming & Johan (2013)Public Policy towards Venture Capital Crowding Out Mechanism United States Australia Canada United Kingdom European / North American Comparisons LSVCC Tax advantage:  Lowers LSVCCs’ required rate of return  LSVCCs outbid other VC funds for entrepreneur investments Institutional investors are risk averse, and commit funds prior to VCs selecting entrepreneurial investments Risk of increasing LSVCC investment Discourages the establishment of non-LSVCC funds 37

© Cumming & Johan (2013)Public Policy towards Venture Capital Cost of Funds Amount of Funds S0S0 Demand S1S1 S2S2 More LSVCC (Ignoring effect on Other Funds) Reduction in Private VC (100% Crowding Out) Reduction in Private VC (WORSE!) (>100%) 38

© Cumming & Johan (2013)Public Policy towards Venture Capital “Crowding Out Private Equity: Canadian Evidence” United States Australia Canada United Kingdom European / North American Comparisons LSVCC Legislation has not increased the total supply of venture capital Crowding out (substitute one form of VC for another) Even more surprising: LSVCC Legislation has led to a reduction in venture capital (unequivocal crowding out) Harm caused by LSVCCs: substitute one form of VC for another  end up with an interior form Harm caused by LSVCCs: reduction in VC investments by about 400 investments per year, or $1 billion in investment activity Crowding out is among the start-up and expansion stages of entrepreneurial firm development 39

© Cumming & Johan (2013)Public Policy towards Venture Capital Aside On Regulation in General United States Australia Canada United Kingdom European / North American Comparisons A necessary condition for someone to be sympathetic to regulation is that there be a clear and unequivocal argument (i.e., theory) and evidence (i.e., data) of market failure. That is, in some market or industry, such as venture capital, there is some structural impediment that reduces the proper functioning of the market Continued… 40

© Cumming & Johan (2013)Public Policy towards Venture Capital This is a necessary but NOT a sufficient condition for 3 reasons United States Australia Canada United Kingdom European / North American Comparisons 1.The costs of regulation, including the direct costs and the distortionary market effects of regulation, are frequently prohibitive, perhaps exceeding the expected gains even if the regulation could correct the claimed market failure. 2.The regulatory process can be hijacked by private parties and distorted to their own ends to the detriment of economic wealth. 3.Once created, the regulatory process is hard to stop even if the underlying market failure disappears (elements of the production of the good or service become unsustainable at competitive prices through the market) again to the detriment of economic wealth. (It is not impossible to stop wealth-destroying regulation.) (Example: deregulation of the New Zealand financial services sectors.) 41

© Cumming & Johan (2013)Public Policy towards Venture Capital UK VCTs are remarkably similar to Canadian LSVCCs United States Australia Canada United Kingdom European / North American Comparisons Mutual fund that invests in private equity Similar tax subsidies Similar covenants 43

© Cumming & Johan (2013)Public Policy towards Venture Capital UK VCTs (to 2005)Canadian LSVCCs (to 2005) Riskmetrics Risk-Grades Rank 1-Year Return3-Year Return 5-Year Return Pseudo Beta 1-Year Return 3-Year Return5-Year Return Mean59.0199.027-6.175-34.3950.097-3.664-6.915-6.968 Median54.3905.800-10.000-40.3000.090-4.130-6.370-5.010 Standard Deviation53.87921.61342.79139.0380.0819.8807.7016.738 Minimum1.360-43.600-70.100-82.900-0.030-34.640-26.010-23.840 Maximum381.28086.200191.10095.2000.34026.2005.4601.660 Number of Funds for which data exists in column 72786938471114423 Total Number of Funds as at March 2005 99123 Year of legislation allowing first fund 1995 1983 Quebec, 1988 Federal Canada, 1989-1994 Other Canadian Provinces Aggregate pool of capital in asset class managed as at March 2005 £1.6 billion£4.3 billion Broadly described tax incentives for investors to invest 40% tax relief on individual investments of up to £200,000 (after Finance Act 2004); 20% tax relief on individual investments of up to £100,000 (before Finance Act 2004) The maximum tax subsidized investment in any year is $Can 5000 (£2164). The after-tax cost of a $5,000 LSIF investment made through the vehicle of an RRSP (see section 2) ranges from $1180 to $2390, or roughly 27 to 48 %of the nominal dollar cost of the investment 44

© Cumming & Johan (2013)Public Policy towards Venture Capital Institutional and Other Investors Venture Capital Funds Entrepreneurial Firms Fundraising Returns Supply of Investments Demand for Investments Part II Part I Part III 3 Parts to the Analysis of Government VC Funds Armour and Cumming (2006 Oxford Economic Papers) 46

© Cumming & Johan (2013)Public Policy towards Venture Capital Armour / Cumming Findings Across Western Europe and North America United States Australia Canada United Kingdom European / North American Comparisons 1.Favorable tax and legal environments facilitate the establishment of venture capital and private equity funds and increase the supply of capital. 2.Temperate bankruptcy laws stimulate entrepreneurialism and increase the demand for venture capital and give higher returns. 3.Government programs, by contrast, crowd out private equity investment and lower industry returns. 4.These effects are both statistically and economically significant, and more pronounced that the effects from control variables pertaining to stock market MSCI returns, real GDP growth, patent activity, etc. 47

© Cumming & Johan (2013)Public Policy towards Venture Capital Summary (1/2) Law Matters United States Australia Canada United Kingdom European / North American Comparisons Low EVCA Index better (low taxes and stronger La Porta et al. legal variables) Favorable Bankruptcy Law better (short time to discharge) Law is more important than many of the “economic variables” for investing, fundraising and returns Policy Implication: governments can facilitate VC by improving legislation 52

© Cumming & Johan (2013)Public Policy towards Venture Capital Summary (2/2) Government VC Funds United States Australia Canada United Kingdom European / North American Comparisons Can impede the development of VC markets (Canada / UK model) Can help the development of VC markets (US / Australia model) 53

© Cumming & Johan (2013)Public Policy towards Venture Capital Public Policy for VC and PE Cumming & Johan (2013, Chapter 9) 1.

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© Cumming & Johan (2013)Public Policy towards Venture Capital Public Policy for VC and PE Cumming & Johan (2013, Chapter 9) 1.

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