American VC Is No Fan Of Section 116

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By Shawn Lawrence

In the February issue of Biotechnology Focus we introduced our readers to Section 116.

We looked at the issues and concerns surrounding it from the point of view of lawyers from both the U.S. and Canada.

This month we revisit the same issue, but this time from the point of view of a U.S. venture capitalist.

Charlie Lax is the founder and Managing General Partner of GrandBanks Capital., a VC firm based in Boston that has a track record of investing in Canadian entities.

Lax’s own investment career has included investments in 41 portfolio companies, which have resulted in 30 exits thus far.

He has written extensively of how current Canadian tax regulations make it particularly costly to invest in Canadian companies and likewise why tax regimes like Section 116 are partially to blame for Canada’s fledgling VC industry.

Lax echoes the concerns of Canada’s Venture Capital and Private Equity Association that Section 116 is destroying Canada’s venture capital industry and posing a significant challenge to investors from across the border wishing to invest here in Canada.

“If Canada wants significant US venture capital to flow north, they’ll listen when I tell them to eliminate Section 116 certificates immediately,” he states.

“Generally, it’s a cumbersome and expensive process, where essentially, the Canadian government is trying to tax our profits before they get back to our limited partners and that goes against the way venture capital and private equity firms work,” he said.

Specifically, while some LP’s are taxable entities, a number of limited partners are tax free entities, like foundations, schools, endowments, pension funds and plans.

“The way it should work is our LP’s get the money individually and then they’re taxed on an individual basis just like it’s an investment on any other thing.”

He explains that rather than dealing with the hassles or exploring the loopholes in Section 116, many U.S. investors look upon the troublesome tax rule and avoid investing in Canadian companies altogether. If t wasn’t for his knowledge of these loopholes, his company would have ceased investing north of the border long ago.

“At GrandBanks Capital, we’re not afraid of Canada – in fact; we’ve invested in four excellent Canadian companies that have $120 million in capital. But Firms like mine must create an exchangeable share structure in which we invest in a Delaware Corporation that acts as the parent of the Canadian investment. The drawback is that it is what I would call the full employment act for lawyers. This expensive workaround costs us dearly, sometimes anywhere between $200,000 to $400,000 U.S. Keep in mind that this is money that could be invested in the creation of GNP behind talented Canadian entrepreneurs rather than filling the pocket books of lawyers.”

While his firm can afford these types of expenses, many U.S. investors can’t.

Couple this with the fact that legal expenses for the same type of Series A investment on an early stage startup in the U.S. will only cost his company between $35-70,000 one has to question the logic of coming north of the border.

“That’s why the number of investors that will do deals in Canada on an early stage basis is pretty thin, it’s just too expensive. The whole idea of having to go around the 116 model and spend a quarter of a million dollars plus to do a deal with lawyers is a total waste of money, time and it’s brain dead stupid. I don’t have to do that with investments that I make in London (U.K.), it doesn’t cost me that kind of money when I invest in Israeli based companies and it doesn’t cost me that kind of money when I invest in Asia. It costs me that much money only in Canada,” he said.

As such Lax feels Canada needs to follow the lead of other countries that recognize the critical role venture capital plays by offering full transparency on cross border deals. He feels this will improve access to venture capital for Canada’s promising knowledge-based economy.

“The Canadian government has been talking about fixing this problem for many years and the Canadian venture capital association will openly tell you that there is no venture activity in Canada. So you need the money from the U.S and the best way to do that is get rid of 116, allow full transparency for the U.S. to invest in Canada and Canadian investors to invest in the U.S. so that when we do Delaware corporations, We don’t have to do this exchange share model. Get rid of it and then more money will flow across the border.”

And should the Canadian Government ever decide to close the loopholes?

“If they change it, I’ll figure out another way to get around it, and if they close all those loopholes and there’s no way to get around, in no uncertain terms I’m out of there. Enjoy your oil revenue you’re not getting anymore money out of me.”