Why Canada needs to extend flow-through shares to the innovation sector now

Flow-through shares (“FTS”) are a uniquely Canadian innovation.

The structure is a key driver in bringing risk capital and the resource sector together. The Canadian government introduced the flow-through share instrument over 60 years ago via the Income Tax Act. A flow-through share provides tax incentives to investors by enabling resource companies to “flow through” eligible exploration and development expenses to FTS investors. The investor is able to deduct these renounced expenditures against their income.

The product was an important stimulus for bringing risk capital to the resource sector and it became a catalyst for Canada to become one of the resource finance capitals of the world.

I would argue the innovation sector shares a number of similar characteristics. At their core, companies in both sectors often face significant expenditures well before commercialization. While Canadian investors have become comfortable with the risk/reward aspects of resource companies (as evidenced by the total financings in Canada every year), the appetite for risk with respect to technology companies is scarce, albeit improving.

There have been a number of articles supporting FTS for the Innovation sector; however, Financial Post business writer Kevin Libin recently examined a number of concerns.

The story keys in on two major issues. In one study (in the period between 2008-2012), it showed investors lost about 50% of their investment in FTS and small issuers performed much worse. The second significant concern is the tax revenue the government forewent (estimated at $440 million in tax revenue per year between 2007 and 2012).

I see strength in Canadian knowledge-intensive sectors. The problem is that many of these companies do not have sufficient access to risk capital.

Mr. Libin makes a direct parallel to the innovation sector without any support for his view, nor does he suggest ideas to improve the existing framework such that these issues are mitigated. He argues the FTS idea for the innovation economy “is based on the idea that a Canada weak in these knowledge-intensive sectors needs government policy to help make us stronger.”

I would argue something quite different. I see strength in Canadian knowledge-intensive sectors. The problem is that many of these companies do not have sufficient access to risk capital. This is a different argument.

I see the two main issues of FTS in the resource sector in a different light with respect to the innovation sector. First of all, public Canadian technology companies tend to outperform most sectors, especially resources. For example, the S&P/TSX Capped Information Technology index 3 year annualized returns were 17.9% ending December 31st, 2016 versus the S&P/TSX Composite of 7.1% (5 year annualized returns were 19.0% versus 8.3%, respectively). Both the S&P/TSX Oil & Gas and Materials indices have produced negative returns over the last 5 years. There is a much lower percentage of “drill and hope” companies in the innovation sector. Second, technology companies’ largest expenditure category is people – and thus will also have a much higher proportion of Canadian employees, on average, than resource companies that utilise FTS. This is a major differentiator: a significant portion of the foregone tax revenue may be offset by increased revenue from personal income tax.

Prior to joining the venture capital community, I was a sell side equity analyst for 15 years. There are no shortage of solid public companies who would benefit. I can think of dozens of public companies that, at one point in time, needed and often struggled to raise $5 to $10 million and then were acquired for multi-hundred million dollar price tags. Several have broken through the billion dollar mark. The current and former Federal Government have introduced a number of policy initiatives in the venture capital industry to spur growth. However, there is not a single path of capital sourcing for technology companies. There are only so many Shopify-type examples of consistent rapid growth and fundraising.

Canadian investors have developed a risk appetite for the resource sector. The use of flow-through shares will introduce a larger group of investors to the technology sector and further develop comfort investing in innovation over time.

I believe the Government of Canada should treat the innovation sector with the same importance as the resource sector. The Government has been seeking new ways to fund innovation yet there is an existing system (FTS) in place that has proven it can flow large capital to risky ventures. At a minimum, it should institute a pilot project. Insure its not a hand out. Technology companies who want to qualify for flow-through should meet a set of criteria consisting of minimum capital raised threshold (outside the FTS structure) and tests on the number of Canadian employees. As importantly, we should measure the impact of the program and refine where necessary.

Canadian investors have developed a risk appetite for the resource sector. The use of FTS will introduce a larger group of investors to the technology sector and further develop comfort investing in innovation over time.

There are many ways to morph Canada’s economy toward one that has a greater balance of growth companies. Flow through shares are one of those ways the balance can be tipped to create a better, more diverse future for everyone. The mining and oil & gas sectors will continue to play a large role. However, technology companies should not have to take a back seat in capital allocation decisions.

Canadian innovation. Let it flow.

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