Big Idea 4

1What is the idea?

Canada needs to re-think both the ways firms obtain financing and how infrastructure is financed. We will start by examining the problems of bottlenecks to firm financing.

A common theme that emerged during the roundtables was the difficulty in obtaining financing, which was seen as being partly responsible for Canadian firms failing to scale-up. Problems cited included difficulty obtaining second- and third-stage venture capital, unnecessarily complicated and occasionally incoherent government funding programs and barriers to obtaining financing to commercialize innovations. Furthermore, roundtable participants discussed how government funding programs often compete with private lenders on some dimensions, while failing to address financing market failures on other dimensions. We believe Canada needs to re-invent firm financing, with a focus on addressing the core market and regulatory failures at play. Here are our recommendations on how Canada can do so.

Recommendation: The Cooperative Capital Markets Regulatory System (CCMRS) or provincial governments should create an online finance matchmaking portal (FinMatch) where eligible small and emerging companies can be matched with both private and public providers of capital.

On the demand side for capital, entrepreneurs or companies could apply to join FinMatch, for a nominal fee, at one of three levels. FinMatch would vet applications and successful applicants that met the “listing requirements” for that level would be entered into the system:

Level 1: Pre-startups looking for pre-seed capital for businesses they would like to start.
Level 2: Startups that have been in business less than two years.
Level 3: Established companies that have been in business two or more years.

On the supply side of capital, accredited investors could apply to join the portal with a modest yearly subscription fee. These accredited investors would include individuals, financial institutions, businesses and government entities, such as the Business Development Bank of Canada (BDC) and Export Development Canada (EDC).³⁴ Furthermore, all firms that met the Level 3 “listing requirements” would also be given the option to obtain accredited investor status, which would allow them to act as suppliers
of capital.

FinMatch would act as a matchmaking service between suppliers of capital and entrepreneurs needing funding. FinMatch would suggest potential matches, but members of the system would also be able to view the profiles of other members.³⁵ Within FinMatch, firms could be matched with accredited investors and raise funds in some different ways, including (but not limited to) the following:

a. Loans and other debt instruments
b. Grants and loans from government funding agencies
c. Selling (or buying) whole companies to (or from) other accredited investors

Once a company reached a certain size, it would be able to apply for Level 4 status, which would allow shares in the company to be traded on FinMatch. The Level 4 “listing requirements” would be less onerous than those for firms wishing to list on exchanges such as the TSX Venture Exchange, but would still provide protection to potential investors. As well, the “listing fees” and “annual sustaining fees” would be set substantially lower than those of traditional exchanges.

Our equity market portion of the FinMatch recommendation is adapted from a 2013 recommendation made by the U.S. Securities and Exchange Commission Advisory Committee on Small and Emerging Companies.³⁶ In their Recommendation Regarding Separate U.S. Equity Market for Securities of Small and Emerging Companies, the advisory committee detailed a plan to reduce the barriers preventing high-growth firms from obtaining equity funding. While the proposal was intended for the U.S. market, the first four points of the advisory committee’s proposal are particularly relevant to Canada’s firm-financing ecosystem:

The Committee believes that current U.S. equity markets often fail to offer a satisfactory trading venue for the securities of small and emerging companies because they fail to provide sufficient liquidity for such securities and because the listing requirements are too onerous for such companies.
The frequent failure of U.S. equity markets to offer a satisfactory trading venue for small and emerging companies has discouraged initial public offerings of the securities of such companies, undermines entrepreneurship, and weakens the broader U.S. economy.
Establishing a separate U.S. equity market specifically for the securities of small and emerging companies, where these companies would be subject to a regulatory regime strict enough to
protect investors but flexible enough to accommodate innovation and growth, offers promise of providing a satisfactory trading venue for small and emerging companies, which may encourage
initial public offerings of their securities.
A possible feature of an appropriate regulatory regime for such a market would be limiting investor participation to accredited investors who meet a standard designed to assure that the regulatory protection afforded is appropriate given the characteristics of those investors.

We believe that the creation of such a portal would better match sources of capital with investment opportunities, increase liquidity and make it easier for Canadian companies to scale up through mergers. Canada’s lack of mid-sized firms is a commonly cited reason for the country’s lagging innovation and productivity;³⁷ we believe the merger activity that FinMatch would facilitate would accelerate firm growth and assist aging business owners to receive value for their companies. Finally, FinMatch would make it abundantly clear where the holes in Canada’s firm-financing system are and where government programs are competing with private lenders (and each other).

In an ideal world, there would be a single portal at the federal level rather than separate portals in each province, though it may be possible for the five provinces and one territory that have joined the Cooperative Capital Markets Regulatory System³⁸ to have a single portal. However, given the lack of a national securities regulator, the portals will most likely need to be administered by the provinces.

Recommendation: The federal government should continue negotiations to create a national securities system that includes all provinces and territories.

While we believe FinMatch would be incredibly useful, we also recognize that it is not a silver bullet and would take substantial time to develop. As such, we have additional recommendations, including the following:

Recommendation: Given the positive externalities created by growing knowledge-creating firms, Canadian tendencies towards risk aversion and ultra-low interest rates on government borrowing, we recommend the federal government significantly increase the funds allocated to the Venture Capital Action Plan and implement the recommendations of the auditor general³⁹ as they pertain to selection process, performance measurement and reporting.

The cost of capital for the federal government is incredibly low, with nominal bond yields hovering around one per cent for 10-year bonds and under 1.7 per cent for 30-year bonds, both under the Bank of Canada’s two-per-cent inflation target.⁴⁰ Given this incredibly low cost of capital and the positive externalities created by growing knowledge-creating firms, the federal government is well-positioned to make equity investments in companies. One mechanism it already has at its disposal is the Venture Capital Action Plan (VCAP), which uses a fund-of-funds approach to leverage private-sector knowledge and capital with government investments. We recommend that in Budget 2017 the federal government allocate additional funds to the VCAP. Furthermore, we feel the results of the program can be strengthened by implementing the following three recommendations from the auditor general’s 2016 report on the program:⁴¹

When making investments that are similar to those of the Venture Capital Action Plan, the Department of Finance Canada and Innovation, Science and Economic Development Canada should fully respect the values of fairness, openness, and transparency while meeting the purposes of the investment. Respecting these values will maintain the venture capital industry’s confidence in selection processes run by the Government of Canada.
To appropriately assess the performance of the Venture Capital Action Plan and inform decision making, the Department of Finance Canada and Innovation, Science and Economic Development Canada should expand the Action Plan’s Performance Measurement Framework by considering the inclusion of performance metrics, such as exit performance of recipient companies, recipient
companies’ export growth and their financial performance, new patents and patent citations, and the number of new or additional key investment personnel and lead investors. To increase transparency, the two departments should report publicly relevant information about Action Plan activities and performance.
In formulating future interventions such as the Venture Capital Action Plan, the Department of Finance Canada and Innovation, Science and Economic Development Canada should allow for an early exit of the public-sector partners.

Finally, we believe firm financing should not just be top-down by large financial institutions or governments, but that community investors have a role to play. The State of California created a useful piece of legislation to give residents more autonomy when making investment decisions. AB 2751, also known as the “California Local Economies Securities Act” (CLESA), has the express goal of making it “easier for small businesses, farms, and renewable energy projects to raise money from local investors and to enable California residents to move their money from Wall Street to their local community.”⁴⁰ In our view, the most valuable change the bill offers is to make it easier for citizens to invest in local start-ups. CLESA allows start-ups to sell equity stakes without permit requirements, provided they meet the following conditions: “The business provides basic offering and business information to the public, the total amount raised during the offering does not exceed $500,000, and no individual non-accredited investor invests more than $1,000. Accredited investors would be limited to investing no more than 5 per cent of their net worth.”⁴³ The California state legislature has not passed CLESA, so there is no data on its effectiveness. We believer, however, it still provides a model worth investigating.

Recommendation: The Cooperative Capital Markets Regulatory System (CCMRS) or provincial governments should adopt the “small investments” exemption in the California Local Economies Securities Act (CLESA).

We recognize that many individuals would not have the ability to make direct investments in firms, but would appreciate the ability to invest in local businesses in a broad sense, which leads us to our final firm-financing recommendation:

Recommendation: The federal government should work with financial institutions such as credit unions and social finance organizations to create investment vehicles through which individuals could invest in funds that finance local businesses.

Next, we believe the federal government can improve how it finances infrastructure investments. The prime minister’s mandate letter to the minister of Infrastructure and Communities contains the following priority:⁴⁴

Work with the Minister of Finance to establish the Canada Infrastructure Bank to provide low-cost financing (including loan guarantees) for new municipal infrastructure projects in our priority investment areas. This new institution will work in partnership with other orders of governments and Canada’s financial community, so that the federal government can use its strong credit rating and lending authority to make it easier — and more affordable — for municipalities to finance the broad range of infrastructure projects their communities need. This should include preparing for the launch of a new Canadian Green Bond that can enable additional investments when a lack of capital represents a barrier to projects.

We would expand this proposal and create a Canadian Infrastructure Investment Bank (CIIB) that would be responsible for federal funding of infrastructure projects. We would suggest that the U.S. model created by Korin Davis and William A. Galston in Setting Priorities, Meeting Needs: The Case for a National Infrastructure Bank, be adapted to Canada, with a focus on adapting the following items:

Establish the bank as an independent government-owned corporation (GOC) outside of any governmental agency. This would endow the NIB with greater budgetary flexibility and not unnecessarily narrow the scope of infrastructure projects it could support.
The bank’s leadership structure should feature a CEO and board of directors, some nominated by the president, others by the leaders of the two parties, confirmed by the Senate, serving staggered terms of about six years. Such a leadership model would give Congress some oversight authority but would sufficiently insulate its operations from political whims and create enough of a buffer so that elected officials would neither determine strategic choices or project selection nor be called on the carpet for unpopular or controversial decisions.
Create a division of the bank responsible both for analyzing the viability of proposed projects and for advising those seeking support. A strong and permanent professional staff would provide financial and technical advice to further improve resource allocation.
To achieve leverage, the new entity would have to attract private investor-depositors as well. Its authorizing legislation should be drafted to permit such offerings, subject to the bank’s meeting specific quantitative tests.
Do not limit the bank’s lending to specific categories of infrastructure, such as transportation. Instead, the bank should be free to invest in a wide array of infrastructure projects, including technology, environmental and energy projects, public utilities, or the renovation of schools and hospitals.⁴⁵

Recommendation: Canada should create a “Canadian Infrastructure Investment Bank” (CIIB) tasked with providing financing for infrastructure projects.

Recommendation: Like the Bank of Canada, the CIIB should be at arms-length from the government. The CIIB should be given a five-year mandate by the government, but be free to pursue that mandate in the manner they best see fit, so that projects are chosen on their merits rather than on political considerations.

2Who will be responsible for administering the idea?

The FinMatch portals and Canadianized versions of CLESA will be created by the federal Cooperative Capital Markets Regulatory System (CCMRS) and by each province that is not a member of the CCMRS. The creation of the CIIB and increased funding for the Venture Capital Action Plan (VCAP) will come from the federal government.

3What mechanisms for accountability or measurement can be put in place for the idea?

FinMatch: One of the potential benefits of FinMatch is that it would allow the government to keep track of the performance of companies. This data could be incredibly useful for the designing of economic policy. As well, we would recommend that the government set goals for the performance of the portal (companies signed up, deals completed, etc.) and report once a year on the performance of the portal relative to those goals.

VCAP: We advise the government to put into place the three recommendations from the auditor general’s report.

CLESA: We would recommend that the program be examined once a year by provincial auditors general.

CIIB: We believe the Bank of Canada provides a useful framework that allows the CIIB to operate at arms-length but still be ultimately accountable to the federal government.

4What failures is the idea trying to solve?

Our re-invention of firm and infrastructure funding is attempting to solve some failures, including the following:

Information Asymmetries: An obvious question to ask about the creation of an online financing portal is, “If it’s such a good idea, why hasn’t the private sector done it already?” In some cases, they have, as for the buying and selling of companies at sites such as mybizon.com and successionmatching.com. Private-sector solutions, however, suffer from an information asymmetry problem, where the owners have a great deal of information about the value of the investment that the buyer does not. The buyer can obtain much of this information through the negotiation process, but this imposes significant transactions costs. The proposed portal’s listing and reporting requirements would ensure that potential investors quickly have access to the information they need to make an informed decision, similar to disclosure requirements for publicly traded companies. It is certainly possible that government could simply establish the reporting requirements and that private-sector companies would set up portals. While we prefer this option over nothing, we believe this is an appropriate area for government because of data security concerns and the fact that network externalities and co-ordination effects make having multiple portals inefficient.

Externalities and Tech Spillovers: Governments have a role to play in the financing of knowledge-creating companies, as these firms generate positive externalities through knowledge spillovers (and, as such, will be undersupplied by the market). FinMatch and increased VCAP assist in addressing this externality.

Risk Aversion: Companies at Level 1 of FinMatch can enter the system and determine if there is an appetite for their ideas by potential sources of funding before they have committed too much of their own time and capital. We believe that if FinMatch leads to more high-growth firms in Canada, this will incent others to take the risks of entrepreneurship.

Thin Markets: Making it easier for firms to be matched with suppliers of funding should lead to the creation of more firms (and more opportunities for the creation of new firms), thus thickening markets.

Regulatory Failure: The CIIB is designed, in part, to address the issues of infrastructure projects being chosen on political considerations rather than on their merits. A successful CIIB creates experience in financing and evaluating infrastructure projects on which companies and other levels of government can draw.

5What are the potential benefits of the idea and what are the costs?

Benefits: By making it easier to match sources of capital with investment opportunities (be they investments in firms or infrastructure), on both sides of the transaction, investors get more for their investments, and companies can grow faster and increase trade, benefitting the Canadian economy.

Costs and Risks: Any time individuals are granted more ways to invest their money, we risk opening them up to fraud. As well, government digital programs like FinMatch come with potentials for cost overruns and data breaches.

6Will the idea increase economic inclusion and/or enhance autonomy? If so, how?

Economic Inclusion: One of the goals of a reinvention of firm financing is to make it easier for people with great ideas but not a lot of capital to obtain funding. Obtaining superior value along with leveraging private-sector funds when financing infrastructure projects allows the government to build more infrastructure per dollar spent, benefitting all Canadians.

Autonomy: By allowing individuals to invest in their local communities, we are giving them the opportunity to regain economic autonomy. This increase in autonomy helps “solve” the ketchup
problem, where individuals are desperately looking for an outlet to assist in the economic development of their communities. Furthermore, by making it easier for people to start new businesses, we are giving them additional options.

34 The Ontario Security Commission’s accredited investor exemption includes individuals of sufficient financial means along with individuals who currently are, or once were, a registered adviser or dealer, other than a limited market dealer; financial institutions; governments and governmental agencies; insurance companies; pension funds; registered charities; certain mutual funds, pooled funds and managed accounts; companies with net assets of at least $5 million; persons or companies recognized by the OSC as an accredited investor. The accredited investor exemption, (Ontario Securities Commission, 2016).
35 Subject to the user’s privacy settings. Privacy would naturally be a concern in a system like FinMatch, but we believe dating websites provide a good template for allowing users to decide who can access parts of their profile.
36 Security and Exchange Commission, Recommendation Regarding Separate U.S. Equity Market for Securities of Small and Emerging Companies (2013).
37 What’s Happened to Canada’s Mid-Sized Firms? (Business Development Bank of Canada, 2013).
38 As of August 2016, British Columbia, New Brunswick, Ontario, Saskatchewan, Prince Edward Island and Yukon are members of the Cooperative Capital Markets Regulatory System. (Cooperative Capital Markets Regulatory System, 2016).
39 Office of the Auditor General of Canada, 2016 Spring Reports of the Auditor General of Canada, Report 1 — Venture Capital Action Plan (2016).
40 On August 26, 2016, the yield on a 10-year bond was 1.090 per cent, whereas the yield on a 30-year bond was 1.687 per cent,Market data, (Financial Post, 2016).
41 Office of the Auditor General of Canada, 2016 Spring Reports of the Auditor General of Canada, Report 1 — Venture Capital Action Plan (2016).
42 Sustainable Economies Law Centre, California Local Economies Securities Act (2016).
43 Sustainable Economies Law Centre, California Local Economies Securities Act (2016).
44 Office of the Prime Minister, Minister of Infrastructure and Communities Mandate Letter (2015).
45 Korin Davis and William A. Galston, Setting Priorities, Meeting Needs: The Case for a National Infrastructure Bank (Governance Studies at Brookings, 2012).

About the Authors

Dr. Mike Moffatt is Senior Associate at Canada 2020. He is also an Assistant Professor in the Business, Economics and Public Policy group at Ivey Business School at Western University, where he teaches courses in international trade and firm-level strategy. Mike is Director of Ivey’s Lawrence National Centre for Policy and Management, a public policy centre that is taskedwith bridging the gap between business strategy and government policy.”