The Economist put out a great film on Startup Culture
On July 18th of this year the Finance Department released proposal relating to the taxation of private corporations in Canada. The stated goal was to ‘level the playing field’ and eliminate unfair tax advantages enjoyed by Canada’s wealthiest taxpayers. They have tried to suggest that this will only affect the so-called ‘one per cent’.
I actually applaud the Finance Minister’s intentions here. The problem is that their proposals are very poorly thought-out. I have already seen the damage for one of my small business clients.
The business community and the tax administrators have a kind of necessary competitive tension. Sometimes this translates into Finance drafting measures in an attempt to win. The proposals are very complex and pretty much impossible to discuss intelligently with the uninitiated.
I have the benefit of more than 30 years of experience working in the income tax field. I’ve been a tax auditor with the CRA, a senior manager in a tax specialty with one of Canada’s Big 4 accounting firms, taken the CPA’s In-Depth Tax Course and spent 3 hours of professional development time this summer studying the proposals. The proposals are complex and cannot be discussed intelligently in the media or on talk shows.
The average citizen simply doesn’t have any idea about the theory of tax integration. The tax system was designed generally so that it shouldn’t matter whether income of a certain kind was earned directly by an individual, or through a corporation and then flowed out to the shareholder as wages, dividends or whatever. Mostly this works.
Perhaps because technophiles in the Department of Finance believe they have out-smarted the competition, they are not open to change and are instead hunkering down trying to withstand the massive backlash this has caused in the business community.
I represent a small business client who recently sold his business after about 10 years. The value in the business was a combination of goodwill and intellectual property. All in all, pretty standard for a service-based businesses (software in this case).
So of course he would simply use up his capital gains exemption right?
That is actually pretty hard to do. No lawyer worth his salt would allow his client to purchase shares in a privately held corporation. They would invariably be worried about skeletons in the closet – and rightly so. That is one of the main problems with the capital gains exemption.
The business community needs to urge Finance to consider better legislation to facilitate arm’s length sale of assets when a small business owner sells his business. Small businesses are mostly service businesses, and their assets typically intangibles like goodwill or intellectual property. Nobody likes to pay very much for these kinds of assets, since the purchaser can’t deduct the costs very efficiently.
The capital gains exemption was introduced by a pre-Harper conservative government. Typically it was aimed at wealthy Canadians. It originally allowed for a $100,000 tax-free capital on public company shares and other passive investments. Heck I even got my late father to benefit – even though he didn’t really need it. While subsequent governments eliminated the $100,000 portion related to passive investments, the program has continued and even been expanded for qualifying small business corporation shares amongst other things.
However it remains awkward to use in true arm’s-length sales. Predictably the accounting profession has worked long and hard to find ways to use it for estate planning with their high net worth clients. In their lust to defeat this kind of tax planning, the Finance Department has proposed fiddling with rules related to the capital dividend account. That might work to defeat some of the more egregious tax schemes for high net worth taxpayers.
However it would also cause excessive – and I believe unintended – tax to be payable by my client trying to sell his software company.
The worst thing about these proposals however is the way in which the Liberals have allowed technophiles in Finance to score points against their adversaries in the accounting profession – instead of building good tax policy. The Liberals lost sight of “sunny ways” when it comes to tax fairness.
It attempts to address benefits enjoyed by one – admittedly annoyingly self-entitled – part of society (i.e. wealthy professionals). However it also ignores another equally smug and self-entitled group of Canadians:
Public sector workers who enjoy health benefits and indexed pensions that are the envy of everyone in the small business world.
I live on Pender Island which is a strange mixture of farmers, small business people, former hippies and retirees from the public sector. Retired government employees will support the proposed measures because it targets someone else and ignores fact that public sector workers in the province routinely take early retirement and have the benefit of full health coverage and indexed pensions for the rest of their pampered lives. The small business community is already taking aim at public sector workers, as they gear up to fight these proposals.
The Finance proposals are playing to the politics of envy. Instead the Government needs to look at evidence-based policies to improve tax fairness. They need to embrace the notion of “sunny ways’. If the Government can avoid vilifying Donald Trump in public for the sake of NAFTA negotiations, surely they can do the same for Canada’s wealthiest professionals in the interests of developing a fairer tax system.
Instead of punishing tax professionals and their high net-worth clients for developing innovative new tax planning strategies – render many of them expensive and pointless by extending income splitting to ALL Canadian couples. Heck – if you think of it, it’s only reasonable. And it will benefit public sector employees, seniors and the 45% of BC residents who work in small business.
Do they want to go to the electorate in 2 years having alienated 45% of the population (i.e. the self-employed and people that work for them)?
In the same way, instead of penalizing public sector employees by taxing their (gilt-edged) benefits, allow ALL Canadians to directly deduct medical expenses from income. This would be a vast improvement on the miserly tax credit available to most of the self-employed AND their employees (in BC 45% of working population). It would also be important for seniors who don’t have indexed, public sector pensions and health benefits.
Stephen Harper started using the CRA as a weapon against environmentalists and anti-poverty groups. I have already seen the beginnings of the politics of envy amongst CRA auditors, who appear to be using their powers arbitrarily against small business owners. This invariably is felt by small business owners who don’t simply get T4s from their employer. Unlike employees, the self-employed have to self-assess tax. Navigating the complexities of GST, PST, payroll (think of the “Phoenix Payroll System” debacle) and income tax isn’t for the faint of heart. I could relate numerous anecdotes in the last year or so, within my own practice.
My point is, let’s keep it positive (‘sunny ways’). Speak to the value of ALL Canadians, whether they work for large businesses, government or for small businesses. Don’t pit one group against another. That kind of divisive approach won’t end well.
According to Startup Genome 2 of the top 20 startup ecosystems in the world are located in Canada.
Vancouver (No. 15)
The Vancouver startup ecosystem is currently comprised of 800-1,100 startups and shining success stories. In the early days Slack’s founder estimated the market for the software to be $100 million, which they exceeded in just three years—and have now become the fastest growing business software of all time.
Broadband.tv is now the third largest video streaming site in the world after Facebook and Google.
The dating app Plenty of Fish sold to Match.com for $575 million.
Bitstew exited in 2016 for $157 million – accounting for the largest exit in Canada last year, while TIO Logic exited for $233 million within the first few months of 2017
Toronto-Waterloo (No. 16)
The Toronto-Waterloo Corridor stretches from Toronto, Canada’s largest city and financial center to the Waterloo Region, which boasts the second highest density of startups in the world and is the headquarters of some of Canada’s largest tech companies.
These two startup ecosystems have been considered separately in past rankings. However, over the past year, there have been strong signals that the region is increasingly behaving as one ecosystem. Overall, an estimated 2,100-2,700 startups thrive thanks in part to world-class engineering talent, strong entrepreneurial culture, an aﬀordable rental market, and a global base of customers.
On January 16, 2017 the Alberta Government has introduced a new Alberta Investors Tax Credit, providing a tax credit for investments in private, early stage companies in Alberta (Dentons).
Under the terms of the legislation, the province provides tax credits of 30% calculated on the gross amount of the investment. For individuals the tax credit is refundable, so individual investors will get a tax refund if their Alberta tax liability is less than $30,000. For corporate investors, the tax credit is deducted from tax otherwise payable.
A quick read of the review by Dentons indicates that it was copied almost word for word from BC’s Small Business Venture Capital Act. It seems that both provinces cap the tax credits each year at about $30 million, so businesses need to register early to avoid disappointment.
In BC, if companies arrange for offerings that are eligible, they need to quickly file Share Purchase Reports to ensure that their investors receive the tax credit. So waiting until the end of the calendar year isn’t advisable.
The US introduced a new “refundable” tax credit for startups. Commencing in 2017, companies will be able to apply up to $250,000 to offset payroll withholdings on behalf employees.
According to Miller & Chevalier, CPAs:
For purposes of the credit, a “qualified small business” is an employer with gross receipts of less than $5 million in the current taxable year and no more than five taxable years with gross receipts. Qualified small businesses may claim the R&D payroll tax credit in tax years beginning after December 31, 2015.
It appears that the applicable amount of the federal credit is capped at $250,000 per year – for a maximum of 5 years. The effective amount of the benefit federally appears to be about 10% of qualifying wages (“QREs”) – compared with 54.25% in Canada. If QREs exceed $1 million Canadian, the percent will start to decline. State incentives for R&D include job credits, R&D tax credits and a variety of investment credits.
Hopefully Canada’s Federal Government will take this into account in their review of supports for the knowledge-based industry ecosystem.
As CPAs we are bound by the pronouncements of the Chartered Professional Accountants of BC. CPA firms that provide what are known as “assurance services” are required to have their clients adopt 1 of 2 competing financial reporting regimes:
- Accounting Standards for Private Enterprises (“ASPE”)
- International Financial Reporting Standards (“IFRS”)
According to a brochure put out by PwC LLP in 2011 – ASPE or IFRS? –
Private enterprises should consider ASPE as the best
alternative if they have:
• No plans to access public equity markets
• No plans to access public debt markets
• Signifcant domestic competitors, customers and suppliers that
• Current reporting that is relatively simple with minimal accounting
• Minimal reliance on benchmarking and comparative analysis
• No immediate transition plans; goal is to maintain business within
family or private individuals
• Minimal or no external equity investors who may have different
views of the enterprise’s future
• A mentality of ‘simpler the better’
• Minimal accounting resources to spend on training, education
• An intention to stay within a familiar principles-based
• Prepare fnancial information principally for owners, lenders and
Private enterprises should consider IFRS as the best
alternative if they have:
• Signifcant competitors, suppliers or customers in jurisdictions that
already adopted IFRS
• Plans to issue equity for growth or expansion through an Initial
• External fnancing and the enterprise’s intentions are to provide a
consistent platform for bankers and credit analysts
• Sophisticated users of fnancial statements
• Plans to expand operations globally
• Complex operations dealing with fnancial instruments or
• Signifcant partnership with foreign companies, investors or public
• An intention to hold themselves to public company standards
• Competing against public companies for access to credit
• A transition plan that includes a possible sale to a private equity
investor or public company
• A foreign parent company or foreign subsidiaries who already
report in accordance with IFRS
• Plans to access capital or debt markets outside of Canada
• Plans to maintain fnancial reporting on the same basis as their
public company competitors to help with benchmarking
So Which Framework Should Your Company Choose?
For most of the 98% of BC companies that have fewer than 50 employees (and many of the ~7,500 “large” private companies as well), assurance services are seen to be too expensive. Hence most CPAs prepare “non-assurance” compilations for the majority of their clients (aka “Notice To Reader” financial statements). When we compile financial statements for our clients, we’re expected to refrain from implying that the statements were prepared in accordance with Canadian GAAP (either ASPE or IFRS).
So until your company is prepared to pay the price for assurance services, you’ll not actually be using either standard. In fact you might be better to embrace a completely different non-GAAP framework.
US TINY “GAAP”
In 2013 the American Institute of Certified Public Accountants (“AICPA”) introduced a Financial Reporting Framework for Small and Medium-Sized Entities. Much of it was based upon Canadian GAAP which was more principles-based than US GAAP. Presumably the new framework was in response to complex financial reporting requirements mandated in 2002 by Congress and the SEC in response to earlier financial scandals (Enron and Worldcom).
The “FRF for SMEs” accounting framework draws upon a blend of traditional accounting principles and accrual income tax methods of accounting. It utilizes historical cost as its primary measurement basis. In addition, it provides management with a suitable degree of optionality when choosing accounting policies to better meet the needs of the end users of the fnancial statements. The framework eschews prescriptive, detailed standards and voluminous disclosure requirements. Being a more intuitive and understandable framework for small business owners and the users of their financial statements, the framework lays out principles that encourage the use of professional judgment in the particular circumstances of a transaction or event.
While the AICPA is quick to point out that the framework is not GAAP in the US, it seems likely that it will eventually take hold there as a kind of “tiny GAAP”.
WHAT REPORTING FRAMEWORK SHOULD STARTUPS USE?
The trouble with startups is that most aren’t yet businesses. They are more likely to be in the process of defining their core business. Before you know exactly what you are, choosing a financial reporting framework based upon PwC’s decision tree (above) is a bit premature.
Since a startup is expected to spend at least 4 to 7 years in the wilderness without preparing audited (or reviewed) GAAP financials, whatever option is eventually chosen will require a re-statement. This will invariably be needed to comply with whatever flavour of GAAP is selected.
However the chances are that most startups won’t produce an exit for its founders by way of an IPO. Faced with the precipitous decline in the number of US pubco listings since 1996, an article published in Bloomberg View mused:
Are small closely held companies looking for an exit via acquisition or merger rather than an initial public offering?
If an acquisition is the far mare likely route, startups must consider whether their acquirer will be US-based. In fact it also quite likely that some investors will be US-based as well. In any event using the AICPA’s FRF for SMEs won’t be much of an impediment for most startups. It’s not that you will likely provide fully compliant financials in any event. However, you should probably avoid financial statement presentation that is clearly at odds with that framework.
Old style politicians tend to prefer direct funding programs because they can trumpet their successes – in other words they provide photo opportunities. Since direct funding programs generally involve a selection process, that also provides opportunities for politicians to sell their influence.
That simply isn’t true for the SR&ED program, since tax information is confidential – and taxpayers have a right in law to funding if the meet the eligibility requirements.
In the current review of the effectiveness of different approaches to encouraging innovation, some key voices are speaking out against SR&ED and other so-called indirect programs. This began a number of years ago with the Jenkins Report and other conservative voices in academia and the business press. Too many of these pundits confused Adam Smith’s “invisible hand” with “the hand of God”.
While there clearly are issues with the way the administration of the SR&ED program has evolved, it is still a valuable program – particularly for early stage technology programs. Finding effective ways to fund growing businesses has always been difficult. According to an article published by fundable.com:
…less than 1% of startups are funded by angels or VCs. The article points out that startups are 3 times more likely to rely on crowdfunding than they are to attract arm’s-length investors…
So how well does equity crowdfunding work?
On April 5, 2012 President Barrack Obama of the United States signed the JOBS Act into law with a remarkable level of bipartisan support. The intent was to update the U.S. Federal Security laws and make it legal for entrepreneurs to use crowdfunding to raise a limited amount of early-stage equity-based financing. Congress gave the Security Exchange Commission 270 days to draft the rules necessary to implement the legislation.
However it wasn’t until May of 2016 that crowdfunding portals in the US were open to anyone other than “accredited investors”. A few months earlier – in February of 2016 – the BC Securities Commission introduced regulations that allowed startups to raise small amounts of money from BC-based Crowdfunding portals…
A quick review of the National Crowdfunding Association of Canada’s directory (see above) reveals just how much this resembles the wild west. Many of the BC portals have abandoned their websites, some portals have no listings – and the busiest I found showed a single active listing, along with many “future listings”.
One of the equity portals listed – seedups.ca – has already pivoted away from its origins as an equity crowdfunding portal:
“We have evolved to be better aligned with the needs of these companies and the investors wanting to back them by focusing our efforts on a lead investor, member network model. As a result of these changes, we are no longer operating as a crowdfunding portal.”
Given the current state of flux in this sector, it may be wisest for early stage companies to look at crowdfunding as a way to launch creative content (eg. video games or internet-based tv series) or new products using Kickstarter or Indiegogo…
The upfront compliance and regulatory costs associated with equity crowdfunding are very high. Admittedly it costs less than going public, however existing equity crowdfunding portals don’t appear to have much, if any traction. As a result those upfront costs will almost certainly be stranded.
In BC where I practice, small business (50 or fewer employees) accounts for 55% of private sector employment (Source: BC Stats – Small Business Profile 2016). If politicians want photo opportunities and political donations, it makes sense to focus on direct funding approaches. If they want the economy to work, they should support and enhance the SR&ED program.
Companies that are seeking private equity from angel investors or angel groups should understand that they will need to withstand some degree of financial due diligence. Depending on the sophistication of the investors, the degree of rigour applied can vary a great deal. Regardless, it is best to clean up your financial information and assumptions to get rid of the rough edges before you present them to potential arm’s length investors.
At a recent meeting of Keiretsu in Vancouver, BC – I had a chance to review financial information provided by 6 companies presenting information to the group. Each of these had significant rough edges in their financial presentations – most of which can be categorized in one of 3 ways:
- EXCESSIVELY HIGH VALUATIONS
- FINANCIALS THAT DON’T CONFORM TO GAAP
- UNREALISTIC REVENUE PROJECTIONS
In fact most exhibited at least 2 key sticking points in their presentations, any one of which would give prospective investors pause during due diligence.
In their first year of operations, one company expected to spend $400,000 in development costs with no revenue. They are looking at a pre-money valuation of $3.5 million before the end of the year.
In their second year of operations with projected revenue of about $700K and a monthly burn rate of $250K, the company is looking for a pre-money valuation of $10 Million.
In their second year of operations the company experienced a fourfold decrease in revenue and a $1 million loss – compared to a break even year in their first year. They explain their $7 million pre-money valuation based upon a “pivot” in the second year.
The company experienced a $250K loss in the first 3 quarters of the current year. They are now projecting a $250K profit for the entire year and based upon that they are looking for a pre-money valuation $12 million. This is down from $15 million post-money valuation from an earlier round.
FINANCIALS THAT DON’T CONFORM TO GAAP
Company showing a negative inventory of $65,000. This presumably arose when the bookkeeper made an entry to correct cost of sales. Effectively it is impossible to have negative inventory. That probably represents revenue, a liability, or simply a posting error. The thing is, when you’re presenting to investors, get your CPA to ensure that they make sense before you distribute them.
Company with half of their $800K of assets represented by other assets – which remains identical from one year to the next. Given the nature of the business, the assets were probably development costs. Since the company is in a loss position – and has never been profitable – they would not meet the standard for capitalization under generally accepted accounting principles(“GAAP”).
UNSUBSTANTIATED EXPONENTIAL GROWTH
Since angel investors are looking for exponential growth, it is pretty much expected that investee companies will project exponential growth. However it strains credibility if you project 200 times revenue growth in a single year. Most of the rest of the companies in my sample used 10 times growth at least once in their projections – which is almost certainly way too optimistic.
While most presentations by startups feature some or all of these 3 key financial sticking points, angels themselves have developed interesting “back-of-the-napkin” approaches to deal with some of these problems:
MILLION DOLLAR DOG FOOD RULE
“No deal is worth more than a million dollars unless some dogs are paying to eat the dog food!” (i.e. unless there are customers)
DOUBLE HAIRCUT METHOD
This method assumes that most founders will overstate revenue in year 5 by at least 75%. That means halving the revenue projection twice in year 5. It also assumes the same level of capital as required in the original forecast.
TWICE AND A HALF RULE
Assumes that twice the amount of capital will be required to achieve half of projected revenue in year 5.
Recently I spoke to one of the founders of a medical device company who was looking to go public in order to fund the development and regulatory approvals for their new products. Assuming that the company accurately projects their capital needs at $4 million I thought it would be a useful exercise to look at the impact of the decision to go public on the company’s burn rate.
To begin with I looked at a study published by PwC in 2014 –
According to PwC estimates:
How much can the costs of going public add up to?
Underwriter costs for an IPO – up to 10% of the proceeds.
Legal, audit and accounting costs – from $200K to $500K for a smaller offering
Marketing and road show costs ?
Miscellaneous costs (eg. printing costs, filing and transfer agent fees)?
What’s more many of these additional costs are ongoing.
Based on this analysis at least half of the cost is directly attributable to going public too early in the life of the company. Given that this is a medical device company, the cost of foregone SR&ED refunds could easily exceed the IPO and maintenance costs.
Ideally going public should be seen as a possible exit for Series A or Series B investors instead of a strategy for raising money for a development stage company.
A few years ago I watched as a young colleague with an MBA took it upon himself to advise the proprietor of a crepe stand about operations and business strategy – in exchange for a free crepe. As a former journeyman chef I was amused by the exchange. It was clear to me that my colleague’s advice was vastly overpriced.
Last week I served on an advisory panel for early stage companies at Innovation Island on Vancouver Island.
One of the participants seemed to be struggling with too much advice. The presenter had stopped working “in the business” in favour of working “on the business”. When I heard that I couldn’t help thinking that someone lifted that line verbatim from an introductory management consulting textbook.
In the past year or so the company had successfully sold their services to at least 3 large government organizations – which isn’t trivial for a small startup on northern Vancouver Island.
However the presenter seemed to think that selling services isn’t scalable – and that the company wasn’t a good fit for a seed round. I had to ask myself who got to them. It seemed to me pretty likely that one angel investor couldn’t see the potential – and they took it to heart. Based upon one man’s opinion they had decided their only option was to bootstrap the business themselves.
Some years ago I read an opinion piece by an intellectual property lawyer. He recommended that a startup developing IP should keep it close to the chest until they secured investment. He didn’t like the idea of using the IP in services in order to prove out the technology. Maybe that works for an IP lawyer who gets paid when the IP is protected – but it sounds like bad advice to me. How does a startup know whether their IP is worth protecting until they established that it’s useful?
How do you know that a minimum viable product is viable unless a customer has tried it out?
If an angel investor doesn’t want to invest in your company, it doesn’t mean that you don’t have something. It could simply be that the particular angel investor doesn’t understand it and can’t see it. If instead you hear the same refrain from a number of investors – maybe you should take it seriously.
If you’re getting advice, you really have to consider the source.
Technology companies – in fact most small businesses – often have difficulty taking advantage of the recently enriched lifetime capital gains deduction. When first introduced the capital gains deduction was targeted the first $500,000 of capital gains on family farms and qualified small business corporation shares (“QSBCs”). Since then the lifetime capital gains limit has been increased to $806,800 for QSBCs and $1 million for family farms.
However it is always difficult for sellers to sell shares. Buyers prefer to buy assets for 2 reasons:
- The cost of shares is not deductible by the buyer against income – while most assets are at least partially deductible
- Shares of small business corporations are much more complex beasts to acquire and may include undisclosed liabilities or other “surprises” that buyers are understandably nervous about acquiring
Buyers and their legal representatives will typically discount the purchase price if the vendor insists on selling shares. In some cases buyers simply won’t consider acquiring shares.
Many small, private corporations have at least a few skeletons in their closets. Closely-held companies often operate a little too close to the line and sophisticated buyers will often engage professionals to uncover at least some of these.
As a former senior manager with PwC LLP in Vancouver I was seconded to a due diligence team looking at the potential acquisition of a technology company. As it happened, the target company was one of a number of companies owned by the same entrepreneur. The entrepreneur had separate accounting firms handling each of his companies.
The problem was that he never informed his accountants of the existence of the other companies. Each year he filed for refundable SR&ED tax credits with one of his companies. Presumably his accountants were unaware of the existence of these other companies, since they were not disclosed on the tax returns as “associated” corporations.
Because of the amount of taxable income of the associated group, the corporation would not have been entitled to high-rate refundable tax credits. Thus any purchaser could be on the hook for undisclosed tax liabilities – and penalties – in the millions of dollars.
Of course it isn’t only undisclosed tax liabilities that could surface after an acquisition. There could be problems with employees, former employees, customers or suppliers. With small corporations eligible for the lifetime capital gains exemption, financial statements are often merely compiled with little or no assurance from the public accountants drafting the statements.
For that reason most accounting and legal professionals will advise buyers of QSBCs to purchase assets – or to discount the purchase price and conduct significant due diligence before determining that price.
CAPITAL DIVIDENDS AS AN ALTERNATIVE STRATEGY
Technology entrepreneurs looking to sell their companies should understand that the value of their companies is most often determined by the value of their IP.
Eligible capital property of a business is intangible capital property, such as goodwill and other “nothings”, the cost of which neither qualifies for capital cost allowance nor is fully deductible as a current expense in the year of its acquisition.
Selling intellectual property developed by a technology company results in a gain on disposition of eligible capital property. These types of gains are similar to capital gains – in that only 1/2 of the gain is taxable. The remaining un-taxed half can be distributed tax-free to shareholders via an amount paid out of the capital dividend account (“CDA”).
So rather than selling shares – typically at a discount – the entrepreneur keeps the company and sells the IP within the company. So the sale price is higher, the sale is only partially taxable and may even be shielded by non-capital losses, SR&ED ITCs or SR&ED expenditure pools within the company. When the proceeds are distributed, the company can elect to pay dividends from the CDA account.
While this works well for technology companies that have IP, it can also work for any corporation selling goodwill as well. Of course buyers will typically attempt to structure their purchase so that proceeds are allocated more to tangible assets which can be depreciated more quickly.
CASH VOUCHERS ($2,500-$7,500) TO EMPLOY STUDENTS
The BCIC Innovator Skills Initiative offers BC-based technology companies from $2,500 to $7,500 to hire post-secondary students.