On the usefulness of tax incentives for informal investors

Abstract

This article analyses the QBIC programme introduced in Quebec to help capitalize SMEs. Taxpayers that invest in holding companies that finance one or more growth corporations receive substantial tax credits. Companies financed by this programme are apparently of mediocre quality. After the financing, the firms' growth is weak and their operational performance is significantly inferior to that of companies of comparable size and sector. The programme apparently does not fulfil its primary objective, to attract angels. On average, capitalization of companies via the programme has diminished. This result is foreseeable because the programme design does not take into account phenomena inherent in the financing of closed companies, namely agency costs, asymmetry and adverse selection.

Key words:

• Public policy
• small business
• financing
• tax incentives
• informal investors

Notes

1 In the US, Lerner (1998) maintains that the most visible effort to encourage individual investors in SMEs has been the Angel Capital Network (ACE-Net). This internet forum allows small businesses to post business plans and communicate with accredited investors. The Canadian Angels Investment Network has similar objectives.

2 Nonetheless, the authors found that the proportion of funds giving rise to the deduction that would have been invested without the programme is between 52% and 87%. The cost per adjusted monetary unit (compared with the scenario where the programme does not exist) is thus between 1.15 (0.55/(1− 0.52)) and 5.08 (0.66/(1− 0.87)). It is therefore uncertain whether the programme is indeed cost effective.

3 The report does not use the term ‘business angels’, which appears later in the literature. It uses the term ‘individual investors external to the firm’, and reports that these investors play a strategic role in the starting and expansion of closed corporations (p. 39).

4 All amounts are in Canadian dollars.

5 All amounts are in Canadian dollars unless specified otherwise.

6 This situation can be traced to the willingness to correct the inequity created by the implementation, in 1979, of the Quebec Stock Savings Plan. This programme grants Quebec investors a tax credit if they buy shares of public corporations, but no such credit is issued if they purchase the shares of a private company.

7 A supplementary exemption, known as the tax-shelter securities exemption, allows the company to increase the maximum number of shareholders to 50 (R.S.Q., Chapter V-1.1 and section 48).

8 According the security laws, a reporting issuer has ongoing reporting requirements with the security exchange commission and its security holders.

9 The programme was suspended for evaluation in June 2003.

10 The number of QBICs differs from that of QCs because 12 QCs are financed by more than one QBIC and six QBICs finance more than one company.

11 The Registraire des entreprises is a government organization that helps protect the economic and social relations of enterprises, associations and the public. Accordingly, it maintains a public register, the Quebec Enterprise Register Computer Centre. It processes, stores and distributes key identification data on associations and enterprises incorporated or operating in Quebec. The mandatory annual form required by the registraire lists the related persons, defined as shareholder, director, chief executive officer, etc.

12 According to Sohl (1999, p. 105), ‘The life-style ventures … have 5-year revenue projections under [US]$10 million and are the “classic” small business. The life-style firm is of no interest to investors.’

13 For a review of the control aversion problem, see Berggren et al. (2000) and Cressy (2002).

14 The programme prohibits a majority shareholder of the operating company from controlling the QBIC. However, the programme makes it possible for two majority owners of the QC to control the QBIC, as well as the sole owner of the QC, his/her spouse and their children.

15 If the signal is costless, false signals can be sent at profit and the signal does not convey any information.

16 We hypothesize that the managers will probably reinvest intensively in the QBICs. If the QBIC shareholders are the managers of the QC, there is no agency relationship and no need for incentive contracts. However, both the design of the programme and the wealth limitation of the managers implied that several other investors will be involved and, indeed, we observe that more than 60% of the QBICs shareholders are neither the managers nor the close family. The agency relationship should then prevail.

17 This principle can be illustrated as follows: if an investor requires a return of 5% on his investment and invests $100 in a QBIC, under the maximum deduction rate, the investor has effectively invested $16 after taxes. To attain the return objective, this amount must be worth $26 after 10 years. The $100 effectively placed can therefore lose 12.6% of its value annually without affecting the investor.

18 The underperformance following the inception can also be traced to the low quality of firms attracted by the programme. We cannot disentangle these two effects. However, the two hypotheses deserve attention. In a standard context of private equity investing, it is expected that firms that perform poorly improve their performance under the monitoring of competent investors.

19 This situation is consistent with the rules of the programme. When three or more shareholders hold all of the shares of the QC, they qualify to hold jointly all of the shares of the QBIC.

20 Source: Investissement Quebec (2001). Consequently, this programme surely attracts a share of love money that the QC would have received regardless of whether a QBIC existed.

21 According to the Bank of Canada, 100 basis points equal 1% and 25 basis points one-quarter of 1%. For example, if the target for the overnight rate is raised from 2.75% to 3%, it has been increased by 25 basis points.

22 The poor quality of firms using the tax incentive programme in Quebec was already evidenced by Suret and Cormier (1997) in their analysis of the Quebec Stock Savings Plan.

23 The ratio of total debt to total assets (not reported) deteriorates sharply on average for each of the cohorts except that of 2001. For the oldest cohort (1998), total debt increases from 53% to 69%. In 2002, the total average debt load of QCs exceeded 70% regardless of the validation year. This debt increases by 20 points or more, since year 1, for all cohorts for which three or more years of data were obtained.