David Ross, CEO, Ross Video Ltd

How to use SR&ED to reverse the decline of Canadian-owned mid-sized companies

By David Ross

Canada doesn't have an innovation problem, it has a commercialization problem. This article explains this problem, the causes, and offers several concrete suggestions. In particular, a subtle but critical tweak to the SR&ED funding formula will reverse the decline of Canadian owned mid-sized companies, and allow them to evolve into large Canadian global powerhouses.

We have a crisis in mid-sized companies that needs to be addressed. According to a 2013 Business Development Bank of Canada study, from 2006 to 2010, the number of Canadian mid sized firms decreased by 17% (from 9,370 to 7,814). The manufacturing sector was particularly hard hit, with over half of its mid sized firms disappearing from 2001 to 2010 (from 2,807 to 1,381).

The SR&ED program does a fantastic job helping tech startups create technology. It has a strong focus on innovation and has financial and technical auditors that for decades have prevented this program from becoming a government handout. For small companies, we're getting the innovation that taxpayers are paying for. Another nice component of the program is that it doesn't attempt to pick winners and therefore is creating a vibrant diversity of ideas and opportunities for Canada.

Because of SR&ED and many other government policies and initiatives focused on technology creation, small innovative companies are abundant. In fact, there are more than 1700 knowledge based companies in Ottawa alone. The vast majority are extremely small.

However, as soon as these small startups try to grow, government policy reduces refundable SR&EDs dramatically which forces mid-stage companies to seek funding elsewhere. Where do these firms turn? Many of them turn to American private equity firms for investment as they offer the highest valuations. This starts a clock typically of 5 to 7 years for the private equity fund's exit, which is almost inevitably a sale to an American company. For many of the few Canadian tech companies that are counted as mid-sized, the seeds of their departure from Canada have already been sown.

US companies acquire these successful new Canadian companies because they can leverage their larger US run global sales forces, brands, and market reach to quickly maximize the commercial opportunities that have been created. The profits go to the states and often the jobs and growth follow.

For startups to remain in Canada, they need their growth to be fueled primarily by profitable customer sales, not venture capital or private equity as that leads to an early exit. In most cases, these sales need to be global as fast as possible as the competition is already global. Most of these companies' sales are business to business, requiring local sales people in other countries that are part of the local culture and speak the local language.

It is politically unfeasible for the Canadian government to directly pay for sales employees outside of Canada. It is, however, possible to develop policy that indirectly rewards this.

Slow down the grind

If the SR&ED program slowed the grind down of refunds by a factor related to percentage of exports, mid-sized tech companies would be strongly encouraged to continue to reinvest both in R&D and international sales forces simultaneously. Because this is a SR&ED initiative, the export incentive only kicks in if further innovation is occurring.

This concept of slowing the grind down by a factor of exports has many interesting effects:

• It doesn't require the creation of yet another program.

• It stimulates exports.

• It drives the commercialization of Canadian technology around the world.

• It increases the efficiency of innovation because it is being sold to more customers.

• It increases Canadian competitiveness.

• It automatically picks winners because these products are already being sold.

• It drives winning companies to do even more innovation.

• It funds Canadian company growth through sales, reducing the need for debt or equity investment

• It encourages Canadian companies to grow larger, develop stronger brands, and powerful foreign sales forces

• It will encourage Canadian talent to stay in Canada to work for these new exciting companies

• It will reduce the drain of Canadian companies being acquired by foreign companies

• It may stimulate Canadian companies to do acquisitions both domestically and internationally to further commercialize technologies

• It will transition small Canadian companies to medium and then to become large

• It brings foreign money, through export sales into Canada, paying for the program

That last point, bringing foreign money into Canada, is important. There is little government appetite for programs that add to taxes. If a program creates more tax dollars than it consumes, that's a different story. It's probably worth assuming that this was a central intent of the SR&ED program when it was created.

No net new taxes are required because the cost of the additional refunds would be paid by the international marketplace buying more Canadian products. This would create new taxable Canadian jobs to support the growing business, and additional taxable corporate profits. Any successful exporting Canadian company should have between 50% and 95% of their revenue coming from outside of Canada. That creates a big taxation opportunity, funded by foreigners.

Since this is a factor added to an existing program's calculations, this can be phased in and experimented with. This doesn't have to be brought into full force all in one year as it might have to be if it was a program on its own.

If the premise of SR&ED is ultimately to stimulate innovation that can be commercialized by Canada, this tweak does an even better job. Consider a small 20-person company getting SR&ED. What are the real chances that the innovations being funded will be quickly sold around the world? Consider instead a mid or even large Canadian company doing similar innovation but has an established global brand, and a sales force to instantly commercialize this technology. It's clear that the same SR&ED dollars will turn into tax dollars faster with the larger companies.

Today's reality is that policy is very hard on companies transitioning from small to mid-sized and beyond. When a technology company passes through $3 million in profits (which is a small number for most mid-sized companies and hasn't changed in decades), SR&ED refunds drop faster than profits rise. The net cash brought into an increasingly profitable company doesn't return to the $3-million level until the company passes through $7 million in profits, a very large number and a big gap to jump. This creates crisis in most early stage, successful companies, driving them to intentionally keep profits low, stall growth, or seek external investment.

If a mid-sized company tries to do it on its own, driving both export sales development as well as continuing new product development, then the taxable capital rule kicks in regardless of whether the company is making any money, eliminating SR&ED refunds again, just when the company is trying to sell globally.

Canada has a choice. We can maintain the status quo and watch the continued alarming decline of mid-sized companies. Or, we can add a tiny formula to the SR&ED tax calculation related to percentage exports, and see Canada create a wide range of innovative global technology brands, proudly Canadian-owned, creating Canadian jobs and prosperity.

David Ross is CEO of Ross Video Ltd, headquartered in Iroquois ON.