Are Canada’s tax incentives causing startups more harm than good?

Still not sure if it’s a safety harness, a leach or a noose.
- Montreal-based entrepreneur

The person above, who didn’t want to be named, is referring to one of the government programs that fund R&D activity in Canada. Programs with alphabet soup names like SR&ED and IRAP can repay up to 85% of your developers’ salaries. (Yes, 85%)

Fred Lalonde, an experienced entrepreneur and founder of Hopper Travel, recently said these programs are the devil. And I think he was being nice. Here’s why:

  • These programs create bureaucracy. The government hires technical “experts” to audit companies and decide whether the work they’ve done is innovative enough. To navigate through their requirements and make sure you use the right buzzwords, startups hire consultants (some of them previously employed as the aforementioned government auditors) to prepare their claims. All of this costs money.
  • They’re a distraction. None of the people above add any value to your business. Every minute you spend dealing with them is a minute you could be spending learning about your customers/users, getting to product/market fit or gaining market traction.
  • They create incentives to misalign resources. This is dangerous because it’s insidious. When you’re getting back 85% of your engineering salaries, it’s easy to just throw more engineers at your problems. As a result, Canadian startups have world class engineering teams, but often fall short on the product and user experience side.

I’ve spoken to a several Canadian startup entrepreneurs in the past few weeks about these programs and there is clearly a lot of frustration regarding them. Yet at the same time, there is a reluctancy to discuss the issue publicly for fear of biting the hand that feeds them giving the already limited pool of capital available to early stage startups here.

I’ve come to the conclusion that these programs do more harm than good, and it’s time we have an honest conversation about getting rid of them.

But wait, you say, how will our tech industry continue to exist? You can argue it’s time to just drop the crutches and learn to walk. After all, these programs don’t exist in Silicon Valley, yet they seem to be doing just fine.

Or, the government can take that capital and redeploy it in other ways, such as:

  • Investing in venture capital. You don’t want the government investing directly in startups, but they can act as a catalyst by acting as a limited partner in funds managed by people with operational experience. This model has worked in Israel, and Quebec has taken some big steps in this direction recently with the creation of the Teralys Capital fund of funds as well as investing in Real Ventures.
  • Invest in infrastructure that creates conditions for innovation and risk-taking, from universities to places like Notman House in Montreal or MaRS in Toronto.
  • Creating startup friendly tax policies. We give tax holidays to foreign “specialists”; why not do the same for entrepreneurs, or early employees who decide to take the risk on a startup, or angels who invest in them?

What has your experience been with these R&D programs? Should we keep them or replace them, and if so, with what? Let’s get a discussion going in the comments below.

  • http://www.cantechletter.com Nick Waddell

    Interesting. Would you put flow-through shares in this category? They seem to have done their job attracting capital to mining, with somewhat less hassle….

  • http://www.favvas.com/ George Favvas

    I don't have any personal experience with flow through shares, but that doesn't sound like a bad idea at all.

  • Jeremy

    Excellent points.

    In my opinion, those programs do serve a purpose, but they do so in a strange way:
    1. They make it easier to attract foreign capital. When you can tell a potential investor that for $1 of investment you can pay for $4 of engineers without diluting their equity, they no longer feel so badly about investing over here.
    2. About 1/3 to 1/2 of the money spent on these programs actually accrues to a small company, and more for larger companies. This is better than nothing. The rest is lost in many direct and indirect ways:
    * The administration time and overhead spent on doing the paperwork;
    * Consultants, etc to do the work;
    * Salaries of auditors and the whole machinery (for example, there are some very talented and qualified people at the NRC who spend their time essentially doing admin rather than research);
    * A general loss of competitiveness due to companies being insulated from making tough decisions
    * Salary inflation for those categories of employee where you can get essentially everything back since everyone wants to hire a resource that costs practically nothing

    To me, the principal problem with these programs is that they greatly increase the risk that a company faces. I've seen a company with a bona fide R&D program spend a hundred thousand dollars chasing government grants, only to miss out and nearly hit the wall. That's money not being spent on R&D. Secondly, the criteria are not really objective at all, and an aggressive auditor can push a company right to the wall even when everything is done in good faith and with careful attention. Finally, larger companies are more successful at using these programs as they can amortize the resources and risk over more employees and tend to have better relationships with the government as they are a known factor. These factors put small companies at a real disadvantage in the marketplace and mis-allocate resources.

    To fix these problems, I'd advocate for a different set of programs for small companies vs larger companies, possibly using equity or convertible notes as collateral. The small company program could have looser rules but a cap on the total amount. Politically it'd be impossible, but I'd also say that since (to my mind) over 1/2 of the money is actually wasted (in that it's lost in inefficiencies), it would be better to accept that 20% of the money would be lost to fraud and simplify the rules significantly than maintain the status quo. Maybe it would also make sense to start prosecuting cases of serious fraud as criminal cases.

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  • http://jkealey.myopenid.com/ Jason Kealey

    Hey George. It has been a while since we sat next to each other at the F&F event! I totally get where you are coming from, as I sense the same danger. I dislike the industry that has been built around these R&D programs and, more importantly, am worried about the resource misalignment you mention.

    To date, these incentives have been of tremendous help to my company, without sidetracking us. The primary reason for this is we claimed them after the fact and didn't plan on these incentives to build the business. However, since we did get them (a very long time after claiming them), they have helped us tremendously.

    That said, I agree things should change.

  • http://www.favvas.com/ George Favvas

    Hey Jason – Thanks for the feedback and for stopping by. We should catch up!

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  • http://Website Neil Derraugh

    Being in the process of applying for SR&ED credits for the first time, I am glad that we have this opportunity.

    With regards to your your comment about maligning resources, I think that really comes down to management. If you’re of the opinion that throwing more engineers at a problem helps then that’s probably an opinion you hold whether you are getting tax incentives or not.

    I am on the fence in regards to direct investment by government like IRAP. SRED on the other hand isn’t really direct investment, it’s incenting R&D. Tax what’s bad, subsidize what’s good — works for me.

    On the flipside I entirely agree that they create nasty beuraucracies, they are expensive, they take up otherwise productive time.

    So I guess my view is that it really comes down to opportunity cost.

    And having (gratefully) had no experience asking VCs for money I am also happy to retain my equity as I rightly deserve.

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