Part 1 of this series described the basics of flow-throughs and Part 2 examined both the structure and the level of financing that flow-through shares have provided to the mining and oil & gas industries. This part analyzes the factors contributing to a decision by the government to expand flow-throughs to healthcare and biotech companies, and the impact that decision might have on the industry.
Assuming that the government is willing to consider the expansion of flow-throughs to other industries, it would probably have a close look at both regulations and revenues before making any decisions.
- It would probably be politically unacceptable for any expansion of flow-throughs to be restricted to healthcare. Any expansion would probably have to include all knowledge-based industries and perhaps even any industry that has SR&ED qualified expenditures.
- CRA (Canada Revenue Agency) would have to determine what expenditures by healthcare companies would be comparable to the CEE and CDE expenditures of mining and oil & gas companies. All research, preclinical and clinical expenses would be a reasonable base but all expenses under the existing SR&ED rules might also be used.
- Based on these changes, the Finance Department would have to look at the impact of these changes on its revenues. There would be a reduction in current tax revenues from the decline in personal taxes payable by investors, which would be about 45% of the amount of new flow-throughs assuming all investors are in the highest tax bracket. There might be increased personal taxes from new employees of the funded companies if flow-throughs provided them with funding for programs that would otherwise not be conducted. Any corporate tax benefit would be delayed until the companies became profitable and paid corporate taxes without the benefit of the tax deductions they passed on to investors. Overall, any extension of flow-throughs to additional industries would probably result in reduced tax revenues in the short term but would probably be more balanced and a good industrial policy in the longer term.
Impact on Healthcare and Biotech Companies
Assuming that the flow-through structure is extended to the healthcare industry, as it deserves to be, there are several factors which could potentially impact the benefits of these changes to the development stage healthcare companies.
Flow-throughs are purchased only by retail investors, whether they buy flow-throughs of individual companies or the flow-through partnerships. Based on the information which was cited in Part 2 of this series, flow-through partnerships account for about two-thirds of all flow-through financings while the rest would be individual retail investors. We assume that retail investors purchase flow-through partnerships because it is easier than choosing from amongst all the flow-through offerings and it offers portfolio-based risk reduction. It is unlikely that natural resource flow-through partnerships would change their investment criteria to purchase non-resource flow-throughs. If only a few healthcare companies initially offer flow-throughs, it is unlikely that new flow-through partnerships would be dedicated to healthcare but would more likely be a combination infotech, clean tech plus healthcare investment strategy.
Mining and oil & gas companies usually simultaneously offer both flow-through and unit financings. They have overhead expenses which do not qualify as CEE and CDE and must be paid for with the proceeds from unit offerings. Development stage healthcare companies will be in a similar situation. Individual companies will have to consider whether simultaneous flow-through and unit financings will bring additional investors and funds or whether it will just split the funds which would be available from a simple unit offering. On a broader basis, will the expansion of the number of industries allowed to offer flow-throughs attract new funds and investors or will the pool of funding remain the same and just be split amongst more industries?
Flow-throughs are unlikely to help the private development stage healthcare companies. Retail investors probably want to sell, or at least have the ability to sell, their shares or mutual fund units within the two year liquidity timeframe offered for most of the resource flow-through partnerships. Resource flow-through partnerships can invest in some late stage private resource companies because those companies can probably do IPOs in the current market. There has not been a development stage healthcare IPO on the TSX since IMRIS in late 2007.
For public companies, one drawback of unit offerings has always been the preference of many investors, both retail and institutional, to sell the shares as quickly as possible and just hold the warrants. This creates downward pressure on share prices immediately after unit offerings are closed. Would a mixed flow-through and unit offering reduce some of that downward pressure? The answer probably varies with the company, the investor and the deal structure. If the investor is looking for tax deferral, there might not be an urgency to sell. If the investor is looking for quick profits, there is probably an urgency to sell and move on to the next deal.
My assessment of the two mining financings used as examples in this blog series was that public companies in a ’hot’ industry with relatively liquid stocks have been able to complete financings using a combination of pricing, warrant and tax incentives. With or without flow-throughs, development stage healthcare companies have to compete with resource companies for the attention of Canadian retail investors making high risk-high reward investments. Healthcare is currently not as hot as natural resources and many stocks are not liquid.
The annual capital deficit for the development stage healthcare companies is probably at least $500 million, based on the current $500 million and the previous $1 billion annual equity funding levels. Development stage healthcare companies deserve the option to offer flow-throughs but I believe that the initial impact will likely satisfy only a small portion of this capital deficit. It would likely take time and sector success for flow-throughs to become a significant source of funding for our sector.