Sherman Kreiner
(Owner's At Work, Summer 1995)
Canadian tax. law permits provincial labor organizations to sponsor the creation of capital pools in their provinces which provide equity capital to small and medium-sized businesses. The first and largest fund, the Quebec Solidarity Fund, was established in 1984, and now has more than $1 billion in total assets. There are now sixteen existing or emerging funds across Canada.
The bulk of the capital for these funds comes from investments made by individuals, who invest in what is essentially a targeted mutual fund. The Canadian tax system which gives rise to these funds offers investors a 20% Provincial tax credit and a 20% Federal tax credit on annual investments up to $5000, and permits investments to be made through Registered Retirement Savings Plans (RRSP -- the Canadian equivalent of the Individual Retirement Account or IRA). Thus, for a Canadian in an average 40 % tax bracket, the current cost for an investment in shares valued at $5000 is approximately $1000. (Tax credits are valued at $2000, and the tax deferral associated with the RRSP investment is an additional $2000.)
The Crocus Fund was created by the Manitoba – Federation of Labour in response to capital flight from Manitoba.
investment Fund is unique in its focus on promoting employee ownership and employee participation in corporate governance and management. The Crocus Fund was created by the Manitoba Federation of Labour in response to capital flight from Manitoba. Its primary objective is to retain Manitoba capital in Manitoba and use that, capital to create jobs in small and medium-sized Manitoba businesses.
This strategy is based on two assumptions. The first is that government is not a source of wealth-generating jobs in value added sectors. Targeted government policies can make people more employable, but significant job creation requires access to resources of large capital institutions. The second is that large capital institutions have abandoned Manitoba and are not likely to change course. As a result, Manitobans need to rely on their own institutions to mobilize their own financial resources for their own benefit.
Rise of capital flight
Capital flight results from the actions of many individuals and institutions. Large corporations, aided by trade and tax policies, have taken profits garnered from the labor of Manitoba workers and reinvested them offshore. According to The Canadian Manufacturers Association, manufacturing employment in Canada has plunged by 350,000 jobs. A spokesman noted, "Because we have a jobless recovery, very few have come back. Half are gone forever." Bank lending has been insufficient. The Government of Manitoba, in its 1993 Framework for Economic Growth, noted the particular capital access problems of information and technology industries, and concluded that, without a solution, "Manitoba will be constrained from building an idea-based innovation economy." A 1994 report by the Manitoba House of Commons Standing Committee on Industry highlighted the decline of bank lending to small business. Even businesses with unblemished credit histories have felt this credit crunch. Yet companies with fewer than 100 employees account for more than half of Canada's workforce, 40 percent of the national output, and 87 percent of the new jobs created in the past ten years.
Venture capitalists have historically been reluctant to come to Manitoba. Today, venture capital is virtually non-existent. Statistics Canada's 1994 investment forecast predicted that private sector investment in Manitoba would decline 4.8 percent, by far the worst performance among provinces. The largest single factor contributing to this decline is investment in manufacturing, which was predicted to drop by 15.7 %.
And it's not just conventional capitalists who have fled. Unions and employers often oversee the investment of pension funds out of the province. When individual employees invest in a group RRSP, or a self-directed RRSP, or a bank certificate of deposit, they also make decisions as to Where their money will 'be invested. When individuals invest in Hong Kong mutual funds, or a fund which does not say it is reinvesting domestically, their money is, in fact, being invested elsewhere. In making these decisions, individuals also contribute to capital flight from Manitoba. Usually, the only factors taken into account in these decisions are risk and return, with one investment being chosen over another because of small differences in return rates.
The consequence of all these actions is that Manitoba financial resources are used to create jobs elsewhere, rather than in Manitoba, and sometimes at the expense of Manitoba jobs. The resulting erosion of the tax base also threatens social services and the public sector.
The Crocus Fund is crucial to the Manitoba economy because it helps to fill the venture capital gap.
Investing at home
The Crocus Fund is designed to begin a reorientation of investor thinking regarding the consequence of investment decisions and to demonstrate the positive impacts of a capital retention strategy. The Fund is predicated on a belief that a successful reorientation of investor thinking requires an effective alternative. Rhetoric regarding the consequences of capital flight will not result in capital retention, unless investors can concretely be shown the social policy benefits of capital retention -- with competitive rates of return.
The Crocus Fund is crucial to the Manitoba economy because it helps to fill the venture' capital gap. Based on the Fund's current rate of growth and the experience of other labor sponsored funds, Crocus should, within five years, have between $75 and $100 billion in assets. Each year thereafter, it will grow by at least $15 million. Because it makes equity investments, each $100 million in investment assets will lever another $150 to $200 million in loans from banks and credit unions. Each $100 million in Fund investments will save and create approximately 2500 new jobs in Manitoba.
The Fund can also serve as a vehicle for larger financial institutions to invest their capital locally, as special provisions have been made for the sale of shares to credit unions, banks, union strike funds, and pension funds.
The Fund can also be a catalyst for other capital retention strategies, such as legislative mandates requiring significant reinvestment by local pension funds in the local economy.
Finally, by retaining that portion of the Fund's portfolio which is not in targeted investments in a domestic bond portfolio, the Fund provides a mechanism on a small scale to purchase Canadian and provincial debt with Manitoba capital, rather than being beholden to foreign investors. The fiscal and monetary policies which must be implemented to placate these individuals have a severe detrimental impact on short-term and long-term economic growth and the well being of Canadian citizens.
The Crocus Fund began with a strategy targeting individual investors
Implementing capital retention
The Crocus Fund began with a strategy targeting individual investors because of the opportunity presented by the labor-sponsored venture capital corporation legislation, which provides a 20 % Provincial and 20 % Federal tax credit to individual investors. It is the Fund's intention to use that capital base and the successful investments which flow from it to induce Manitoba-related institutional investors to retain a portion of their 'capital in Manitoba as well, assisting the social policy objectives of the Fund through an institutional investment in it. The Fund has specifically been designed with a special class of shares for institutional investors.
When it matures in its fourth year of operation, 40% of the Fund's assets will be invested in Canadian and Provincial bonds, predominantly in Manitoba and Manitoba Hydro bonds. This part of the portfolio supports infrastructure development in the Province. The remaining 60% will be invested in small and medium-sized Manitoba businesses which are defined as businesses with $50 million or less in assets and a majority of jobs in Manitoba.
These investments are not seen as conventional venture capital investments. The fund is not, as a general proposition, seeking early stage companies at the top of the deal pyramid, with the concomitant high risk and high return potential. The Fund believes that few such opportunities exist in Manitoba, but further, such companies do not best advance the social policy objectives of the Fund.
Rather, the Fund is seeking existing companies which require equity capital to grow, whose balance sheets are not deemed strong enough by lenders to lever the bank debt necessary to finance expansion. The Fund will provide that equity capital.
The Fund is also seeking opportunities in companies which are, or will become employee owned, and which are predisposed to employee participation in corporate governance or management. There are a number of social policy goals associated with this objective. Employee owernship maintains local ownership, assures that major decisions affecting a Manitoba business are made locally, and creates a mechanism for intergenerational transfer.
Crocus will serve as a friendly equity partner.
The Fund specifically seeks to assist ownership transitions for successful Manitoba companies facing a crisis before the owner is reaching retirement age with no succession plan. Often such an individual considers one of two options. One is sale to a trans-Canadian or multi-national corporation, creating a Manitoba branch plant where there was previously a locally owned Manitoba corporation. The second is to cannibalize the company, extracting as much cash as possible prior to retirement, then close the business and sell the remaining assets, resulting in immediate job loss.
The intention of the Crocus Fund is to encourage such owners to view the employees and management of the company as potential purchasers. Usually, they are not seriously considered because the owner properly evaluates their lack of sufficient financial resources. Crocus will serve as a friendly equity partner to them, combining its resources with theirs to lever the bank debt necessary to complete the transaction. Employee ownership as well creates a model for long-term local ownership of business and reinvestment of surplus back in the Province.
Crocus ultimately has as its vision the concept of economic democracy embodied in the Mondragon network.
Employee ownership and employee participation also increase the competitiveness of investee companies. Improved performance over the long term is crucial to the Manitoba economy and is crucial to protecting Crocus Fund investments. Study after study worldwide has shown that companies which combine employee ownership with participative management outperform conventional companies. University of Saskatchewan professor, Dr. Richard Long, in his 1992 study on Employee Profit Sharing and Share Ownership in Canada, confirmed these results for this country as well. Nevertheless, the prevalence of either practice is quite small.
Crocus ultimately has as its vision the concept of economic democracy embodied in the Mondragon network of employee owned enterprises in the Basque region of Spain. That system, driven by a financial institution like the Crocus Fund, has created more than 170 for-profit businesses and community based ventures, employing more than 21,000 individuals. Ninety of the businesses are capital intensive, high-tech industrial companies, with the largest employing 2000 workers. The system also has created the only Spanish research center invited into the European R & D consortium, a chain of supermarkets, service and agricultural co-ops, a comprehensive occupational retraining system, and schools and colleges offering cooperative education.
How do we get from where we are to that vision? During the first three sales' seasons, Crocus raised $23.5 million from individual investors, the largest investment per capita for each of the first three years for any labor-sponsored fund. Part of the reason for this success is that Crocus developed a dual. track marketing system. A portion of sales are made by investment brokers and by mutual fund dealers. This track, paralleling the activities of the other funds in English-speaking Canada, draws upon their existing client base, and capitalizes most aggressively on the available tax incentives. The second track, paralleling the activities of the Quebec Solidarity Fund, utilizes specially trained volunteer members of unions affiliated with the Manitoba Federation of Labour, licensed by the Manitoba Securities Commission, to sell Crocus shares only. Sales are made through a Crocus Fund subsidiary and are supervised by the Fund's staff broker.
Creation of this second sales force creates a growing presence within the labor movement of individuals with a sophisticated knowledge of financial issues, financial planning and investment instruments. It assures a large representation in the Crocus investor pool from the labor movement. Most significantly, it creates a large core of individuals skilled and positioned to provide economic education to Manitobans around a range of issues, including capital flight and responses to it, in the process of marketing the Fund. About half of the Crocus sales are made by these volunteers.
Investment in subsequent years will be further assisted by the implementation of payroll deduction plans. The Fund's enabling legislation mandates employers to implement payroll plans if 20 % of the workforce or 50 workers so choose. Approximately two dozen public sector, private sector and labor movement employers have already agreed to voluntarily implement such plans.
Keys to success
The first key to meeting the capitalization projections for individual investments is that share values of the Fund do not decline in value. This is a problem for any Fund prior to reaching its breakeven point. The annual cost of operating the Fund is approximately $1.5 million. In order to generate $1.5 million in investment income to cover these costs, the Fund must have about $25 million in assets, assuming a 6% rate of return, and slightly less if interest rates remain high. Prior to reaching $25 million in assets, the Fund's expenses will exceed its revenues. Without some source to cover the shortfall, share values would decline, putting the Fund's future in jeopardy.
To meet this problem, the Provincial government has provided $2 million in seed equity. This seed equity will absorb all losses first. As a result, based on current projections, share values will not decline during the pre-breakeven period. The Provincial Government has the opportunity to recoup any losses and earn a return on its investment through the provision of purchase warrants for 200,000 additional shares of the Fund at the initial net asset value per share ($10), exercisable at any time after the year 2000.
The second key to meeting the capitalization projections with regard to individual investments is performance. While no decline in share values in the early years provides some security for investors and an effective rate of return, it neither generates levels of return which encourage accelerated levels of investment, nor does it permit the fund to meet its specific social policy mandate to invest in small and medium-sized provincial businesses. To address this concern, the Fund negotiated a $2 million placement by the Federal government, in declining amounts over 30 months. The placement is used to directly offset operating expenses. As a result, total assets required to generate the income necessary to cover the remaining costs is reduced below current capitalization levels. As a result, all assets no longer need to remain in fixed income securities to cover costs, but can be placed in targeted investments.
While the Fund's enabling legislation requires sixty percent of investment assets to be in targeted investments by the end of
Share values will not decline during the pre-breakeven period.
the fourth year, as a ' result of these agreements with government, the Fund undertook to make placements sooner. A schedule was established whereby twenty percent of investment assets would be in targeted investments by the end of the second year and forty percent would be in targeted investments by the end of the third year.
The bulk of the second year requirement was met by a Fund investment in Infocorp Computer Solutions, a Winnipeg-based software developer, which creates and markets worldwide point-of-sale software for retailers. The company had shown more than three years of unbroken profitability, and a seventy percent annual increase in sales over the previous two years. It also had a capital structure in which sixty percent of the company's 35 employees already had an equity stake in the company.
As a result of the capital structure . . . Fund shares increased in value from $10 on March 1 1994, to $10.99 on January 1, 1995, one of the best performances ever achieved by a labor sponsored venture capital corporation.
The company had previously met certain equity needs by going public on the Vancouver Stock Exchange. The private placement made by the Crocus Fund resulted in the purchase of I million shares of the company at $.72 per share, and the issuance to Crocus of warrants to purchase, within eighteen months, an additional 1 million shares at $1.02 per share. Within three months of the Fund's investment, shares were trading at $1.15 per share.
As a result of the capital structure negotiated with both levels of government, coupled with prudent bond investments, and the rapid appreciation in the value of the Infocorp investment, Crocus Fund shares increased in value from $10 on March 1, 1994, to $10.99 on January 1, 1995, one of the best performances ever achieved by a labor-sponsored venture capital corporation. This, in turn, resulted in the accelerated levels of individual investment which had been hoped for, bringing total capitalization on March 1, 1995, to $26 million.
The Fund has also created some financial incentives to induce institutional investors to place money in the Fund sooner. Institutional investors are permitted limited representation on the board of directors. In addition, "I" shares are structured to share profits on an equal footing with individual shares. However, because institutional investors are not eligible for tax credits, this may be insufficient to induce them to invest, particularly in early years when profits are relatively small. To sweeten the opportunity, the Fund is offering these investors purchase warrants to purchase an equivalent number of shares at a later date (even after they have cashed out their initial shares) at the current share price. Thus, if an institutional investor purchases 100,000 shares at $10 per share today, it can purchase an additional 100,000 shares eight years from now at the same $10 per share, even if the share price at that time is $20 per share. This plan is designed to increase the capital base of the Fund as quickly as possible. The Fund has obtained three institutional investments utilizing this instrument from Credit Union Central of Manitoba, the Manitoba Government Employees Union strike fund, and the Garment Manufacturers and Garment Workers Pension Fund.
The Crocus Fund has also taken a number of concrete steps to meet its employee ownership mandate.
The Fund has developed an instrument, modeled after the U.S. Employee Stock Ownership Plan, to transfer equity to employees by borrowing against the assets of the corporation. Characteristics of this instrument, which ultimately result in employee shares being held in a deferred profit-sharing trust, include the ability to use corporate assets to secure financing, limited worker out-of-pocket investment, ability to transfer ownership to the employees on a gradual basis or all at once, and ability for the employee-owned company to repay money borrowed in a tax-advantaged fashion.
The Fund has developed a set of measures to evaluate the degree to which potential investee companies are participative. It has also developed a set of measures to evaluate the predisposition of senior managers of potential investee companies to make their companies more participative. These evaluations are included in the Fund's due diligence review.
The Fund has included within its term sheet two provisions designed to increase awareness of mechanisms and structures which encourage participation. First, the Fund requires all investee companies to undertake an organizational assessment, involving the CEO and the Fund's organizational development specialist. This will identify strengths and weaknesses and result in the creation of a customized design for intervention to address the weaknesses. Second, the Fund requires the CEO of each investee company to participate in a roundtable of CEO's of all investee companies to address issues of mutual concern, but particularly to focus on issues of participative management and training.
Ultimately, the Crocus Fund will be the linchpin
of a capital retention and economic development
strategy for the Manitoba labor movement and
the Province.
The Fund has also recruited mangers of existing employee owned and participative Manitoba companies to participate in the Fund's CEO roundtable.
We believe we have created sufficient protections and incentives to assure that the Fund will mature, and that, ultimately, the Crocus Fund will be the linchpin of a capital retention and economic development strategy for the Manitoba labor movement and the Province. It will be a large institution. It will be a vehicle for capital retention for individual and institutional investors through direct investment in the Fund. Because it is a source of equity, it will lever additional financial resources into the Province. Finally, it will create a significant number of jobs in businesses whose organizational cultures will improve their competitiveness in a global economy.