One lesson I’ve learned is that anything, and I mean anything, can be your startup’s undoing. With Distil, a ruling by the Canadian Revenue Agency (CRA) years earlier contributed to our eventual sale.
Back in 2007 we had completed our A round and were looking for a bridge. Unable to find a new investor our previous investor, GrowthWorks, stepped up and double downed us. I really have to hand it to GrowthWorks in that they believed in us, our team, and our mission. As part of the bridge round, GrowthWorks became the largest share holder of Distil.
In Canada there is a tax credit program administered by CRA called Scientific Research and Exploratory Development (SRED), the most effective program I’ve seen to encourage innovation. Under this program we were expecting a $1M+ check. But some bureaucrat in CRA ruled that with GrowthWorks being the largest shareholder, our eligibility would be determined by GrowthWork’s eligibility. And GrowthWorks, being an investment fund, was not eligible. Our SRED request was denied.
This was a huge blow. Any time $1M of expected cash evaporates over night you sit up and take notice. Our lawyers worked hard to get CRA to reverse their decision but they wouldn’t budge. In the end we restructured the bridge round as debt, brought GrowthWork’s equity stake with guidelines made up up CRA, and received our SRED check. All over and a happy ending.
Except it wasn’t. Fast forward to Fall 2008 and the collapse of the financial sector. This hit everyone in the financial industry hard, including GrowthWorks. Their LPs were getting nervous and wanting their money out. GrowthWorks laid off staff but in the end needed to liquidate some assets to raise cash.
As any investor will tell you portfolio companies are not very liquid. Most have no capital and aren’t easily salable. Our $2M sales pipe was in the process of collapsing. As management we were working on plans to rebuild a pipe based on the defense market. Most importantly we had another $1M SRED claim that, with judicious cutbacks and sacrifice, could see us through and out the other end.
That SRED claim would be our undoing. SRED claims are transferable, meaning they are an asset that can be sold. Or SRED claim could be liquidated, providing cash to GrowthWorks, but removing all chance of the company making it through. Normally this would be brought up with the board and management, there would be heated discussions, and in the end a decision would be made.
Here is where that previous CRA decision killed us. Remember as a result of that decision we restructured the bridge as debt? Unlike equity, debt can be called. If we can’t pay it then the company enters receivership. See where this is going. GrowthWorks had tremendous leverage over us, because of the arbitrary decision of a CRA peon. In the end we sold the company and GrowthWorks got the cash.
I don’t blame GrowthWorks. They did what they needed to do in a very difficult situation. They acted predictably. If the roles were reversed I would have done the same. I don’t blame our advisors and lawyers. In this case CRA behaved in a manner that was inconsistent with years or previous rulings and decisions. I blame CRA for letting this happen. For giving too much power to an entry level peon with no real understanding of how the SRED program drives economic development.
SRED is coming up for review in Canada. These same bureaucrats that killed Distil and cost 30 jobs are in the process of changing the rules once again, a move that could kill many other startups. I didn’t mean for this post to get political but that is the direction it has turned. Speak out in the comments. Let people know that the SRED program, and government programs the fund innovation and jobs, are important.