Entrepreneurship

More about patent madness

Interestingly, right after my previous diatribe I sat down to read the latest economist and saw this article about the problems with the US patent system: http://www.economist.com/node/21526370. Then, lo and behold, the most recent Wired magazine has an article about my former employer (Kodak) being forced to become a patent troll: http://www.wired.com/epicenter/2011/08/patent-game-kodak. It’s the laws & patent system, it’s not the companies taking advantage of it that are the problem. (Arggghhh… And maybe if Kodak hadn’t shelved their prototype digital camera in favour of the crappy Kodak Disc camera in the early 80s, Rochester would be a compelling place to live again.)

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2011: The year insanity trumped innovation.

2011 might be remembered for a lot of things, but to me it’s the year that the world finally woke up to the mess with the US patent system — to which many of the other country’s patent systems are of secondary importance.  (And when I say “woke up”, I don’t mean “woke up and solved“. ) Anyway, here’s the problem:  Granting patents for questionable & intangible ideas to people/organizations that didn’t really “invent” those ideas, combined with a legal system that is way in over its head trying to assess the validity of such patents has led to an economy based on faux-IP rather than true innovation.   It means that we’re not manufacturing as much and we’re not creating as much value from real and important innovation.  This is all just the opposite of what patents are supposed to do.

Gary Yurkovich recently posted the following comment on LinkedIn:  ”Remember when Apple was innovative with good products? Now it competes best in courtroom. http://zd.net/pcGm0j“.  True, but while patent-litigation over innovation seems to be the trend (see http://www.economist.com/node/21525096 ), I don’t blame Apple. The patent system is broken, not Apple. It’s the ease with which one can now patent things like blatantly obvious software implementations that is the problem (i.e. vague “innovations” that should never be patentable), and Apple is just reacting rationally.

Apple actually innovates better than most: Eg.where’s the competition for ipad when the likes of HP quit at the 1st sign of heavy sailing? That’s Leo Apotheker trying to turn HP into the next SAP and is a very sad development (whither manufacturing?). It truly angers me, having cut my teeth on DEC which was eventually bought Compaq, which was eventually bought by HP, which … has given up the fight.

 

 

 

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SR&ED: Flawed, but worthwhile

I read with interest Saturday’s story in the Globe and Mail entitled “Flawed R&D scheme costs taxpayers billions” by Barry McKenna (see http://www.theglobeandmail.com/report-on-business/flawed-rd-scheme-costs-taxpayers-billions/article1939418/).  One of the things my company does is SR&ED consulting — helping companies determine if they have SR&ED-eligible projects, helping them document their projects in order to apply for SR&ED credits, and helping them establish processes to tap into SR&ED tax credits when SR&ED-eligible work is performed in the future.

The funny thing is, I agree with much of what Mr. McKenna says in Saturday’s article, but I still believe the SR&ED program is worthwhile.  Is it flawed?  Yes.  Show me a tax program that isn’t.   Interestingly, it is not uncommon to question government incentive  programs like SR&ED, no matter what country you’re in.  Yesterday’s Oregonian newspaper, for instance, had an article questioning Oregon’s green energy incentives (see http://blog.oregonlive.com/politics_impact/print.html?entry=/2011/03/how_many_jobs_from_oregons_gre.html).

 

I don’t know if SR&ED fully meets its implied social objective of increasing R&D in Canada.  But I do know it helps retain and increase employment in the technology sector.  One of my clients,for instance, was doing really innovative R&D, but he was using offshore resources to do much of it.  I explained that if he used employees here instead, he would be able to tap into SR&ED tax credits that might enable him to grow the business entirely within Canada.  As a result he has hired two new employees in Canada and has opened an office here as well.  He expects to hire three more in Canada — changing his mix so that instead of having 1 or 2 employees here and 4 overseas, he will have six in Canada and one or two overseas.

Another client would almost certainly have closed their doors in 2009 due to the recent financial crisis.  Most of their customers were in the US and their business virtually dried up by the beginning of 2009.  Instead, they downsized a bit, focused on R&D, obtained SR&ED credits as a result, and are coming out of the recession with a stronger product portfolio.  They are a stronger company now.  They and their employees are thriving in Canada and are paying taxes.  The alternative?  I hate to think about it:  All of those jobs overseas?  Many of the employees on EI?  Loss of a truly innovative technology company?

Oh, and please note that other countries are using R&D tax credits to create or retain industries and jobs.   The USA, Mexico, Australia, France, China, India and others all provide generous credits.  (See http://www.scitax.com/pdf/Scitax.International.RD.Tax.Credit.Survey.Table.pdf).  Just to state the obvious here:  It’s hard enough to compete in the global economy, and I appreciate the fact that our government helps us do that.

So, what’s the problem?  I think that Mr. McKenna’s article was correct about the unscrupulous use of SR&ED credits by companies that don’t deserve them.  They are taking advantage of the subjectiveness of the assessment process and of the lack of resources at the CRA to more thoroughly examine every case.

There is little I can do about that other than to make sure that I only assist companies that have valid claims and who are willing to do the work needed to fully document them.  When they do that, I’ll go to the mat with the CRA for them to make sure their legitimate claims succeed.

 

 

 

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SR&ED Creativity… Just Be Careful

I came across the following blog post recently: “SREDing Sweat Equity”.   It describes a maneuver to use SR&ED to enable paying yourself a salary during the early stages of your company’s development.  Part of my work at Axxiton Consulting involves helping companies to maximize SR&ED claims by identifying eligible projects & activities, analyzing and documenting projects & activities to claim for SR&ED, and establishing processes to help assure repeatable success.  So I found the aforementioned blog post interesting.  But I have the following observations:

The proposed maneuver is quite interesting.  SR&ED is a great program, and I’ve seen some companies survive the economic downturn solely due to SR&ED — it literally kept the lights on so that the companies survived until the the economy recovered.  However, companies need to make sure they don’t see SR&ED as an entitlement.  They still need to demonstrate technological advancement.  It must be credible and documented. And they need to be aware of the rules – both for claiming SR&ED credits and for paying their employees.

SR&ED can help keep the lights on during an economic downturn

The first problem I see with the proposed maneuver is this:  Specified employees (i.e. a person who owns 10% or more of company or who does not deal at arm’s length w/the company) can only claim up to 75% of the time (and presumably salary) for which they were directly involved in SR&ED for the Prescribed Proxy Amount (PPA) top-up when computing SR&ED.   That reduces the SR&ED-eligible expenditures in the example from $70K to $52.5K for the PPA.  Max SR&ED credits for the $70K salary will therefore be about $43K in Ontario.

Steve & Steve

Another problem is that an entrepreneur is unlikely to expend 100% of their time on SR&ED activities.  In fact, companies that claim all of their principals’ time as being for SR&ED might trigger increased scrutiny of their SR&ED claim as a result. If you do so one year, you can’t count on getting away with it every year.  Be careful here:  If you mysteriously claim exactly 100% on SR&ED activities year after year, someone’s going to decide to take a more careful look (even if you claim 90% and deem it to be 100% under the “all or substantially all” rule).   Be realistic.  As a founder, some of the time you spend on your company will be for bizdev, financing, admin, etc..

Another important point is this:  Suppose you do pay yourself with an IOU, the company must still withhold and pay remittances for personal tax, CPP and EI.  In the blog’s example, using 2011 tax rates, that would be $15,180 in tax and $6,323 for EI and CPP.  That’s $21,503 you need to come up with in cold, hard cash to pay the government while you’re waiting for the SR&ED cheque to arrive.  I believe you can wait up to 180 days into the subsequent fiscal year to pay the salary if it is a bonus, but there are two problems here:  First, bonuses to specified employees will be scrutinized by the CRA to make sure they are not based on profits.  Bonuses paid on profits to specified employees can’t be included in your SR&ED claim.  Second, you don’t know how long it will take to process your SR&ED claim, nor do you know how much of your SR&ED claim will be accepted by the CRA.

IOU

So… now you’re in a situation where you’ve paid salary via an IOU of $70K.  You’ll net about $21.5K in cash (SR&ED claim = $43K, Remittances paid to Receiver General = $21.5K).  That assumes that the entire SR&ED claim will be approved.  And you hope it will be approved in a timely manner so that you aren’t out of pocket $21.5K while you wait for the $43K cheque to arrive.

Just be aware of the risks.  Don’t file frivolous SR&ED claims.  Claim legitimate SR&ED.  Document, document, document!  The best damned thing you can do is to methodically record your time spent each day, and that of your employees.  Always have supporting documents for your claim. (See http://bit.ly/aSsSh6 for my thoughts on this point).

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Purchase new computer equipment before February!

I’m planning to purchase some new computer equipment this year for our company (Axxiton Consulting Inc.) — and I’m going to do so before February 1st!  Canadian tax rules provide a strong incentive to do so. In Canada, depreciation for tax purposes, or the rate at which you can expense capital purchases for tax purposes, is prescribed by the Canadian Income Tax Act.  The amount which you can expense in any given year is called the “Capital Cost Allowance”, or just “CCA”.  For a given capital purchase, you can ordinarily expense a prescribed percentage of its book value for tax purposes (known as the Undepreciated Capital Cost, or “UCC”) in any given year, except for the first year when you are only allowed to expense half that amount.  For instance, the CCA rate for furniture is 20% per year.  So if you purchase a piece of furniture for $1,000, you can expense half of 20% in the first year ($100), then 20% of the remaining amount in the second year ($180 = [$1,000-$100]*20%), and so on. The reason I’m buying computer equipment before February, 2011 is that there is a temporary rule for CCA Class 52 which will allow us to expense 100% of the cost of new computer equipment in the current fiscal year if I purchase it before February.   Specifically, the Income Tax Act says:

“Include in Class 52 with a CCA rate of 100% (with no half year rule) general purpose electronic data processing equipment (commonly called computer hardware) and systems software for that equipment, including ancillary data processing equipment if acquired after January 27, 2009, and before February 2011.”

(See “Classes of depreciable property” on the Canada Revenue Agency web site)

This is big!  It means that if I purchase a piece of “general purpose electronic data processing equipment”, say that costs $1,000, I can expense the entire $1,000 amount as a Capital Cost Allowance in the current fiscal year. We’re trying to minimize our tax expenses, so if we are planning to purchase the equipment this year anyway, it makes sense to purchase it before February. This is important regardless of whether or not the company is profitable this year:  In Canada, we can carry losses back 3 years or forward 20 years to minimize taxes payable.

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Issues to Consider Before Pursuing an Offshoring Strategy

Canadian companies often feel besieged in a globalized economy where it seems as if we can’t compete against the onslaught of low-cost labour from abroad.   I often hear Canadian business people comment that they can pay offshore developers in China, India, Vietnam, or the Eastern Block a fraction of what they have to pay their own employees.  (“It costs me $50/hr for an employee here, but I can send the work to India for $20/hr.  I can get 2.5X the work done for the same cost if I send the work overseas.”).  Well that thinking is just plain wrong.

Before undertaking an offshoring strategy, keep in mind that there are significant qualitative factors to be considered – any one of which might nullilfy the advantage you expect after a simplistic labour-rate comparison.

  • Travel: Talk to a few managers who have outsourced development work.  They’ll tell you about their frequent trips to places like Bangalore or Shanghai.  Not only are costs for such trips real and substantial (definitely include them into your cost/benefit analysis), but travel is tiring – and it takes you away from managing the business here.  Your marriage and/or your business could suffer.
  • Management costs: Besides the travel issue just mentioned, you still have to manage the development process.  That becomes more difficult and costly when you send work overseas.  Even though you might travel to your outsourced operation periodically, you’ll need managers there to keep an eye on things from day-to-day.  Even the managers will need to be managed, and they will be paid more than the base rate that you might have used in your original back-of-the-envelope calculations.
  • Unexpected costs and situations: Regardless of the type of outsourcing arrangement you have, you may find that you need to supply equipment and software:  VOIP phones;  Software licenses for specialized software you use; VPN software; etc..  Administering this in your own office can be a headache.  Believe me, administering it overseas is more of a headache.  (And think about what happens when you visit the overseas office and discover something  surprising, like developers using pirated copies of a popular software package.)
  • Turnover: The booming economies that you outsource to also provide lots of opportunities for job-hopping.   Don’t be surprised if team-member retention is difficult in your outsource destination.  One solution is to offer better compensation … but you outsourced to avoid that game, right?
  • Intellectual property: This should be a big concern.  There are often protections, e.g. working with large, reputable outsourcing firms, but the protections are not ironclad.  You’ll need to become familiar with your company’s legal rights in the outsource destination, and will have to be willing to incur the costs to exercise them if you discover a problem.  Unfortunately, you might have little recourse if you suspect that a competitor has hired one of your outsource team members and is exploiting their knowledge of your operations and products.   (Trade secrets are hard enough to protect on our own turf!)  How about theft of designs, prototypes , source code or customer lists?  Consider how to protect these.
  • Inability to directly oversee work: Maybe I’m old-school, but I like to see my employees doing their job.  I like to know when they arrive and when they go home.  I like to talk to them about their work while they’re doing it.  I like to ask questions, or be asked questions.  I like to listen, mentor, discuss, help, critique, observe, and, well, be part of the team that I lead.  Like gravity, one’s ability to oversee work decreases as a square of the distance from the workers.  And once there is a time zone difference, it becomes almost impossible.  Skype and Webex can never make up for sitting down with someone and having a face-to-face discussion.
  • Time Zones: You’ll be out-of-phase with your offshore development team.  Plan to come in (very) early or stay (very) late in order to have real-time discussions with your team.  Alternatively, do it from home after the kids (and your spouse) go to bed.  You’ll need to do this, and your local employees who interact with the offshore team will need to do this.  It wears thin very quickly, and there is a strong incentive to minimize the length of such phone, skype and webex meetings.  You may end up having to pay your employees a premium to do this – higher salaries, bonuses or overtime.  Alternatively, the offshore team can work late or come in early in order to talk to the local office during your business hours.  They have lives too, so this isn’t necessarily a good solution to the problem.
  • Holidays and weekends: This is similar to the time zone problem.  Don’t forget that your Chinese or Indian team will be a day ahead of you.  It might make it difficult to reach them on Fridays in North America – unless you require them to work Saturdays.  Alternatively, you can get your team to talk to them on Sunday – which, like time zone problems, wears thin very quickly.  And if they hit a roadblock at the beginning of their week, your outsourced team may not be able to get a hold of you to report or resolve the problem.   Then there are holidays.  Your holidays and the other country’s holidays.   These rarely coincide, and often result in “surprise” on-the-job downtime on one side or the other.
  • Language: When you can’t meet face-to-face, written and oral communications becomes increasingly important.  It is guaranteed that language differences and difficulties will be an impediment to successful development.  There will be very real misunderstandings and misinterpretations due to language difficulties.  And toss in to the mix the fact that engineers sometimes prevaricate when they have dug themselves too deep a hole:  Nuances in language are a great way to bend or obfuscate the truth (consider BP’s recent obfuscations with their daily reports – and we supposedly share the same language!!).
  • Cultural differences: There are many cultural differences which need to be taken into consideration, but my pet peeve is this:  I want engineers who will tell me the truth, not just what I want to hear.  More often than not, you’ll have an outsource team that is eager to please.  Add to that societal differences where there is a strong respect for authority and a culture of bureaucracy – and you find that you’re working in an echo chamber.   You’ll never get any push back and you’ll only hear your own voice.
  • Morale: At best, your local employees will merely be suspicious of your intentions for offshoring.  At worst, they’ll jump ship or sabotage the endeavor.  If you do it right, they’ll accept it like any other change.  It’s not easy to do it right, however, and you are likely to run into problems due to time zone issues, compensation gripes, worries over job security, etc.. The concerns and complaints will be real, and they could adversely impact product quality and productivity of your local employees.
  • Short-sightedness: Why are you offshoring?  Is it a long term strategy that will ensure the future prosperity of your company, its products and its employees?  Or are you doing it to maximize short-run profit.  The paradox is that offshoring will only work if you do it as a long term strategy because the start-up costs of offshoring are generally large, and the payback long-term.  And if you are in it for the long-haul, consider dealing with all of the above-mentioned issues for the long-haul as well:  E.g. travel, time-zones, IP, language, culture, etc.. (I’m talking about offshoring development projects, not making dinner reservations a la “My Outsourced Life”.)
  • Ethics / exploitation: I want my employees to be productive and to have a good life.  That extends to my offshore team.  My moral duty and duty of care does not stop at my country’s borders.  Full treatment of this issue will have to wait for another blog entry.

Believe it or not, I am not philosophically opposed to offshoring.  We have a global economy and there are bound to be legitimate labour-rate differences in different countries – It is OK to take advantage of those differences.  Just look before you leap!

In my next blog I’ll talk about how Canadian companies can compete even if just labour rates are taken into consideration.  If you play your cards right, a $100,000 per year developer can be employed for close to $2,000-$42,000 per year ($1 to $20 per hour).

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