Are Hawaii's Tech Tax Credit Worth the Cost?

Comment

Comment by John on January 9, 2009 at 3:56pm

Hi Bill,

Thank you for responding to the thread. I hope your participation will lead to a better and more enlightened understanding.

To start, let me mark off a few points of agreement (or at least no debate):

- I am not suggesting there is massive abuse going on.
- I am not advocating an increase in the clawback
- If you think the best time to tweak it is in 2010, that's fine.

As for whether the report paints a picture of strong progress, I encourage readers to go to the report and read it, especially the last page, the conclusion - which paints a picture of $750 Million of our tax money already committed for 1,450 full-time positions at 177 QHTBs.

Now maybe these companies expand rapidly in the next few years and creates tens of thousands of job. However, to me the report paints a picture of, at best, a work in progress.

I'd like to focus on two key issues that we as a group have been discussing and ask for Bill's thoughtful feedback:

1. Act 221/215 encourages moral hazard and poor risk taking
2. 221/215 does not address the real issue - a lack of technology talent

Moral Hazard

Copying my earlier comment on the issue of moral harzard:

When risk and reward are separated, it encourages people to take bad risks. Examples:

- Investment banks were historically partnerships where the bankers were the owners. In the last 10 to 20 years investment banks went public and the bankers no longer had much long term interest. Bank executives now where playing with other people's money, took crazy risks (CDOs, etc.), made lots of short term money then blew up the financial sector.

- Fred Wilson, the famous VC and blogger has a nice post on the risk of separating risk and reward. He examines bad actions that occur when executives are playing with other people's money.


221/215 encourages risky behavior because investors and executives have little downside but lots of upside. In other words, it encourages startups to take bad risks.

The executive risk is low because they get good compensation packages and easy money subsidized by the state. The investors risk is very low because they get the tax credits.

Even for mainaland investors, when you get more company for less money, the company can do worse and an investor can still be ok.

For instance, let's say a startup struggles and eventually is sold for only 60% of the capital invested. Normally, investors would take a loss. With 221/215, because they are getting more company for less money, the investor may actually make money even if the company is sold for less than the capital invested. The local investor is profitbale off the tax credits and the mainland investor,via the 2-to-1 mechanism, makes money because they got extra equity via the credit exchange.

History shows people take less care and more risks when it's other people's money.

This is what I mean about an invitation to fraud and abuse.


Insufficient Talent

One of the things that Dan, Laurence and I, among others, have been discussing is the issue of whether Hawaii lacks technology talent for building startups. Readers who are interested should read that thread on Hawaii technology talent. This concern is also shared by Guy Kawasaki.

When money exceeds talent, waste occurs. Even with the money, the startups struggle because they do have sufficient talent to compete at that level.


Take these two forces together, moral hazard and insufficient talent, and the risk is high that the billions we eventually spent may ultimately be wasted because we have the wrong structure and plan to make the technology sector grow.

I am looking forward to your response. I would only ask that you discredit the ideas and not the person with an eloquent explanation.

Comment by Daniel Leuck on January 9, 2009 at 3:41pm

Bill Spencer: For those of you who have never started a real company and tried to raise investment capital, you haven't got a clue how hard it is and what it takes.

I can certainly attest to this. Although we have been running a services company for a little over four years, this is the first time we have sought funding for a product company. It is just brutal, even if you have a solid idea, great technology, great people and a clear path to profitability.

Comment by GB Hajim on January 9, 2009 at 2:11pm

Thank you Bill!

Comment by Lance Furuyama on January 9, 2009 at 1:57pm

Hi Bill,

I didn't mean to put you on the spot. With so much content is this thread, I wanted to get a better handle on the points that you were trying to get across.

Thank you for elaborating.

-Lance

Comment by Bill Spencer on January 9, 2009 at 1:18pm

Thanks Lance...what caught my attention were comments from "John" as per below.

John's comments seemed to reflect some of the issues I am addressing. Investors don't just give companies large pots of money with little restrictions. This is a ridiculous an uninformed notion.

John said in his post:

"Giving companies large pots of money with little restrictions sounds like a bad idea. None of the reports I have seen shows otherwise.

John's further comment here about the invitation to fraud and abuse is also ill informed and makes no sense.

"While I am sure many companies using 221/215 are legitimate and have noble intentions, the program as a whole, seems to be an invitation to fraud and abuse."

Sorry to pick on you here John, but you don't really understand how venture investing works apparently.

Comment by Lance Furuyama on January 9, 2009 at 12:59pm

Bill Spencer: "10) Learn something about venture investing and what it takes to start and fund a company before you start throwing around unfounded statements about abuse. If you look carefully at the DoTAX report, you will find that it paints a picture of strong progress. Building a tech sector in Hawaii may take 20 years. Building strong tech companies will take 7-10 years. Don’t be too quick to judge."

Hi Bill,

Are there any particular statements in this thread that you are referring to?

Respectfully,
Lance

Comment by Bill Spencer on January 9, 2009 at 12:53pm

Don't believe everything you read in the paper and don't believe everything you read in the lastest release of the Department of Taxation Report on Act 221.

1) Members of the governor's office edited the report's conclusion to twist the facts to their liking, for example attributing all the costs for 7 years to one year worth of job creation. They did not include contractor jobs which more than doubled the job count. Further, jobs are not the only and best metric of return on investment.

2) The governor's office also only used 38 profitable companies divided into the total amount of investment to reflect the "cost" of Act 221, despite the fact that there are 333 QHTB's and 178 who actually filed data. This is a further mis-representation of the facts.

3) A great company is not built over night. It takes 7-10 years to build a company that hires lots of people and generates tax revenues for the State. It is short-sighted to rely on a snap shot of the benefits of Act 221 based on barely 5 years of good data.

4) Companies received $1.2 Billion in investment and put $1.4 Billion back into the economy when tourism has been shrinking.

5) The $757M cost figure includes a projection for out years that may not be accurate. Act 221 has attracted at least $3 dollars of outside investment for every dollar invested by local tax advantaged investors. This is a critical metric that is overlooked and has important meaning. Why would someone who doesn't need the tax credits invest in a company if the company was just abusing Act 221 or if the only reason were tax credits. Think about it.

6) The whole notion that companies are just being given money without oversight is ridiculous. These are legitimate investments in properly organized companies. Investors don't just throw their money around. They expect accountability, return on their investment, a thoughtful management team to run the company, etc. It is absurd to think there is massive abuse going on. Abuse of Act 221 is an urban legend founded by the Advertiser's Sean Hao, who continually refers to one movie deal, Blue Crush, where investors were allowed a high multiple. This practice was stopped in 2004 with Act 215. As of 2006 only 3 of 15 suspected abusive deals have been audited. That's 3 out of 333 QHTB's, less than 1%.

7) Changing the rules of Act 221 before it sunsets sends a terrible message to investors here and throughout the country. When Act 215 was enacted in 2004, the Governor promised no more changes to Act 221, that she would let it run its course. Changing the law now tells investors they cannot trust the State to keep its word. The time to tweak Act 221 is when it is extended beyond 2010.

8) Increasing the clawback from 10-50% is a stupid idea. It penalizes the investors for no good reason. If a company has a legitimate business reason to move then the investors will support it no matter what the clawback. This is not a meaningful disincentive to stay in Hawaii.

9) For those of you who have never started a real company and tried to raise investment capital, you haven't got a clue how hard it is and what it takes. For the 13 years before Act 221, Hawaii companies raised a total of less than $250M in venture and other investment capital. Compare that to the $1.2 Billion raised since 2001-2007. Would you like to go back to the pre Act 221 days and try and raise capital for your company? Surely you would do like most companies, Digital Island, for example, and move to the mainland. How do you build a tech industry and diversify our economy without venture investment?

10) Learn something about venture investing and what it takes to start and fund a company before you start throwing around unfounded statements about abuse. If you look carefully at the DoTAX report, you will find that it paints a picture of strong progress. Building a tech sector in Hawaii may take 20 years. Building strong tech companies will take 7-10 years. Don’t be too quick to judge.

Comment by Laurence A. Lee on January 9, 2009 at 12:09pm

The thought of our Government funding, sponsoring, or rescuing an industry generally goes against my Laissez-Faire tendencies; but for bootstrapping to stimulate growth, I think it's as good an expense as the other stimulus/rescue plans that were flying around in the past few months.

If the Government is going to provide Matching Funds to investors' stakes, there should be something in exchange for that investment. Like how Fannie/Freddie was handled - the government essentially received preferred stock. If the business fails, the Government should be first in line to recoup losses.

221/215 is a terribly, hastily-written piece of legislation that shouldn't be used as the guiding model for a Federally-Administered program. At best, it could be a starting point, but it really needs more teeth: More accountability, Tax Credits tied to number of qualified jobs, and some kind of penalty if the business fails or moves out of state within the first 10 years.

If 221/215 were amended to be set up as 5 years to receive the full Tax Credits; along with an additional 5 years of "business risk" before those monies are "free and clear" from the State, I'd be much more receptive to extending it beyond 2010. Considering the excess Tax Credits will "roll over until exhausted", I think this is a fair arrangement.

I personally think Acts 221/215 are too broken to be worth fixing, and we should start from scratch when that legislation expires in 2010.

Comment by John on January 9, 2009 at 11:46am

From an email I just received from the HVCA:

"Despite the Department of Taxation's analysis of the costs and benefits of Act 221, which demonstrate an overwhelmingly positive impact, Act 221 is being threatened as never before.

The fight to extend Act 221 begins now. We must be vigilant. We must let your voices be heard. We must show the legislature, the press and the governor that there is a tech sector composed of real people who care about Hawaii's future and who care about the need to diversify our economy. We cannot tolerate changes to the rules."

Two questions:

1. Can someone explain how the Department of Taxations' analysis "demonstrates an overwhelmingly positive impact"? Did I read a different report from the Department of Taxation? I am seriously confused and would appreciate an elaboration on this point.

2. What about real people in the tech sector who care about Hawaii's future and the need to diversify the economy but feel changes to the rule are essential?

Comment by Tom Benson on January 8, 2009 at 5:58pm

Here's a side question, since this is such a thoughtful group,

What about the possibility of the Federal government launching an innovation funding project? It seems to me that they intentionally want to pump money into the system and are looking for any viable way to do it. Venture funding, for all the risks it entails, can be a huge jolt to the economy, so if the feds really want to pump money, my vote would be they pump it into some sort of innovation or venture plan. Maybe this could be just a boost in the existing SBIR funding that already comes from NASA, DOD, etc. Maybe it could be a specific innovation plan. Maybe the feds ask all 50 states to start up innovation funds or grants along the lines of Hawaii's 221/215 plan.

I realize that not everybody would be happy with such an idea, but for the time being, I would ignore the political part and just consider, well, if such a plan were to happen, what would be the best way?

Yes, I'm fantasizing a bit, mea culpa. But If such a plan is being considered then we're as good a group of people as any, maybe better, to provide input for it.

Ideas? Anybody heard any rumors? Any other groups or discussion boards where this has come up? Any ideas welcome.

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