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It’s Back-to-Business for Hawaii Tech Companies!

Well, it’s official. The Governor did not veto the Legislature’s Bill 199, so Hawaii’s Investor Tax Credit for high technology companies has now been scaled back from a maximum of 200% to “only” 100% return of high tech investment through tax credits, and the credits will now be claimable at no more than 80% of State income tax liability per year. Actually, the scaling back of benefits was not so bad. Rather, it was the way the whole tax credit program has been conducted over the past 10 years, reinforcing the perception that Hawaii is not a good place to do business. There is plenty of blame to go around on all sides, from the tech industry’s resistance to disclosure of jobs created and companies benefitted or to timely compromise to help the State close its huge budget deficit, to the Administration’s fecklessness in administering the tax program and articulating its support of development of the tech sector. This whole charade is mandated to sunset in 18 months anyway. Hopefully, the next iteration will be better conceived, supported and executed.

So, what now? The national economy remains in recession, trillion-dollar federal budget deficits will continue to grow, and the State will see declining revenues and negative growth in its mainstay real estate and tourism industries for years to come. If there is any desire of investors to invest in technology companies in Hawaii, they will be tight-fisted and very choosy over fewer deals. So is our tech sector doomed to wither and die? Not necessarily. Even in Silicon Valley, the new wave of tech investment is toward smaller amounts in more focused companies. Hawaii tech companies can thrive using an alternative business model in which smaller amounts of capital, possibly leveraged with research grants, are used to validate technology and secure IP rights that can be licensed, pooled or sold to more established, national or global companies that have the size and economies of scale to commercialize the technology in their industries.

This is actually not a new thing in Hawaii. Most of our successful tech deals and investor exits over decades have followed this model, although not by calling it the “R and D business model”, and often only when facing bankruptcy or business default. For example, Verifone pioneered its credit card POS technology in Hawaii, but moved to California for manufacturing and sales growth, in effect exporting its IP rights in patented technology to the Mainland. Hawaii Biotech also ended up exporting its IP rights in tropical vaccines to an Australian pharma company while retaining only a research presence in Hawaii. Ad Tech sold its IP rights in broadband test equipment to Spirent, and Spirent now maintains a regional sales office here. Digital Island was acquired by U.K.’s Cable & Wireless essentially for its IP rights. BAE Systems bought STI’s patented hyperspectral imaging technology, and maintains a research office for its biomedical spinoff here. Almost all significant Hawaii tech deals have gone this route. That is why we continue to see good technologies developed in our university and DoD research labs, but no permanent manufacturing or product sales from the Islands.

In the alternative business model, the R and D company can secure IP rights in the form of copyright-protected software and media, patented invention rights, and/or licensable engineering know-how. It can monetize these IP rights by licensing, pooling or selling to established companies in the Mainland U.S. and globally. As a further option once its technology has been validated through licensing, it can seek the next stage of venture capital funding for spinning out a sublicensed company to commercialize the now-proven technology in local or regional markets.

The R and D business model can greatly reduce investor risk by focusing on technology validation and securing IP rights. This allows the constrained venture funding pool in Hawaii to fund more companies to develop more innovative technologies with the small amounts of venture capital available. The research activity also fits squarely within the qualifying guidelines for the 100% high tech investor tax credits in the next year and a half, which helps to reduce investor risk. So, far from doom and gloom, our R and D companies can now focus on their real business mission and hopefully thrive.

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Comment by Daniel Leuck on July 24, 2009 at 11:54am
That's one of the many things I like about your website. It focuses much more on the positive --and the possible-- than on the negative.
Mahalo. We work hard to maintain a positive atmosphere and facilitate honest debate, free from ad hominem attacks. If we all agreed on everything it would be a boring community :-) Its all about respect and admitting that there are intelligent, experienced people on both sides of issues like Act 221 / SB 199.

At this point the SB199 debate is largely academic. As Leighton rightly pointed out, its time to focus on whats next for tech in Hawaii.
Comment by Bruce M. Bird on July 24, 2009 at 10:59am
I've lived in a number of places, and I always find it interesting why some areas are able to attract and grow high-tech businesses, while others aren't. One of the many things I've observed is that a metropolitan area typically has to have a certain size job base in order to have a critical mass of tech jobs. This critical mass leads to an interaction of ideas --many of them wild, a few of them doable-- that every once in a while leads to the creation of a viable high-tech business.

It also helps to have well-funded research universities, a well-educated workforce, good transportation, and a significant federal presence in the metropolitan area. Many of these metropolitan areas also tend to be fairly desirable places in which to live. Granted, there are exceptions, but think about the high-tech areas that come to mind on the Mainland. Silicon Valley. Boston. San Francisco. Washington, D.C. Seattle. Dallas.

Look at Hawaii's natural advantages. A decent size city (Honolulu). A significant federal presence (military). A gorgeous place in which to live. A research-oriented university (although it isn't as well-funded as it could be). Decent transportation to and from the Mainland. Quite simply, Hawaii has many of the "pieces" that are needed to grow high-tech businesses.

The only reason I mention this is that I think Leighton is really on to something when he writes about re-thinking Act 221 (well, actually, he uses the term "back-to-business").

Leighton wrote: "Hawaii tech companies can thrive using an alternative business model in which smaller amounts of capital, possibly leveraged with research grants, are used to validate technology and secure IP rights that can be licensed, pooled or sold to more established, national or global companies that have the size and economies of scale to commercialize the technology in their industries."

It just seems to me that, over time, this type of model might lead to a critical mass of high-tech workers in Hawaii.

Anyone have any thoughts on this?
Comment by Bruce M. Bird on July 24, 2009 at 10:54am
Hi, Daniel.

Yes, thanks for the explanation. The way you describe it, your business plan makes a lot of sense.

re: Food fights

That's one of the many things I like about your website. It focuses much more on the positive --and the possible-- than on the negative.
Comment by Bill Dash on July 24, 2009 at 9:41am
It is time for me to drop out of this thread. I know it is a waste of time to try and have a rational discussion about Act 221. I am a part timer in Hawaii and live along Route 128 outside Boston. As a mainlander professional VC I have looked at a number of Hawaii Angel deals and talked with my colleagues in Silicon Valley. Act 221 is destroying Hawaii's reputation in the mainland VC community because many of the Act 221 deals look like tax scams. Also Hawaii's ethics are also at risk. I was just trying to point out that Act 221 is a very slippery slope and is doing Hawaii high tech a lot of harm. It takes years to build a good reputation that can be destroyed by one un-ethical act.
Aloha and Goodbye.
Comment by Daniel Leuck on July 24, 2009 at 8:30am
Bruce M. Bird: There are times when a "freemium" model ends up being more of the former (advertising) and less of the latter (licensing). If, in the fullness of time, your B2C evolves into more of a free content than premium content model, am I correct in assuming that this might possibly create an issue regarding your company maintaining its QHTB status? If so, would you then arguably be faced with having to reject advertising revenue in order to maintain your QHTB status?
Without getting into too many details regarding our business plan, I don't think it will be an issue because our primary focus is B2B, which is pure licensing. The B2C business is more promotional. Even if this weren't the case, I can't imagine the state requiring us to forgo revenue on which we pay taxes :-)

re: Food fights
We've always worked hard to make TechHui a place where people can have honest debate. I had to jump in when I saw my friend Ken being mentioned next to Bernie Madoff :-) I'm happy to buy a beer for you and Bill and chat about this topic anytime.
Comment by Bruce M. Bird on July 24, 2009 at 8:12am
Hi, Daniel, Ken, & Bill.

Daniel: Thanks for the info.

There are times when a "freemium" model ends up being more of the former (advertising) and less of the latter (licensing). If, in the fullness of time, your B2C evolves into more of a free content than premium content model, am I correct in assuming that this might possibly create an issue regarding your company maintaining its QHTB status? If so, would you then arguably be faced with having to reject advertising revenue in order to maintain your QHTB status?

I only mention this because one of the unintentional consequences of Act 221 is that it can work to pit the interests of one owner/shareholder against the other. That's purportedly what happened with HotU. If I'm running a company, I owe a duty to all of my common stockholders (whether or not they are claiming the nonrefundable investment tax credit under Act 221).

While both the Hawaii shareholders and non-Hawaii shareholders want the QHTB to succeed, first and foremost, the Hawaii shareholders want the company to remain a QHTB during the 5-year period in which the nonrefundable credit can be claimed. (This was especially the case under prior law when special purpose entities (SPEs) were used to "goose up" the Hawaii shareholders' nonrefundable Act 221 credits in exchange for reductions in their ownership interests).

Maybe this aspect of Act 221 should be part of a future discussion about its relative merits. (By the way, "orthogonal", excellent word choice...)

Ken: As my good buddy Judge Learned Hand has written on numerous occasions, "tax avoidance" is perfectly legal, while "tax evasion" is illegal. When you wrote that Act 221 is a "productive tax dodge", I think you meant it to be an example of "tax avoidance". (Daniel's section entitled: "re: Act 221 and Ethics", also focuses upon "tax avoidance").

Please note, though, that the term "tax dodge" is more often than not used to describe something that is either of dubious legality or that constitutes "tax evasion". That's why I wrote that your phrase "tax dodge" is a loaded one. (And why I keep inviting you to stop using it).

For what it's worth, I have no doubt that you are an ethical person. I don't think I implied otherwise in any of my posts. I am surprised that what I wrote has somehow "morphed" into a discussion about ethics in general (and yours in particular).

In any event, please accept my apology for inadvertently starting a food fight and then leaving the room.
(My guess is that when you started out writing a letter to the Honolulu Advertiser you never dreamed you would have ended up in a figurative "guilt by association" line-up with some of the most ethically-challenged white collar criminals in recent memory).

Bill: Many people assume that if something's legal, it's ethical, but that if it's illegal, it's unethical. While most of the time this is true, it's not always the case (and that's why I'm a fan of Hosea Williams and Rosa Parks).

I think that Ken meant "tax avoidance" (not illegal "tax evasion"). I agree with Daniel that there is nothing per se unethical about an investor who legally complies with the law claiming an Act 221 credit.

On an unrelated note, I agree with your observations that sometimes individuals who work at certain companies "rationalize" their way their way into unethical behavior and that the "tone at the top" is important.
Comment by Daniel Leuck on July 23, 2009 at 6:59pm
Bruce M. Bird: Daniel, thanks for the info. By the way, does your SaaS company operate by just licensing its software or by both licensing its software and selling ads? If the latter, is there any informal "rule of thumb" that you know of regarding the Department of Taxation's policy in this regard? Would a 50-50 split be O.K? 40-60? 20-80? Just wondering...
Hi Bruce - Our plan is to do both for our B2C model. The "freemium" model is very common in the SaaS world. We also have a B2B model that is purely licensing and maintenance. As to your question about what split is acceptable, I don't have a good answer. We expect the majority of our revenue will be from licensing. I don't know if we would have had problems if the reverse were true.

Bill Dash: Also gravity still seems to be working so I assume the earth is still spinning.
Gravity is a function of mass, not spin. ;-) Bill, I think the point Ken is making is that its bad policy to change the law under people with little warning. Its unreasonable to expect businesses to plan for the type of sudden and extreme modifications that SB199 represents. It also has a lasting deleterious affect on our state's standing with outside investors. This debate is orthogonal to the discussion of the relative merits of Act 221.

re: Act 221 and Ethics
Have you ever used a tax credit? Do you take any write-offs on your taxes? Do you often forgo legal write-offs or tax credits on ethical grounds? If not, is it fair for you to have these expectations of tech companies?

Word choice aside, having had business dealings with Ken, I assure you he is an ethical person.
Comment by Ken Berkun on July 23, 2009 at 5:20pm
This has really sidetracked from my original points. There are legitimate tax havens (a better word) and those that are not. If you can not stop yourself from sliding down the slippery slope then you are bad news. None of this has anything to do with Rep. Choy's editorial. I think it's time to stop going down this particular rat hole.
Comment by Bill Dash on July 23, 2009 at 2:36pm
Ken...not to belabor the point but Enron, MCI/Worldcom, Bernie Madoff, etc all started as small steps crossing the ethics line and in some of those cases were sort of legal. At MCI , CFO Scott Sullivan ( 37 years old at the time) had 1 customer put in a purchase order for one day after the quarter end instead of the current quarter. One day. Sort of closing a Act 221 deal on December 32nd which happens here. Scott chose to amortorize some items that were expenses so that it made earning look OK and as if that P.O. had come in one day earlier. Unfortunately the next quarter the issue persisted and he did it again. The SEC found out, MCI was forced into bankruptcy and $78 Billion in market cap was destroyed. Thousand lost their jobs and saw their pensions destroyed, Scott is in jail and Bernie Ebbers, CEO is serving 25 years. It was a small ethics lapse but it was a slippery slope. Act 221 encourages that kind of behavior. You should care.
Comment by Ken Berkun on July 23, 2009 at 9:11am
I'm not sure so I'm a quality guy, but my product is terrific! I am neither condemning nor condoning tax dodges, as I indicated earlier I think "dodge" was a poor choice of words and I wish I hadn't used it. That's what I get for dashing off a quick letter.

Tax dodges exist and if they are legal, well, I can't blame someone for using them. I think it obvious that I draw the line at illegal activities like the ones Enron was engaged in. It is up to the legislature to define the tax code well enough that loopholes don't exist.

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