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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 Bill Dash on July 20, 2009 at 12:17pm
Leighton---best non-emotional blog about Act 221---well done. I just looked out my window and the sky is not falling. Also gravity still seems to be working so I assume the earth is still spinning.
100% is still the most generous tax credit I can find in the US ( world???). If Hawaii tech companies can't make it with investors taking a zero financial risk, maybe those companies aren't such a great investment opportunities. Maybe the tech community should focus on building great companies instead of spending their time begging for government welfare. Growing up responsibly instead of dependence on the legislature which over time is never dependable.
Comment by Daniel Leuck on July 20, 2009 at 10:14am
Hi Bruce - We didn't have to change our business model but our attorneys emphasized the fact that we license the software rather than use an ad supported model. I've read the law, and it makes no mention of this distinction. It appears to be a DoTax policy.
Comment by Bruce M. Bird on July 20, 2009 at 9:30am
Hi, Daniel and Leighton.

For what it's worth, my understanding is that most SaaS companies don't qualify as QHTBs. The business models of most SaaS companies make for a bit of an awkward "fit" with Act 221 as currently written (or interpreted). And that's a shame, because, among other things, many of them can be started with little seed capital.

Daniel, I am happy to learn that you were able to secure a favorable QHTB comfort ruling for your SaaS company (Ooi). I wonder if you had to "tweak" your original concept or business model a bit in order to receive a favorable ruling?

Also, your point about "packaged software" is well-taken. Someone ought to call the "Logic Police" on that one...

Leighton, by the way, your blog is chock full of insights about Act 221.
Comment by Daniel Leuck on July 19, 2009 at 6:35pm
Our SaaS company (Ooi) has received a QHTB comfort ruling. It is my understanding that SaaS companies are eligible as long as they charge a fee and are not solely ad supported. The rules seem very arbitrary, but it is my understanding that this is how things currently stand.

SaaS is the least expensive and most environmentally sound way to deliver software. The idea that it differs from packaged software in terms of the amount of R&D involved is absurd. Its simply a smarter way to deliver software, especially for companies in geographically isolated areas such as Hawaii.

Leighton K. Chong: Dan and Bruce, I heard from other attorneys that the State Tax Dept. came down about a year ago ruling that SaaS does not qualify for Act 221 credits because it is not research or subsequent sales of a software product that is sold or licensed, since it is a service that is being sold.
Comment by Leighton K. Chong on July 19, 2009 at 5:46pm
Yes, those areas where Hawaii has a natural advantage are promising. However, there are some hurdles in the ones you mentioned though:

Dan and Bruce, I heard from other attorneys that the State Tax Dept. came down about a year ago ruling that SaaS does not qualify for Act 221 credits because it is not research or subsequent sales of a software product that is sold or licensed, since it is a service that is being sold. With the current climate to enforce limits on Act 221 credits, I would guess that this ruling would remain in place and not be reversed. This may make it difficult to get funding for SaaS ventures.

Aquaculture, and especially ocean aquaculture like Bill Spencer's proposed OTEC-powered fish growing cages, seems a natural for Hawaii. But at a recent UH conference rumbles are starting to be raised that this is exploitation of Hawaii's land and sea for export, and not "pono" or "local sustainability focused". Also, huge building and maintenance costs are involved for anything deployed in the ocean. This is the reason that tidal power projects were demoted to low priority on the State's list of near-term renewable energy areas for development.

As I've mentioned in my blog, renewable energy projects also tend to be installation cost intensive, and also have NIMBY issues when done on a utility scale. However, I do like the chances for "brain trust" research on extracting efficiency gains out of conventional PV and windfarm installations.
Comment by Daniel Leuck on July 19, 2009 at 8:51am
Very true - I should have listed Aquaculture. I'm really hoping Bill Spencer gets his Ocean Spheres off the ground!
Comment by Alex Salkever on July 18, 2009 at 8:55pm
Add to that aquaculture, Dan -- NELHA is a huge advantage that most places do not have.
Comment by Bruce M. Bird on July 18, 2009 at 5:55pm
Hi, Leighton. I can't help but wonder how many SaaS ventures requiring little initial seed capital could have been set up in Hawaii had only Act 221 been designed to encourage them.
Comment by Daniel Leuck on July 18, 2009 at 8:08am
You are spot on. R&D is one of the few areas where Hawaii's geographic isolation is irrelevant. I see the growth areas for tech being:
  • Research and development (brain trusts)
  • Software as a service (SaaS) - web application companies generally require little capital and can be located anywhere
  • Renewable energy - one of the few areas where being in Hawaii is an advantage

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